Why Sainsbury Looks Tasty

A possible deal between the British supermarket chain and private equity groups is helping its stock price jump

Shares in British supermarket group J. Sainsbury hit an eight-year high on Feb. 2, as private equity groups Blackstone Group, Kohlberg Kravis Roberts, and CVC Capital Partners confirmed they are considering a takeover bid. The stock price rocketed by 18%, to $9.97 a share, giving the group a market value of more than $17 billion.

In a joint statement, the private equity firms noted that "no decision has been made regarding the relative merits of an offer and as a consequence there can be no assurance that any offer for Sainsbury will be forthcoming." Sainsbury confirms that it has been contacted by the private equity consortium but says it hasn't received any proposal and has no further comment.

If completed, the deal is likely to be Europe's biggest private equity buyout, with an expected price tag of as much as $20 billion, surpassing last year's $15.3 billion acquisition of Danish telecom giant TDC, says market research firm Dealogic.

Founded as a small dairy shop in London 138 years ago,Sainsbury developed a reputation for quality products at low prices—a strategy that eventually made it Britain's biggest supermarket. In 1995 its crown was usurped by Tesco, which aggressively chased Sainsbury on price and quality.

Slow to respond to the challenge, Sainsbury fell into third place behind Wal-Mart's (WMT) Asda in 2003. "Sainsbury was too complacent," says Bryan Roberts, retail analyst at market research firm Planet Retail in London. "The company's tag line at the time was "good food costs less at Sainsbury's," but a more accurate one might have been "average food costs more."

Surging Revenues

No longer. Things have looked up since CEO Justin King came on board two years ago, and the company's share price has risen nearly 50% percent in the past year.

Under King, the company has introduced new food ranges, slashed prices, and refurbished many of its 769 stores. The revival has led to eight quarters of increasing same-store revenues. For the fiscal year ending Mar. 25, 2006, Sainsbury posted operating profits of $450 million on revenues of $32 billion.

Sainsbury's share of the $236 billion British grocery market grew to 16.4% from 16.2% a year earlier, according to London market research outfit Taylor Nelson Sofres. That puts Sainsbury neck and neck with Asda, which has 16.6% of the market compared with Tesco's 31.4% share, for the No. 2 slot.

Sainsbury isn't the usual private equity turnaround play. Indeed, the timing seems odd, now that its fortunes have improved and shareholders are upbeat about the company's future. The big attraction, analysts reckon, is the company's strong cash flow and $14.8 billion property portfolio, the sale and lease-back of which could be used to finance a potential bid.

Some analysts, however, are skeptical. They point out that supermarkets usually prefer to own their properties. The alternative—paying often exorbitant rents—makes it harder to keep costs under control and so offer lower prices to customers.

Risky Business?

Some analysts point out that for a private equity buyer, the deal is risky. Britain's Competition Commission is likely to limit any piecemeal sale of stores and prevent a full purchase by any of the existing major British supermarket chains.

That means any buyer looking for an exit will be forced to sell to either a U.S. or European retailer. Even experienced non-British players might find it challenging to wring growth out of such a crowded and mature grocery market, says Ching Mei Chia, associate director at Fitch Ratings. "Approaching the checkout till, the main unknown for a takeover bid by private equity houses for a supermarket chain such as Sainsbury would be the near-term exit strategy," she notes.

The Sainsbury family's stake in the company has long been seen as a possible obstacle to any takeover. So when the family cut its stake to 13.9% from 16% on Jan. 31, takeover speculation increased.

For the private equity firms, the deal's success hinges on convincing shareholders, especially the Sainsbury family, to sell a business that is finally showing signs of growth again. And with Sainsbury trading at a pricey 32 times 2007 earnings, compared with 19 times for Tesco, a deal won't come cheap. But with private equity funds awash in cash, price isn't likely to be a dealbreaker.

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