Richard J Clarke, ACA richard.clarke@bernstein.com +44-207-170-0536 Ahold: Initial Thoughts on Reported "Early Stage Discussions" of Delhaize Merger: Very Bad Idea Ticker Rating CUR 8 May 2015 Closing Price Target Price TTM Rel. Perf. EPS P/E 2014A 2015E 2016E 2014A 2015E 2016E Yield AH.NA M EUR 17.24 20.00 11.3% 0.89 1.08 1.23 19.4 16.0 14.0 3.1% MSDLE15 1542.83 88.43 91.89 103.88 17.4 16.8 14.9 3.1% O Outperform, M Market-Perform, U Underperform, N Not Rated Highlights Over the weekend, several sources from the Belgian press, L'Echo and De Tijd, reported quoting "unnamed sources" that Ahold were in early stage discussions with Delhaize on a potential merger. At first sight the markets this morning have responded very positively to this news (Ahold up 7%, Delhaize up 14%). We see no reason to celebrate and worry about the bankers winning the upper hand over the common-sense of a well-grounded food retailer. This seems at first sight a bad deal for Ahold to us, fraught with lots of execution risk and benefiting from very limited cost saving advantages, likely to go the same way as most other historical big food retail M&A. We do not cover Delhaize as part of our coverage, so our view is firmly from the point of view of Ahold investors. We see very limited merits in this merger. - Cost savings: not enough overlap. Cost savings are most easily generated when there is plenty of overlap between the 2 businesses or the acquired business is a small tangential region. They allow the combined businesses to quickly improve regional scale advantages: improve supply chain densities, combine local marketing spend, potentially rationally space. This is not the case for this proposed merger: the overlap in their geographies is very limited. Commentators argue for the benefits of 'complementary space': the logic of cost cutting makes this very bad for cost savings. For this proposed type of merger, you are restricted to the cost benefits from 'systems integration', 'common head office functions', etc. More on those further down. Both businesses are already very large at the local level and have buying consortium agreements already, to make 'buying-scale advantages' very questionable. If anybody thinks that Albert Heijn can materially improve its buying scale advantages in the Netherlands, they should think again. - Better management? Some investors argue that Ahold is the better run business, especially in the USA and Ahold's management team would make a better job of generating cash from those operations (Delhaize's FCF yield is already high at over 7%, excluding the effect of the divestments in Sweetbay, Harveys and Reid's). We caution against assuming superhuman powers for any management team. Changing management team at an underperforming retailer seems more straightforward than merging two large businesses. - Precursor to splitting USA from Europe. After merging the two businesses, they could be split again into a USA retailer and a European retailer. Some investors make the argument that USA retailers are trading at higher multiples than their European counterparts and Ahold and Delhaize currently don't benefit from those higher multiples. We can't exclude this argument out of hand but we think investors are more sophisticated than that and are able to value a Sum of The Parts of 2 regions. See Disclosure Appendix of this report for important disclosures and analyst certifications.
We see material risks from this merger, far outweighing potential benefits: - Big M&A in Food Retail doesn't work, and with reason: We struggle to think of any proven successful big M&A deal in food retail. Plenty of examples of failed deals (Morrisons, Carrefour, etc.). In our view M&A deals for growth can work (in-fill acquisition, foothold in new geography) but M&A deals to fix trading performances don't work. When 2 large retailers merge, to reduce costs with the hope of improving margins, they get fixated for several years on post-merger-integration. Those cost saving programs are very complex and time consuming. While the entire management team is fixated on delivering those cost saving programs, their local competitors busily focus on the consumers and eat away their customer base. You don't fix bad trading (arguable the case historically for most of Delhaize's US businesses) by cutting costs but by improving the retail offer to consumers. - It eliminates part of Ahold's growth potential: We see Belgium as an important part of Ahold's growth potential: through the supermarkets, through Ah.nl and bol.com. A better option than merging with a business is to compete with that business and acquire its customers (and potentially its franchises) through better retailing. Ahold foregoes that option through the merger. - Cultural differences: Half of Belgium may officially speak the same language as the Dutch but even that similarity in language is only wafer thin. And even in Belgium we have two materially different cultures (The French speaking Wallonia and Flemish speaking Flanders). The merger of the two companies may not be exactly a merger of equals (market cap of Ahold is about twice the size of Delhaize), but it clearly would be a merger and not an acquisition with very different cultures being combined around the management table. - Valuation: Ahold is not in business-recovery mode. It is facing tough competition in all its markets but that is the nature of food retail. Delhaize needs to rebuild margins, by materially improving retail propositions, particularly in its core Belgium market. There is a risk for Ahold shareholders that they have to pay upfront for the expected recovery of Delhaize rather than financially benefiting from that recovery. Investment Conclusion Ahold is one of our favourite companies in the Sector. In our view Ahold's distinct retail offer enables it to retain and grow market share, while also having access to low risk, low cost growth opportunities adjacent to their major markets. Ahold also demonstrates the best cash generative earnings in our sector, and we forecast this to continue. We value this company upon its ability to keep adapting to intense competition, generate cash, use it wisely for small in-fill acquisitions or return it to shareholders. This deal goes against this logic of a solid verywell-run cash-generating food retail machine. We don't think it is the right type of corporate activity (postmerger integration) to consume management's attention for years to come as they will lose their customer focus in the process. We rate the stock MP, TP 20. Details 2
Exhibit 1 Sales breakdown both have c.60% of sales in USA Sales Breakdown (2014 Sales) million 118 28,694 17,054 1,488 10,907 118 11,640 3,225 4,788 4,714 15,695 Ahold Delhaize Combined Entity Western Europe Eastern Europe US Other Source: Company Reports, Bernstein analysis 3
Disclosure Appendix Valuation Methodology To value stocks in our coverage we use a discounted cash flow (DCF) methodology to generate the Enterprise Value of the entity and then subtract off the fair value of the financial debt of the company and add on the value of any non-operating assets. We adjust income statement, balance sheet and retained earnings for the impact of capitalising all operating leases. We go back through historical filings to recreate the asset value at the moment the lease was initiated. Operating lease assets are then depreciated linearly over time while the value of the operating lease liability changes over time, as interest rates change and the debt is amortised. Cash flow is calculated for each company as NOPAT (net operating profit less adjusted tax) plus any decrease in Invested Capital, adjusted for the impact of FX on Invested Capital. NOPAT and Invested Capital are modelled using proprietary models over 15 years, after which a terminal value is taken. For Companies that operate across multiple industries (MEO) or geographies (TSCO, CA, CO and AH), we perform a separate DCF for each major segment of the industry. This is then benchmarked against a DCF performed on the entire entity. The WACC for each company or segment DCF is calculated as follows WACC = E x Ke + D x Kd * (1-T) E + D Where: E= the equity of the entity, Ke = the cost of equity (adjusted for the country and company risk), D = the debt in the entity (adjusted for operating leases,fair value of debt and other non-financial debt), Kd = the market cost of debt (adjusted for country risk) and T is the statutory tax rate. Cost of equity is based on risk free rate (by country and region), company specific beta, market risk premium and country risk. First an industry beta is calculated from the last 8 years of daily, weekly and monthly return data, correlated against the MSCI Europe Total return index. Beta is adjusted for the impact of leverage. Company specific betas are derived from this industry beta, adjusted for differences in product mix and differences in leverage. Market risk premium is derived from current S&P valuations, current S&P earnings forecasts and backsolving for market risk premium. Country risk is derived from yield premiums on sovereign debt, denominated in USD and Euros. The final valuations are then benchmarked against a Price/Earnings (Next FY) multiple, adjusted for expected earnings growth (from Next FY to Next FY+1) and adjusted for estimated cost of equity. Risks There are certain risks that are common to the all companies in our coverage: Prevailing economic conditions In each of the territories our coverage companies operate in, the food retail spend is correlated to the prevailing economic conditions. Thus any unexpected deterioration or improvement in the macroeconomic conditions in these countries will impact the growth assumptions applied to those operations 4
New Entrants All companies in our coverage are at risk from new entrants either at a local/regional level (i.e. a new supermarket opening locally to an incumbent) or national level (a new entrant entering a whole market). Currently the greatest expansion is being seen at the lower (Lidl/Aldi in the discount sector) and higher (Waitrose/Wholefoods ) ends of the market or online (Amazon). These companies may continue to outpace the sector and impact the growth of the companies in our sector. Similarly successful operators in certain regions/countries, e.g. E.Leclerc in France, could expand beyond their current boundaries. As a lot of the non-coverage companies are privately held, it can be difficult to assess the ability and willingness of these companies to expand further Koninklijke Ahold NV Risk that price will decrease more than expected Pricing pressure continues in the US further decreasing margins. Pricing pressure continues in the Netherlands further decreasing margins. Cash is burning a hole in management s pockets and there is a risk that this will be diverted to large scale investment projects rather than returning more cash to investors Risk that price will increase more than expected Further strength in the US dollar An acceleration in cash being returned to shareholders A transformational acquisition that is well received by shareholders 5
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