The global repercussions of the terrible events that occurred in the US on September 11 are still becoming apparent. As financial minds attempt to quantify the likelihood of a global recession in the face of lower consumer confidence in the US and elsewhere, supermarket credits have again taken up the mantle and offered investors a defensive option. Vivek Ahuja reports.
Whether consumer spending is at a high or a low, "everyone has to eat", as the saying goes among bankers. For that reason, supermarket credits have been seen as a defensive sector that offers stability during periods of market volatility or depression.
Of course, the sector is not entirely resistant to negative economic data. However, in a depressed economic environment food remains vital, making it one of the last sectors to be affected by reduced consumer spending. As a result, supermarket bond spreads, while generally moving in line with spreads across the market, are less volatile than other sectors and investors appreciate the protection that affords.
During the past couple of years, supermarkets have endured pressure on margins, which have been hit by several factors, not least greater competition in mature European markets. But to some extent, the sector has proved its resilience to adverse events, such as the recent foot and mouth crisis in the UK and Europe. Customers, like investors, embark on a flight to quality in times of trouble, and health concerns arising from the foot and mouth outbreak, for example, have driven shoppers to buy better grade products rather than cheaper alternatives.
"Market growth has been extremely strong this year, although that should present a greater challenge going forward," says Richard Chadwick, director of corporate finance at Sainsbury's (A2/A). "There has been a trade up to quality, helped partly by the foot and mouth crisis. Also, in the initial phases of an economic downturn, people eat out less often, which means they shop for more food and that is mildly positive for us."
In the UK, event risk remains, as ever, a concern, although market players have weathered the worst of the storm in that respect. Safeway (A3/BBB+), for example, was a financially viable target for takeover a couple of years ago, and at one point its share price touched a low of £1.50. The question then was whether the company represented a good buying opportunity for either a strategic buyer or a private equity firm. No strategic purchasers came forward, and in the meantime Safeway's share price has recovered, effectively pricing out the possibility of a buy-out by a private equity house.
The UK market is largely mature and nowadays the focus is on expansion overseas, predominantly in Eastern Europe and Asia Pacific. Globally, the sector still bears a degree of event risk, although that is lower than in other sectors as food is a basic commodity that will never become obsolete.
However, while event risk is less of a worry than in the past, supermarkets seeking to expand overseas nevertheless face tangible planning risks when entering new markets, as success is linked to the economic make-up of those markets and the competition restrictions in place there.
"In a foreign country that has fairly liberal guidelines on competition, a company might become the first to gain a foothold, only to see its competitors allowed to enter the market and usurp custom," says Claudia Hopstein, a senior manager in fixed income credit research at HSBC.
There are also substantial integration and strategic risks involved in expanding overseas that must be weighed against the possible benefits of pioneering entry into a new market. This is particularly true in Asia and the Middle East, where understanding cultural differences is paramount for firms such as Tesco (Aa3/AA-), which sought to set up a business in Thailand, and Sainsbury's when it moved into Egypt. The latter has since wound down its operations in Egypt as part of a strategy to return focus to the domestic food retail market, although other sources have pointed to problems of cultural understanding as the reason.
Even within the generally stable and mature European market, there are examples of the pitfalls associated with cross-border acquisitions. When Wal-Mart Stores (Aa2/AA), the largest food retailer in the world, became the first foreign player to penetrate the German market with the acquisitions of Wertkauf in 1997 and Spar the following year, success was expected, but the move has proved problematic in reality.
"Wal-Mart has failed to gain substantial market share mainly because of the lack of understanding of the local market and underestimating the strength of existing discounters," said HSBC's Hopstein earlier this year. "Nevertheless, we can't dismiss Wal-Mart's potential impact on the market over the longer term."
Others believe the mistake lay in offering German customers an unfamiliar name. "While Wal-Mart is one of the most well known brand names in the supermarkets industry on a global basis," says one analyst, "that does not mean to say that its reputation is prominent in every market across the world."
While Wal-Mart still faces an uphill struggle to establish a successful operation in Germany, the US company appeared to have taken on board a valuable lesson when it acquired the UK's Asda in July 1999.
"The key to making Wal-Mart's first step into the UK market an effective one lay in keeping the Asda brand name," says Hopstein at HSBC. "Asda, while it has lagged behind Tesco and Sainsbury's in the UK, nevertheless enjoys a loyal customer base that knows and appreciates its name. Such customers may have been disillusioned and taken their business elsewhere, had the Asda brand disappeared from the map, and Wal-Mart on this occasion demonstrated sound business acumen."
Asda represents, therefore, a positive first step into the UK market for Wal-Mart, although bankers note that there is a caveat. While choosing not to replace the Asda brand name from the outset makes strategic sense on the one hand, the decision does raise the question of just how dedicated Wal-Mart is to the UK market, and specifically to Asda. Some market watchers have speculated that the more hands-off attitude Wal-Mart employs in the UK than that evident when the company targeted the German market is a sign that the US company is not entirely committed to Asda. Analysts suggest that it may sell off its interest and switch into another UK player with a greater market share.
Should such a move actually happen, it will not be in the near term, as Wal-Mart must show that it can make a success of its investments in both Germany and the UK before pursuing any further acquisitions. If it fails to demonstrate an ability to accommodate the needs and foibles of individual markets, the US firm risks damaging its reputation.
Focus on organic growth
It is equally unlikely that any of the top players in the UK market will indulge in acquisitional growth for the foreseeable future. Competition restrictions prevent any alliance between the major UK companies, while international expansion also seems to be off the agenda, while UK players concentrate on boosting top line figures through organic growth and the integration of past acquisitions. Omar Saeed, a rating analyst for UK and Dutch retail at Standard & Poor's (S&P), believes there are two reasons for this.
"On the one hand, it can be extremely difficult to get planning permission in Europe," says Saeed, "while margins are lower than in the UK. So for the UK players, the move into Europe is not that lucrative. But the high level of investment needed to realise a decent return in the UK make it extremely unlikely that any foreign players will seek to enter that market in the near term."
The UK sector has been largely benign for the last 18 months or so, disappointing widespread expectation that the arrival of Wal-Mart would spark a cost-cutting war within the market as Asda's new US parent flexed its financial might. But that is starting to happen now and several of the larger UK firms have announced price cuts in the last month.
Reduced prices, together with a declining underlying economy, have enhanced competition in the UK market. Analysts say that while the leading players, such as Tesco and Sainsbury's, will be able to cope with the price pressure, many smaller firms will be effectively priced out of the market.
At such a time, it seems that all market participants are focused on positioning their business and on organic growth, and to a large extent acquisitional expansion has been ruled out. Sainsbury's is only one year into its three year store refurbishment programme, and while the company has stressed that it can comfortably bear the costs of restructuring, that should become more difficult as competition intensifies in the UK. Sainsbury's has already said that it is wholly concentrating on organic growth for the time being.
Safeway, which has dedicated itself in the last two years to repairing its business and financial profile, is about to embark on phase two of its redevelopment strategy, which involves building new stores in the UK. That will require enough capex to ensure that the company does not pursue any acquisitional goals.
"The next six to 12 months will be crucial for Safeway as capex will start to rise now that the company has entered the next stage of redevelopment," says Stephanie Underhill, associate director in European fixed income research at Bear Stearns. "It has succeeded in turning business around since earlier problems and continues to post good results. That has not really shown on the bonds side as its outstanding issues are fairly illiquid."
While Safeway's programme is progressing well, the company has suffered from price pressure in recent times, which triggered a rating downgrade to BBB+ by S&P, and analysts do not rule out further cuts in the industry.
"Margins have also come under pressure at Sainsbury's," says Peter Din, a senior industrial analyst at Bank of America, "and that may lead to a downgrade later this year. While sales and volume growth have been strong, that should not be at the expense of margins. However, even if a company were to incur a one notch downgrade, that is unlikely to spark major selling of that company's bonds."
Tesco, the clear leader in the UK with sales for 2000-2001 of £22.8bn and operating cashflow of £1.9bn, has more financial flexibility than its domestic peers and has embarked on an ambitious expansionary strategy at the same time as building organic growth. The retailer has acquired a foothold in eastern Europe and Asia that yielded profits this year and the indications are that it is still prepared to consider further purchases. Further acquisitions will put pressure on the company's Aa3/AA rating and some analysts say that a high single-A rating is more in line with its business and financial profile. Moody's has already hinted that it may downgrade the credit if capex continues to outstrip cashflow.
In the last financial year, Tesco had free cashflow of some £1.3bn, while capex stood at £1.9bn. The bulk of this was raised through debt issuance off the company's EuroMTN programme.
"We still see a need to consider all forms of finance," says Keith Richardson, associate treasurer at Tesco. "There is huge demand for our debt right along the yield curve and in the secondary market our performance is almost second to none. We are an opportunistic borrower and we try to raise funds at the point in the curve where demand is strongest."
Tesco continues to impress
Unlike its rivals, Tesco has been able to generate organic growth in the UK, underpinning strong like for like sales figures with a healthy calendar for new store openings, which in turn will support sales as those stores mature. The company has posted consistently impressive figures for organic growth, adding more than one million square feet of space per year - a faster pace than any of its rivals. Such a performance has helped boost Tesco's lead in terms of domestic market share. (See graph on page 2)
On September 19, the company posted solid interim results. In the UK, sales were up 7.5%, including 3.9% like for like growth for Q2 2001 compared with 3.7% sales growth in Q1 2001. On the international front, total sales were 42% higher, while operating profit had risen by 67% to £15m, even after adverse currency fluctuations that restricted profits growth.
David McCarthy, an equity analyst at Schroder Salomon Smith Barney, shares Tesco management's belief that the company possesses the three attributes necessary to succeed overseas - scale, growth and capability.
"Tesco is increasingly using its international scale, particularly for non-food," says McCarthy. "Its strategy of heavy investment in a limited number of markets should ensure leadership in each country in which it operates, while its position in the UK can only be helped by its international scale and by the establishment of buying hubs in Asia and central Europe.
"Tesco also has the best organic growth of its major international competitors. By 2002, we forecast sales growth of 11.5% for Tesco, compared with just 7% forecast for [leading French retailer] Carrefour, and we believe the market is underestimating the strength of Tesco's underlying sales growth."
McCarthy sees long term profit growth as inherently driven by sales growth, and believes Tesco's strategy and comparative strengths in a highly competitive industry have made it "one of the world's best food retailers - if not the best".
Tesco's approach has meant that while other European players have found entry into the Asian market a bridge too far, Tesco has enjoyed greater success. Its business in Thailand has more than doubled in the two years since acquisition, and its 24 stores in the country form the backbone of its presence in the region, where sales amounted to £370m for the first half of 2001.
On the back of strong performance in Asia, Tesco launched a ¥50bn five year transaction in July at 19bp over the JGB, and that paper is still trading at around plus 20bp, outperforming better rated transactions launched soon afterwards at similar levels that are now around 10bp wider.
"The deal performed tremendously," says Tesco's Richardson. "It was entirely driven by demand and very little marketing was needed. Around 80% of the paper went to accounts in Tokyo, which was extremely pleasing. We are prepared to consider all forms of funding and that transaction opened another avenue for us. We were able to raise funds in yen at roughly the same cost as we would have paid in sterling."
In contrast, the UK's number two player J Sainsbury, with sales of £16.9bn, has chosen to focus on its core domestic food retail expertise. In line with that strategy, which was implemented by group CEO Sir Peter Davis on his appointment in March 2000, Sainsbury's sold off its Homebase DIY business that month and terminated its food retail operations in Egypt. At the same time, the company launched a three year programme of business transformation aimed at modernising infrastructure, delivering quality products and offering an improved shopping experience.
"Our focus for now is on getting our UK supermarkets right," says Chadwick at Sainsbury's. "We are not going to be aggressive in the UK market, although if there is consolidation activity, we would seek to participate. We would also consider small, bolt-on acquisition in the US.
"We are a UK and US company. The situation in Egypt was a distraction for management. To grow operations fast, we needed considerable capex, and when the political situation worsened in the Middle East, we decided to pull out sooner rather than later."
In June, Sainsbury's launched a dual tranche bond to refinance outstanding debt and to prefund capital spending needs for its transformation programme. Management expects capex for each of the next three years to be in the region of £1.1bn.
Aiming for broader appeal
Launched via joint bookrunners HSBC and Deutsche Bank, the transaction was initially intended to comprise a £200m-£250m 11 year tranche as well as a Eu750m seven year piece, the supermarket's first fundraising in the single currency. After a comprehensive roadshow around the UK and Europe at which Sainsbury's set out to explain its positive credit story and robust strategy, strong demand led to an oversubscribed book and the tranches were subsequently increased to £300m and Eu800m, respectively.
"Given that Europe was a new investor base that did not know Sainsbury's," Sainsbury's Chadwick told EUROWEEK at the time, "it was a matter of demonstrating Sainsbury's reputation for quality and value for money, and taking through our strategy for the next few years."
The debut euro tranche attracted a book in excess of Eu1bn, comprising orders from investors in 14 European countries as well as interest from Asia, the Middle East and US offshore accounts, while the sterling tranche drew an audience of more than 45 accounts, an extremely strong showing in the sterling market.
"As things stand, we do not expect to return to the bond markets for another year or so," says Chadwick, "but we may raise funds through small private placements should the need arise. We are trying to steer towards more regular, more opportunistic issuance in the future."
Strong premarketing for the transaction allowed Sainsbury's to establish a European footprint in the bond markets. It generated interest from a number of European accounts that have historically bought paper from more familiar, and larger, credits such as France's Carrefour (A1/A+), Koninklijke Ahold (Baa1/BBB+) of the Netherlands and Metro (Baa1/BBB+) in Germany, the world's three largest retailers behind Wal-Mart.
European food retailers, like their UK counterparts, have faced considerable difficulties during the last two years. The consolidation spree that encompassed the entire sector in 1999-2000 was prompted by a recognition that high levels of competition across Europe meant that scale of business and cost efficiency were paramount.
The merger with Spain's Promodès in 1999 created substantial potential cost savings for Carrefour, for example, and the market initially reacted positively to the news. However, by 2001 the pitfalls involved in integrating two such overlapping businesses have become apparent, and Carrefour may continue to lose market share for some time, particularly given the competition from speciality retailers in France. In spite of business difficulties, Carrefour remains a solid performer in the bond markets.
"Carrefour benefits from a strong following from French institutional investors that know the name," says Underhill at Bear Stearns. "It should continue to be a stable credit as further acquisitions are probably off the agenda after the problems with Promodès. The company will be mindful not to fall behind the competition, so it will focus on consolidating its domestic business rather than on overseas expansion."
Ahold, in contrast, has won praise for its foreign expansion strategy, which now sees 60% of the Dutch firm's sales and profits generated in the US. Ahold is also investing heavily in Argentina, but its sensible approach to international acquisitions has instilled confidence in the European investor base. Spreads on Ahold euro paper have ground in steadily this year and the company has been among the best performers in the European retail sector.
"Ahold has woken up to bondholder concerns," says Bank of America's Din. "Several debt financed acquisitions in the past saw the company's rating cut to high triple-B, but more recently the company has followed a trend of using equity to fund or part fund acquisitions, so there is less event risk for bond investors than there was a year ago."
Ahold's recent acquisitions of Bruno's and Foodservice in the US, as well as the purchase of Spain's Superdiplo, were all equity funded. The US acquisitions were part of a strategy to move into the higher margin foodservice sector, complementing its existing businesses and distribution channels in the US.
"Moving into food distribution shows that Ahold is developing vertically, and that is a sign of a strong long term business strategy," says S&P's Saeed. "Ahold is proof that foreign expansion can work as long as management is able to translate its experience to suit local markets." *
|Bookrunners of all international bonds by UK and European Supermarkets Ñ 2001 (September 28, 2001)|
|Rank||Lead manager||Amount Eu m||No of issues||Share %|
|7||Dresdner Kleinwort Wasserstein||450||2||3.75|
|10||Royal Bank of Scotland||281.54||2||2.35|
|Source: Dealogic Capital Data Bondware|