CONSOLIDATION IS EXPECTED FOR SMALLER CHAINS IN U.K.

JAMES FALLON

LONDON -- The U.K. market is entering a period of consolidation among some of its smaller players, who are increasingly being squeezed by the strength of Tesco, J. Sainsbury and Asda.

The first changes came as the retailers Kwik Save, Prestatyn, England, and Somerfield, Bristol, England, agreed in February to a $1.99 billion (1.2 billion pound) merger to create a business with sales of more than $10 billion (6 billion pounds) and about 1,500 stores. Their combined market share would match Safeway plc's 11%.

Kwik Save has a discount format and had been trying to move upmarket following the invasion of such European hard discounters as Netto, Aldi and Lidl. Somerfield has performed strongly over the last few years by improving margins but remained a weak fifth in terms of market share.

Both chains were suffering because their stores are concentrated in center-city locations and generally are smaller than the market leaders' edge-of-town superstores.

While details of the merger still are being sorted out, the two companies expect to save $83.5 million to $102.4 million (50 million to 60 million pounds) through greater efficiencies in buying, the supply chain and marketing, and by closing one of their head offices. There also are expected to be some store disposals, although analysts said it is too early to say how many and questioned predictions of up to 200.

Industry observers and financial analysts generally applauded the deal, believing the two retailers had little option but to merge with each other. However, analysts questioned whether it will solve either of their problems in the long term since the analysts thought both will continue to lose market share to the three leading U.K. retailers.

But the Kwik Save-Somerfield merger would place further pressure on Safeway, Hayes, England, which has been struggling to maintain its market share against a resurgent Sainsbury and a continued strong Asda.

Safeway issued its third profits warning in a year in mid-February, saying pretax profits in the year ended March 31, 1998, were expected to fall to about $626.25 million (375 million pounds) from $718.1 million (430 million pounds) the previous year. It also said it was spending $66.8 million (40 million pounds) on marketing and promotions in the current year, which is expected to leave profits flat in the year ending March 31, 1999.

Analysts say it's now only a matter of time before Safeway and Asda renew their merger negotiations. The two companies had been in talks last fall about a possible merger but called them off when news of the discussions leaked to the press.

Tony McNeary, an analyst at Natwest Securities, said an Asda-Safeway merger is the likely outcome despite speculation that a foreign retailer might swoop in and buy Safeway. McNeary questioned the logic of an overseas retailer buying the chain since it would gain no economies of scale. It's unlikely either Tesco or Sainsbury would make a run at Safeway because of antitrust considerations, McNeary said.

Not everyone is convinced an Asda-Safeway merger is the best solution, however. Clive Vaughan of Verdict Research, London, said the consultants are concerned about the companies' two different cultures and market positions.

"We think it would be a disaster," he said. "Merging such two differently positioned businesses isn't easy."

Vaughan agreed a foreign retailer buying Safeway also wouldn't solve the U.K. retailer's problems. While there have been reports that Ahold, Zaandam, Netherlands, might be interested in acquiring Safeway, Vaughan warned against the deal. "Ahold wouldn't derive any synergies," he said. "Safeway's problems wouldn't go away; it still would be a weak No. 4 in the market."

The skeptics of any Asda-Safeway deal believe the future for Safeway depends on whether one of the three largest chains stumbles and creates an opportunity for Safeway to gain market share. Asda's growth is slowing but it is consolidating its position as the third-largest chain. Sainsbury also seems back on track after losing market share to Tesco about 18 months ago.

As for the other small players in the United Kingdom -- such as William Morrison, Bradford, England, and Waitrose, Bracknell, England -- analysts believe these are strong niche players that are likely to survive any changes that affect Safeway, Asda, Kwik Save and Somerfield.

"There aren't many chains in the United Kingdom left to be consolidated," one analyst said.