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03/01/2014

Staying In the Game

The retail marketplace is in a state of flux. Open any newspaper or click on any financial newsfeed, and you are likely to find information pertaining to mergers, acquisitions and changes aplenty in the retail landscape. In today's recovering economy, where prudence prevails across the M&A spectrum and capital management is top of mind for retailers of all sizes, even those companies that are happy just to hang on to what they've got, remain in a state of alert because, in today's market because, as 2013 illustrated, anything can happen.

2013 proved to be a memorable year for five of the industry's biggest players: Walmart, Safeway, Tesco, Kroger and Supervalu.

As one of the industry's key companies, Kroger Co. experienced an exceptionally strong year in 2013, with the company achieving 40 consecutive quarters–that's a full decade–of positive identical supermarket sales, as reported in its 2013 third quarter earnings report. The report also showed Kroger's total sales jumped 3.2 percent to $22.5 billion, or 4.7 percent excluding fuel. Kroger also reported record first, second and third quarters earnings in 2013, attributing much of its success to the company's "Customer 1st" strategy, which has led to strong sales and earnings growth, lowered costs and helped improve Kroger's connection with customers.

So does this compare to Safeway's recent track record? It doesn't. While Kroger continues to steal market share from its largest competitors, Safeway has experienced one of the industry's sharpest declines, selling off numerous stores, exiting the Canadian and Chicago markets, and showing a 58 percent drop in profit for the third quarter of 2013. Safeway's exit strategy for the Chicago market, which was home to the company's Dominick's supermarket chain, was partially the result of increased competition from Walmart and Aldi's – both of which consistently draw in customers with lower budgets. The endgame for Safeway was a sale, announced last month, to Cerberus Capital Management, the parent of Jewel-Osco, Albertsons and other banners.

And while Supervalu experienced declining revenue and sharp declines in its stock prices in fiscal 2013, resulting in the company slimming down and reevaluating its market position, Supervalu has made a significant comeback in its third quarter 2014 financial results. The company's quarterly net profit nearly doubled, with net sales at $4.01 billion, and the company's net earnings rose to $31 million. Restructuring its supermarket business resulted in Supervalu selling five of its largest grocery chains, including Albertson's, Acme, Jewel-Osco and Shaw's/Star, to Cerberus Capital in 2013–the same Cerberus that would go on to announce a deal to buy Safeway in 2014.

Not surprisingly, with an ever-changing retail player landscape, thanks in part to the ongoing mergers and acquisitions, industry players are focused on their capital management initiatives. Take Britain-based Tesco, for example. In a startling move to some, Tesco exited the U.S. market in 2013, writing off $1.8 billion when selling more than 150 Fresh & Easy stores. In fact, Fresh & Easy filed for bankruptcy to complete the sale.

And while Tesco focuses its efforts on realigning its strategic initiatives with its remaining brands, Walmart continues to experience overall solid growth, expanding further into Canada, and experimenting with its neighborhood market and Walmart Express storefront concepts. Currently Walmart operates nearly 20 Express stores and more than 290 neighborhood markets nationwide, with a goal of having 500 neighborhood markets open by the end of 2014.

Evaluating The Landscape

"Retailers have traditionally put less emphasis on managing the balance sheet–such as where capital management occurs–and more on the operating statement," Bill Bishop, chief architect of Barrington, IL-based Brick Meets Click says. "In fact, most senior managers are still more comfortable looking at the business through the operating statement."


"Retailers have traditionally put less emphasis on managing the balance sheet–such as where capital management occurs–and more on the operating statement.""

– BILL BISHOP,

Brick Meets Click


When evaluating the five leading retailers, experts interpret their positive and negative financial situations of 2013 in a variety of ways.

"The experience of all of these companies shows that there's excess capital investment in stores and that companies, like Kroger, who've been managing capital more effectively, are doing better," Bishop says. "Similarly, Walmart is shifting its investment outside the U.S. and inside the U.S. from Supercenters to neighborhood stores to make more effective use of capital."

According to Mike Stone, mergers and acquisitions expert with Dealreporter, a specialist news and analysis service that tracks and analyzes current and expected corporate events, of the retailers mentioned above, Walmart has been the most effective in using capital to take market share from traditional grocers.

"Margins in grocery are already thin, therefore traditional grocers' market share is being pressured as companies like Target or Walmart expand into grocery," Stone says. "The trend will be consolidation in grocery. Kroger deployed capital effectively this year via the purchase of Harris Teeter, a regional grocer. Scale and margins will be the name of the game if traditional grocers hope to remain competitive with large discounters expanding into grocery."

That said, even some of the success stories in retail are of concern to the industry. "Growth just isn't at the rates we were accustomed to in previous eras," says Carleton English, chief operating officer and portfolio manager at Belus Capital Advisors. "Companies really need to be more strategic in what markets they enter and how they cater to that demographic. A 'one size fits all' model just isn't going to work. Customers are more intelligent and discerning now."

Experts see a definite disruption in the retail/grocery arena, with several mitigating factors at play. According to English, some of these businesses likely expanded too rapidly in areas where there wasn't consumer demand and they're now realizing that they have to pull back.

"Overall, the way people eat and consume household products is changing," English says. "Consumers have more options and more refined tastes–the big box model may not make the most sense in densely populated areas." What's more, this industry is one with significant overhead costs including real estate, employees and energy consumption.


"Consumers have more options and more refined tastes–the big box model may not make the most sense in densely populated areas."

– CARLETON ENGLISH,

Capital Advisors


"Unwinding this investment – as Safeway, Tesco and Walmart are doing – is likely to prove to be costly in the next few quarters," English says.

Stone stresses that 2013 was challenging for retailers, who generally should have had a much easier year as the economy recovered. "Buyouts in retail should have been aplenty in 2013. However, uncertainty in the boardroom led to fewer deals," Stone says.

Stone expects market conditions, especially for mergers or buyouts, to improve because extremely inexpensive financing remains readily available.

What The Future Holds

Today's companies are looking for similar organizations where opportunities exist to combine complementary business and product offerings for cost savings, geographic coverage and cross-marketing. Future mergers and acquisitions within this retail category will likely look more toward adding product lines as well as buying or merging with competitors.

Stemming from this, when looking at the state of affairs of the five retail leaders, and others within the segment, experts see a few key trends that are most significant to these retailers and the industry as a whole.

"The trend is discounters entering grocery," Stone says. "That's the most significant force in this sector. All of the signs point to further industry consolidation."

Looking at the broader retail industry, another trend involves retail customers starting to shop, or at least price–shop, online. As English points out, brick-and-mortar retailers have to recognize this shift in consumption and adapt.

"Groceries are probably the last area where middle America has shown resistance to online shopping, but fears and worries about food freshness are alleviated as online grocers evolve and families realize the time savings in online shopping," English says. "There will always be a need for brick-and–mortar, but companies will have to look at ways to get clients in the door and maintain the right balance of inventory."

Bishop agrees that the big trend impacting capital management is the growth of online shopping, which will make it even more important to reduce capital investment in stores if a retailer's going to maintain the rate of return.

To minimize costs, English sees stores possibly shrinking and their offerings declining, but these stores will have to work harder to win on service – perhaps by having national franchises cater more to local demand.

"We see significant growth in online shopping in some markets in 2014, so all these companies will have to react more quickly than in the past to avoid experiencing a lower rate of return on capital in these markets, and this will not be easy," Bishop says.

English adds that acquisitions are the easiest way for companies with cash on the books to expand in new markets. "If you look at Kroger's acquisition of Harris Teeter, they're gaining a foothold into a new geographic region and a loyal high-end customer base," English says. "They're basically buying generations of Harris Teeter's R&D. Now of course, that is the hope; whether or not Kroger continues to deliver the service remains to be seen."

Bishop sees the trends of today's mergers and acquisitions as the result of three forces.

"Only one of these trends is broadly recognized today, and that is the need for retailers to achieve real growth, above the rate of inflation, in a slow-growing economy," Bishop says. The other two trends include the growing use of digital in grocery shopping, which will require new and different capital investment, and the shortening life cycle of retail formats and innovation in general.

"It's the last one that is most underappreciated today," Bishop says. "And it's the last one that probably will cause the greatest problems in the short term, moving forward."

Of course, proposed mergers and acquisition activity will result in retailers continuing to buy growth and market share when it is inexpensive.

"The 2013 class of mergers was not nearly as large as market expectations for 2014. A true leader, within a retail 'food group,' has the opportunity to break out of the pack in 2014 through a transformative acquisition," says Stone. "With debt this cheap, it is possible for an aggressive retailer to either hit a home run, or get themselves into a lot of trouble as their financing matures in a few years' time."

Pursuing the Deal

In the changing retail landscape, companies are expected to continue to pursue mergers and acquisitions deals, and for several good reasons, according to experts:

Market share: Companies want to increase size and sales volume to create economies of scale.

Assets: Unique assets or technologies can be acquired.

New customer base: A business can expand its customer base into a new area by acquiring a firm that already has customers in that area. A specific niche also can be filled this way.

Defense: Some companies acquire or merge with a target to beat out competitors. Other companies fear being acquired if they are small and merge defensively.

Getting rid of the opponent: Whether they admit it or not, some companies eliminate competition by reducing the number of players through mergers and acquisitions.

Maura Keller is a Minneapolis-based freelance writer, editor and author. She is a frequent contributor to publications that focus on the retail industry.