£6.8 Billion Takeover of ASDA
Brothers Mohsin and Zuber Issa and the private equity firm TDR Capital are buying Asda, the Supermarket Chain, in the UK’s largest leveraged buyout (LBO) in more than a decade. An LBO involves buying a firm with debt and repaying it during the duration of the private equity firm’s ownership. As more debt is repaid, the stake of the private equity firm increases and can then choose to sell the acquired company in a couple of years. Asda is going through the same buyout structure with the deal sponsors (Issa brothers and TDR Capital) putting up only 12% of fresh equity in the deal worth around £800 million according to the Financial Times. The complicated financing structure minimises the sums the buyers themselves have to put at risk. The deal raises a lot of questions about the private equity industry and its future which we will explore in this article.
Can Asda’s Business Model Provide Returns?
Asda has a range of business offerings from supermarkets to petrol filling stations. In order to assess whether Asda is a suitable LBO candidate we need to look at a range of factors which are used in the private equity industry to select target companies. The first aspect we will look at are the revenues of the company. The supermarket chain has turned over £22 billion in the past 6 years. This is the sort of consistency that PE firms like to see with firms as they can comfortably project their potential earnings from deals due to the lack of variability of the company’s sales revenue. However, being involved in a saturated industry might not bring significant revenue growth which could mean the new owners must reduce expenses to grow EBTIDA margins.
After revenue, we will take a look at working capital requirements of the supermarket. One thing to note is that companies like ASDA tend to have a high number of account payables as they buy the majority of their goods on credit. This may represent a significant portion of working capital. As a result of constantly high account payable figures may indicate that the company has to constantly use its non-current assets and liabilities to carry out is day to day funding. However, this is not the case as the firm has favourable liquidity positions due to the structure of its business model. The diagram below depicts why this is the case.
The negative operating cash cycle number indicates that the company is funded for the period of days before it has to pay its creditors. This means the supermarket chain does not have to use their own funds to keep operations running. As a result, the firm tends to have the liquidity to fund its day-to-day operations and does not need to burn cash to fund its activities. This is suitable for a PE firm as it means the cash they potentially save from not having to fund the firm’s working capital requirements can be used for debt repayments.
In order to deliver on the new owner’s entry and exit strategy, a strong management team is necessary. Asda has strong brand reputation due to its large-scale presence which can be attributed to their management team. The current President and CEO was vital in turning around the company back in 2017 and has proved his worth in growing the company. In order for the LBO to be successful, it is important strict financial discipline is imposed to generate enough free cash flow for debt repayments while also aiming to improve EBITDA margins. The CFO, Rob McWilliam, has held an executive position at Amazon UK and has the necessary qualifications to keep the company financially sustainable. Although a question mark does surround his capability of managing the company with a big load of debt which the owners will put on the company. The Issa brothers and TDR Capital could choose to put in their own CFO for compatibility. Overall, I feel the Asda management team is strong enough to guide the new owners through a successful entry and exit.
The last three aspects I will look are the asset base, revenue expansion and expense cutting, and maturity of the firm itself. Asda has a large asset base in terms of portfolio companies and tangible assets. According to the FT, the Issa brothers have planned on selling off Asda’s petrol stations to fund parts of the deal. Some of the land and buildings can be disposed of and rent agreements can be set up with new owners of the assets. This could reduce depreciation which would increase profitability. Cash generated from disposals can also be put towards debt repayments. Asda’s large asset base will provide the new owners a variety of options in terms of strategy. The FMCG industry has become increasingly saturated and room for growth is small for Asda. However, expenses can be cut by employing more technology reducing the need for human capital. Lastly, Asda is a mature firm which means it’s likely not to have to burn through cash in order to grow as it already has grown to its full potential. These factors add to the suitability of Asda as an LBO candidate.
Can the deal provide returns?
I believe despite Asda’s low margins, its business model can generate enough free cash flow for debt repayments and its large asset base can also be used to increase the owner’s stake in the company. It is yet to be seen whether the current management will be given a chance to stay and run the company through its next stage although it can be argued that, for continuity purposes, the same team should be kept to put the company in the right direction during the entry stage. Overall, I believe this is a potential deal which can set a precedent for more LBOs in the FMCG industry and if done right can provide significant returns to investors.