Stockwatch: Keep 'buying the dips' here

Takeover plays merit attention for useful trading in deflationary times, but anticipating the first move is not vital. Indeed, Warren Buffett has, since the 1950s, supplemented his returns from long-term investing with "takeover arbitrage" - essentially exploiting differentials between market prices and declared terms. 

This is becoming more relevant as companies struggle to grow revenues and profit margins are also exposed. Takeovers provide a step-change for market share and achieve operating synergies (i.e. two plus two equals five). 

Mind there is also a regulatory risk where competition issues arise from larger business groups. Argos-owner Home Retail is a useful example of these points, and, at 173.7p, the stock retains attractions on an arbitrage view.

Weak earnings and opportunity

It's easy to think one missed the boat when Home Retail traded down to 90p last year, only for Sainsbury's to announce in January it was considering a cash-and-shares offer, substantiated on 2 February as comprising a total 161.3p per share. But underlying trading from September to December 2015 was revealed as uninspiring, with sales at the principal operation, Argos, up only 0.9% as like-for-like slipped and digital increased 3.1%. 

Home Retail's de-rating has prompted other firms to consider how they might gain from integrating its assetsSince then, the analysts' consensus has downgraded earnings per share forecasts by 13.1% for the year to end-February 2016 and by 10.5% for 2016/17. So, without takeover interest and considering a volatile stockmarket, Home Retail shares might only be bumping along in a low range. 

Certainly the strong net tangible assets per share position (see table) has lent intrinsic support, but when earnings are deteriorating it's hard to expect the market to take a more charitable view than "assets are worth what they can earn".

Home Retail's de-rating has, however, prompted other firms to consider how they might derive synergies by integrating such assets into their operations - e.g. a substantial customer loan book with £580 million-worth of debtors and investment in digital towards same-day delivery options.

Sainsbury's unlocking value

Once Sainsbury's went public with its offer terms it was a game-changer for value perception, hence my making a 'buy' case at 150p on 15 January. I suggested the risk/reward profile implied near-term scope for about 30p upside in the region of 180p per share, against a drop in the order of 20p if Sainsbury's backed off. 

News on 13 January it had agreed to sell Homebase for £340 million had started the process to crystallise value, and to help establish a higher support for market price. I noted Cantor Fitzgerald's analysts going out on a limb to proclaim a break-up value of over 260p per share due to "one of the strongest balance sheets in the retail sector". And this value allegedly did not even price in anything for Homebase. 

It now appears a straw in the wind as to possible rival offers, and interesting to reconsider, i.e. whether business operators can see higher values than the city consensus.

Steinhoff bid alters dynamics again 

A fully-cash offer worth 175p per share now proposed by South African retailer Steinhoff affirms both the macro context - of firms resorting to takeovers to build growth - and the micro, i.e. unlocking asset values. 

Steinhoff, which owns Bensons for Beds and Harveys Furniture in the UK and Conforama in France, implies it sees scope to integrate Argos with all-round operational benefits in Europe. The logic of takeover contests is that no-one starts off by playing their final hand, so the question becomes: to what extent is Steinhoff likely to return with an even higher offer, should Sainsbury match or better 175p? Its all-cash offer is superior to Sainsbury's approach, which includes shares.

Longer-term opinion is mixed as to whether acquiring Argos makes financial sense for Sainsbury's anywaySainsbury's is truly in a bind as, the higher it tries to bid, the more liable it becomes to be seen as over-paying, which depresses its share price (only a 0.2% slip so far, to 256p) and devalues its offer. The emergence of a cash-rich rival is, therefore, a major setback. 

Despite the likelihood of Sainsbury's asking the takeover panel for an extension of its 23 February deadline to make a firm bid (on grounds of completing due diligence), Steinhoff now has the upper hand, hence, Home Retail shares advancing 13% to 173.7p, much closer to Steinhoff's proposed terms than the 150p level reached after Sainsbury's 161.3p proposed offer.

Sainsbury's still strongly motivated

A chief reason behind my case for buying Home Retail continues: that Sainsbury's management comes across as determined to own Argos, and the sunk costs they have incurred imply a modestly higher offer as likely forthcoming. 

This explains why takeover arbitrage specialists still appear to be accumulating Home Retail stock, given some chunky trades around a 172p offer price after Steinhoff's approach. Now, an indicative 175p cash offer creates a better support point, and there is scope for higher offers. Home Retail's board has a fiduciary duty to recommend the best terms for shareholders, hence Steinhoff is well-positioned to trump Sainsbury's next move.   

Bear in mind, any Competition and Markets Authority inquiry into a Sainsbury's-Argos combination could throw sand into the takeover machine, extending the process. We've seen that already with Ladbrokes/Coral becoming an in-depth "level two" investigation. This could offer another advantage to Steinhoff if combined with a slightly higher offer than Sainsbury's. Also, if Sainsbury's offers over 186p then takeover rules require its shareholders to vote. Steinhoff is presently the cleaner option.

Long Home Retail or short Sainsbury's?

It all begs the question whether traders may continue to adopt the tactic to buy Home Retail and sell - or short - Sainsbury's shares. Meanwhile, longer-term opinion is mixed as to whether acquiring Argos makes financial sense for Sainsbury's anyway. 

Failure won't reflect well on its management, mitigated perhaps if they say they have backed off after consultation with shareholders. 

Such long/short stances may be the domain of traders, but, at the very least, Home Retail remains a 'strong hold' and 'buy on any dips', and there are lessons for playing the next takeover.

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.