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British Grocer Land Spinoffs Seen Fraught With Risk: Real Estate

Real estate held by some of the U.K.’s biggest supermarket chains is attracting private-equity firms and hedge funds after a 35 percent gain over five years made the stores worth more than the companies that run them.

Activist investor Elliott Management Corp. wants Wm Morrison Supermarket Plc to create a separate company for its real estate, saying it would immediately lift the shares. Elliott last month told Morrison that if Morrison announced a spinoff of most of its real estate, the stock could rise by 45 percent the same day, two people familiar with the matter said.

Elliott “has the right idea,” said property entrepreneur Robert Tchenguiz, who in 2007 tried to persuade J Sainsbury Plc to spin off its real estate. “The markets didn’t listen to me, but they might listen to them. It’s for the benefit of all the shareholders.”

Britain’s big grocers are sitting on buildings and land that are worth more than the stock-market value of the companies and they’re coming under pressure to increase shareholder returns after trailing other parts of the retail market last year. Supermarket shareholders are only realizing about half the potential value of the real estate held by the companies, Tchenguiz said.

A fund backed by the Persian Gulf state of Qatar had offered to buy Sainsbury for more than 10 billion pounds ($17 billion after Tchenguiz, 53, pushed for the company to realize the value of its real estate. At the time, he controlled 10 percent of Sainsbury, the U.K.’s third-biggest grocer.

Failed Bid

While neither the bid by Delta (Two) Ltd. nor Tchenguiz’s intervention was successful, they did push Sainsbury shares to a peak of 600 pence in July 2007. They’ve since fallen 42 percent, while Morrison has lost 26 percent of its market value.

Tchenguiz, who was brought up in Tehran, has also owned a stake in pub owner Mitchells & Butlers Plc. He and his brother, Vincent, considered taking over department-store operator Selfridges Plc in 2003 and were worth a combined 850 million pounds in 2007, according to the Sunday Times Rich List of the wealthiest people in England. That was the last time Robert appeared in the list.

Both Sainsbury and Tesco Plc, in which Elliott also owns shares, would benefit from a similar separation of real estate, according to the people, who asked not to be identified because the information is private.

Representatives of Tesco and Sainsbury declined to comment on Elliott’s analysis. An Elliot spokesman also declined to comment.

Strategic Review

Under a plan outlined by New York-based Elliot, Morrison would place about 75 percent of its freehold properties into a separate company and list 25 percent of it, the people said. Morrison said it doesn’t plan to own less than 80 percent of its real estate assets, which could free up 800 million pounds to 900 million pounds, a person with knowledge of the matter said.

In September, the supermarket operator announced a review of its financial strategy, including unlocking cash from its stores, 90 percent of which are owned outright by the company. It hasn’t yet announced the result of the review.

The company’s outlets, which tend to be the smallest among the big supermarket chains, should become “more attractive assets as they prove more optimal for local food needs,” Mike Dennis, an analyst at Cantor Fitzgerald LP, wrote in a Jan. 13 note to clients. “They may now be the best positioned in the market.” Dennis has a buy rating on the stock.

Declining Sales

Morrison’s share of the increasingly polarized U.K. grocery market is declining as shoppers defect to discounters, upmarket stores, online grocers and convenience stores. The company started its Internet grocery service last month and will double the number of convenience stores to 200 by the end of the year, as Chief Executive Officer Dalton Philips tries to reverse seven quarters of falling sales.

Morrison’s market share fell to 11.3 percent from 11.8 percent in the 12 weeks to Feb. 2, researcher Kantar Worldpanel said Feb. 11. Its main rivals, Tesco Plc and Wal-Mart Stores Inc.’s Asda unit, also lost sales over that period as the overall grocery market expanded at the slowest pace in nine years, Kantar said.

The average value of the real estate through September was close to the highest in six years, according to an index compiled by Investment Property Databank Ltd. That’s after values climbed about 35 percent since the market’s last low-point in March 2009.

Founding Family

Morrison estimates the value of its property at 9 billion pounds. That compares with a market value of about 5.6 billion pounds.

The founding family has so far been unable to find a buyout partner because of concern about Morrison’s slow sales growth and the size of the deal, said two of the people familiar with the matter, who asked not to be named.

Tesco, the U.K.’s biggest supermarket operator, owns about 70 percent of its stores, which have a total value of about 38 billion pounds. That compares with Tesco’s market value of about 27 billion pounds. Sainsbury owns 62 percent of its property assets, valued at about 11.8 billion pounds. Its market value is 6.6 billion pounds.

Morrison could do a sale-and-leaseback deal through a single transaction or a series of sales, Ben Jones, a fund manager at M&G Secured Property Income Fund, said in an interview. “It’s something we’ll have a look at, being probably the largest owner of supermarkets in the U.K.”

‘Risky Plan’

There are also reasons for the supermarkets and their investors to avoid selling their real estate on a large scale right now. A big sale-and-leaseback deal would load up the trading company with long-term rent commitments that aren’t on their books now.

Even the plan favored by Elliot, in which Morrison would in effect become its own landlord by controlling the property company created to hold the assets, is too risky, said Richard Marwood, who helps manage 700 billion euros for Axa Investment Managers in London and holds shares in all the U.K. grocers.

“We can see there is value in the property assets of these companies, but separating the operational and property companies would make the operational part more volatile,” he said. “Even some clever structure where you split the business in half brings risks with it.”

Canadian Precedent

That model was tried by Canadian grocer Loblaw Cos. last year. Loblaw shares rose 14 percent on Dec. 6, 2012, when the company announced it was spinning off properties into a real estate investment trust. Loblaw retained a stake in the company, Choice Properties REIT, after selling shares in July. The stock has since gained 4.5 percent.

The U.K. grocery market is more competitive than Canada, so it doesn’t lend itself to a similar arrangement, according to Exane BNP Paribas analyst John Kershaw.

“As a single-user asset with lower alternative-use values, stores are only really worth the cash flows of the occupant operator,” he wrote in Jan. 26 note. “Presently these cash flows are pressured, and operating margins are thin, so a retail fix is first required before credibly trying to showcase property value.”

Estimated property values for the big grocers are inflated because they are based on unrealistic rent expectations, Exane BNP Paribas analysts including Andrew Gwynn said in a note to clients. Sainsbury’s valuation is based on rents that are twice as high as the company would reasonably pay, they said.

Unwelcome Interest

While some may refer to the grocers’ real estate as their jewel in the crown, Michael Lister, a lecturer at University of Westminster and a former head of U.K. property lending at Bank of Ireland Plc., said the assets could also attract unwelcome interest.

“For Morrison and Sainsbury, the holding of property also makes them susceptible to a takeover for asset stripping,” he said. “Less so with Tesco, as they are so big.”

Supermarkets are appealing to investors because of the length of leases and the locations, Jones said. Insurers and pension funds are seeking to buy properties rented for 20 to 30 years to supermarkets because they need assets that match their future liabilities, he said.

“Clearly there’s interest from investors who want long-term income and can find very cheap cost of funds,” Lister said. That means buildings occupied by established tenants are “very attractive,” he said.

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