With supermarkets in Australia raking in the cash there has been almost constant speculation that the money is burning holes in their pockets and a rash of acquisitions is imminent. Analysts are keen to see Woolworths bid for Foodland, but is it just a pipe dream? David Robertson investigates from down under.

Woolworths, the largest supermarket chain, is the obvious candidate as the number two chain, Coles, probably has sufficient internal organisational issues to deal with right now without buying in new problems.

Woollies under pressure to purchase

What merchant bankers would like to see is Woolworths using its goodwill in the stock market, enormous cash flow and rapidly growing profits to buy something (anything would do as long as there are healthy commissions to be had).

But despite having the means to make acquisitions there has been very little corporate activity in the retail sector for several years. Franklins, the third-placed chain, fell apart two years ago but that turned into a fire sale with small bits of the company going to lots of buyers.

Foodland speculation – much ado about nothing?

Nobody has made a really impressive, market-grabbing bid for years, which is why all eyes are on Woolworths’ relationship with the new third-placed chain Foodland. Some retail analysts approach the possibility of a Foodland bid by Woolworths like kids making a request to Father Christmas: they are wishing really, really hard but don’t want to say too much in case it doesn’t come true.

Foodland is turning into a remarkably successful stock in a very competitive market. It is based in West Australia, where it has about a 27% market share and 100% of the grocery wholesale business. It also has 42 stores in Queensland and northern New South Wales, which were bought from Franklins and trade under the Action brand. In New Zealand the company has a 45% market share after buying Woolworths NZ (no relation to Woolworths Australia) for NZ$690m (US$387.8m) last year. It also has 71 Farmers non-food department stores.

In the six months to the end of December Foodland’s sales rose 50.5% to A$3.22bn (US$2.0bn) compared with the same period in 2001. Pre-tax earnings were up 49.2% to $144m, although obviously the NZ acquisition had a large impact on these gains. The results were enough to convince analysts to upgrade results: UBS Warburg increased 2003 fiscal earnings by 6.5% to $122m and JP Morgan increased its full year forecast by 6.3% to $134.3m.

Time of consolidation needed now

But having built the company up so quickly in the last couple of years it appears that management has decided a period of consolidation is now required. Executive incentives have been changed so rewards are no longer based on improving earnings but, instead, on improvements in capital return i.e. bonuses will depend on making the company more efficient.

And there appears to be plenty of slack to take out of the company. According to JB Were, Foodland’s inventory management is poorer than its rivals and it needs to cut warehouse stocks. The broker said that in January Foodland had 32.9 days worth of stock compared with Woolworths’ 28.6 days of stock and Coles’ 25.7 days.

Action needs radical overhaul

Action supermarkets also needs a radical overhaul: there was, after all, a reason that Franklins was failing and merely changing the stores’ names will not cure the problems. Earnings from Action fell 12.1% to $15.3m in the six months to the end of December despite a 22.9% increase in sales to $592.2m.

The stores are, according to Foodland’s rivals, run down and have a poor distribution system; Foodland chief executive Trevor Coates also believes that his stores are suffering because of Woolworths’ anti-competitive practices. Woolies has a 45% market share in Queensland, which Coates recently described as “ridiculous”.

“Mischievous and dangerous”

Coates complained that there were some “clear examples of a very large operator using their size” to rock Action. Roger Corbett, the chief executive of Woolworths, fired back saying: “It’s the type of nonsense statement, not based on fact, that is mischievous and dangerous. They’re silly comments to make. What does he suggest we do? Increase prices and charge our Queensland customers more?”

Were they flirting?

Foodland also needs time off to concentrate on getting its expanded NZ business right. So far Progressive, as the division is called, has exceeded expectations with forecast synergies this year of $24m compared with initial estimates of $10m. But Farmers, which could fairly be described as a second-rate department store chain, continues to be a headache with unreliable earnings and analysts expect Foodland to sell it.

So, while Foodland gets its house in order, is Woolworths waiting to pounce?

There is no doubt that Woolworths could afford it, in fact Woolworths could just about buy Foodland from the petty cash tin. Foodland would give Woollies access to the New Zealand market and consolidate its position in WA and Queensland. But the competition regulator would almost certainly savage any bid with so many conditions that it seems unlikely that Woolworths will bother in the short or medium term.

One analyst did note, however, that if a foreign buyer were to enter the Australian market through a bid for Foodland, which might make sense for somebody like Tesco (a former Woolworths suitor), Woolworths would almost certainly counter bid to protect its market-leading position.

In the meantime, Foodland will focus on improving what it currently owns and further acquisitions seem unlikely, which will continue to disappoint Australia’s merchant banking community.