Safeway remains in the sights of private equity firms

Retail experts believe Britain's fourth-largest supermarket is vulnerable to takeover

Fresh speculation has broken out regarding a possible bid for Safeway, Britain's fourth-largest supermarket group. The City rumours centre on a financial buyer, possibly Royal Bank of Scotland Private Equity.

Royal Bank of Scotland was linked with a possible £3bn bid for Safeway in October in a deal that could have seen the former Asda chief executive, Allan Leighton, appointed chairman of the supermarket group. RBS was approached by investment bankers trying to put together a deal but backed away.

Yesterday RBS said: "We don't comment on any market speculation." Safeway said it had heard nothing about it and added that RBS is one of the group's bankers. The deal would be surprising as the bank's equity finance division tends to specialise in mid-market transactions of up to £200m. Even so Safeway shares rose 3 per cent to 213.5p in a falling market. Volume was heavy with 15.4 million shares traded.

But even if the rumour turns out not to be true – this time – many retail experts believe that this is the year in which Safeway will be taken over.

As one Safeway insider admitted: "That seems to be almost the consensus view. It is something we have had to live with for months now."

Another retail insider said: "There is no doubt that Safeway would like to do a deal. David Webster [Safeway's long-standing chairman] has been there a long time and it doesn't look like Safeway is going to be able to trade its way out of problems. A deal would provide the solution."

One retail analyst added: "I think it is perfectly possible. A lot of people have been sniffing around it. The timing would be slightly odd as Safeway has a trading update next week but, then again, everyone knows what the numbers are going to be like anyway. My view is that, trading at close to net asset value [200p] it is hopelessly undervalued. It would be worth much more to a trade bidder but they would probably all be blocked by the competition authorities."

The logic for a bid is simple. Safeway is struggling again after a period during which the flamboyant Argentinian chief executive, Carlos Criado-Perez, appeared to have kick-started a recovery. Like-for-like sales growth has fallen sharply from the 6.1 per cent achieved 18 months ago to just 1.1 per cent when the company reported its last figures in October. When Safeway announces its third-quarter sales update next week, analysts do not expect anything more impressive than underlying sales growth of 1.25 per cent. This is below forecasts for main rivals, Tesco and J Sainsbury, while Wal-Mart said last week that underlying sales at the rapidly advancing Asda are up 5-10 per cent.

Safeway has also been losing market share as the figures in our chart demonstrate. In the past year its share of the UK grocery market has fallen from 10.8 per cent to 10.1 per cent. It is now well adrift of third-placed Asda, which is now breathing down Sainsbury's necks for second place.

The other problem is price: the bête noire of the Safeway brand. With Tesco and Asda piling on the pressure with yet more price cuts announced this week, smaller players such as Safeway are struggling. It does not have the buying power to match the largest players. It also lacks the non-food sales that Tesco and Asda are using to reinvest in lower food prices. Similarly, its "hi-lo" policy of offering headline-grabbing bargains on some lines but charging higher prices on the rest appears to have run out of steam as the slowing sales show.

Finally, there is the valuation. Safeway's shares have fallen back to 209p after reaching 230p late last year. This is close to the net asset value, with Safeway's stock market value now standing at just £2.2bn. A bidder might have to pay about £3bn but this is still way short of the £6.7bn paid by Wal-Mart for Asda in 1999. As one analyst points out: "The Asda deal was done on a p/e [price-earnings ratio] of 20, at a price just a penny short of its all-time high under Archie Norman. Safeway trades on a p/e of less than nine."

Wal-Mart has been linked with an offer for Safeway last year after it was reported to have sought confidential guidance from the Office of Fair Trading on whether a bid might be cleared. But, so far, it has not made a move. One retail insider said: "I think Asda is quite keen to do it. But Bentonville [Wal-Mart's US headquarters] are still quite sceptical. They have still got to get a return on their Asda investment and there is lots of organic growth still to go for. And if you look at all the things they've done its pretty consistent – no small stores, very little internet investment."

As for the regulatory hurdles, the retail expert says: "There would be a political dimension to it. Gordon Brown loves Wal-Mart but the Government has got them here now. There's no need to court controversy by allowing them to gobble up another operator."

It is understood Tesco got a rough ride from the Office of Fair Trading over its acquisition of T&S Stores, the convenience store group. Though the deal was cleared without conditions, the rigorous nature of the discussions demonstrates that the OFT is still very concerned to maintain local competition in food retailing.

There is no doubt that should a bank or private equity group bid for Safeway then all the major rivals would be keen to snap up chunks of the estate. One analyst said: "Sainsbury would be as keen as mustard. Sir Peter Davis wants to do something and the Boots option seems to have gone away. The only group who could bid on their own is Morrisons. But I don't think Ken [Morrison, the group's veteran chairman] wants to do that. He's doing very well anyway and he's already got more money than God."

A financial buyer might satisfy the regulatory authorities on the subject of market dominance. But if a takeover turned into a break-up bid it would obviously turn the "Big Four" supermarkets into the "Bigger Three", something the Competition Commission has been nervous about allowing.

The other supermarket operators could argue that Morrisons would be a credible number four as it is already bigger than Safeway in stock market terms. They could also argue that a break-up bid for Safeway would enable them to lower prices for consumers. But with Asda and Tesco doing that anyway, it is questionable whether this argument would hold much water.

But with legions of under-employed investment bankers stalking the market for deals, creative solutions to these problems could yet materialise Don't count on Safeway remaining independent by the end of the year.