London/Frankfurt, May 22 - Metro AG's plan to create a German department stores champion is a bold attempt at tackling an underperforming sector, but risks distracting management from the main aim of growing abroad.
Metro, the world's fourth-biggest retailer, has proposed merging its Kaufhof department stores with the Karstadt chain of debt-laden competitor Arcandor to create a "German Department Store Inc".
The plan is tactically shrewd -- "a brilliant move", according to Commerzbank analyst Juergen Elfers.
It will make it harder for rival Arcandor to claim state aid, could deliver big savings and in the longer term enable Metro to exit Germany's embattled department stores sector altogether, as the combined asset would be an easier sell.
But some analysts think Metro should be reducing its exposure to Germany, where consumer spending growth has lagged the euro zone average for each of the last five years, and focus instead on expanding its most successful formats abroad.
"The best thing Metro Group can do with its money is really plaster central and eastern Europe with cash and carries and Media Markt consumer electronics stores," said Planet Retail analyst Boris Planer.
Metro has little margin for error. Its shares trade at 14.1 times forecast earnings, a premium to bigger rivals Wal-Mart, Carrefour and Tesco.
"BRILLIANT MOVE"
Metro's department store plan was launched in part to counter Arcandor's request for 650 million euros ($896 million) of state loan guarantees to stave off insolvency, which Metro believes would give it an unfair competitive advantage.
By offering an alternative, Metro is giving lawmakers, some of whom are reluctant to pour money into a business with such longstanding problems as Arcandor, an excuse to say no.
This could either drive Arcandor into talks with Metro in a weak bargaining position, or ultimately lead to its demise, giving Metro the chance to grab its market share.
The merger plan also offers Metro a quick way to lift returns from Germany's troubled department stores sector.
Commerzbank's Elfers believes a deal could deliver synergies of between 300 million and 600 million euros ($414-827 million).
It also improves Metro's chances of ultimately getting out of the German department stores sector, which has been struggling for years in the face of competition from specialist retailers, discounters and out-of-town retail parks.
Metro has said Kaufhof is not a core part of its business, but so far it has not been able to sell it.
Under its plan, Metro and the owners of the Karstadt stores' real estate would each hold just under 50 percent in a new German Department Store Inc, with banks and investors owning the rest. A source close to the matter has said this is not set in stone and Arcandor could also take a stake.
Some analysts think Metro might have a better chance of selling a minority stake in a stronger, enlarged department stores business, or could try for an initial public offering when market conditions improve.
CHALLENGES
However, a merger would by no means be straightforward.
Firstly, combining Germany's two biggest department store groups would require approval from competition regulators.
Cheuvreux analysts believe this would not be insurmountable if regulators take a broad view of the sector, as department stores account for just 3-4 percent of Germany's retail sector.
Secondly, for the merger to work for Metro, a large number of stores in overlapping areas would need to be sold or closed, and thousands of jobs would have to go.
Merck Finck analyst Robert Grell believes 20-30 percent of the combined Kaufhof-Karstadt estate of almost 250 stores in Germany could be sold off or shut down.
LBBW credit analyst Stefan Schmitz estimates the merged group would employ around 35,000 people. Currently, Karstadt and Kaufhof employ over 50,000 people in Germany.
German politicians may be reluctant to sanction such a high level of job losses with an election looming in September, and even if they do, Metro will have to spend considerable time negotiating with trade unions and landlords.
This is a risk at a time when Metro is battling tough trading conditions and has just started a big restructuring programme aimed at adding 1.5 billion euros to profits by 2012.
"Any deal could distract management from the ongoing restructuring," said Bernstein analyst Chris Hogbin.
Planet Retail's Planer is also concerned that a merger, which comes just three years after Metro bought Wal-Mart's German hypermarkets, could divert the company from growth abroad.
"If they take over Karstadt, that is the second very big deal in three years that seems to be counter productive to the overall strategy."