Tesco's (LSE: TSCO) announcement that it had agreed to pay £3.7bn for wholesaler Booker Group(LSE: BOK) at the end of last week shocked the market. Few had believed Tesco could even attempt to strike such a deal. Indeed, after several years of sales declines, fraud investigations and asset sales, Tesco isn't the retail giant it used to be, but apparently, the group's ambitions are still big.
The big question is, will Tesco regret its decision to buy Booker? There have been some serious concerns about the state of Tesco's balance sheet in recent years and paying up to acquire Booker won't alleviate those concerns.
What's more, thanks to a vicious price war, Tesco's operating margins have more than halved since 2010. Analysts see further price pressures on the horizon for Tesco, including price inflation and higher wages.
Initially, after the deal was announced last week, analysts began to ask why Tesco, a retailer with a weak balance sheet was offering a price equivalent to 24 times earnings for Booker. However, after crunching the numbers analysts have started to come round to the idea.
Tesco is paying for Booker mostly in shares, to lessen any potential impact on its balance sheet. Booker shareholders will receive 42.6p in cash and 0.86 in new Tesco shares. The merger will result in Booker shareholders owning 16% of the combined company.
Further, Tesco says it can squeeze £200m of synergies from the deal. Potential cost saving ideas, such as using Tesco's delivery vans for wholesale deliveries when they are currently idle between 5 am and 8 am, and offloading food not suitable for supermarket sale to caterers, have been put forward.
To some extent, these potential synergies do justify some of the premium being paid.
A bigger risk
The biggest risk to the deal is competition concerns, something Tesco cannot do anything about.
Booker supplies 5,463 franchise convenience stores while Tesco owns 3,569 shops, including 2,839 small stores, and over 700 'One Stop' shops. Combined, the enlarged group would control 27% of the UK convenience store market and over 30% of the overall food market. The Tesco group would also have unprecedented pricing power over the catering industry.
As the deal is set to create such a massive industry giant, analysts believe it could take two years for the Competiton Commission to provide a ruling as to whether or not the deal can go ahead. During this time plenty could go wrong. Tesco's shares may sink, forcing the retailer to hand over more cash in the deal, or Booker's shareholders may decide they don't want to accept Tesco's shares as currency and vote down the deal in favour of a higher cash offer.
Is Tesco's offer to buy Booker a huge mistake? No, not yet. Right now it looks as if the retailer has chosen Booker as a way to bolt-on cheap growth in its home market where significant cost synergies can be achieved. That being said, if the Competition Commission rules against the deal, it may turn out to be an expensive mistake for Tesco.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended Booker. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.