Consumer

Andrea Felsted is a Bloomberg Gadfly columnist covering the consumer and retail industries. She previously worked at the Financial Times.

Chris Hughes is a Bloomberg Gadfly columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.

It's time for Wal-Mart to cut Asda's apron strings.

The U.S. retail giant has struggled with the U.K. supermarket it bought for 6.7 billion pounds ($8.9 billion) in 1999. A sale to a private equity firm would make sense -- but might need some concessions from Wal-Mart to make it happen.

Losers and Losers
The big U.K. grocers have had a terrible five years amid a vicious price war
Source: Bloomberg

The U.K. grocery sector has become viciously competitive in recent years thanks to the rise of the German no-frills supermarkets Aldi and Lidl. Asda has been particularly hard hit: its appeal was always low prices. With that diminishing, it has had little to fall back on. Same-store sales shrank by a record 7.5 percent in the second quarter, the company said last week.

Asda Priced Out
The supermarket's sales have been battered by intense competition
Source: Bloomberg, company reports

Asda's problems aren't just price. The discounters typically sell only about 1,500 lines in a given store -- less than 5 percent of a traditional supermarket. Asda needs to be as cheap as possible in these products, but can charge more for the rest. Customers will pay for a broader range, perceived higher quality and a better shopping experience. Asda's challenge is to deliver all three.

Underperforming Asda
Asda's sales growth has trailed the supermarket's three big rivals
Source: Kantar Worldpanel
Note: January 2016 includes two readings: one for Jan. 3 and another for Jan. 31.

Wal-Mart seems to know where it's gone wrong. The company says it wants to add a "great experience" to its traditional offering of price and variety.

A new CEO, Sean Clarke, has just started at Asda and is focusing on increasing its market share rather than protecting profit. Selling is probably the last thing on his and Wal-Mart's mind.

The snag is that fixing the business will take a long time and involve considerable investment. Even a successful turnaround would barely register in Wal-Mart's accounts: Asda is estimated to have accounted for 8 percent of sales in 2014, the last figures available for the U.K. arm. That portion could shrink further as Wal-Mart's domestic business recovers.

So a sale of Asda would make sense, if only a buyer could be found.

A U.K. grocer probably wouldn't be tempted. Morrison has too many stores in the north of England that would overlap. Tesco's 28 percent market share makes it a non-starter. It's true that a Sainsbury-Asda combination would be a neat geographical fit. But Sainsbury's recent acquisition of Argos would create antitrust obstacles in the non-food business.

A bid from overseas is possible. Retail billionaire Christo Wiese has in the past hinted that he could be interested in British supermarkets. Brait, the investment vehicle he backs, owns 57 percent of frozen-food retailer Iceland. But it's hard to identify a foreign buyer that really needs to enter the U.K.

That leaves private equity -- flush with funds, short of targets and generally keen on turnaround opportunities. An overhauled Asda could be returned to public markets after five years or so.

There are two financial obstacles to a leveraged buyout. Firstly, Asda would be a very big target. Sales in 2014 were 23 billion pounds. Even assuming a 5 percent fall in 2015 and 2016, revenue would be some 21 billion pounds. Asda's three big U.K. peers are valued at about 40 percent of their estimated sales for the next 12 months. That implies Asda has an enterprise value of 7.5 billion pounds. Add an acquisition premium and that would push the figure to more than 8 billion pounds.

Secondly, it looks hard to load up Asda with debt. The last accounts show cash used for investment was 1 billion pounds, against operating cashflow of 1.3 billion pounds. Since then, operating cashflow is likely to have fallen, suggesting even less cash would be available to cover interest payments.

Yet a club deal could address the size issue. One option would be a sale and leaseback of Asda's property in partnership with a real-estate specialist. And the financing snag may not be as big as it seems given Asda was spending heavily to develop its online presence two years ago. Lowly geared Wal-Mart could afford to finance the buyer, or keep a stake to share in the upside.

The risk is that Asda isn't a big enough problem to force Wal-Mart to make a decision today, and the parent lets it drift past the sell-by date for any deal.

--With assistance from Shelly Banjo.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the authors of this story:
Andrea Felsted in London at afelsted@bloomberg.net
Chris Hughes in London at chughes89@bloomberg.net

To contact the editor responsible for this story:
Edward Evans at eevans3@bloomberg.net