INDUSTRY CONSOLIDATORS SHUN RISK FOR PRECISION 2004-11-29 (1)

JON SPRINGER

News and rumors of supermarket merger activity appear to be on the rise this year, but industry observers don't expect it will mean a return to the vigorous wheeling and dealing that marked the late 1990s.

Increased consolidation, they predicted, will accompany more precise strategies and, in some cases, different objectives than the last time around, reflecting an increased aversion to the risk and costs of entering new markets given changes in the competitive landscape. Retailers have also realized that acquisitions in smaller doses can help avoid the regulatory scrutiny that impacted returns from the mega-mergers of the late 1990s, some analysts noted.

"Ten years ago, the competition was just the old-fashioned grocery store across town -- maybe one was EDLP [everyday low pricing] and the other high-low. Today, the competition is Walgreens, Dollar General, Wal-Mart [Stores] and many others selling the same things," Sheila M. McNeeley, director, Fitch Ratings, Chicago, told SN. "It is very hard today to corner one thing and say, 'This is our competition."'

That has led in part to fewer companies breaking into new markets via acquisition and more concentration on strategic in-market buys, she explained. Further, McNeeley said assessing the wider range of competitors, particularly in competitive markets, could result in buying activity focused more on the real estate than on the tenant.

"If you can get a cluster of stores in a core market, that's the way to go, rather than buying lock, stock and barrel a large entity in a new market. That just takes a lot more time and may involve buying stores you wouldn't want to keep," McNeeley said.

The underlying real-estate value of some retailers, including Sears, Kmart and Winn-Dixie, have been the focus of some analysts and investors this year. A July report from Deutsche Bank Securities, New York, suggested that Kmart's net asset value based on real estate with cheap, long-term leases could be worth $150 a share, while Winn-Dixie Stores, the Jacksonville, Fla.-based supermarket operator, had potential value tucked away in the significant amounts of store fixtures and equipment in its balance sheet. This sentiment, the report noted, could drive interest in those companies behaving as "store banks," selling off pieces of real estate to other retailers.

Kmart, Troy, Mich., led the way in this endeavor, selling groups of stores to Sears and Home Depot to raise cash, which it in turn used to fund a merger with Sears that was announced earlier this month. Edward Lampert, the Kmart chairman who engineered the merger, said the combined companies would behave less like a real-estate concern and more like a retailer, though asset sales remain a possibility.

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., told SN the sentiment of retailers having greater value in their real estate than in their operations was somewhat overblown, noting that many markets are already overstored and that retailers intending to sell stores have generally had trouble attaining the sale price they desire. "If this notion of a real-estate play were true, all the retailers in the world would liquidate and become [real-estate investment trusts]."

Wolf said, in general, he expects supermarket companies will continue to look at strategic store purchases in existing markets, except in rare cases when a new market acquisition nets a well-regarded regional retailer at a good price, as was the case when Albertsons purchased Shaw's Supermarkets for $2.5 billion earlier this year. "Some franchise sellers were seeking valuations that are too high," Wolf said. "Shaw's sold at about seven times EBITDA [earnings before interest, taxes, depreciation and amortization]. If valuations were five or six times EBITDA, we might see more. But in general, the Shaw's deal was the exception and not the rule."

More common this year have been in-market deals, such as Kroger's acquisition of six former Thriftway stores in Cincinnati operated by Winn-Dixie. According to the Deutsche Bank report, regulators might once have quashed that deal, noting Kroger's 43% grocery market share in its home city. Yet changes to the Hart-Scott-Rodino Act in late 2000 raised the limit on the size of transactions requiring reports from $15 million to $50 million. Purchases for less than $50 million, like Kroger-Thriftway, therefore need no scrutiny from the Federal Trade Commission.

Though last year was marked mainly by the merger deals that did not materialize -- reported deals for Kings in New Jersey and Dominick's in Chicago both fell through -- the lack of activity was more of a temporary lull than a signal that consolidation had stopped, said Rob von Furth, senior vice president of Deloitte & Touche Corporate Finance, New York. Von Furth worked with Leominster, Mass.-based independent Victory Supermarkets in its recent deal to be acquired by Delhaize America, Salisbury, N.C., and folded into its Hannaford division.

"There hasn't been tons of M&A activity, but I also think it kind of hit a trough, and it's coming back," von Furth told SN. "I think there's always going to be a certain level of M&A activity, largely fill-in, small acquisitions that will fill in footprints."

These deals help retailers gain local leverage, and tend not to carry large risk, he explained. "The [financial] market wants [supermarket companies] to be cautious, and their trading multiples are suggesting that they have to be risk-averse in their acquisitions," von Furth added.

Albertsons' purchase of Shaw's earlier this year took many industry observers by surprise, but analysts said that deal represented a unique opportunity in a market where ground-up development is difficult and expensive. More typical are drawn-out sales of chains, such as Ahold's slow unloading of its Bi-Lo and Bruno's divisions, both of which are expected to be sold by the end of the year after being put on the sales block in February to help Ahold restructure its finances.

"Because of the way the landscape's changed, everything's going to be a part of a special situation, and I think Shaw's was one of those," McNeeley said. "This was not a deal that was out there for a long time. It was done very quickly and very quietly, and was much more exciting.

"That's very different than Ahold or Dominick's, where everybody knows the company is up for sale for operational reasons," she added. "Those deals are obviously more difficult to complete, because those are not divisions you can buy without a lot of trouble."

According to von Furth, chains like Victory -- small-to-medium independents with strong local brands -- are likely to find new owners, or at least hear from interested buyers in or near their markets. Such activity will only increase as the economy improves, he added.

"I'm sure there are independents who've been approached left, right and center by potential buyers," von Furth said. "And they will have to sit back and evaluate whether or not [selling] is the right thing to do."

As was the case with Victory and Delhaize, the seller's comfort with the buyer was key to the private-to-public deal, von Furth noted. "For many private family businesses that have been held for generations, there's a lot of concern that there's the right party taking the reins. There's a pride involved," he explained. "There's got to be a dramatic level of appreciation for the buyer. The [DiGeronimo] family [Victory's owners] got very comfortable with Delhaize as operators. In Hannaford, they found a common bond with their local community."