SAFEWAY BUY OF RANDALL'S SEEN AIDING PROFIT GROWTH

ELLIOT ZWIEBACH

PLEASANTON, Calif. -- The pending acquisition by Safeway here of Houston-based Randall's Food Markets will ensure Safeway's strong earnings growth for at least two years while enabling the chain to pursue additional acquisitions, industry observers told SN last week.

Safeway said it would pay approximately $1.8 billion for the $2.6 billion chain that operates 116 stores in Houston, Dallas and Austin, Texas. The price includes $1.425 billion for Randall's equity -- encompassing approximately $855 million in cash and 10.9 million shares of Safeway common stock -- and assumption of Randall's debt of approximately $375 million.

Randall's 116 units include 46 Randall's stores in the Houston area and 12 in Austin, plus 58 Tom Thumb stores in the Dallas-Fort Worth area. Safeway said it would retain both banners.

It is Safeway's third acquisition deal in the last 12 months, following the acquisition of Dominick's Finer Foods, Northlake, Ill., in November, and Carr Gottstein Foods, Anchorage, Alaska, earlier this year.

Safeway said it expect the deal to close in mid-September, boosting annual sales to approximately $30 billion in an operation comprising more than 1,645 stores in 19 states and western Canada.

Steve Burd, chairman, president and chief executive officer of Safeway, told reporters during a media conference call his company is "absolutely" still in an acquisition mode. "This industry is consolidating, and in Randall's we inherit a great management team with a great track record, so we won't consume our bench strength. As a result, we could easily do another acquisition this year," he said.

However, overseas expansion is unlikely, he added. "Our focus is on North America, where we have 7% of the national market share, and there are lots of opportunities to consolidate and merge in the U.S. without burdening our management team by going trans-Atlantic or trans-Pacific."

Securities analysts told SN last week they believe Safeway is capable of making another acquisition fairly quickly. Possible targets, they said, could include Winn-Dixie Stores, Jacksonville, Fla., which has been the subject of takeover speculation for several months; Hannaford Bros., Scarborough, Maine, also rumored to be a takeover candidate; or another Eastern chain that would help Safeway make better use of its Baltimore-area distribution center.

According to Ed Comeau, an analyst with Donaldson Lufkin & Jenrette, New York, "What the Randall's acquisition does is propel Safeway's earnings growth for this year and the next two years, which gives the company a little more breathing room to do additional deals."

Safeway's growth rate was on the verge of decelerating in the next year, Comeau explained, "but with the addition of Randall's, Safeway is looking at earnings growth of 18% to 20% in each of the next two years, and it won't need to do another deal like it needed to do this one to lift the bar on earnings growth. As a result, anything else it acquires in the next few months will be gravy."

Comeau said Safeway's acquisition targets will be other small- to medium-sized companies like Carr Gottstein and Randall's; larger supermarket chains, an option in which its choices are limited; or related-interest companies like drug stores or discounters.

Comeau also said Safeway could make some smaller acquisitions in the Texas marketplace, "although aside from competing with Albertson's and Kroger, that part of the country is Wal-Mart alley. Safeway has more opportunities for expansion in connection with Dominick's in the Midwest, where there are lower barriers to growth and more stable competition than in Texas."

Gary Giblen, New York-based managing director of Banc of America Montgomery Securities, San Francisco, said Safeway's acquisition of Randall's indicates the company is not driven by geography "as much as by the logic of the asset available -- it's the quality of the asset and how well it fits with Safeway's acquisition criteria."

Jonathan Ziegler, a San Francisco-based analyst with Salomon Smith Barney, New York, said he expects Safeway to continue to buy regional players. "Acquiring chains like Randall's that are large but not huge and regional but not multi-regional is a low-risk strategy for entering new markets," Ziegler said, "and it shows Wall Street that Safeway can keep expanding with sustainable growth rates.

"Safeway is unlikely to grow by the shovel-full as Kroger and Albertson's have but rather to take smaller bites to avoid digestion issues and counter Wall Street's cynicism. I think Safeway will continue its pattern of making acquisitions at the rate of about one a year, with each one contributing to results in the current and following year," Ziegler added.

Burd told reporters the merger with Randall's will enable Safeway "to further leverage our size and improve the operating profits at Randall's. And there are dozens of things Randall's does better than Safeway, and we won't be shy about borrowing some of those practices.

"For example, part of this business is excitement and theater, and Tom Thumb stores do a better job in that area than Safeway, and that's one area we expect to learn something," he said.

Asked how Safeway expects to cut Randall's operating expenses, Burd replied, "We don't want to be too specific because we're not eager to give Kroger and Albertson's our trade secrets.

"But in procurement, we can buy everything at a lower price than Randall's; in advertising, we have more buying power for media, paper costs and printing; in private label we carry double the assortment Randall's carries, so we see great opportunities to provide quality products at substantially lower costs with higher margins; and in the area of best practices, we've figured out some better ways to operate in-store bakeries and other functions; and we can leverage our 43 manufacturing plants in terms of the price of raw materials."

According to R. Randall Onstead Jr., chairman and CEO of Randall's, "Safeway has an established track record of successfully integrating operations to create value, and we feel this transaction represents an exciting opportunity to continue to build our franchise in line with the history of quality and excellence that has always characterized our stores."

Onstead said he believes Randall's "chose the right partner in Safeway for several reasons. We have similar operating philosophies, our management has been an admirer of Safeway for years and we've modeled a lot of our approach to the business on the way Safeway runs its business."

He told reporters Safeway would not make any changes in Randall's short-term growth plans. "We anticipate opening 10 to 12 new stores next year and completing more than 20 remodelings, and there will be no changes in those plans," Onstead said. "We don't see any slowdown in our growth plans as part of Safeway."

He said he would continue to oversee the Randall's operation, while Mark Prestridge would continue to oversee the Tom Thumb stores.

Both Burd and Onstead said size was a motivating factor in the deal.

"With combined sales of $30 billion -- 10 times greater than what Randall's is currently doing -- we can certainly buy better than Randall's can at $2.6 billion," Burd said.

According to Onstead, "Size matters more today than it ever has, and that is one of the main reasons for this merger. As a stand-alone company, Randall's couldn't be on the same playing field as some of our competitors.

"This merger will allow Randall's to take advantage of Safeway's buying practices, its manufacturing capabilities, its private-label programs and its best practices."

According to Comeau, "Safeway is not going to have to do anything dramatic at retail because Randall's is already so strong. But what Safeway brings to Randall's is the ability to leverage its productivity, logistics and store brands."

Giblen said Randall's "is already a world-class operation in terms of perishables and customer service, but it can benefit from Safeway in the areas of cost control and logistics, and both companies can benefit in the area of private label -- Safeway by increasing its manufacturing economies of scale and Randall's by replacing President's Choice with a premium line that can help boost sales."

Ziegler said the acquisition "also enables Safeway to pick up some intellectual capital [from Randall's management staff], plus a variety of best practices that Randall's can provide to Safeway and vice-versa."

The two companies are linked through Kohlberg Kravis Roberts & Co., the New York-based investment firm that engineered a leveraged buyout of Safeway in 1986 and became the majority shareholder in Randall's in 1997, with a 62% stake.

KKR Associates, a business affiliate of KKR, continues to own 5.9% of Safeway's equity; after the merger with Randall's its stake would rise to 7%.

The companies pointed out that the merger was approved by directors of both chains who are unaffiliated with KKR.

A KKR spokeswoman told SN last week the decision to approach Randall's about a merger was made by Burd "on his own initiative," adding, however, that KKR did play a role in negotiating the merger.

According to Ziegler, the ownership overlap "telegraphed that the two companies were likely to get together someday. However, Randall's had been considering an initial public offering, and I don't know what role KKR played in actually getting the deal done."

Giblen said the KKR connection was a critical linchpin in the deal. "This merger was not brokered by investment bankers -- Safeway did its own homework, and it was easy enough for its personnel to chat with KKR representatives about Randall's."

He said KKR will get "an enormous return-on-investment" on its two-year-old investment in Randall's "as it should, because Randall's has improved dramatically under KKR's oversight. Randall's is the most dramatic turnaround story I've ever seen, going from a 5% profit margin a year ago to 7.6% in the fourth quarter."

Speaking during the media conference call, Burd said Randall's is a perfect fit for Safeway "because we have pursued a common strategy for the last six or seven years and we operate similar stores.

"And like our acquisition of Vons, Dominick's and Carr Gottstein, we believe we are catching an outstanding operation that's in the process of turning its financial numbers ever further north. And we believe Safeway can add to that momentum in Texas."

Burd said he expects Randall's to help Safeway achieve its goal of a 10% operating cash flow margin. The chain's current margin on earnings before interest, taxes, depreciation and amortization is 9.2%, "and we believe, with the addition of Randall's to the balance of Safeway's operations, we can get to that 10% level," Burd said.

He said Randall's profitability "has been on a steady uptick the last two or three years, and Randall's would have come close to achieving Safeway's profitability goals on its own. The main advantage of this merger is that we can get there more quickly."

Asked how long it would take Safeway to achieve its goal, Burd replied, "We don't like to talk about a timetable because, although we know how we want to get there, we're determined to protect our market shares in all markets and we never know from one quarter to the next how much firepower we may need to do that."

Burd said the transaction is expected to be cash accretive this year and earnings neutral for the first 12 months after it is completed but additive to earnings in succeeding years.

According to Giblen, Safeway has never been so confident that it can get an acquisition up to its target level of profitability. "It's being hyper-conservative in saying the acquisition will be earnings neutral for the first 12 months, given the post-acquisition performance of both Vons and Dominick's," he said.

"And when I asked Burd about that, he said the experience with Randall's should be the same as it's been at the other two chains, and he added that he expects to blow the doors off those estimates."

Burd said there may be some administrative reductions in Texas, "but those decisions will be up to Randall Onstead. There is some redundancy between Randall's support structure and Safeway's, but we will sort that out between now and the time the deal closes.

"But with our growth plans, there should be no effect on store employees, and, within a year, the total number of employees should be greater than it is today."

Burd said Safeway is "thrilled to be re-entering the fast-growing Texas market," which it exited in 1988 as part of the rationalization that followed in 1986 LBO.

Asked about negative memories of Safeway by local consumers, Burd said he doesn't anticipate that will be a problem. "We are a completely different company today. And once the news of the acquisition fades, people will continue to go to their Randall's or Tom Thumb store as always, and the only changes they will see are better product offerings at better values."

Onstead said he's aware of the negative attitudes toward the old Safeway, "but my family would not support a transaction that would put us in partnership with a company that we didn't feel good about. Safeway today is a totally different company than the one that left 11 years ago, and Randall's and Safeway will get better together."

Asked about facing off in Texas against Kroger and Albertson's, the nation's two largest volume retailers at $43.1 billion and $33.4 billion, respectively, Burd replied, "We know both companies well. We face Albertson's in seven of our eight divisions and Kroger in five.

"But the interesting thing is, although Kroger has greater sales, Safeway is quite a bit more profitable, and our cash flow is greater than Kroger's or Albertson's. There are a number of ways to compete, and ours will be to differentiate ourselves from them. But we're not frightened off by someone with $43 billion in sales."

Although most Safeway divisions are unionized, Randall's is not, "and we don't anticipate any change in that," Burd said.

Robert Onstead, one of the founders of Randall's and its retired chairman, said during the media call the merger "represents a great day for our company and for Safeway. Thirty-three years ago we never anticipated this, especially when Safeway came to Houston four years later."

The senior Onstead said the merger "will be great for our customers because it will give them a great opportunity to benefit from things that a company like Safeway can bring to us."

In financial results disclosed the same day the merger was announced, for the year ended June 26, Randall's said sales rose 6.9% to $2.6 billion and comparable-store sales jumped 6.6%, while net income increased 103.7% to $42.2 million and EBITDA margins rose 38.6% to $172.2 million, or 6.7% of sales, compared with $124.2 million, or 5.1% of sales, a year ago.

For the 12-week fourth quarter, sales rose 3.6% to $587.8 million and comparable sales rose 1.7% -- after being negatively affected by approximately 1.8% because Easter fell in the third quarter of the year, compared with the fourth quarter a year earlier -- and net income rose 179.3% to $12 million, while EBITDA rose 56.1% to $44.6 million, or 7.6% of sales, compared with $28.6 million, or 5%, a year ago.