Restructuring in Japan's supermarket industry has further to run after large-scale consolidation that has seen the formation of big domestic retail groups and the entry of foreign heavyweights such as Wal-Mart Stores Inc. (WMT), Tesco PLC (TSCO.LN) and Germany's Metro AG (MEO.XE).

The next round may be spurred by the foreign entrants, as well as large domestic players trying to expand their footprint in fragmented regional markets, says Roy Larke founder of retail sector consultancy JapanConsuming.

"The pace of consolidation within Japan's retailing industry has been occurring quite rapidly," Larke told Dow Jones Newswires in an interview.

The key to success for the big global chains like U.K.-based Tesco and Wal-Mart of the U.S. is to tap their huge supply chains, and they require scale in their store presence for that.

"If they are going to make real progress they need to get bigger," Larke said.

Should they then be looking at merger and acquisition activity and capital ties with some of the smaller regional players that are hitting the limits of their organic growth?

"Yes, on all counts for Wal-Mart & Tesco," he said.

For foreigners, the attraction is under-representation in what is one of the world's largest general merchandise markets despite a continuing secular decline in sales.

Japanese supermarket sales have shrunk every year since peaking at Y16.8 trillion in 1998; sales for 2008 were Y13.3 trillion, according to the Japan Chain Stores Association.

For established domestic players on the other hand, boosting domestic sales volume via M&A and then expanding margins by trying to rationalize and leverage off a more efficient supply chain is one of the only ways to counter a shrinking home market.

Tough conditions and problems gauging local consumer taste have caused big foreign names to come unstuck in the past. France's Carrefour S.A. (12017.FR) pulled out of the country in 2005 - selling its local operations to Aeon Co. (8267.TO), Japan's second largest supermarket and retail group by revenue.

Indeed, Wal-Mart has been plagued by well-publicized difficulties in engineering a turnaround at local subsidiary Seiyu Ltd. since first taking a stake in it back in 2002.

Sluggish sales have become the retailer's main bane after recovering from bubble-era overexpansion and soured mortgage-backed loans at former-group company Tokyo City Finance earlier in the decade.

Nonetheless, Larke cautions against writing off the efforts of the U.S. company. "When Wal-Mart bought this company it was virtually bankrupt; now they have something that is, at the very least, a viable going concern," he says.

In contrast, although its footprint is much smaller, Tesco has been successful in developing its Tokyo-focused Tsurukame business, acquired in 2003, and has started rolling out its Tesco Express chains in the country.

Well-run regional Japanese players, meanwhile, may be open to cooperation or tie-ups with larger players. Larke said dominant retailers in the provinces are hitting the limits of their growth, and pushing into surrounding areas would risk overburdening their own supply chain.

"Take a company like Yaoko - it's a great retailer, well run - but it's hit the limits of its growth capabilities within its home prefecture," he notes.

Yaoko Co. (8279.TO), based in Saitama prefecture adjacent to Tokyo, had sales of Y202.3 billion in the twelve months ending March 2008. That squares up against Y5.8 trillion in sales at Seven & I Holdings Co. (3382.TO), the country's largest retail chain.

Still, any efforts to push their presence out into the regions by Wal-Mart, Tesco or Metro may put them into competition with domestic heavyweight and serial acquirer Aeon.

"Aeon's strategy has been one of looking at M&A as a platform for sales volume expansion," says Larke. "It's seen what the large overseas competition have done and come to the conclusion that sales volume is the way to go."

In the past three years it - or its affiliates - have on average conducted a merger, private placement or capital tie-up with another retailer every two and a half months, according to data from CapitalIQ.

(Jamie Miyazaki is a senior writer with Dow Jones Newswires based in Hong Kong. He can be reached at +852 2832 2320 or by email at jamie.miyazaki@dowjones.com. Dow Jones Newswires is enhancing its news, commentary and analysis for the investment banking community, and is providing it on this service temporarily. Stay tuned for information on continued access to the best of Dow Jones news and opinion on companies, sectors and deals for bankers and research analysts.)