Why it would be nuts for Tesco plc to buy WM Morrison Supermarkets plc

Photo: C41n. Cropped. Licence: https://creativecommons.org/licenses/by-sa/3.0/

The latest rumour doing the rounds is that Tesco(LSE: TSCO) is going to team up with a private equity consortium to buy smaller supermarket chain Wm MorrisonSupermarkets(LSE: MRW).

Any such union of the two troubled firms would be nuts, in my opinion!

Long-term decline

Both Tesco and Wm Morrison own businesses on the back foot. These two firms are fighting fires, shedding assets and taking drastic actions such as cutting selling prices and costs to try to negotiate a knife-edge between profit and loss that straddles the economic abyss -- one false move and it could be game over.

The onslaught to the sector from low-cost competitors Aldi and Lidl is relentless. These two firms already control upwards of 10% of Britain's grocery market and they are expanding by double-digit percentages. Aldi and Lidl are rewriting the rules of the game. Tesco and Wm Morrison are struggling to catch up and finding themselves with expensive and outdated business models that could sink them. The faster Aldi and Lidl expand, the faster the clock ticks for Tesco and Wm Morrison, and it's Aldi and Lidl that setting the timetable.

I have no doubt that Tesco and Wm Morrison, with their current operating models, are stewards of businesses in long-term decline. So, faced with problems and challenges of managing contraction, why would Tesco want to double up on its risks by adding another struggling business in the same sector to its portfolio? It doesn't make sense.

Tesco is financially strapped

Tesco set out the scale of its problems back in October when it released its interim report. The firm said it needs to regain competitiveness in its core UK business, protect and strengthen its balance sheet, and to rebuild trust and transparency.

These are big issues, because a firm is in dire straits if it has lost its competitive advantage, has a weak and threatened balance sheet, and when its customers, investors and partners no longer trust it. However, in terms of Tesco's ability to buy out Wm Morrison, the balance sheet is the biggest hurdle. Tesco's borrowings run around 20 times the level of this year's anticipated pre-tax profit -- that's a high level of debt. Tesco is weak financially and forward earnings are uncertain.

Tesco doesn't make an attractive partner for private equity because the firm's existence looks precarious. There seems little prospect of Tesco finding the means to carry off a deal with Wm Morrison on its own either.

A better way

The last thing Tesco needs is to expand within the challenged supermarket sector in any way, given it's already stretched-to-breaking point balance sheet and questionable forward profit sustainability -- even if exterior finance were to partner with any deal.

For a better solution to Tesco's problems I think we should look to what fellow challenged supermarket chain J Sainsbury is doing with its proposed takeover of Argos brand owner Home Retail. With that deal, J Sainsbury hopes to diversify away from grocery provision. The firm's plans may or may not work out, but I think that's a better way forward than doing more of the same in a dying sector.

I won't be buying Wm Morrison shares or Tesco shares based on the current takeover rumours. Instead, I'd rather invest in the firms covered in this Motley Fool wealth report. Our top analysts scoured the market to find companies with reliable cash flow, solid trading positions and great prospects. These firms don't operate in structurally challenged sectors, and they offer solid dividend and capital growth potential. You can find out more about them by clicking here

Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

10 PHOTOS
10 tricks supermarkets use to get you to spend more
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Why it would be nuts for Tesco plc to buy WM Morrison Supermarkets plc
The subtle manipulation starts as soon as you enter the store when you are assailed by the smell of flowers and fresh bread, which are often placed near the door. The smell is intended to put you in a good mood and to get your salivary glands working. You are also more likely to pick up these higher-ticket items when your cart is empty.

Similarly, fresh produce like fruit and vegetables (one of the most profitable sections at the supermarket) is also usually at the front because the bright colours are more likely to lift your mood than bland cartons and cans. Mist is sometimes sprayed on the fruit and veg to make them look fresh but can actually make them rot faster. 

Supermarkets do their best to spread staples far apart to force shoppers to walk through the whole store and lead them into temptation (meat in the back right hand corner, dairy in the back left hand corner).

(Industry experts claim that this is for logistical reasons. Milk needs to be refrigerated straight away and the lorries unload at the back. That does not explain why other staples like eggs are at the back.)

In most stores customers move from right to left. Some speculate this is because in many countries, including the US, people drive on the right. Also, most people tend to be right-handed so this feels more natural. "It is the left hand that pushes the cart, and the right hand that is our grabbing hand," says Underhill. Due to this flow, the things you are most likely to purchase tend to be on the right hand aisle while promotions on the left are designed to help shift the less popular goods.

Pricier items are placed at eye height. The cereal aisle is a good example, where healthier cereal is at the top, big bags of oats and other bargain cereals are generally on the bottom shelf and more expensive, big-name brands are at eye level – easy to see and reach. Some items are deliberately placed at children's eye height, such as highly-advertised cereals.
You cannot assume that items on sale at the end of an aisle are a good deal. Those endcaps are sold specifically to companies trying to promote a product, observes Underhill, consumer expert and author of What Women Want: The Science of Female Shopping.

The music you hear is not just a random playlist. Dubbed 'Muzak,' it is carefully selected by an 'audio architect' who has analysed the store's demographic.
Douglas Rushkoff, author of Coercion: Why we listen to what they say (1999), says grocery shoppers respond best to Muzak that has a slower tempo, making a whopping 38% more purchases when it is played overhead. By contrast, fast-food restaurants use Muzak that has a higher number of beats per minute to increase the rate at which a person chews.
There are 74 Muzak programmes in 10 categories, ranging from indie rock to hip-hop and classical, which are mapped out in 15-minute cycles that rise and fall in intensity using a technique known as 'stimulus progression,' writes Martin Lindstrom, marketing consultant and author of Brandwashed: Tricks Companies Use to Manipulate Our Minds and Persuade Us to Buy.

Shopping carts are getting bigger because research shows that consumers buy more when they can fit more in the cart. Multi-packs are also getting bigger, because the more people buy, the more they tend to consume. If you used to buy a six-pack of coke and drink six cans a week but now buy a 12-pack because that's the new standard size, you're probably going to start drinking 12 cans a week, Jeff Weidauer, former supermarket executive and vice president of marketing for retail services firm Vestcom, told Reader's Digest.
Customers think that when they buy in bulk, they get a better deal. But that's not always the case. Work it out yourself, and only buy as much food as you can eat before it goes off.
Supermarket pricing is often described as a "dark art". Are offers like 'Was £3, Now £2' or 'Half Price' genuine? In Britain, supermarkets have been caught out on putting up prices shortly before discounting them heavily. The Office of Fair Trading clamped down on 'yo-yo pricing' and eight major supermarkets (Aldi, Co-Op, Lidl, Marks and Spencer, Morrisons,Sainsbury's, Tesco and Waitrose) signed up to a set of principles drawn up by the watchdog in late 2012. The principles also say that pre-printed value claims such as 'Bigger Pack, Better Value' must be true.

However even with those principles, the question is whether products were ever priced realistically.
Two for one offers are a money illusion, as you may end up buying more than you need. The Office for National Statistics does not include two for one offers in its inflation numbers on the grounds that they are not a genuine discount, as consumers may not have wanted the second item.

Another well-practised trick is to make promotions very specific and put the sign next to a full-price item. Often customers get confused and end up grabbing the wrong item.

Lindstrom says the average consumer tends to remember the price of only four items: Milk, bread, bananas, and eggs. They often don't have the faintest idea whether they are getting a good deal or not. But the bulk of what shoppers buy they buy every week. So if you are really methodical and keep your old receipts, you would know when something is on sale and stock up then.
If you have a store loyalty card, supermarkets track your spending and send you targeted vouchers through the post to remind you to shop and purchase certain brands. This can work in your favour if you were going to buy them anyway, but might prompt you to buy something you didn't really want or need.
Watch out for 'speed bumps' of goods that go together – for example seasonal displays such as a bunch of Halloween-themed items - in aisles or at entrances. Sample stations along with recipes also slow you down and give you a taste of new products or lesser-known foods such as kale. Mobile displays, LED lighting, floor graphics, ceiling hangers or digital or video marketing are other common marketing tricks.
Chocolates and other sweets have long adorned checkout counters where bored kids are nagging their parents to buy them a treat. Supermarkets have come under pressure from the government to move chocolate away from checkouts and some have responded. Lidl has justbanned sweets and chocolate bars from the checkout of its 600 UK stores and vowed to replace them with dried fruit and oatcakes.

Sainsbury's has a policy of no confectionery next to checkouts in its supermarkets, but not in smaller convenience stores, similarly to Tesco.
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