Saks eyeing buyout talks with top shareholder

(Fortune) -- Saks has long been considered a buyout candidate, and that possibility intensified this week as reports leaked out that the company has had preliminary discussions with its second-largest shareholder, the Icelandic Baugur Group.

Sources confirmed for Fortune that some preliminary discussions have taken place between Baugur and Saks executives, though at this early stage it's not clear that an outright acquisition will result.

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Though Baugur, which owns the British retailers House of Fraser and Karen Millen among other investments, is interested in gaining a foothold in the U.S., the hidden value in Saks (Charts) may be its budding international operations.

The retailer has signed deals to license the Saks Fifth Avenue name in China, Mexico and the Middle East. Only two stores are currently open, one in Saudi Arabia and another in the United Arab Emirates. A store in Mexico City is expected to open this fall; another in Shanghai by 2009.

U.S. department stores have been slow to migrate overseas. Only Saks and Barneys, which operates three stores in Japan, have moved beyond their home borders. Macy's (Charts, Fortune 500) chief executive Terry Lundgren said last year that he was in the early stages of considering international possibilities for the Macy's and Bloomingdale's brands.

Analysts expect a wave of international expansion by U.S. retailers, including specialty stores and department stores, over the next few years as they face saturation at home.

"Because of the maturity of the American market, more and more companies are looking to go abroad," said Marvin Traub, the former chief executive of Bloomingdale's, who now runs a consulting firm that helps retailers evaluate overseas opportunities.

Earlier this week, Leslie Wexner, chairman and chief executive of Limited Brands (Charts, Fortune 500) said international expansion would be the next step for the Victoria's Secret and Bath & Body Works chains. That company reached beyond U.S. borders earlier this year when it bought La Senza, a Canadian intimate apparel retailer that already has licensed stores in 30 countries.

After seeing initial success with a store in London, Abercrombie & Fitch (Charts) is looking to further expand overseas, Coach (Charts) has had great success in Japan and even Ralph Lauren, the quintessential America designer, has been lured overseas with the opening of a recent flagship in Moscow.

If done right, these deals can be extremely lucrative, allowing retailers to offload the cost and financial risk of opening stores onto their local partners. At the same time, the licensing agreements typically give them control over the brand's image, merchandise and marketing.

Lazard Capital Markets analyst Todd Slater estimated in a research note that Limited's international ambitions could potentially add $11 to the company's stock price.

Retailers typically collect a percentage of sales as a royalty fee, as well as marketing and sourcing related expenses -- income that falls directly to the bottom line. "Earnings from international licensing streams should provide a dramatic lift to divisional operating margins," Slater wrote.

As good as these deals sound, they are not risk free. Plenty of U.S. retailers have stumbled abroad in recent years, including Wal-Mart Stores (Charts, Fortune 500), which last year pulled out of Germany and South Korea, and the Gap (Charts, Fortune 500), which sold its German stores in 2004. Bath & Body Works first foray overseas to London in the early 1990s failed when its brand did not resonate with shoppers there. Bain & Co. estimates that less than one-in-three international retail expansions are successful.

In the case of Saks, most of the focus has been on its 103 U.S. stores, which are in the early stages of a turnaround. Chief Executive Stephen Sadove, who declined to comment on a potential sale of the company, has unified the management team, invested in the merchandise and refurbished stores. Saks turned heads this fall when it opened a shoe department spanning an entire floor of its Fifth Avenue store with the ingenious idea that it was so big it needed its own zip code (10022), which it applied for and received from the U.S. Post Office.

Despite a string of strong sales growth, Saks operating margins still lag those of rivals such as Neiman Marcus and Nordstrom. To most observers, this is where the opportunity lies: By selling more Ferragamo shoes and Chanel suits at full price, Saks can become far more profitable.

But once Saks catches its peers on the margin front, where will the growth come from? The probability of opening new U.S. stores is unlikely. Saks over the past three years has closed more than a dozen under performing domestic locations. International expansion is the obvious answer, and Saks is already laying the groundwork with its small, but budding network of licensed stores.

The possibility for overseas expansion was a big part of the attraction in the recent bidding war for Barneys New York by two foreign firms. Istithmar of Dubai beat out Fast Retailing of Japan. Don't be surprised to see a Barneys opening in the Middle East over the next few years.

While Baugur, through a spokesman, insists that its interest in Saks is as a passive investor, could a Saks in Reykjavik be far behind?