Troy Wolverton

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Wal-Mart May Be Planning a British Excursion

Troy Wolverton

Wal-Mart (WMT) may soon enter a new battle of Britain.

Less than four years after jumping into the British market with its purchase of supermarket chain Asda, Wal-Mart is mulling an expansion of its British empire, setting its sites on Asda-rival Safeway U.K. A deal is far from certain, but Safeway, which is not affiliated with the U.S. supermarket chain of the same name, could offer Wal-Mart added revenues and help shore up its international operations.

"Europe has not been a home run" for Wal-Mart, notes Craig Johnson, chief executive officer of retail consultancy Customer Growth Partners. "They really need to goose up that thing."

No one is suggesting that a failure to acquire Safeway would mean the end of the world for Wal-Mart. Far from it. Even without Safeway, the company's international sales grew by about 10.5% in its 2002 fiscal year compared with its previous fiscal year. In the first nine months of its 2003 fiscal year, Wal-Mart's international sales grew by 16%.

But the international sales have been somewhat disappointing. The company has struggled to establish itself in Germany. Meanwhile, in fiscal year 2002, growth of its international sales trailed that of its domestic stores, even though the growth of the company's international store base far outpaced that of its domestic stores.

With the company trading at nearly 23 times its projected 2004 earnings -- compared to 13 times future earnings for rival Target (TGT) -- investors are clearly expecting the company to continue its rapid growth. That will likely have to come from outside the U.S. The company already operates more than 3,300 outlets domestically, including its discount stores, supercenters and wholesale clubs, and could soon reach a saturation point. Meanwhile, its same-store sales, which measure results at outlets open for more than one year, have begun to slow in recent months.

"They're going to need another growth avenue to maintain their EPS growth," said Bill Dreher, who covers Wal-Mart for W.R. Hambrecht. "That avenue is obviously going be international."

(W.R. Hambrecht does not have any investment banking business with Wal-Mart.)

Wal-Mart representatives were not available for comment. In a statement last month, the company said it was considering making an all-cash offer for Safeway.

The battle for Safeway U.K. began last month when the supermarket chain announced that it had agreed to be acquired by rival William Morrison. After the deal drew the interest of Wal-Mart, Tesco and other companies, Safeway withdrew its recommendation on the deal. Originally valued at about $4.5 billion, the all-stock deal has since dropped in value with the fall of Morrison's stock and is now worth about $3.7 billion.

Morrison made its bids formal at the end of last month, starting a regulatory clock. Safeway has until this Friday to accept the offer and if it accepts, the companies have some 60 days to complete the deal.

Market watchers expect Wal-Mart and several other companies, including U.K. supermarket rivals Tesco and Sainsbury, to submit competing bids before Safeway and Morrison can complete their deal.

For Wal-Mart, an acquisition of Safeway would allow it to jump from being the third-biggest player in the U.K. grocery market to potentially the biggest. Depending on how many stores it would have to sell off to satisfy antitrust concerns, Wal-Mart could claim more than 25% of the British grocery market after the acquisition.

Even more important, the company could secure new locations in a country where new retail space can be hard to come by, analysts say. Such an acquisition could be the best way for Wal-Mart to expand in Britain, they say.

"It's a densely inhabited country," noted Mark Miller of William Blair. "Taking market share through same-store sales growth has its limitations. To have a serious shot at being the market leader long term, they have to be part of this process." Miller's company has no banking relationship with Wal-Mart.

Wal-Mart can be expected to fight for Safeway if only to prevent its competitors from acquiring it, analysts say. Were Morrison to gain hold of Safeway, for instance, Wal-Mart's Asda would drop from being the third-biggest British grocery chain to the fourth biggest.

"I think it was something that Wal-Mart couldn't avoid getting involved with," said Patrick McKeever of SunTrust Robinson Humphrey. "They wouldn't want to sit on the sidelines and watch as someone else scooped up Safeway."

(SunTrust Robinson Humphrey does not have any investment banking business with Wal-Mart.)

Although Wal-Mart is the odds-on favorite among British bettors to win Safeway, a deal is not certain. British consumer advocates have already come out in favor of Morrison's bid. Meanwhile, Wal-Mart has yet to even submit an offer.

Because of the large market share it would hold after a merger, Wal-Mart could be forced to sell off a significant number of its Safeway or Asda stores. Johnson, for instance, estimates that Wal-Mart may have to unload 50 to 100 of Safeway's 480 stores. Even if the company has to sell off that many stores, the deal would still be a boon to Safeway, Johnson said.

"It still would dramatically increase their distribution. It will be a nice little leg up," he said.

But Dreher disagreed, saying that selling a significant number of stores could be a deal killer.

"I still don't think it's a likely scenario. I don't think Wal-Mart's going to be able to hold on to enough of the Safeway chain that it makes sense to them," he said.

Even if Wal-Mart is able to overcome regulatory resistance, some question whether a further investment in the British market is the best use of the company's cash. Like other European countries, Britain's economy and population are going to be growing slowly in the future, noted Richard Hastings, chief retail economist at credit-rating firm Bernard Sands. Wal-Mart should be focusing on Asian countries such as India and China that will have huge growth in the next 10 to 15 years, Hastings argued.

"I don't understand why they are interested in Britain," he said. "I think they are wasting their money."

But other analysts say Britain represents a safe bet. The country's consumers have already bought into Wal-Mart's "every day low price" strategy. In contrast, other countries represent a higher risk, analysts say.

"Here is a country that has a lot of similarity to the U.S.," said Miller. "They have a highly successful organization that's already in place. This is a natural opportunity for them to pursue."

Meanwhile, Wal-Mart generated about $10 billion in operating cash flow last year and the company needs to find somewhere to invest its money, Johnson said. A company that made about $245 million in net income on about $15 billion in sales in its 2002 fiscal year, Safeway is not a bad bet, he said.

"Those properties don't come on the market (often)," he said. "This is an opportunistic thing."