The on-again, off-again sale of Albertsons has given retail analysts pause for thought. In the age of deep discounts yet selective extravagance, what must a midmarket grocer do to prosper? David Robertson investigates.

When Albertsons, the second largest supermarket chain in the USA, put itself up for sale last year it was called a once in a lifetime buying opportunity, but days before Christmas, and hours before a US$9.6bn takeover was announced, the deal collapsed.

The company’s decision to walk away from talks at such a late stage has angered some shareholders and baffled many analysts, who were hoping their Christmas stockings would contain a lucrative way out of this uninspiring stock. But Santa Claus appears to have skipped Wall Street and the deal remains off, leaving the US retail sector asking what happens next.

Albertsons, which operates more than 2,500 stores across the US under brands such as Acme, Max Foods, Osco Drug and Shaw’s, decided to open itself to offers in September last year after years of stagnant sales and falling profits.

The company’s third-quarter results for 2005 – the most recent available – revealed just how troubled the supermarket chain was. Net income dropped to $77m (on revenue of nearly $10bn) from $110m in the same period the year before and like for like sales fell 0.4%.

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Five bidders are believed to have expressed an initial interest in Albertsons, including Kroger, the largest supermarket chain in the US. (Analysts think Kroger may simply have been taking an opportunity to snoop over its rival’s books.) Other bidders are thought to have included private equity firms Kohlberg Kravis Roberts, Thomas H. Lee Partners and the Yucaipa Companies.

In the end, however, it was a consortium of retailers and financiers that sat down with Albertsons days before Christmas to thrash out a deal.

Supervalu, a smallish supermarket chain, would acquire 1,100 stores in exchange for stock and Albertsons’ debt. CVS, a drugstore chain, would take Albertsons’ 700 standalone drug outlets for about $4bn in cash.

Finally, Cerberus Capital (Cerberus being the multi-headed dog that guarded Hades in ancient myth) and Kimco Realty, a retail real estate investment trust, put up $3.5bn to take on 700 poorly performing stores.

Under the Cerberus/Kimco plan most of these stores would have been sold as real estate, which seems a sad end for one of the giants of the supermarket industry – Cerberus Capital really does appear to have been welcoming Albertsons into corporate hell.

But at the 11th hour, the deal collapsed. The press releases had been written and were ready to be issued and CVS had invited analysts to a conference call to discuss the deal.

Albertsons walked away, claiming that it could no longer accept the bid, which was valued at $26 a share (about a 25% premium on its pre-auction share price).

In the days that followed there was feverish anticipation on Wall Street as deal makers insisted that this was simply a negotiating ploy by Albertsons and the package would be increased to $27 a share and everyone would still make their end-of-year bonuses.

However, with every day that passes a new deal looks less and less likely and the food industry is beginning to ask what Albertsons will do now.

Albertsons’ problem is similar to that faced by a number of large retailers around the world. If we assume that the typical Albertsons consumer is a harassed mother pushing a shopping trolley the size of her SUV around the store on the weekly shop, this consumer can now go to Wal-Mart and be equally harassed but pay prices that may be a third less.

On the nights when the kids are sleeping over someplace else, our previously price-conscious consumer can eat out or go to one of the burgeoning high-end stores to splash-out on foods with labels containing words like “organic”, “bed of fennel” and “au jus”.

This pattern of consumption has been dubbed “selective extravagance” and it is the same phenomenon that sees people who think France is part of the axis of evil buying Louis Vuitton bags. Like so many mid-market retailers, Albertsons is being squeezed on price by the big discounters and it is also losing out to specialist stores at the top end.

Wal-Mart in particular has hurt the traditional supermarket chains on core product ranges. In the 1990s Wal-Mart began offering a wider variety of fresh-food products and by 2001 it had overtaken Kroger as the largest food retailer in America with food sales of $109bn – compared to Kroger’s $56bn and Albertsons’ $39bn.

The supermarkets have tried a number of strategies to fight back including consolidation, store revamps and heavy promotions – but Wal-Mart continues to dominate.

Albertsons eventually ran out of ideas and put itself up for sale – and even that failed to work out. Albertsons is now hinting that it will break itself up in exactly the same way the Supervalu consortium proposed: selling the drugstores and poorly performing stores.

If Albertsons does downsize and concentrate on the profitable stores some analysts believe Albertsons could prosper. John Chen, an analyst at Cathay Financial, said: “We foresee the “new” Albertsons, one that is composed of only the “good” grocery segment of the old Albertsons, as a potentially stronger competitor that will have the flexibility to be more proactive in protecting its market share from “big box” competitors. We envision the “new” Albertsons having the ability to gradually move up-market to a more affluent customer base… offering higher-margin, higher-quality products such as organic foods and in the process, differentiating itself and somewhat insulating itself from the Wal-Marts and Targets that target the more cost-conscious consumer.”

Is this, then, the future of food retailing: traditional supermarkets downsizing so they can move up-market?

Frank Dell, president of retail analysts Dellmart & Company, doesn’t think so: “Mid-market supermarkets can do well if they have the right strategy. Wegmans, HE Butt, Ukrops, Hy-Vee Publix and Schnuck’s are all examples of mid-market retailers doing well. So they can grow, but only with the proper consumer focus.”

Albertsons’ problem has been that it has failed to develop the sort of strategies that would allow it to prosper in the mid-market. And now its management wants to sell the crown jewels (the drug stores) and a vast number of other stores (essentially for their real estate value) to go upmarket.

Frank Dell is not impressed: “Selling off the poorly performing units is admitting that management has been unable to fix the problem. And with the baby boomers reaching old age, the need for maintenance drugs makes the drug division more valuable [than ever].”

Having failed to survive in the mid-market, Albertsons’ management wants to move the company into an increasingly crowded top-end. This would require radical surgery when, perhaps, another doctor might be able to make an alternative medicine work.

BREAKING NEWS: Albertsons has agreed to be sold and broken into three divisions. The buyer is an investor group that includes Supervalu, drugstore chain CVS, Cerberus and Kimco. Keep an eye on our news pages for further updates.