Does Argos buy make Sainsbury’s the pick of the UK grocery sector?

J Sainsbury, the UK’s second-largest supermarket group by market share, is about to complete its buy of general merchandiser Argos, a deal that will massively expand its offering and give it a major boost in terms of online capability. But will it be enough to put it out in front in a UK grocery sector going through major upheaval.

The ‘big four’ UK supermarkets – Tesco, Sainsbury’s, Walmart Stores-owned Asda, and Wm Morrison supermarkets, had it their way for more than two decades, fighting it out among themselves to capture huge shares of the UK grocery market. But the financial crisis changed everything by making consumers incredibly price driven. This meant German discount chains Aldi and Lidl soared in popularity and it ushered in years of grocery price deflation that prompted a margin-sapping price war in the sector.

Separately, consumer shopping habits are changing fast. The UK is experiencing one of the fastest shifts to online shopping of any country in the world, and that’s brought in new entrants like Ocado and US giant Amazon. At the same time, a trend of shopping more frequently for less has meant that the big box stores of the ‘big four’ are becoming less visited. The generic offerings in those stores is also proving less popular, as some shoppers increasingly demand variety and novelty.

All this has put the big-four on the back foot. Tesco is focused on trying to fix its ‘core’ UK retail business, retreating from multiple other geographies and business lines after an epic failure of supply agreements accounting. Asda has gone from being a key driver of new ideas for Walmart to being its sick business. Morrisons, the smallest of the four, has been struggling on every level with its lack of online and convenience store presence.

Sainsbury’s has perhaps been the most resilient in recent years, but it recognised that to compete in the new environment it was going to need to quickly ramp up its online capabilities and add many more non-grocery product lines to keep shoppers buying Sainsbury’s and not Amazon or other competitors. Crucially, it also knew it needed to bolster its delivery network, as consumers increasingly demand goods ordered online ‘right now’.

Argos was a strong target. Management at parent company Home Retail have spent several years shifting the company from a traditional bricks-and-mortar warehouse shopping destination to a so-called multi-channel (that means online and bricks-and-mortar to you and I) business with a distribution network to match.

Sainsbury’s thinks the deal will allow it to compete with Amazon in the UK, and to leapfrog Tesco in terms of online offering. As it said when it announced its offer for Home Retail, the deal “brings together multi-channel capabilities including digital, store and delivery networks to provide fast, flexible and reliable product fulfilment to store or to home across a wide range of food and grocery, clothing, homewares, toys, stationery, electrical goods, furniture and other general merchandise”. The new company has been dubbed the UK’s Amazon with stores by one investment bank analyst.

The impact that Amazon is having on the UK grocery sector shouldn’t be underestimated. It may only just have brought its grocery delivery service AmazonFresh to the UK and only in London, but its same-day delivery service has already forced Sainsbury’s to roll out same-day delivery from 30 of its stores and Tesco to offer a same-day ‘click and collect’ service at nearly 300 stores. Tesco may be the online grocery leader in the UK, but now it’s having to react as Amazon grows in strength in this sector. 

Sainsbury’s move to buy Argos is a fightback, but it’s the only one of the ‘big four’ to be attempting something new at this time. Tesco already had bigger scale and a bigger online offering than any of its rivals with its Tesco direct and F&F clothing businesses, but the Argos deal potentially puts Sainsbury’s a step ahead.

Investors in the sector should sit up and take keen interest – this is a game changer for Sainsbury’s if it gets it right and ensures it is leveraging the combined experience of the merged group to become the leader in omni-channel shopping in the UK. It may be paying a hefty £1.4 billion, but it can recoup a lot of this through merger synergies, particularly in rationalising the Argos property estate. 

It has already increased its operating profit synergies to £160 million by the third year after completion, although it’s also going to spend some £270 million in exceptional costs and capital expenditure related to the deal over the same period. More importantly for the longer-term, Sainsbury’s says the deal will add to earnings per share by a double-digit percentage and low-to-mid-teens percentage increase in return on invested capital in the third year after next week’s completion. No rival among the big-four can currently forecast that sort of growth in returns. Sainsbury’s is also forecasting reduced leverage for the group. It is intending to keep its dividend policy the same at two times earnings cover.

There are of course risks, and the main fear is that Sainsbury’s will lose focus on its existing grocery business during this ferocious price war while it spends three years merging and integrating the businesses. Those three years of integration could also be the time it takes for Amazon to add further scale in the UK grocery market with its Fresh and Pantry businesses, making it even more of a competitive threat. These are risks worth taking because without the deal Sainsbury’s hasn’t got anywhere to go in a rapidly changing UK retail space.

And where does it leave its rivals? As described, Tesco has the scale in terms of online presence and distribution network to compete already with Amazon and the combined new Sainsbury’s group, but will need to up its game. There are signs emerging that it is managing to stabilise its UK grocery business, but it needs to re-take the initiative in the fast-growing digital market. 

Asda, meanwhile, is reliant on parent Walmart, which is suffering much the same experience in the US at the hands of Amazon and others as the UK supermarkets are here. Walmart is upping its own digital commerce game, most recently with the acquisition of for $3 billion, but it could be a long time before any benefits are added to Asda’s offering. And Morrisons. Well it looks further and further off the pace of change in the longer-term.

As the chart shows, investors have yet to be convinced of the merits of the Sainsbury’s deal. Its shares have underperformed those of Tesco and Morrisons since the deal first came to light on January 5.

The question then is whether the deal pays off over the longer term, in which case we could see the stock of the expanded Sainsbury’s outperform. It’s a long-term play, but one to watch closely.

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