Somerfield in talks with Kwik Save on pounds 1.2bn merger deal

The consolidation of the supermarket sector took a dramatic step yesterday when Somerfield and Kwik Save announced they were in talks that could lead to a pounds 1.2bn merger. The deal would bring together two of the weakest players in Britain's cut-throat food retail sector which is increasingly dominated by the likes of Tesco, Sainsbury and Safeway.

Both Somerfield and Kwik Save have been struggling to maintain sales and market share in the face of increased competition from both the "Big Four" supermarkets and the low price continental discounters such as Aldi and Netto. Kwik Save in particular has been plagued by falling sales, a weak brand and a poor store portfolio.

A combined Somerfield and Safeway would be Britain's fifth largest supermarket group with 1,400 stores and combined sales of pounds 6bn. The new group would account for 7 per cent of the UK grocery market, behind Tesco, Sainsbury, Asda and Safeway. It is therefore considered unlikely that the deal would run into regulatory problems. Somerfield is thought to envisage substantial benefits in increased buying power and reduced costs.

The City was unimpressed with the prospect of a merged Somerfield and Kwik Save saying it would only delay the problems of the two groups. "There may be some short-term benefits but the longer term growth potential is still difficult to identify," said Frank Davidson, food retail analyst at ABN Amro.

Paul Smiddy at Credit Lyonnais Laing said: "I am not overwhelmed by the logic of it. It seems to indicate that neither company can finder a bidder." Another said the deal would still be a distant and very weak fifth behind the big players. "I know there are a lot of global mergers going on at the moment," one analyst said. "But this really is nothing more than a tiny pimple by comparison."

The announcement follows constant speculation that Asda and Safeway are still considering a deal after news of proposed merger talks between the two leaked last September. That deal foundered on regulatory concerns.

A merged Somerfield and Kwik Save is unlikely to trouble the big players unless it starts undercutting significantly on price. But it will increase the pressure on other "second tier" supermarket groups such as Iceland, Morrisons and the Co-op.

It is thought that the catalyst behind the talks were the major shareholders in Kwik Save, which include Dairy Farm and the fund management group PDFM. Both have been concerned about the performance of their investment as Kwik Save shares have slumped from 843p to 307.5p since 1993. Talks between the two companies started late last year.

The deal is certain to lead to store closures and job losses. There is thought to be a store overlap of around 200 outlets which may be closed. One head office is also likely to close with further cuts in distribution and administration. Analysts estimated that the cost-cuts could yield savings of pounds 50m-pounds 100m.

It is not yet clear whether both trading formats would be retained though it is thought that Somerfield will be the dominant partner with some Kwik Save stores being rebranded. It is possible that Kwik Save name would be retained as a discount offer together with Somerfield's Food Giant stores which compete at the lower price end of the market.

Though announced as a "nil premium" deal it is clear that Somerfield would be the dominant partner. David Simons, Somerfield's chief executive, is likely to head the enlarged group as Kwik Save's chief executive Graeme Bowler has already announced his intention to step down in August.

If the merger is structured as a "newco" - which would take over both groups - it would trigger significant share options pay-outs to Somerfield directors. At the current share price, Mr Simons is holding paper profits of pounds 970,000 on his 869,000 options. He also holds 1.1m options under a long-term incentive plan.

Kwik Save has been a disastrous performer in recent years. In November it announced an 18 per cent fall in profits to pounds 74m and a six per cent fall in like for like sales. It has spent millions of consultancy fees to Arthur Andersen and has been looking to roll-out its "New Generation" stores with better store lay-outs and lighting as well as more own-brand ranges. It has also been closing some of its worst-performing stores.

Somerfield shares have done well since the former Gateway business struggled on to the stock market in August 1996. But it, too, has found difficulties in increasing sales and has been closing around 30 stores a year.

Outlook, page 21