Basket case on road to recovery

Is the born-again Gateway chain on course for a historic turnaround? Patrick Hosking reports

IT WAS the leveraged buyout to end all leveraged buyouts. A chartered accountant with no direct experience in the grocery industry persuaded bankers to lend him pounds 2.5bn to buy one of Britain's biggest food retailers, the Gateway chain. He was bright and charming, and had a seemingly plausible plan to make himself and his backers a lot of money.

That was in 1989, the apotheosis of the big-dealing 1980s, when the banks were infected with a collective madness to throw money at any proposition, the bigger the better. Six years later, the accountant, David Smith, has long since moved on (he now runs Cannon Street Investments). But Gateway, after coming within a whisker of collapse, is still very much with us, although haunted by the ghost of that supremely optimistic deal.

Now renamed Somerfield Holdings, restructured, and ring-fenced from pounds 744m of former debt, it proudly announced flat pre-tax profits last week of pounds 33m. The message from its chief executive, David Simons, was of steady progress. Stores converted from the Gateway facia to Somerfield were showing an average 14 per cent increase in sales and fatter margins. The cash position was greatly improved. And the company was on target to float some time before 1998.

But Mr Simons' quiet confidence is not reflected in the price of the company's debt. The price of "strips" of debt - packages of senior debt, preference shares, and loan stock - in Isosceles, the parent of Somerfield, slipped by 2p to 39.5p. In other words, the market now expects Isosceles to repay only 39.5p in every pound it owes. Even Somerfield's own debt is "value-impaired", trading at 82p in the pound.

Jeff Summers at Klesch & Co, the secondary debt trader, reckons Mr Simons has done a good job in bringing Somerfield back from the brink, but the latest figures were disappointing. A year ago, Klesch calculated that a debt-free Somerfield would be worth pounds 630m to pounds 945m on flotation, depending on market conditions. Now it has lowered that range to between pounds 500m and pounds 800m.

Other analysts see a long way to go before Somerfield is ready for a stock market quote. Whereas the supermarket industry is enjoying 5 per cent growth in underlying sales, thanks mainly to food price inflation, Somerfield is achieving only 1-2 per cent. Many of its stores are shabby and lack scanning equipment. And Food Giant, its no-frills operation, has been badly mauled by other discounters.

Mr Simons explains that the poor sales growth is because of a summer "pause" in the store modernisation programme and the ending of a "silly" price promotion on cigarettes. Smaller outlets do not justify the expense of scanning equipment, he says. And Food Giant was a defensive response to the discounters and is not a central plank of the Somerfield business.

Since he left the Storehouse group, where he was finance director, three years ago, Mr Simons is credited with starting to turn round what many have seen as the basket case of the supermarket sector. He introduced much keener prices through the Price Check campaign. Mushrooming costs are now firmly under control. And the group's once notorious shrinkage - wastage and theft - has been slashed. A loyalty card is now being piloted, and Mr Simons expects to roll it out within three months.

He and his fellow executive directors are spurred on by the ultimate incentive. Their bonus is linked to the exit value of Somerfield. If it were to fetch pounds 1.8bn on flotation, they would collect pounds 50m. They would need an incredible turnaround for that. But even a much more attainable pounds 300m would net them pounds 1m.

However, even this modest target will be a challenge in the ultra-competitive supermarkets business. According to Hilary Monk, analyst with the retail consultant Verdict Research, the Price Check campaign produced a strong surge in sales, but that was from a low base. Future progress will be much harder. "Somerfield still looks a lot more vulnerable than the other major supermarket players."

Somerfield has escaped the full brunt of the onslaught by the majors by sticking to high-street stores. But the tightening of planning rules means Tesco and Sainsbury are again opening on high streets, with their respective Metro and Central formats. That puts extra pressure on Somerfield, says Ms Monk.

Meanwhile, unpaid interest at Isosceles continues to pile up at the rate of pounds 50m a year. Mr Simons, who will gain a reputation as the ultimate turnaround merchant if he succeeds, delights in the monumental task ahead. "I'm loving every minute of it."