The UK’s Best Takeover Target: Barclays PLC Or Tesco PLC?

On the face of it, Tesco (LSE: TSCO) and Barclays (LSE: BARC) (NYSE: BCS.US) are not the most obvious investment propositions these days. They are similarly troubled, but their troubles may spell opportunities for investors. Their shares don’t price in any M&A premium right now. 

I would add 3% of Tesco shares as part of a diversified portfolio at this price. As far as Barclays stock is concerned, I am convinced it will hit 200p by the end of the year. 

Tesco Trades Below Fair Value

It’s debatable whether Tesco did the right thing when it announced it would slash dividend payments last week. That decision, didn’t do down well with investors. I think management got their priorities wrong.

Tesco also decided to cut back on maintenance capital expenditures in a number of key areas including information technology, and it will invest less cash in the roll-out of its store refresh programme. This simply means that Tesco may find it more difficult to attract customers than in previous quarters. Like-for-like sales will likely continue to fall into 2015, in my view.

Still, Tesco’s fair value is 233p, according to my calculations. Its stock trades at 225p, so it’s worth keeping an eye on it. The outlook for the food retail sector in the UK is dreadful, as no-frills supermarkets continue to gain market share, but opportunistic buyers may realise that Tesco can be turned around, particularly if it becomes a private entity. It has a market cap of just £18bn right now, or 1.3x the value of its current assets.

Enter private equity. Folks in the PE community must be crunching the numbers to determine whether a leveraged buyout of the largest food retailer in the UK could work. First, Tesco is a fantastic restructuring opportunity, whose shares trade below fair value. Second, it has plenty of assets to sell. Third, employees and suppliers have virtually no negotiating power.

Morrisons has been long rumoured to be a buyout candidate; the same logic behind a Morrison LBO would apply to Tesco, although any take-private deal in the UK retail sector would require a large equity financing.

Barclays: Getting Slimmer

Latest news about the disposal of Spanish assets did little to lift animal spirits as Barclays stock underperformed the broader market on Monday. Shareholder value would be better preserved if Barclays were acquired by Citigroup, to name one possible suitor. Cost synergies are the way forward in the banking industry.

The press speculated about a merger between Credit Suisse and Julius Baer on Sunday and, although I don’t buy into these rumours, there comes a point when banks will have to chase consolidation to deliver value to their ailing shareholders. Barclays is very possibly the most palatable target in the industry.

Barclays stock has more upside than downside, according to analysts at Jefferies. They recently noted that they were raising their earnings estimates for the first time since they initiated coverage in September 2013. In their opinion, Barclays stock could be worth up to 331p. There are reasons to believe Barclays stock may be oversold right now, but Barclays remains a very risky bet. Regulatory and dilution risks will continue to weigh on its equity valuation well into 2015. I wouldn’t invest in the stock until it hits 200p, although at 210p the shares should be on the radar.