Mitsukoshi, Isetan may seek merger: source

TOKYO (Reuters) - Japanese department stores Isetan Co. Ltd. 8238.T and Mitsukoshi Ltd. 2779.T are in talks on capital ties and may seek a merger, a source familiar with the matter said -- the latest alliance move in a fast-consolidating industry.

A potential combination that would create Japan's biggest department store operator with annual sales of 1.6 trillion yen ($13.3 billion) sent shares in Mitsukoshi, the weaker of the two, soaring 8 percent. Isetan's stock ended flat.

Shinko Securities analyst Jun Kawahara said a deal would make sense both for Mitsukoshi, the nation's fourth-largest department store operator, whose sales have slowed in recent years, and for Isetan, the fifth largest, which leads the industry in fashion sales.

"The potential merger would help Mitsukoshi more than Isetan," he said. "But Isetan would also benefit from it in the long run, given the benefits of greater scale."

Many of their rivals have already joined hands in a market that contracted for nine straight years through 2006, hit by deflation and growing competition with large suburban shopping malls.

Daimaru Inc. 8234.T plans to take over Matsuzakaya Holdings Co. 3051.T, while Hankyu Department Stores Inc. (8242.T) and Hanshin Department Store Ltd. 8241.OS are set to merge in October.

Isetan and Mitsukoshi want to hammer out an agreement by the end of August, aiming to set up a joint holding company by the end of the business year in March, the Nikkei business daily reported.

One proposal the two firms were considering was to merge under the holding company through an equity swap, it added.

Mitsukoshi and Isetan said in statements that nothing had been decided.

The two stores are seen as having little overlap, with Mitsukoshi catering to a wealthier clientele while Isetan boasts a strong base in younger customers.

Both started as kimono stores. But fortune has been kinder to 121-year-old Isetan, whose flagship store in Shinjuku, central Tokyo, now lays claim to having the highest clothing sales of Japan's department stores.

The store's June apparel sales jumped 21 percent from a year earlier, ahead of an industry-wide rise of 8 percent.

Isetan's shares ended unchanged at 1,901 yen and its market value of $3.6 billion now exceeds Mitsukoshi's $2.5 billion, although Mitsukoshi, whose history dates back to 1673, once led the Japanese retail industry. Mitsukoshi's stock finished up at 7.5 percent at 587 yen.

Sluggish sales led Mitsukoshi to close four stores in 2005. It posted a 62 percent decline in March-May first quarter operating profit on a 5 percent fall in sales.

Isetan will issue results for its April-June first quarter on Friday.

($1=120.43 yen)

(Additional reporting by Nathan Layne, writing by Edwina Gibbs)