Dairy Farm Ties With Yonghui In Supermarket Play

| About: Dairy Farm (DFILF)

Consolidation continues to advance in the Chinese supermarket aisle, with word that Hong Kong grocery operator Dairy Farm (OTCPK:DFILF) is paying nearly $1 billion for 20 percent of Yonghui, one of China's top chains. A couple of years ago I would have said this deal looked like a good one for both sides, combining Dairy Farm's well-run Hong Kong-based chain of Wellcome supermarkets with Yonghui's sizable Chinese operations. But frankly speaking, China's rapid migration of food shopping into the e-commerce realm makes the whole idea of consolidation of brick-and-mortar operations look like a belated effort with limited growth potential.

All that said, I was still somewhat excited to read about such a large deal in the traditional retail space, since consolidation is really needed in the area. Under the deal, Dairy Farm will pay 5.7 billion yuan, or about $925 million, for the 20 percent stake of Yonghui in their strategic tie-up. Dairy Farm operates some 5,800 supermarkets and health and beauty stores throughout Asia, while Yonghui operates 288 hypermarkets and supermarkets throughout China.

Yonghui is China's 5th largest supermarket operator, in a hypermarket sector that's expected to grow 39 percent to 862 billion yuan in 2016 from 2013, according to one industry estimate. While that number looks good, the fact that it's over a 3-year period means that annual growth is more likely to be closer to 10 percent. That kind of annual growth would be respectable in a more mature western market but looks disappointingly slow for China.

The deal is just the latest sign of consolidation in China's fragmented supermarket sector, where big local names like Sun Art (OTCPK:SURRF) and China Resources Enterprise (OTC:CRHKF) compete with big global players like Wal-Mart (NYSE:WMT) and Carrefour (OTCPK:CRERF). Last year British giant Tesco (OTCPK:TSCDF) effectively pulled out of the market by merging its operations into a joint venture with China Resources Enterprise. Carrefour was reportedly looking to sell its China operations or merge them into a similar joint venture around the same time, though no deal was ever announced.

While the traditional brick-and-mortar retailers vie for the limited market growth, a newer field of e-commerce players is rapidly encroaching into the space. Most of the top e-commerce names are rapidly building up food operations, including leaders Alibaba and JD.com (NASDAQ:JD), as well as Wal-Mart-controlled Yihaodian. Those sites traditionally offered more selection and better prices, but were handicapped by their slower delivery times. But even that is changing, as many of the biggest names roll out new services that can deliver products on the same day and even within 2 hours.

So, what does all this mean for the new Dairy Farm deal, and also for the broader industry? As a former Hong Kong and Taiwan resident, I can attest to the big popularity of Dairy Farm's Wellcome supermarkets, which are compact in size, very well run and generally well suited to Asia's high-density neighborhoods. That's why I previously said that if this deal happened just 2 or 3 years ago, it would have been much more exciting.

But in the current climate, it's a bit harder to get too excited about such a deal due to the rise of e-commerce. Yonghui and Dairy Farm haven't given any more details, but I would expect them to experiment with new stores in China that are more similar to the Wellcome format, and perhaps we'll even see them open more Wellcome stores in China itself. But if the pair are smart, they'll move quickly to develop an e-commerce arm that can compete with the online players. Failure to do so could see this new partnership end in disappointment due to stiff competition and Yonghui's awkward position as a mid-tier player in the market.

Bottom line: Dairy Farm's new supermarket tie-up with Yonghui is likely to end in disappointment unless the pair can quickly develop and build up an e-commerce operation.

Disclosure: None.

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