Study on the Us Stores Takeover of Morrisons Finance Essay

The US Stores' market performance is unsatisfied. The share price and P/E ratio of the firm have been dropping. The company intends to carry out a strategy to expand world-wide markets by acquiring a major UK retailer. Merger and acquisition is one of the approaches to achieve the corporate strategies, such as expanse the market share and proportion of products. In this takeover proposal, the motives for US Stores' takeover are investigated from different aspects. The fair valuation of quasi-acquired company is evaluated to determine the maximum offer price. Finally, the proposal investigates the corporate takeover bids and methods of payment.

Introduction

The US Stores' market performance is not satisfactory. The share price and P/E ratio of the firm have been dropping. The corporate strategy is to expand world-wide markets by acquiring a major UK retailer. Merger and acquisition is one of the approaches to achieve corporate strategies, such as expanse the market share and proportion of products. Other strategies, such as organic growth, establishment of joint ventures, and co-alliance, among which I suggest M&A, because it provides an economic way to entry the European market and acquisition activity is a efficient growth mechanism in the retail industry. One major UK retailer has been chosen as the target company, considering the following reasons: 1) from the global perspective, British retailers generally have moderate or small size; 2) ownership and management are concentrated; 3) domestic market oriented; and 4) excellent cash earning ability. This takeover proposal is structured as below. Section 2 refers to the motives for US Stores' takeover. Section 3 describes the valuation of a quasi-acquired company. Finally, section 4 investigates the corporate takeover bids and methods of payment.

Motivation

The scale of cross-border merger is growing significantly during the 1990s, which aided by globalization and deregulation in the last two decades. By summarizing the previous literatures, Berkovitch and Narayanan (1993) category plenty of hypotheses into three major groups: the synergy motive, the agency motive, and hubris motives. Besides, the motivation of cross-border merger in retail industry has its own characteristics.

1) Synergies

The primary motivation in taking over UK retailer is to achieve synergies. It is defined as the reactions that take place when two elements combine together to produce a more significant effect than the sum of the effects of two parts (Gaughan, 2007).An empirical investigation made by Berkovitch and Narayanan (1993) summarizes that "the synergy motive suggests that takeovers occur because of economic gains that result by merging the resources of the two firms." Friedrich Trauiwein (1990) proposes an efficiency theory, which suggests that shareholders of the bidder will benefit from M&A through synergies. It is believed that US Stores' takeover project will enhance its operating and financial economies of scale and increase its market shares and market image.

2) Market Extension

Taking over a firm in the same industry will result in an increase in its market share and consequently "have a crucial impact on the bidder's market power" (Gaughan, 2007). Robert S. Stillman (1983) argues that, according to a more concentrated industry, the product prices may raise after horizontal mergers, which brings about an increase of bidder's equity values. Consequently, the firm's share value in the affected industry will increase. Trauiwein's monopoly theory defines mergers and acquisition as being "executed and projected to obtain a market power". According to this theory, the US Stores Inc can aim at simultaneously limiting competition in more than one market. The prospects of US Stores' growth opportunity in North America is unoptimistic, and takeover a major UK retailer which can provide an efficient entry to European retail market and the chance of expanding its global market power is an sensible corporate growth strategy .

3) Growth

US Stores takes a strategy to expand its economic scale for the purpose of business growth. Expansion through M&A is more efficient than internal organic growth. Merger and acquisition, which compared with internal organic growth, is a convenient way to control the trend of market production and consumption. M&A is a very ordinary characteristic of modern business activity and M&A form a primary motive force for the growth of firms (Michael Firth, 1979).

4) Management Motives

Cross-border takeover creates numbers of new business opportunities (Healy et al. 1990, 23) and make the entrance to world-wide markets an easy way (Black, Carnes and Jandik, 2001). In addition, cross-border takeovers gain a effect on reputation enhancement, cost reduction, value maximization, earnings volatility reduction, and international diversification.

Valuation

The Selection of Target Company

Wm Morrison Supermarkets plc is the fourth largest chain of supermarkets in the United Kingdom. Morrisons' market share is at 11.8%. We choose Morrisons as our Target Company, rather than Sainsbury plc or Marks and Spencer plc, according to the following factors: First, Under-leveraged companies are attractive targets since the bidder can issue debt to finance its takeover. Shown from the table below, the D/E ratio of Sainsbury and M&S is 129% and 258% separately, which is significantly higher than Morrisons'. The Sainsbury pension fund is a big liability, which will prevent Sainsbury from being acquired to some extent. Secondly, companies which have adequate amounts of cash and liquid assets will be potential takeover targets, because the bidder can payoff its costs with the target company's liquid assets once obtain the control power. According to the of Morrisons' annual report and financial statement, the cash from operating activities increased by £208m (24%) which reflects "the strong profit generation of the Group from increased turnover and good profit conversion, combined with cost control throughout the business and improved working capital management." Thirdly, the P/E ratio of Morrisons is lower than industry average P/E ratio. The EPS will increase if a company with higher P/E ratio takes over a company whose P/E ratio is lower. Fourthly, firms can be successfully acquired if they have a higher proportion of institutional shareholdings. The proportion of Morrisons' private shareholders is much less than institutional shareholders'.

Assumption

Beta: Assume Morrisons' beta is 0.737, provided by Bloomberg web site, is reasonable. Bond price: Using Safeway's bond yield as Morrisons' bond price, which is 4.2%. The interest rate on 10-year government bond is 4.05%. Using CAMP to calculate Morrisons' cost of equity. Taking 10-year government bond interest rate as risk-free rate. Assume that the market rate of return is 10.3%. According to Ibbotson Associates, the S&P has returned an average of 10.3 percent a year. WACC: Using the the total market value of share capital as Morrisons total equity and market value of debt as total debt when calculate the cost of capital. Growth rate: Assume Morrisons growth rate is in line with 10-year government bond interest rate. When calculate the value of the firm, the cost of capital is the WACC. Assume that the FCF will grow at a constant rate. If US stores Inc purchases Morrisons, Morrisons' sales will increase 2% per year faster than 4% for the next 5 years. Due to cost-saving synergies, the CoGS ratio will be reduced by 1% perpetually. Capex: the capital expenditure of 2009 is £678m, which is much higher than its historical average level. Assume the capital expenditure is the average of recent three years. Capital expenditure = (£678 m + £410 m +£269 m) / 3 = £425 m Taking the motivation for US Stores' takeover, Morrisons' corporate governance structure, and the side effects of hostile takeover into consideration, agreed bid is suggested. If the takeover of Morrisons fails to agree, the bidder should then go directly to the targets shareholders. In this case, a hostile takeover is going to be carried out. The market value of Morrisons is A¿A¡7825.972 m, the maximum premium on pre-bid price is 20%, and the maximum price US Stores willing to pay is A¿A¡9.391.166 m. There are five reasons to determine that friendly bid should be our choice: 1. The fair value of the firm plus the synergies is £8519 m, which is not much higher than market value. The premium that range from 25% to 45% paid for a hostile takeover will offset the synergies. In this case, the long-term performance of the bidder will be affected by the value-decreasing. Signal effect: security offer and cash offer have different signaling implications. Literature on share-for-share offer shows a negative stock price reaction to new common stock offerings. Nickolaos G. Travlos (1987) show his result of an empirical study, which indicate that bidding firms suffer significant losses in pure stock exchange acquisitions, but they obtain "normal" returns in cash offers. According to Myers and Majluf model, the market participants regard "a cash offer as good news and a share-for-share offer as bad news about the bidding firm's fair value". Faccio and Masulis (2005) argue that when a security offer is made, the market interprets it as a signal that the shares are overvalued. In that case, the share price will drop. Announcement effect: Similar to signal effect, security offer is associated with negative price movement after the announcement (Faccio and Masulis, 2005). Security offers become less attractive to US Stores as P/E ratio will drop down (Nickolaos G. Travlos, 1987). Cash offer is chosen as payment method and there will bring an increase in price-earnings ratios. Petzemas (2008) finds that "cash payment acquisitions usually outperform stock payment acquisitions." The difficulties US Stores Inc faces are that the earnings are held up well, but the share price and P/E ratio have been dropping constantly. And the market prospect is not optimistic. In this situation, the cash offer signals a high valuation of the corporation (Fishman, 1989). In order to enhance its market share price and P/E ratio, the US Stores Inc is proposed to purchase by cash. Long-term Performance studied by Loughran and Vijh shows that thecash offer gains a positive long-term return and shares offer gains a negative abnormal return. The US Stores Inc cross-border acquisition is proposed for the following motivations: taking over UK retailer to achieve synergies; increase its market share and market power; for the purpose of business growth; and other management motivations. US Stores Inc choose Morrisons as its target among Sainsbury and M&S by evaluating its leverage, assets liquidity and composition of shareholders. And valuate its cost of capital, fair value and synergy value. Taking the motivation for US Stores' takeover, Morrisons' corporate governance, and the side effects of hostile takeover into consideration, agreed bid is suggested. And depend on the bidder's purpose and financial position, the target shareholder's preference and market perceptions, payment in cash should be an appropriate method.

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