Booker Group and Makro UK: A match made in heaven?

Summary

  • Booker has achieved massive success from growing its market share amongst the “Caterer” and “Retailer” customer segments. Sales and margin growth has been excellent. Growth in ROE has been largely due to these operating improvements. However, gains in market share are largely one-time and a substantial portion of the current price is growth. Customers are under pressure and the margins in the wholesale business are very thin. Nonetheless, Booker has carved out a nice niche and stayed in control of its financial position.
  • The Makro deal does not build on any of these advantages. Makro does most of its business outside of Booker’s niche, operates larger stores, and offers far more products. Potential gains from a delivery and internet service seem realistic but the immutable fact is that Makro is operating in a far more competitive space with no hope of moving towards Booker’s niche.
  • The company has failed to outline a clear plan of action for turning Makro arou. If the company thinks it can turnaround Makro within its current niche I would say it cannot. If the company thinks it can turn Makro into Booker I would say show me how. The company’s plan offers pages and pages of legal minutiae but there is probably less than half a page of detail, if it can be called that, about how they are going to make this work. Hubris and empire-building spring to mind.
  • Booker is paying a very cheap price for this deal. Looking at the property Booker is getting I would estimate they are being paid about £15m to take Makro off Metro’s hands. Unfortunately, in the long run this may not look like such a bargain.
  • Considering the limited upside in this deal for current holders of the stock and the fact they are probably sitting on large paper gains, I would watch this one through the year as a potential short. Given the current valuation, any failure to recognize synergies would be a disaster.

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Booker are far from the typical value stock. Equity is worth just under £1.4bn and trades at around 18.5x trailing earnings. This valuation is understandable as there has been a tremendous turnaround over the past few years. What alerted me to Booker was the announcement last month that is was proposing a takeover of Makro UK, the UK wholesale arm of Metro AG. The deal is part cash and part shares with a roughly value of £140m, this makes it a tier-1 deal (i.e. the company needs shareholder approval) and the company has sent today a circular convening a general meeting on July 2 to, potentially, approve the transaction. The success of many companies has floundered on ill-conceived transactions, the aim here is to determine whether this might be a deal too far for Booker or whether the company can perform a turnaround of this struggling wholesaler and repeat the success of recent years.

Booker has an extremely long history, the company was founded in the 1830s, and has been involved in an extraordinary range of industries. Until 1998, it owned the rights to Agatha Christie’s books and was involved in film production in the late 1980s. The company as it operates today was bought by Iceland who was then bought by Baugur, the infamous Icelandic group, which then reversed into Aim-listed Blueheath group to form Booker. Baugar sold its stake in Booker in mid-2008. Since then, the company has gone from strength to strength.

 

KPIs 2012 2011 2010 2009 2008 CAGR
Revenue 3932.8 3595.8 3386.9 3179.2 3078.2 5.0%
UK Store Revenue 3860.0 3600.0 3390.0 3180.0 3080.0 4.6%
Operating Income 89.1 79.0 71.6 62.8 52.9 11.0%
RNOA 12.3% 11.8% 11.6% 10.3% 8.5% 7.6%
PM 2.3% 2.2% 2.1% 2.0% 1.7% 5.7%
ATO 5.4x 5.4x 5.5x 5.2x 5.0x 1.7%
ROCE 20.3% 17.7% 17.6% 14.8% 11.7% 11.6%
Stores 172 172 173 173 172 0.0%
Rev/Store 22.44 20.93 19.60 18.38 17.91 4.6%
Caterer Rev 1220.0 1110.0 1010.0 930.0 850.0 7.5%
Retailer Rev 2560.0 2410.0 2310.0 2190.0 2150.0 3.6%
Other Rev 80.0 80.0 70.0 60.0 80.0 0.0%
Caterers 338 326 305 296 258 5.6%
Retailers 83 78 73 72 72 2.9%
Other 60 55 53 46 76 -4.6%
Customers 481 459 431 414 406 3.4%
Caterers/Customers 70.3% 71.0% 70.8% 71.5% 63.5% 2.0%
Rev per Caterer 3.61 3.40 3.31 3.14 3.29 1.8%
Rev per Retailer 30.84 30.90 31.64 30.42 29.86 0.6%
Rev per Other 1.33 1.45 1.32 1.30 1.05 4.8%
Rev per Customer 8.02 7.84 7.87 7.68 7.59 1.1%

 

The table above outlines the key figures and clearly demonstrates that there has been a significant turnaround in operations, as opposed to just growing through increasing store numbers. Indeed, store numbers haven’t grown at all but the annual increase in sales per store has been rapid. The reason for this are the changes in customers. Booker has improved in every area here. The company rapidly grew the number of caterers using Booker’s stores and, to a lesser extent, grew the amount they spent whilst there. More important for the top-line was the growth in the number of retailers, although growth was slower here this is, in absolute terms, a larger market. Of course, we should be cautious here, what has happened is that Booker has taken share from somewhere else in the market. Growth has come through increasing the volume of customers not what they spend, clearly this cannot continue forever. The other point of caution I usually raise with retailers is leverage. As usual, the hidden leverage here is substantial however, the company has managed it extremely well. Ex-operating leases Booker is net cash and only 100bps or so of the huge growth in core ROE relates to the company’s financial position.

unsurprisingly, the gain for shareholders has been substantial. At the end of 2008, the company was trading at 28p. With the company now trading around 87p this is an increase of some 211%. However, as I mentioned before, the company has found this success through taking market share a process which may slow down soon. If it does the company will still be making an excellent return of around 12% on net operating assets however, I do not think it will be able to maintain such its earnings multiple without changing its strategy. For example, a rough estimate of value using a somewhat generous 8% discount rate suggests a “no-growth” equity value of 48p*. This is not to say the company is not worth more, the historical performance is outstanding but this implies growth is worth, at the current price, around 39p (or 45% of the total market cap). The question then is how does Makro UK fit into this story?

 

Booker Makro
Sales 3860 787
Net Profit 74.9 -63.2
Stores 172 30
Sales/Store 22.4 26.2
EV/Store 7.86 4.66
Typical Size (sq ft) 36 100
Typical SKUs 8.50 29.00
% delivered 27% 0%
% internet 16% 0%
Retailers 83 39
Caterers 338 129
Other 60 963
Customers 481 1131

(EV for Makro is implied by acquisition price)

 

As the table above highlights, these are two very different businesses. Makro UK is losing a lot of money, around £60m in the FY to December 2011, and is only still in business because of a £150m share issue in 2010 and the large loans extended by the parent company. The customer base is completely different and half of Makro’s sales comes from “Other” with the rest split equally between “Retailers” and “Caterers”. Makro’s stores are larger and carry more products and they do not deliver. Frankly, whilst Booker seems to be a specialist retailer, Makro is more like a large supermarket. As a result, I imagine it is failing due to the direct competition with supermarkets. The average “Retailer” customer produces around £30,000 of sales per year, the same customer at Makro produces only £5,000. The same trend is true with the average “Caterer” and “Other” customer. Booker is clearly hoping for some kind of turnaround but it isn’t clear whether it is going to try and build on its core advantage or try something a bit more risky.

In the circular Booker suggests it is going to move in three areas: choice, prices, and service. Starting with the last first, Booker has strong internet and delivery capabilities, the company implies it will bring both to Makro. This is the most important, if Booker starts delivering it can improve Makro outside of the other category. Looking to prices, Booker notes it has good value private label brands it can bring to Makro and vice versa. Again, this suggests useful integration. Finally, Booker notes the SKU gap and suggests it will make Makro’s product range available through Booker branches or via the internet. Part of this we know about as it is in price as well, the internet part is more worrying. It implies that Makro’s stores are too big, this is the problem with this deal. Booker’s advantage has been in appealing to the “Retailers” and “Caterers” groups, does the acquisition build on this or detract from this? From the vague content of the circular, Booker has not laid out a plan to turn this around. Given past success, I can understand why management feel like they don’t need to.

However, there are some good points about this deal. Internet/delivery opportunities are clearly strong if Booker wants to try and move towards “Retailers”/”Caterers”, are the stores too big for this though? Doesn’t Makro hold to many products? Another aspect is that Booker is getting 30 large stores for a very reasonable price. As far as I can tell from the circular, Makro owns all of its stores which is, of course, quite unusual. Net book value of these is some £155m. Of this, £26m is Dutch property that, presumably, will be sold quick. Booker could pick up 30 large stores for around £4.3m a piece, this sounds pretty good. With a sale leaseback this would recoup the purchase price of Makro. In fact, Booker is being paid £15m upfront to take Makro from Metro. Does a bad deal for Metro mean a good deal for Booker though?

If I was a Booker shareholder I would be pretty worried. The financial side of the deal all checks out and Booker is not paying much, or anything, for Makro. The problem, as I see it, is that these are two very different businesses. Booker has a tight niche whilst Makro is more like a supermarket. Booker has succeeded because it can defend this niche, Makro has failed because it cannot. The only strategy that will work is if Booker moves Makro towards its niche however, it cannot do that with Makro’s store/supply base. Moreover, Booker has given no indication that it is going to attempt this let alone explain how this can be done. I suspect the problem with Makro is competition with supermarkets which Booker is totally insulated against, although the generally low margins of the wholesale business are worrying. Add to this concerns about the one-time nature of Booker’s recent progress, concerns about Booker’s customers, and the fact that this deal will be highly dilutive in FY/13 then the deal doesn’t seem to add up. More worryingly, the company has been proudly expanding into India, this deal just suggests hubris and empire-building.

I originally was excited about this deal. Booker appeared to be a great business picking up some useful assets at a cheap price. Now I am thinking from the short side. The company’s plan offers pages and pages of legal minutiae, there is probably less than half a page of detail about how they are going to make this work. The assets do not fit with what Booker does and they physically can’t be made to fit. Booker isn’t on the hook for pensions but I can’t imagine it will be easy to get rid of Makro and if anything goes wrong in the underlying Booker business in FY/13 this could very wrong.

Moreover, what is the upside for shareholders here. They have made money over the past few years what is can happen from here? The company is moving away from its key area of advantage. If I was sitting on a 100% or 200% gain here, I would see this deal and take my profits. What is the point? I can see why management might like this deal, I can’t see why shareholders would. Given past success, there is no way this deal is going to be turned down by shareholders and the distinct lack of substance in Booker’s circular suggests management think that too. Given what the little information available suggests about this is deal this is pretty unfortunate.

*The calculation takes current net operating assets of £727.5m (inc. the PV of operating leases) and multiplies this by 1.53x (2012 RNOA of 12.3% divided by an 8% discount rate) to get a rough enterprise value of £1.11bn. Subtracting from this net financial obligations (again inc. the PV of operating leases) of  £358.1m achieves the equity value of £756.2m which divided by shares outstanding is 48p.

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