Why Sainsbury 8217 s tie up with Home Retail may make sense after all

For Sainsbury’s, everything most important right now begins at ‘Home’.

Even Homebase, which the supermarket has signalled it doesn’t want.

The supermarket’s play for Home Retail Group was puzzling at first, but began to gain credibility after news HRG was close to exiting the DIY business.

After a week of trying to make the supermarket’s sums stack up, things started to make (some) sense.

Priceless

Sainsbury’s has made no bones about its priorities this week.

‘Scan our Christmas update’, Britain’s No.2 supermarket seemed to tell investors on Wednesday, after fractionally better-than-feared key sales.

But the message that it sees HRG as a “very strategically compelling opportunity” got more emphasis.

Here’s a slick multi-coloured slide deck about the deal.

Notice it still doesn’t mention a price.

Multiple puzzles

But word that the value of the initial rejected offer was around £1.1bn leaked out; who knows how.

The press also suggested key Home investors steered Sainsbury’s to the figure of £1.6bn, about 200p per share.

Exactly double HRG’s share price a day before the first news.

£1.6bn would also equate to just 6.55 times the general retailer’s 2015/16 forecast clean EBITDA, according to Reuters data.

We pointed out last week that would be well below multiples in similar recent deals between 8.6-9 times.

HOME would be priced at an even sharper discount using its £386m 14/15 EBITDA.

Sainsbury’s in theory would be picking up the group for just 4 times core earnings under that scenario.

In that event, some HOME shareholders who’ve kept schtum so far would point out that distressed UK multiples start around 6.

On the other side would stand Sainsbury’s finance chief to repeat that the supermarket “won’t over pay for this transaction”.

Aussies slide in

Maybe he won’t need to.

The week also brought news that Home Retail was close to selling Homebase to Australia’s Wesfarmers for £340m.

It’s always been clear Sainsbury’s interest in Homebase is minimal (it founded the chain before selling it a decade ago.)

There was no mention of Homebase in the supermarket’s initial statement last week or in its multi-media pizazz this week.

Maybe Sainsbury’s timing was just lucky.

Though it’s also clear now SBRY approached HRG just weeks after Wesfarmers started talks in September.

HRG’s poor showing at Christmas could also advantage Sainsbury’s.

Even among retailers whose sales growth was anaemic at best, Home Retail’s was close to worst.

Flagship chain Argos’s same-store sales slid 2.2% in 18 weeks to 2nd January vs. +0.3% forecast.

  FROM ‘ACCELERATING OUR STRATEGY FOR GROWTH’

Not meaning to state the obvious, but…

  Please click image to enlarge

Home economics

So would a Sainsbury’s deal make more sense if Homebase was lopped off?

Well, HRG’s last underlying FY operating profit was £149m.

Extract Homebase’s £19.8m contribution, leaving £129.2m.

Times that by the lower end of our Retail Exit Multiple Range (8.6-9x; see above) and we’re almost bang on Sainsbury’s first offer.

The initial offer starts to look like it’s in the right ball park.

Execution risks would remain high, but even cost savings and operating profit rises at HRG in single-digit percentages could still give Sainsbury’s a double-digit percentage return in three-five years.

Sainsbury’s could even afford to buff-up its original offer with credit.

It would get a more sympathetic ear at the bank than Morrisons and Tesco, which are leveraged up to 33% and 42.5% of Ebitda respectively.

Sainsbury’s is 20% leveraged.

Digital growth

As to its probable rationale on the assets, whilst Homebase appears profitable, the supermarket sees more value in Argos.

For a start because the catalogue shop has latterly made 72% of HRG’s last FY sales to Homebase’s 26%.

Also, whilst Homebase’s like-for-like growth has been outstripping Argos’s, the latter’s operating profit has grown faster.

(Tiny Habitat can be pretty much ignored in my view.)

Argos is being transformed into a digital business with market-leading fast delivery, though there’s some way to go.

Sainsbury’s may stand a better chance of making the formula work than HRG.

It has a surer-footed recent track record of space usage too: HB’s store space fell 3% last FY, whilst Argos’s rose just 0.5%.

Sainsbury’s aim would be to cross-sell bigger ticket items to food buyers “whenever and wherever they want to shop” (to quote Sainsbury’s CEO).

That’s the theory at least.

SBRY’s affair with HOME could of course fall apart at any time; before the put-up/shut-up deadline of 2nd February or after a fresh offer.

But latest developments suggest the general retailer’s investors should at least hear Sainsbury’s out.

We’ll look at potential risks and opportunities in Sainsbury’s and Home Retail Group shares from a possible offer soon, in a separate post.