With Daiei Inc. expected to take Aeon Co. as its business partner, analysts say Daiei still faces a big challenge to turn its business around.

Although Daiei has reduced its interest-bearing liability and returned to the black, analyst Hidehiko Aoki at Merrill Lynch Japan Securities Co. said Daiei’s rehabilitation begun in April 2005 under the Industrial Rehabilitation Corp. of Japan did not improve Daiei’s retail earnings and competitiveness.

“Daiei has received a huge amount of financial aid, but the financial support merely helped Daiei to stop bleeding,” Aoki said. “Daiei will need to map out its own retail strategy based on a new concept” that appeals to customers.

“The retail industry is such a competitive market, no one can survive without viable strategies,” he said.

Marubeni Corp. became Daiei’s top shareholder in August with a stake of 44.6 percent after buying 33.6 percent from the state-run IRCJ. Its executives dominate the board.

Marubeni has been looking for a major retailer to be Daiei’s partner, and Aeon and Wal-Mart Stores Inc. of the United States submitted proposals for tieups earlier this month.

Analysts and the media have been speculating for some time that Aeon will be chosen to be Daiei’s partner, and recently, Wal-Mart dropped out of the running.

“Aeon has been successful in turning around (Mycal Corp. and Yaohan Co. — renamed Maxvalu Tokai Co.) and has established its own distribution network,” said Masafumi Shoda, an analyst at Nomura Securities Co.

Aeon has made massive investment over the past decade to create its own distribution network and now has eight centers nationwide.

Merrill Lynch’s Aoki said Aeon is also a good choice because its supermarket locations compliment the Daiei network.

“There is little overlap of the locations of Daiei and Aeon outlets,” Aoki said.

Daiei outlets, on an unconsolidated basis, number about 210. Aeon has about 380 and Seiyu has roughly 200.

Aeon, which posted record high sales and profit for the February-August period, would also benefit from a partnership with Daiei.

Aeon is reportedly interested in Daiei subsidiary Maruetsu Inc. — owned 37.8 percent by Daiei and 30 percent by Marubeni.

By tying up with the parent of Maruetsu, which operates 193 supermarkets in the Tokyo area, Aeon would be able to expand its retail network into the region, where the nation’s largest retailer has only a small presence.

Rival Wal-Mart was a less desirable choice for Daiei because it lags behind Aeon in its distribution network and rehabilitation at Seiyu Ltd., Nomura Securities’ Shoda said. Seiyu is 52 percent owned by Wal-Mart, the world’s biggest retailer, which entered the Japanese market in 2002.

The new and only Seiyu distribution center, in Saitama Prefecture, covers just the eastern Kanto region.

Seiyu narrowed its pretax loss for the first half of fiscal 2006 to 4.28 billion yen from 6.92 billion yen the previous year, but had an initial target of a 1.7 billion yen loss.

Wal-Mart, which was seeking economies of scale in a tieup with Daiei, will be put in a difficult situation if Daiei and Aeon tie up, Shoda said.

“Wal-Mart may have to think of withdrawing from the Japanese market in two to three years if Seiyu continues to struggle and fails to turn itself around,” Shoda said.

However, the path is not clear for Daiei, for even with a tieup with Aeon, it cannot expect a strong recovery unless it has a clear strategy to recover its earnings, analysts say.

Daiei, once the country’s largest retailer, went under the IRCJ control in December 2004 to undergo corporate rehabilitation.

Marubeni and private equity firm Advantage Partner Inc., which owns about 23 percent stake in Daiei, were picked in March 2005 as sponsors to help IRCJ rebuild Daiei.

Under the government-backed bailout agency, Daiei has improved its balance sheet through a roughly 110 billion yen capital injection, by reducing its capital by 119 billion yen and debt forgiveness of about 400 billion yen from its creditors.

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