Tesco 8217 s growth opportunity is no magic bullet

Happy Booker, happy shareholders

Tesco shareholders have reacted positively to its ‘merger’ (which looks more like an acquisition) with Booker. After all Tesco is choosing one of the best growth hot spots in the sector. However it’s still appropriate to examine whether Booker represents the best way of gaining exposure to the opportunity, and whether the £3.7bn purchase price—equivalent to a rich 18 times Booker forecast Ebitda—is justified.

Savings should put most cost concerns on the backburner. Conservatively, these are expected to be £175m annually with a net present value above £1bn. Additionally, Booker’s operating margin has been steady between 2%-3% for 5 years. Tesco only returned to operating margin growth last financial year. Some of Tesco shareholders’ ebullient reaction on Friday is also due to secondary benefits expected from bringing more of the supply chain in house, though more quantifying detail is needed given ongoing flux in Britain’s retail, supply and consumption outlook.

In terms of scale though, Booker is the best-known and the largest entity of its kind in the UK, as primary supplier to around 700,000 restaurants, convenience stores, pubs etc. In turn, Booker’s model, including Makro, which was bolted on 4 years ago, has shown some resilience to challenging grocery market currents. Booker’s Q3 like-for-like growth of 3.2% would be the envy of many retailers.

However, Booker has not been entirely immune. LFL growth in Q3 2011 was 5.4%, and fell 1.9% in 2015/16. Variability stands to increase as suppliers try to offset the uneven rise of input price inflation. Furthermore, Booker has excluded cigarettes from underlying sales figures for years, as wholesale tobacco returns have been a consistent drag due to rising taxes and regulation.

Lost in space

We’re also minded that the Booker purchase risks blurring lines around key strategic pillars Tesco established in 2015. Thinking particularly about store space and property, Tesco reduced stores for the first time in four years to around 6,600 stores by last financial year end. The Booker purchase hikes stores to the highest for at least a decade with some 9,800 outlets. More importantly, Tesco has sought to purchase freeholds if strict criteria are satisfied, whilst reducing non-core property entirely. This has reduced exposure to rental increases. Is there now a hidden cost for more disposals, rent, and integration? That seems likely, though it will probably be quite moderate. Still, easing up on space discipline brings its own concerns. We expect Tesco to clarify space and property issues further in due course.

That said, the ‘merger’ does remove some incongruity between Tesco’s operating profit goal of making 3.5p-4p for every retail pound received and the massive store space reduction over the last two and a half years, some 10 million square feet.

Overall though we think shareholders would be mistaken to see the Booker purchase as a ‘magic bullet’ for growth.

Booker’s profile is quite commensurate with other businesses in the food purchasing and supply sphere, with little immunity to the same challenges. What we’re left with is essentially a promising, if unproven idea: potential improvement of Tesco’s ability to let shoppers shop how they like, when they like. It’s interesting to note Booker’s online growth was 12% in the year to last March 2016. Tesco assesses its own online growth as ‘moderating’; partly due to costs from recent consolidation, upgrades of its offering and promotional price thresholds.

Still, we think the balance of risks to returns depend more on Tesco’s much improved market positioning, financials and management dexterity, and less on the vehicle it has chosen to cut a new path to growth.

The moderate opportunity cost makes no waves. But the impact on Tesco’s outlook is only a little better than neutral. However, we still see current shareholder confidence in the group’s progress as well deserved.