Bringing home the bacon

Private equity likes the retail sector. An intriguing debate has done the rounds for much of 2004 regarding the possibility of a private equity bid being mounted for UK supermarket chain J Sainsbury Plc. Once the undisputed leader of the sector, the company has suffered from fierce competition and, some say, poor management. But does the private equity community have the firepower – both financial and operational – to take on one of the UK's most established brand names?

Sainsbury's current market capitalisation is around £4.5 billion. Forecast net debt balances for the end of the current financial year (March 31), adjusted for operating lease commitments and a significant pension fund deficit, add another £4 to 4.5 billion, resulting in an enterprise value of around £8.5 to £9 billion, or €12.5 billion. That's no small figure. But in the current market raising such staggering amounts appears to be within reach – if, to use an old leveraged finance adage, it involves “the right business”. But is Sainsbury's right enough?

Putting to one side the potentially considerable problems of agreeing a resolution of the company's pension deficit which at more than £400 million is nearly twice the size of the one that de-railed the private equity bid for UK retailer WH Smith, and the potential additional complications of assuming all of the existing lease obligations, you are still left wondering if Sainsbury's makes the cut.

Any answer is bound up with some of the company's other issues – most notably strategy. However, taking consensus forecasts at face value, the business is expected to generate £850 to 950 million of EBITDA and at least £650 million of operating cash flow per year over the next few years. Adding back operating lease costs results in EBITDAR of up to £1.2 billion. More importantly, and despite strategy issues and their short term cash flow impact, the fundamental stability of the business suggests the company can support a relatively high multiple, especially in the current market.

The main problem would be capital expenditure: somewhere in the region of £500 million a year is expected, although a significant element of this is in connection with fixing major IT issues, which should only take a couple of years.

One approach to solving the puzzle is to access the property-based financing market. Sainsbury's still holds the freehold on 55 per cent of its portfolio by floor area. If one takes Debenhams as a benchmark, where total net debt was approximately 4x EBITDAR, a figure of £5 billion is achievable. If this could be stretched to 5x, then £6 billion is within reach. Would this be enough?

Possibly, although the exit strategy would be crucial in determining whether an acceptable IRR would be likely. After all, a 20%+ IRR on an initial investment of up to £3 billion represents considerable annual capital growth in sterling terms. And all this without considering what kind of premium existing shareholders might require.

STRATEGY AND MANAGEMENT: MORE CHANGE?
Amongst the analyst community the company's strategic development has been a widely explored topic for some time. Indeed, the company only recently conducted a wide-ranging review, presented to analysts in mid- October, under the banner “Making Sainsbury's Great Again”. The market nonetheless remains sceptical. But at least the company appears to have acknowledged the fact that, operationally at least, it has got some things wrong.

However, there are further aspects for prospective private equity owners to consider. For example: is Sainsbury's financial services business worth having? Arch competitor Tesco's success here would suggest it is. But with only 55 per cent owned by the group – HBoS holds the rest – it's an obvious disposal opportunity.

Looking at the negatives, competition restrictions will likely make it more difficult for any new owner to adjust the store portfolio and, to financial sponsors, closure would likely not be an option due to the costs.

Formulating and implementing the right strategy is of course the responsibility of senior management. CEO Justin King appointed in March this year appears to have been fairly well received by the market thus far, but private equity bidders would need to find a credible – and high profile – name to front a bid to have a hope of success. Who would that be? A number of names have been mentioned, though ex-ASDA chief Archie Norman is perhaps the most obvious choice and, according to one senior banker, “the chat is, Archie is interested”.

Another, perhaps logical solution to this issue: stick with the existing team. Particularly if some of the Sainsbury family members choose to roll their holdings into the deal, then this would seem sensible – provided any buyer and the incumbents would be comfortable with each other.

TACTICS
Although the Sainsbury family no longer has any material board or operational influence, as a significant minority shareholder, at least collectively, their view of any potential bid will be central to its ultimate success or failure. This implies that developing relations with the various factions of the family will be important for any private equity consortium. Indeed it may well be – as has been the case in the past with other family controlled groups – that two camps emerge; those that favour a cash exit and those that want to remain with the business. In the short term this may hamper the progress of any bid. But as time progresses, it could in fact strengthen the position of a bidder that manages to get some of the family on their side. And of course the reduction in the funding necessary would also be very welcome.

A tempting cash offer is ultimately a carrot that institutional shareholders, let alone some of the Sainsbury family, will find difficult to resist. Any substantial premium to current prices is likely to be beyond the reach of any private equity bid however, due to the constraints on the financial structure discussed earlier. Hence – in a very real sense – the more aggressive the offering from the leveraged finance community, the more likely it is that a bid will emerge.

AND THE EXIT: THE WORLD'S LARGEST SECONDARY?
Whatever happens, if the transaction goes ahead, the result will only be as good as the ultimate exit achieved. Considering the numbers highlights the scale of the task. If the initial equity injection totals £3 billion, then a target IRR of 22 per cent over a three-year period (probably the minimum necessary to evidence a turnaround in performance) means an equity value on exit approaching £5.5 billion, an increase of £2.5 billion. Even an equity investment of £2 billion would imply capital growth of over £1.5 billion to achieve the same target. Is that possible?

Paying down debt by this amount would seem unlikely. However, if Sainsbury's manages to achieve growth in sales of £2.5 billion by 2007/8 at improved margins due to a combination of cost savings and operating leverage (as is management's plan), this alone could constitute additional operating profits of £150 million per annum or more. On a multiple of only 6- 7x, this amount would represent a £1 billion increase in value. That would likely be good enough when combined with potential reductions in net debt.

This of course further assumes that none of this projected growth is reflected in the current share price and hence wouldn't already have been paid for.

But how would an exit be engineered – through a relisting? It would require a bold GP indeed to take on such a sizeable bet in today's environment. So how else? Although appealing in its irony, the suggestion that Sainsbury be rolled up with Marks & Spencer should be discounted. An M&A-based strategy has validity but probably implies less certainty than flotation, particularly given the likely regulatory restrictions. Given the options for refinancing and releveraging presently available to sponsors, such a partial exit probably provides the route with greatest certainty. This would reduce the size of any subsequent (or even contemporaneous) flotation or secondary transaction. This possibility is tantalising.

Is this all idle speculation? Looking purely at the numbers, it seems that some kind of transaction is within reach; but that a ([A-z]+)-based financing solution, combined with an endorsement by the Sainsbury family and confidence in the post-acquisition strategy will be required to bring a bid to fruition. In the end, however, it may come down to old-fashioned guts and glory. Is the private equity market in the UK about to move up a notch by doing deals of this size? Such a challenge may prove irresistible for some. Commented one observer: “I'd be surprised if something doesn't happen: if a company is seen to have been put in play, it has to do quite a lot to fight it.” Watch this space.