THE NEXT BIG DEAL

DAVID GHITELMAN

It has been a quiet first half in the supermarket industry in terms of merger and acquisition activity.

But the major companies' ongoing quest for growth could soon spark some merger activity, according to industry observers. Although conditions are still not ripe for another wave of consolidation like the one of the late 1990s, some acquisition activity is expected before too much longer.

In recent months, acquisitions have been limited to small groups of stores that have been discarded by their previous operators.

One major national company, Albertsons, Boise, Idaho, pulled out of a handful of the markets in which it was neither first nor second, selling off its stores there piecemeal and closing the few that found no buyers.

A struggling regional, Winn-Dixie Stores, Jacksonville, Fla., gave up on trying to compete in Texas, selling off -- again piecemeal -- most of its 71 stores in the state, closing the others.

In the Northeast, two small deals were consummated.

Wakefern Food Corp., Elizabeth, N.J., followed the lead of any number of distributors, acquiring a 31-store supply customer, Big V Supermarkets, Florida, N.Y., that had been languishing in Chapter 11 bankruptcy protection.

And U.K.-based retailer Marks & Spencer finally has accepted an offer for Kings Super Markets, Parsipanny, N.J., clearing the way for D'Agostino Supermarkets, Larchmont, N.Y., to acquire the 28-store chain.

Probably the most notable feature of these last two transactions was how difficult they were to bring about. Wakefern had to go to court last year to hold Big V to its supply contract and then fend off this spring an effort by Stop & Shop Supermarkets, Quincy, Mass., an Ahold operating company, to work out an acquisition deal with Big V's creditors, while Marks & Spencer had been trying on and off to sell Kings since it first decided to abandon its North American retail operations nearly three years ago.

All this is in marked contrast to what was happening in the industry as the final decade of the 20th century drew to a close. In 1999 alone, Kroger, Cincinnati, bought Fred Meyer Inc., Portland, Ore.; Albertsons acquired American Stores Co., Salt Lake City; Supervalu, Minneapolis, got Richfood Holdings, Richmond, Va.; Delhaize America, Salisbury, N.C., purchased Hannaford Bros., Scarborough, Maine; and Safeway, Pleasanton, Calif., snatched up Randall's, Houston; Carr Gottstein, Anchorage, Alaska; and Dominick's Supermarkets, Northlake, Ill.

Those were the days.

What followed was a slow and difficult (or at least more difficult than publicly predicted) period of integration, as the companies gradually melded together their computer systems, merchandising strategies and corporate cultures.

However, industry observers do not expect the current lull to last much longer. Instead, they told SN that as the large companies will soon return to the bargaining table, eager for more acquisitions -- not because the majors now believe (if they ever believed) that mergers are the easy way to corporate wealth, but because acquisition may well be the only growth game in town.

Sandy Skrovan, vice president, Retail Forward, a Columbus, Ohio-based retail consultancy, said she expects the pace of acquisitions to pick up, perhaps considerably, in the next three to five years.

She noted that in 1997, the 10 largest U.S. supermarket chains controlled a market share of 35%. Today, following the wave of big mergers that ended the '90s, that share has grown to 50%. By 2007, it could grow to 55%, a small surge, admittedly, but a surge nonetheless.

Or, she added, the top 10 could control as much as 70% of market share, which would require a rate of consolidation rivaling that of the late 1990s.

WHERE HAVE ALL THE MERGERS GONE?

However, at the moment, mergers and acquisitions are an endangered species throughout the economy, not just in the supermarket industry. Jeff Hooke, a McLean, Va.-based investment banker and author of "M&A: A Practical Guide to Doing the Deal," told SN that M&A activity overall "is down about 50% from last year."

He attributed this to "the collapse of high-tech stock prices. About 60% of mergers in the last three years were high-tech related."

In the retail food sector, industry observers attributed the fall-off in consolidation to a variety of factors.

The generally uncertain economy and recently weak stock market have discouraged supermarket companies from making too many bold moves, noted David Rachman, professor of marketing, Baruch College, New York.

"People go into mergers to penetrate a market," he said. "At this point, they're not sure what any of this is going to do for them. It's very hard to figure out what the future of the business was going to be in terms of competition and profits. I can certainly see why companies are sitting around looking at this point. It's not an activist time."

The declining stock market has also made it more difficult for companies to use their equity to finance deals, according to Andrew Wolf, equity analyst, BB&T Capital Markets, Richmond, Va.

"At present, using your stock to buy someone is very expensive," he explained. "You have to issue far more shares, and therefore it becomes dilutive. In terms of doing a large deal, it's kind of off the table unless you're willing to take some dilution."

Some observers told SN the current lull was a result of the easiest and most obvious deals having already been made.

Rachman cited a remark Steve Burd, Safeway's president and chief executive officer, made a number of years ago. "He said, 'Our strategy is to increase the number of stores through merger,"' Rachman recalled. "That was easy to do because he could go into Chicago or go to Alaska. Those pickings are no longer around."

Also, several of the most attractive takeover candidates -- regional operators such as H.E. Butt Grocery Co., San Antonio, and Publix Supermarkets, Lakeland, Fla. -- do not appear to want to be taken over, observers commented.

Steve Chick, equity analyst, JP Morgan, New York, noted, "Most of the quality assets are tightly held. It's up to those companies and whoever owns them, families or other entities, whether they want to sell or not.

"If you're a family company, you're well entrenched in the market, and your goal is to earn a return for family shareholders, pay a dividend, whatever it is, you don't have to sell. And if you do, it's going to take a very attractive multiple that's going to make it compelling. Do some of these big food retailers want to pay multiples for other assets that are at or above what they currently fetch?"

Uncertainty about how the Federal Trade Commission will treat mergers is also seen as limiting acquisition activity. During the Clinton administration, the FTC consistently blocked mergers that involved in-market acquisitions. However, for the past year three of the agency's five commissioners have been Republicans, who might be expected to take a more merger-friendly position.

Observed Chick, "The FTC in the past was relatively strict, and nobody's really tested that recently.

"A good example of that is Winn-Dixie wanted to sell its 71 stores in Texas to Kroger. They didn't get sold. What did they do? They ended up remaining in the hands of a struggling operator only to close two years later, when economically the right thing to do was sell those stores to Kroger two years ago."

Wolf noted, "The most accretive form of merger and acquisition activity is to do an in-market acquisition. The chains would love to do that. They're probably assessing their chances now, and someone will test the new administration's approach to antitrust to see if it has changed. I think if you find a changed FTC in regard to in-market acquisitions, you'll see a ton of them."

The Bush administration's FTC may have already signaled its intent to be less strict on mergers, according to Rachman. He noted that the agency has not blocked the pending deal that has Wal-Mart Stores, Bentonville, Ark., purchasing Supermercados Amigo, San Juan, P.R., a leading Puerto Rican supermarket chain.

"The FTC is allowing Wal-Mart to take over the market," he said. "The government is letting that go. It looks like they're letting that slide."

INTEGRATION INDIGESTION

Across the entire economy, it's unclear how many acquisitions fail to live up to expectations. Two-thirds is a figure that occasionally gets cited. Investment banker Hooke said he thinks that number is a little high. "In my general experience, it's around half that don't work out or don't meet expectations," he estimated.

In the supermarket industry, few observers would say that any of the big deals of the late 1990s were failures. But nearly all agree that none of the integration efforts that followed them were as painless as initially forecast.

And most would say that the length and difficulty of the integration process helped keep most of the major players out of the acquisitions market.

Skrovan said, "The larger players have really spent the last two to three years since they made those big acquisitions digesting and integrating the operations and getting a hold on the synergies part of the transactions."

Gary Giblen, director of research and senior vice president, C L King Associates, New York, noted, "I think the big acquisitions did take some stuffings out of the acquirers. Albertsons and American was not smooth. Kroger and Fred Meyer wasn't. Surprising, even Safeway, which made less ambitious acquisitions, has had acquisition integration problems."

One integration challenge the integrators continue to face is posed by their desire to balance economies of scale with a focus on local marketing, according to industry observers.

Commented Skrovan, "Part of the reason the big companies want to get bigger and standardize things is to work out more of the costs and have one private label across the board to gain efficiencies and economies of scale. At the same time, they will have to use technology and all the information that they're gathering on a micro-merchandising level and be able to drill down and take customization and customer relationship management to a finer level."

Giblen said, "Despite vigorous protestations from the industry, I think consolidation tends to incinerate local brands."

However, most observers noted that for all their difficulty, virtually all the major supermarket industry deals of the late 1990s resulted in stronger companies.

Noted Giblen, "They all were 10 times more painful than anyone thought they would be, but eventually gain was achieved. In each case, the company was a better company for it, but it was very painful."

Skrovan said, "The deals probably created more value. I just don't know if they created as much as we had thought they would."

WHO'S NEXT?

However difficult the integration process is, many observers still maintain that acquisition remains the easiest way for large companies to grow.

Chick said, "Consolidation can still work. It's still a fragmented industry. I don't anticipate any sizable deals. What I think you're going to see is one deal every now and then."

In many markets, there is simply not enough vacant land in good locations for companies to build a significant number of stores from the ground up, according to Skrovan. "There's a lack of green-field development opportunities," she noted. "It probably makes more sense, if a company wants to have a presence in a particular market or increase its presence there, to go in and buy something that's already existing, especially if you're looking to put stores in desirable locations."

Some observers said acquisition is virtually the only viable way for large companies to grow sales.

Giblen said, "Growth has ground to a halt. Kroger and Safeway and everyone has had to lower their growth targets. You're seeing a variety of new corporate-growth initiatives, the urban stores or warehouse stores, different formats, but also acquisitions are part of that.

"I think that just as there was a sudden cessation, there's going to be a sudden surge. Also, the stock prices are down. Just at the time that the industry has to look for other growth avenues, it's very convenient to buy a regional company at a very cheap price."

Some companies, however, might not be quite in shape to rejoin the acquisitions race. Netherlands-based Ahold, whose acquisition of Bruno's Supermarkets, Birmingham, Ala., was last year's biggest deal, appears bogged down with shoring up its Latin American investments. (See story below.)

Safeway, which acquired the 44-store Genuardi's Family Markets, Norristown, Pa., in a deal that closed earlier this year, also appears to be out of the running.

Observed Chick, "Safeway will be acquisitive, but I think Safeway has to wrestle with its own issues now. I think they have to look within and say, 'What's our next step here with this company?"'

The major issue, according to Wolf, is poor sales performance at its last two acquisitions, Randall's and Genuardi's, fueled in part by post-merger customer dissatisfaction at those banners as well as Dominick's.

"Safeway has to recover its sales productivity," said Wolf. "That doesn't preclude a deal, but a deal would probably be distracting. Their last two acquisitions are below plan. They need to be fixed."

While observers noted that Kroger appears to be in an acquisitive mood, Albertsons was the consensus choice as the company most likely to start the next buying spree.

Several analysts cited the company's appointment last month of Eric Cremers to the newly created job of senior vice president, corporate strategy and business development. Cremers came to Albertsons from US Bancorp Piper Jaffray, Minneapolis, where he ran the consumer mergers and acquisitions group. Before that, he was vice president, strategy and business development for Pillsbury Co., Minneapolis, where he executed mergers and acquisitions. Giblen called Albertsons' hiring of an M&A specialist "a dramatic departure from corporate culture."

It may be a departure from the company's past, but Wolf pointed out that M&A is a business well understood by Larry Johnston, who last year became Albertsons' president and CEO. "If you look at what Johnston did at GE, he built successful businesses through M&A," he said. "That's his track record. Albertsons, what's missing there is equity, but they still have access to the debt market. Without equity they can't do a megamerger, they can't buy a very large chain or even a large regional, but they could buy a moderate supermarket chain."

Chick said it is very possible that the company will look to acquire a company outside the supermarket industry, following the lead of Supervalu, which earlier this year acquired Deal$, St. Louis, a 45-unit chain of dollar stores. "The management team at Albertsons is relatively dynamic," he said. "I get the sense that they're trying to think outside of the box with their business model.

"My impression is they want to know what might be contiguous to their own business and how can they leverage their core competencies. Sure, they could buy a food retailer, but they could do something else. I'm not saying Albertsons is going to go out and buy dollar stores, but I think they're trying to think dynamically, as Supervalu did."

International retailers, particularly international chains that do not yet have a U.S. presence, could also come calling, noted Skrovan. "We don't really have a crystal ball to anticipate how it will play out, but we anticipate there will be more global activity," she said.

Skrovan observed that U.K.-based Tesco, which has no U.S. stores, has formed an alliance in which it is sharing its e-commerce expertise with Safeway. This could be "a precursor of something more permanent in the States," she said.

"Conventional wisdom dictates that anyone who wants to be a truly global player has to play in the U.S. market. There are several big players out there like [France-based] Carrefour and Tesco that really don't have a foothold in the States yet. They very well may look to a supermarket acquisition."

Skrovan added that U.S. retailers might also decide to acquire overseas companies. "They need to do that rather quickly if they're going to make a move," she said, "because the size and ownership structures and prices to make those kind of acquisitions viable are becoming more and more limited."

IN THE SLOW LANE

The pace of consolidation slowed to a crawl in the first seven months of 2002, with some of the largest sales resulting from major companies exiting markets and selling off assets piecemeal, or from distributors buying retailers mired in Chapter 11 reorganizations.

January

Giant Eagle, Pittsburgh, acquired six Country Market grocery stores, two in Pennsylvania and four in Maryland.

February

Wal-Mart Stores, Bentonville, Ark., said it has signed a deal to acquire Supermercados Amigo, a 35-store chain based in San Juan, Puerto Rico. The acquisition has still not closed, pending regulatory approval.

March

Wal-Mart agreed to purchase what it called a strategic stake in Seiyu, Tokyo, a Japanese retail chain with $8 billion in sales last year. Under the agreement, Wal-Mart could eventually acquire 66.7% of the company.

Albertsons, Boise, Idaho, announced it would exit four "underperforming" markets: Houston; Memphis, Tenn.; Nashville, Tenn.; and San Antonio. The resulting sales included: 17 stores -- 16 in Houston, one in Louisiana -- to Kroger Co., Cincinnati; the 12-store, Memphis-area Seessel's chain to Schnuck Markets, St. Louis; nine stores, including five in San Antonio, to H.E. Butt Grocery Co., San Antonio; four stores in Mississippi to Brookshire Grocery Co., Tyler, Texas; and one distribution center in Tulsa, Okla., to Fleming, Dallas.

April

Willis Stein & Partners, a Chicago-based investment firm, acquired Roundy's, Pewaukee, Wis.

May

Winn-Dixie Stores announced plans to sell or close its 76 stores in Texas and Oklahoma. The resulting sales included: 17 north Texas stores to Brookshire; seven Dallas-Fort Worth-area stores to Kroger; all five Oklahoma stores to GLN, Checotah, Okla.; four Dallas-Fort Worth-area stores to Fiesta Mart, Houston; and one Dallas-Forth Worth-area store to Harvest Supermarkets, Saginaw, Texas.

June

C&S Wholesale Grocers, Brattleboro, Vt., acquired the distribution business and facilities of Tops Markets, Williamsville, N.Y., an Ahold operating company.

Wakefern Food Corp., Elizabeth, N.J., acquired Big V Supermarkets, a 27-store chain based in Florida, N.Y., that had been in Chapter 11 bankruptcy protection.

July

Associated Whole Grocers, Kansas City, Kan., acquired Homeland Stores, a 44-unit chain based in Oklahoma City, that had been in Chapter 11 bankruptcy protection.

D'Agostino Supermarkets acquired 29-store Kings Super Markets, Parsippany, N.J., from U.K.-based retailer Marks & Spencer.