BREAKING OUT OF THE MALAISE

NEW YORK -- Supermarket retailers looking for an upswing in financial performance may be in for a long wait as consumers seek lower-priced alternatives in a weakened economy, security analysts told SN.They projected a generally bleak outlook during SN's seventh annual Financial Analysts' Roundtable here, citing a combination of high prices and high margins, a lack of merchandising excitement and an

NEW YORK -- Supermarket retailers looking for an upswing in financial performance may be in for a long wait as consumers seek lower-priced alternatives in a weakened economy, security analysts told SN.

They projected a generally bleak outlook during SN's seventh annual Financial Analysts' Roundtable here, citing a combination of high prices and high margins, a lack of merchandising excitement and an inability to create points of difference with other formats, primarily Wal-Mart, that has left sales and earnings in free-fall for many operators.

"Heading into this recession, food retailers were not in a good position in terms of pricing," Lisa Cartwright, director at Salomon Smith Barney, New York, said. "As [retailers] focused on integrating acquisitions and dealing with technology issues, they basically took their eye off the ball in terms of where they should price, so when the economy started to move into a downturn, they really weren't where they should have been in terms of pricing."

According to Jack Murphy, vice president at Credit Suisse First Boston, New York, "There's a fundamental misunderstanding by supermarket managements about the potential level of growth that exists in the business, so there's been pressure to drive earnings growth through expansion of gross margins, and that has kept the supermarkets from being as price-sharp as they should be."

For Neil Currie, New York-based executive director for UBS Warburg, Stamford, Conn., the problems go deeper than the economic downturn. "I think the economy is a red herring, which may just prove to be a catalyst to drive people to discounters quicker," he said. "The fact is, there's too much capacity in the market plus lots of potential for competition, and everyone's chasing that marginal sale."

Chuck Cerankosky, managing director for McDonald Investments, Cleveland, said the move by consumers to trade down "is going to lead to faster consolidation in the industry because with all the effort the chains are putting on stronger price messages and more attractive promotions, it's going to force out the weaker companies sooner."

The analysts said they expect the situation to get worse before it gets better.

The financial outlook for the second half of the year "is pretty discouraging, and it's hard to see how things will get better," Gary Giblen, director of research for C L King Associates, New York, declared.

Ted Bernstein, managing director for Dresdner Kleinwort Wasserstein-Grantchester, New York, said he anticipates a new round of price wars. "The difficulty when you get into [the current] environment is that everybody's in it and so everybody gets more promotional, and that could mean a return to the kinds of bloodbaths that we've seen in the past where operators just get irrational and start promoting like crazy and nobody makes any money."

According to Cartwright, "I think we'll probably see more downside before we see upside."

One way retailers can try to improve their performance is to try to differentiate themselves, Jonathan Ziegler, San Francisco-based managing director for Deutsche Banc Alex. Brown, New York, suggested. "There are some signs out there that the industry is waking up to the idea that this is a segmented market. They've got to wake up to the fact that merchandising changes are necessary."

But mainstream supermarkets can't compete with Wal-Mart on price, Ziegler added. "Wal-Mart has got a more favorable operating-cost structure, so it seems foolish for retailers to compete with them on price when you can't win the game."

Currie suggested that supermarkets might be able to boost sales by directing more capital investment toward renovating what they have rather than building new units. "[Opening new stores is] just a fruitless exercise because there are certainly enough stores in most markets."

Murphy said he agreed. "The one thing [retailers] can do is to somehow drive comps because that's really where you get higher incremental returns on capital because you're not having to put new units into the ground to generate a top line."

The analysts also said they believe supermarket stocks will continue to suffer as long as the chains lose sales. "To gain sales momentum, some of the chains are going to have to give up some margin or stop letting margin grow," Cerankosky said.

But even companies whose sales are expanding have seen their stocks lose value, Ziegler pointed out. "Everybody's getting clocked here, and it's just negative sentiment."

The complete text of the first half of the roundtable follows. SN will run the rest of the discussion in a future issue.

THE ECONOMY SPIRALS DOWNWARD

Efforts by some supermarkets to go upscale and to expand gross margins at the expense of competitive pricing have made retailers vulnerable to the downturn in the national economy, the analysts said, as more consumers choose to shop at supercenters and other alternative formats.

SN: It's obviously been a challenging year for the industry, encompassing the impact of the very difficult economy and the very difficult stock market, fallout from the accounting scandals and the ongoing challenge for supermarkets to eke out growth despite competition that just keeps ratcheting up every year. Let's start with the economy and its effect on the supermarket sector. How are declines in consumer confidence impacting the industry?

TED BERNSTEIN: For the first time since I've been covering this industry, we're seeing a real economic impact from the overall economy on supermarket retailing, and I think that's because the industry is at a near-universal rollout of higher-end specialty departments, and I think that has generally exposed supermarket retailers more to the overall ups and downs in the economy. And since this is the first significant economic downturn that we've seen in the U.S. in 10 or 11 years, that's being reflected in supermarket retailers' results as well as in their expectations going forward. I think it's also having a tremendous impact on promotional activities and capital expenditure budgets. [Three of the companies discussed during the roundtable -- Kmart Corp., Pathmark Stores and Wal-Mart Stores -- are investment banking clients of Dresdner Kleinwort Wasserstein-Grantchester, New York, and/or its affiliated companies.]

CHUCK CERANKOSKY: To say it a different way, I believe the combination food-and-drug operators have worked really hard to segment their stores toward a more upper-income clientele, and they've succeeded. But now that clientele is trading down a bit or at least being more price-conscious and more careful about its spending in the stores. We've seen that reflected in comments from several major chains, and I think it's going to lead to faster consolidation in the industry, because with all the effort the chains are putting on stronger price messages and more attractive promotions, it's going to force out the weaker companies sooner. And it's going to cut across various sectors -- not just food stores but also discounters like Kmart and some of the drug retailers as well.

JONATHAN ZIEGLER: But people are still spending money on automobiles and housing, despite the negative consumer confidence report issued in early August, and they're still making payments and taking out mortgages. So does all that spending on houses and cars mean people can't afford food?

CERANKOSKY: When we're looking at the economy for the rest of the year, one thing we're concerned about is consumer debt level, which has continued to run up via equity lines of credit and second mortgages. That seems to be OK as long as housing prices hold up, but if housing prices weaken substantially, then people would worry about how much debt they're taking on, the banks might get a little nervous, and that would put more pressure on consumables purchasing. But I don't think people's basic food spending is influenced by the cost of debt or interest rates. They'll replace a car with another car or a house with another house. With some of these loan-to-value ratios being very high, I think people might be mortgaging their futures by taking out an equity line of credit to go on vacation. But they'll still worry about buying another bottle of wine or a certain quality-level bottle of wine, and it's that kind of incremental purchase that adds a lot of profitability and sales to a shopping trip.

LISA CARTWRIGHT: Heading into this recession, food retailers were not in a good position in terms of their pricing, and I think everybody would agree that as they focused on integrating acquisitions and dealing with technology issues, they basically took their eye off the ball in terms of where they should price vis-a-vis supercenters and club stores. So when the economy started to move into a downturn, they really weren't where they should have been in terms of pricing. They had allowed the gap with Wal-Mart to widen to such a degree that when people started to really feel the pinch and focus on price, they weren't in a position to offer value.

JACK MURPHY: I think that has happened because there's a fundamental misunderstanding by supermarket managements about the potential level of growth that exists in the business, so there's been pressure to drive earnings growth through expansion of gross margins, and that has kept the supermarkets from being as price-sharp as they should be. That's something they're going to have to address over the next five years, and it's really going to be a major impediment to the type of growth rates they've had in the past.

GARY GIBLEN: The other thing that's happening is, a lot of companies are in a turnaround mode, and any turnaround really gets more or less negated by an adverse economy. So you have a company like A&P, for example, that seems to be making some progress and then boom, that disappears, and there's really no clear indication of when it can do better. It's just that the economy, combined with competitive factors, is pretty well negating the possibility of improvement. I would say the same is true for Albertsons and others -- it's simply hard to move ahead when you're swimming against powerful tides.

NEIL CURRIE: I think the economy is a red herring, which may just prove to be a catalyst to drive people to discounters quicker than they would have done. I've witnessed two major downturns in my career -- one here and one in the United Kingdom -- and in both instances, food retailers have not been defensive stocks, and I think it's because while they sell products that are by nature defensive, that doesn't really mean a lot. The fact is there's too much capacity in the market plus lots of potential for competition, and everybody's chasing that marginal sale. So I think we need to destroy this myth that this is a defensive sector. Certainly in my 13 years as an analyst, that does not seem to be the case.

ZIEGLER: The way I see the industry, an analogy can be made to a bucket with a hole in the bottom and a hole in the top. The hole in the bottom is the drain from beef to chicken or Hamburger Helper and the shift in center store sales to the discount stores or supercenters. And the hole in the top is the fact people aren't traveling, particularly since Sept. 11. Tourist demand is really down, and I think people are staying home and therefore eating more at home. And with more people eating at home, the industry should be doing a lot better than it is.

LACK OF INTEREST IN FOOD-TO-GO

Despite the economic downturn, people are still eating out, but supermarkets are failing to capture those share-of-stomach sales, the analysts said.

CERANKOSKY: I think the issue of food-away-from-home is separate from whether or not people are traveling. Every time I look at the food-away-from-home market, it continues to take more total share-of-stomach, if you will. The Applebee's style of casual dining is doing really well, and while people may not be dining out at the white-tablecloth restaurants, they're still making time to go to Applebee's or TGIFriday's or even McDonald's. And every time one of those meals takes place, it's a meal not purchased at a food chain or one of the competitors, so that side of the market continues to grow, with or without the economy.

CURRIE: The problem is that supermarkets should be capturing some of that growth. If you look across the world at the fastest-growing category in Europe, it's convenience foods.

CARTWRIGHT: But what's interesting about that is that in Europe, and the U.K. in particular, you don't really have cheap casual dining, either because of regulations or because the barriers to entry, including availability of land, are so great, so your choices are either to dine out at an expensive restaurant or buy the food at the supermarket. But here in the U.S., we don't have that. We have a proliferation of cheap dining alternatives.

GIBLEN: I think it's also the inability of the food retailers to capture even a small amount of entertainment value.

CURRIE: Having lived in the U.K., I can say there is cheap casual dining available, though there probably was more in the past. The supermarkets there have ensured that some of the lower-quality, casual dining places have gone out of business because they offer such a fantastic [heat-and-eat] product to take home at great prices. The supply chain they have in conjunction with the manufacturers has developed to an extent whereby they can offer gourmet meals to take home for $3 a head, and the guests wouldn't notice any difference. But in the States, that supply chain doesn't exist and the retailers really haven't forced that issue.

CARTWRIGHT: But with competition from restaurants that offer casual dining at a cheap price, I think supermarkets see an uphill battle, to a certain extent.

ZIEGLER: Then why are we so focused on price? I mean, if you're going to go out to eat and the price of the meal is exactly the same at home or at the restaurant, then going out to eat costs you 25% more by the time you add the sales tax and tip, so the supermarket shouldn't be worried about price because the restaurant isn't a price-impact competitor.

CURRIE: If you look at retailers that are successful with home-meal replacement, like Whole Foods and H-E-B [H.E. Butt Grocery Co.], I think they prove that the demand is there -- it's just that the supply isn't.

ZIEGLER: But those guys have figured out how to attack the food-away-from-home market.

DISAPPOINTING FINANCIAL PERFORMANCE

A combination of competitive pressures from Wal-Mart and other price operators could force supermarkets into a series of promotional price wars that will have a negative impact on sales, earnings and cash flow going forward, which could lead to accelerated consolidation, analysts said.

SN: Let's focus on making the connection between the economy and the industry's financial performance. What are your perspectives on the industry's performance in the second half of this year and the first half of next year?

GIBLEN: Joe Pichler [chairman and chief executive officer of Kroger Co.] really saw it coming last fall when he said this is the toughest time he's seen in 20 years or more in the industry, and that's played out perfectly. You have the most intense competitive battles in years. You have Wal-Mart cracking the code on how to merchandise food in at least a tolerable manner so that its supercenters are finally fully competitive; you have the economy keeping general sales levels down and you have food deflation. And I believe the beef sanitation expose on "Dateline NBC" has had more impact than the chains are owning up to because other than maybe reducing some perishables sales and causing meat deflation, it might also have increased costs, because you now have to have more labor to rotate the product and perhaps to accept more shrink.

Usually I'm pretty optimistic about the industry, and I've been saying since the early- to mid-1990s that Wal-Mart wouldn't wipe out the industry. But now I think the combination of all these factors is pretty discouraging looking ahead to the second half of this year, and it's hard to see how things will get better. I think there will be some consolidation, which might take some people out of their misery and might produce some synergies, but consolidation is not a panacea, so it's going to be tough.

BERNSTEIN: I also think it's pretty tough out there, but I don't necessarily think you can blame it all on Wal-Mart. I think Wal-Mart is still very much a regional factor, and there are still regions of the country where Wal-Mart is simply not a factor at all, and it can't be because of the geography, population density and zoning requirements. But I would agree that the combination of pressure from Wal-Mart supercenters, other supercenter operators, plus the general pressures being exerted on family budgets and the changes in buying habits that result -- I think all of those factors do conspire to hold results down. I think it's hurting same-store sales, and the difficulty when you get into that kind of environment is that everybody's in it and so everybody gets more promotional, and that could mean a return to the kinds of bloodbaths in certain regions that we've seen in the past where operators just get irrational and start promoting like crazy and nobody makes any money.

Over the next year or two, I think we're going to be in a period where we differentiate even more clearly the haves from the have-nots. There are a lot of supermarket chains out there that have relatively low costs of capital and spend tons of money on cap-ex, and those are the ones investing in their store base and trying to be more competitive, and that's going to hurt those that don't have that access to capital, and they're going to fall just further and further behind.

CERANKOSKY: What you just described leads to faster consolidation in the industry.

BERNSTEIN: And that consolidation is going to come from bigger guys buying smaller guys or maybe big guys merging, and it's also going to come through bankruptcies.

GIBLEN: You also need capacity reduction to have some impact, so in that sense, Albertsons' actions [exiting some markets] in Texas were favorable. But that's really just a drop in the bucket.

CURRIE: I would agree with all that if the better-capitalized retailers were actually using their balance sheets in order to become more competitive. But actually the pockets of excellence aren't the big three retailers. If you look around the country at the retailers that are seeing better sales growth, producing better stores and more exciting products and actually taking market share, it's the smaller retailers. The better-capitalized retailers must realize that they need to use their scale to actually add some points of difference between themselves and the smaller retailers. The customer doesn't know that they're better capitalized. Supermarkets need to be extremely customer-focused and to use their scale to give the customer something different from the next supermarket in terms of better prices or better quality or better ranges.

CERANKOSKY: Aside from supercenters, the other sector taking share from supermarkets are the clubs, and that's more of an upscale shopping environment. People enjoy shopping those stores, which shows again that a point of difference will attract customers, even if that means buying a big-screen TV while you're picking up some beef tenderloin.

ZIEGLER: When you talk about capacity coming out, one of the things that impresses me about our space is that this is a terrific cash-flow-generating industry, notwithstanding the problems we have in growing sales, and I think that makes it difficult for people to go bankrupt in this kind of environment.

CURRIE: But to counter that -- cash flow is positive now, but what if EBITDA [earnings before interest, taxes, depreciation and amortization] margins fall 200 to 300 basis points, which I think they will, over the next five years? Suddenly, that cash-flow profile changes quite significantly.

ZIEGLER: But you're arguing that retailers are not going to be rational on pricing.

CURRIE: I don't think they're in control of that. They're going to be reacting to what other people do.

A NEED FOR MORE MARKET SEGMENTATION?

Supermarkets need to emphasize their points of difference from other formats and lower their pricing to become more competitive, analysts said.

ZIEGLER: I think there are some signs out there that the industry is waking up to the idea that this is a segmented market, so you have the Stew Leonards of the world, and Whole Foods, and Central Markets and Sav-A-Lots segmenting the market, and I believe some of these mainstream operators are waking up to the fact they have to do that.

CARTWRIGHT: But supermarkets are so far behind. They're not Whole Foods, they're not Central Market and they're not Wal-Mart supercenters or a club. They're just stuck in the middle. They have big stores, and their prices are 20% higher than a supercenter's, but they aren't differentiated enough.

MURPHY: All that free cash flow they're generating is being put into capital to open more stores that are just like the ones they've opened over the last five years.

ZIEGLER: And that's the problem. What I'm saying is, they've got to wake up to the fact that merchandising changes are necessary. I think Kroger, for example, has really figured out how to segment the market.

CARTWRIGHT: Kroger is ahead of most, whereas Safeway, for instance, basically mistook a geographic advantage for operational prowess. Management homogenized the store base. What they did was to take all the differentiation out of the stores, cut costs to the point where the stores are almost boring, and then it entered Houston, where it forced that approach on Randall's. It works in San Francisco, where Safeway has no competition, but management mistakenly assumed, as we all did, that its advantage in San Francisco meant it would be the pre-eminent leader in the industry, across all markets.

SN: Is Safeway realizing that now and doing anything about it?

CARTWRIGHT: I think they are realizing it. That's why you see them quietly putting in new division managers everywhere.

ZIEGLER: But I thought they were centralizing everything.

CARTWRIGHT: Centralizing procurement is not the same thing as stripping your stores bare. I mean, they took out all the bells and whistles in the store, and who wants to pay 20% more to shop in a produce department where the displays are flat rather than massive and eye-catching as they had been? I want baskets. I want hanging plants. I want music. I want to feel like I'm in a market. I don't want to stand in some antiseptic box.

ZIEGLER: I think you're 100% right. It's that homogeneity, boredom and lack of merchandising excitement that's robbing Safeway of potential market-share gains.

CURRIE: The other thing Safeway and other large retailers have to do is lower their pricing. These are not niche retailers. These are mass market retailers with a format that 100% of the population uses at some point, and they can't afford to put themselves in a niche.

SN: Is there time for supermarkets to turn their financial performance around?

CARTWRIGHT: I think it's going to take a long time, and I think we'll probably see more downside before we see upside. Retailers in general are going to have to invest more, not only in lowering prices but also in coming up with ways to enhance the format to differentiate themselves from Wal-Mart, and that's going to mean lower margins and lower growth near term.

MURPHY: And that's a moving target, because while they're attempting to address price differentials with mass discounters in center store, Wal-Mart can continue to cut prices. We've seen Wal-Mart being very aggressive on dry grocery rollbacks, so it's going to be very difficult for supermarkets to catch up from a price-image perspective.

ZIEGLER: Wal-Mart's got a more favorable operating-cost structure, so it seems foolish to me for retailers to compete with them on price when they can't win the game. I think Lisa's right. It's going to take a lot of time to re-merchandise these stores for supermarkets to win back share from Wal-Mart and the specialty guys because they're not going to win on price. Our folks have to figure out what they need to do, other than price, to win back share because if they try it with price, they lose.

CARTWRIGHT: But if you talk to H-E-B, for instance -- a $12 billion company with comps running in the 3% to 4% range -- and if you ask them what they do that the other guys don't, they'll say they never get more than 3% to 5% higher in price than Wal-Mart, and they offer a lot more in terms of product and assortment. And they tell me they invest a lot more in the stores. So the return might be higher, but you take a bigger impact to your returns initially and then slowly get the benefits.

CURRIE: Ted mentioned that there's going to be a difference between the haves and the have-nots. The ultimate "have" is Wal-Mart. It has the balance sheet, and it knows how to use it. The biggest threat to the sector is if Wal-Mart starts putting hanging baskets in its stores. If you look at the quality of its meat and produce, it's getting a lot better every year. Wal-Mart is using its scale to procure better, and it reinvests that in some cases in price and in some cases in the quality of what it's selling. And if and when it ever gets the quality of its meat and produce up to the levels of the supermarkets, the supermarkets are going to be in real trouble. So supermarkets need a multipronged response. They can't compete with Wal-Mart prices or they'd go out of business, but they have to be in the ballpark. At the moment, I don't think they are.

HOW TO ALLOCATE CAPITAL

It may make more sense for retailers to allocate money to paying down debt and shoring up their existing store base rather than investing in new-store expansion, the analysts pointed out.

GIBLEN: And yet many companies are cutting cap-ex, which is going in the wrong direction.

MURPHY: Why would you put cap-ex into a declining return-on-capital business?

GIBLEN: Well, it's the haves and have-nots.

MURPHY: It depends on who you are. If you actually have a new unit that's going to have a return-on-invested-capital that's at or better than what you're operating at today, then it makes sense. But for some public companies that have a decent shot at being cash-flow businesses but which are spending too much capital, the only responsible thing to do would be to cut cap-ex and either pay dividends or pay down debt, and I encourage that. When I see managers just spending money on deteriorating returns, that's irresponsible, and that's why their stocks are down as much as they are.

GIBLEN: Well, it would be better for a company like A&P to increase the return than reduce the investment. To do it the way it's doing it may be a death spiral, and that's actually been the history of the industry. You cannot sustain yourself that way. You can get a little breathing room for a while in your balance sheet, but ultimately it doesn't work.

CURRIE: Jack's right, though. It depends on how a company is spending the money. If it's opening new stores, I think that's just a fruitless exercise because there are certainly enough stores in most markets. I'd rather see a shift of capital allocation to renovating existing stores and trying to get sales up.

ZIEGLER: And that's why Albertsons' program makes sense, because that's what it's doing. And I think Kroger has a program that makes some sense because it's doing in-market acquisitions and using cash to do it. And when you do fill-ins in existing markets such as Atlanta, Houston and Dallas by buying other companies' properties, it seems to me that's a very effective use of capital. Albertsons is doing remodels and Kroger is doing in-market acquisitions and those two approaches impress me as the directions in which the industry should go.

CARTWRIGHT: And Kroger's stores are a little bit more differentiated, so if it can get prices down, maybe it will be a little bit further ahead than some of the others.

CERANKOSKY: It's interesting to look back at the last recession in this country and how food chains fared. Wal-Mart wasn't as strong then, but most of the chains had gone through a period of being very highly leveraged and they weren't opening a lot of new capacity. This time around, we've seen a lot of new capacity added, and while some of it has come off through bankruptcy, you've got stronger supercenters and you've got stronger clubs, and suddenly price is a lot more important. As Jack mentioned, the center of the store is the broad competitive price barometer, whether you're in a Wal-Mart, Kroger or Whole Foods. After all, Cheerios is the same product everywhere, so suddenly price is important, and I just keep feeling that capacity's got to be reduced.

GIBLEN: In the recession of the early 1990s, you didn't have all the challenges the industry has today, and supermarkets did poorly for about two and a half years. It was a terrible time in the industry, and now there's even more to deal with. Back then, the big driver was food deflation, combined with a recession that was very difficult to deal with.

CARTWRIGHT: Food deflation was outpaced by overall inflation in that period?

GIBLEN: Food deflation was worse, so you had labor and other costs going up while food prices were down. You had that but not the other things, and it was really very difficult.

WAL-MART JUST KEEPS ROLLING ALONG

Wal-Mart will continue to roll out supercenters at a faster pace than its Neighborhood Market format, though both are improving their merchandising prowess, the analysts said.

SN: Let's turn our attention to Wal-Mart, which is at the core of so much of what we're talking about. As Wal-Mart continues to grow its supercenter base, have supermarkets really learned to co-exist with Wal-Mart, as they keep saying? Also, we're still waiting for the aggressive rollout of Neighborhood Markets. When is that going to happen, and what kind of effect is that going to have?

ZIEGLER: I think Wal-Mart is very pleased with the return on capital it's getting on the supercenters, but I sense there's also some fear of big-box laws and it wants to get grandfathered, so I think it's focused on supercenters for awhile. While the Neighborhood Market is certainly generating the sales volumes needed to give Wal-Mart the green light to expand, I sense that it's not as high a priority because the returns aren't as good as the supercenters.

But Wal-Mart is turning up the heat on the industry. It's what I call the frog and the cauldron. If you take a frog and put it in a tub of cold water and then take it out and put it in a tub of scalding water, it's going to jump out. But if you put it in a tub of cold water and you turn up the heat until it's scalding, the frog's going to die. That's what Wal-Mart is doing to the industry -- turning up the heat slowly. Our market-basket-pricing studies show Wal-Mart is raising prices year over year in many markets, but there are more Wal-Mart supercenters out there that are selling consumer goods at lower prices, so it's deflationary for the overall space. And Wal-Mart is probably only halfway through [its supercenter expansion], because it only has 1,100 supercenters, and I think the goal is to turn all Division One stores into supercenters.

CERANKOSKY: Wal-Mart already knows where all its best Division One stores are and which would be the best to convert to supercenters, and that helps its very high ROA [return on assets] to stay high.

CURRIE: I agree that Neighborhood Markets will take a back seat to supercenters. I think Wal-Mart is pretty happy with the returns, but besides the fact Neighborhood Market returns are not as good as supercenters, there's also a big problem getting enough quality managers because when you find good managers, would you rather put them in a Neighborhood Market or a supercenter? The supercenter will always take precedence. But what we're also overlooking is that a small opening program for Neighborhood Markets can be a significant opening program for somebody else, so if Wal-Mart opens, say, 30 Neighborhood Markets next year, it's peanuts to them, but it's pretty big for whichever towns they're putting those stores into. It may be 20 stores this year and 30 next year and 50 to 70 the year after, and that may not dent Wal-Mart's sales growth very much, but it's going to dent somebody's sales growth.

But is the supermarket industry learning to live with Wal-Mart? I think the answer is no. A lot of analysis has been written about market shares, but they've forgotten to look at market share per store, which is deteriorating for supermarkets that face Wal-Mart. It's easy to grow market share if you build a lot of stores. But actually if we look at market share per store, there are not many positive numbers floating around, and that's half the story because it potentially could lead to deteriorating returns on capital. But it misses the point that the real impact Wal-Mart is going to have on supermarkets is not so much getting market share as much as changing the pricing environment that forces supermarkets to lower their prices, and that's the big issue I see facing West Coast operators as Wal-Mart opens supercenters there over the next few years, because margins in California, Oregon or Washington are considerably higher than in the rest of the country.

GIBLEN: Wal-Mart definitely has a big war map, and like a heat-seeking missile, it goes after the weakest chains and independents, which means it's going to be doubly hard for a second-tier chain, let alone most independents, to survive because Wal-Mart is specifically saying it seeks to grow at the expense of those weak operators. I think it's not an accident Wal-Mart is only now going to California. Wal-Mart cunningly sharpened its shark's teeth going up against weak chains and independents and tearing them apart, and now it's ready to attack Safeway.

CURRIE: Do you think Wal-Mart actually targets anybody specifically, or do you think it just builds stores and is successful wherever it goes?

GIBLEN: I think it targets bad operators, and it knows very well who they are.

CARTWRIGHT: And it targets low-cost markets first and foremost. Winn-Dixie certainly is a good example. Wal-Mart saw there was weakness there and focused on that chain and the markets in which it operates. I'm not so sure Wal-Mart focuses just on the small players and the independents as it used to. Now I think it focuses more on those companies whose formats and cost structures make them vulnerable.

GIBLEN: I think the independents are so widespread that it's hard to focus in on them. But I don't think it's an accident that Winn-Dixie in Texas had to be disbanded because of Wal-Mart's saturation siting there. Winn-Dixie just was not defensible there, and Wal-Mart forced it out. And indeed there actually is capacity reduction from that, even though some stores got picked up.

SN: What has Wal-Mart been doing with its various formats to improve the boxes, whether it's the warehouse club or the supercenter? Has it continued to make improvements?

ZIEGLER: Oh, yes. Wal-Mart starts out with the deuce of clubs and winds up with the ace of spades. I remember seeing the first Neighborhood Market in Fayetteville and feeling it really needed a lot of work. But when you look at the new one in Rogers [Arkansas] and see what the company has learned in just two years, it's really remarkable how much better that store is. It really is designed to be a convenient small-box store.

But I think there are some challenges for Wal-Mart. One is that as the wealth of America moves up, does Wal-Mart have to move up with it? And if it does, that creates a whole new vacuum below Wal-Mart for the Aldis and the Save-a-Lots of the world. How do they price-position themselves? And also, isn't there a challenge in getting real estate for Neighborhood Markets? I would think there's a challenge getting an adequate number of sites -- maybe 200 a year, if that's what its game plan is.

CURRIE: Maybe it can buy all those supermarkets that it's putting out of business.

CERANKOSKY: Wal-Mart has shown it can segment markets. If you look at Sam's five years ago vs. Sam's today, there's a big difference. All you need to do is look at a meat case in a Sam's and a meat case in a Wal-Mart supercenter -- they're light years apart. One is downscale, one is upscale. And Wal-Mart clearly understands that its customers differ in each. Wal-Mart is targeting a distinct demographic with its supercenters and the Neighborhood Market, and that's different from the Sam's stores, but it clearly knows who it's going after, and I think it keeps driving a value message through the supercenters.

CURRIE: It's not as if Wal-Mart is new to the supermarket game. It does own Asda, which is a very experienced supermarket operator that can offer a lot to the Neighborhood Market concept in terms of differentiation. I think Wal-Mart is learning a lot from that business.

A DISMAL STOCK MARKET

Analysts said they expect the share prices on most supermarket stocks -- for well-managed chains and those in turnaround -- to be negatively impacted as sales and earnings slow.

SN: Let's look at the performance of food retailers in the stock market. The SN Composite for the first half of the year was down 3.5% to 4%, compared to a drop of 7.7% in the Dow Jones and 15.7% for the S&P, so food stocks were down by any measure. What's your prognosis for the market going forward, and how will it affect the stock performance in food retailing?

CERANKOSKY: Retailing has got to be sales-driven. We did a valuation study a month or so ago and saw an amazing correlation between a company's sales growth, return on investment and dividend yield. You can hold ROA up for a while by repurchasing stock, but the sales momentum seems to be growing in importance. And I think Whole Foods reflects that -- best multiple, best sales momentum, best comps and best new-store growth. So to get sales momentum of their own, some of the chains are going to have to give up some margin or stop letting margin grow. That's their choice.

GIBLEN: When we talked about stock prices a year ago, we said the turnaround companies were doing great and the big, well-run companies were not. But now the well-run companies have become much less successful, and the turnarounds have generally broken down, too. There just aren't that many companies that are successful. Whole Foods is one that's been successful, and when Wild Oats was able to turn the corner on good positive comps and better earnings trends, that was a successful turnaround. But both Whole Foods and Wild Oats are outside the mainstream of the industry, and within the mainstream, you have both the steady, well-managed companies and the turnarounds having poor results for different reasons. So it's tough, and that's probably how it's going to be for at least the intermediate term.

ZIEGLER: But even for the companies with sales growth, their stocks have come down. Whole Foods and Costco are two names I cover with really respectable sales growth -- more than respectable sales growth -- and those stocks have been hammered as well. So everybody's getting clocked here, and it's just negative sentiment. That will turn around when sentiment toward the stock market becomes more positive, and then I think the rapidly growing top-line companies will probably outperform the market. But having said that, I think we all have to recognize -- and maybe we already have -- that earnings growth rates in this space are either coming down or have come down, so that the earnings-per-share growth of 15% that we talked about a year ago is high. So earnings growth has to come down, and the chains have to figure a way to get the top line going again.

CURRIE: I think the industry has to decide whether it's going to see earnings growth at all. I think there's a real risk in the sector that there are going to be earnings declines. And whilst the valuations of these companies are extremely low and getting into single-digit price-earnings ratios seems low enough, what is uncertain is the E part of the P and E. I think we're potentially at the very early stages of a long period of secular decline in margins. Whilst this uncertainty exists, I'm not sure that supermarket valuations are going to improve greatly. If earnings come down further, we could see continued pressure on the share prices.

MURPHY: I agree in the sense that if you look at the earnings power of these companies, they're really stuck with one variable that's very hard to move, and that's sales growth. There's not a lot they can do with square footage, though the big three, in a sense, talk very similarly about the type of unit growth they can have, particularly Safeway and Kroger, and the rest is just identical-store sales growth. So at most, you're talking about maybe 6% sales growth, and I'd call that very aggressive. It's probably something closer to 4% or 5%. And stable margins obviously mean operating earnings growth of 4%, and that's not very exciting, and that's why the valuations are where they are. And if margins actually do back up the way Neil is suggesting, and I tend to agree, the valuations can get worse. So setting all that aside, I think the one thing they can do is to somehow drive comps because that's really where you get higher incremental returns on capital because you're not having to put new units into the ground to generate a top line. But that's a very tough thing to do.

ACCOUNTING ISSUES COME TO THE FORE

Analysts said they will be more skeptical of supermarket results that use non-recurring charges and other legal accounting standards to make their results look better.

SN: Let's move on to the accounting situation in the U.S. We've seen a lot of companies scrambling to deal with past accounting improprieties. Is there more of that to come?

BERNSTEIN: We can't look at supermarket retailing in a vacuum. We have to look at it relative to other industries. Supermarkets as a business are infinitely more transparent than, say, the health industry and moreso than technology. And certainly there will be accounting issues that come up because of supermarket divisions that book vendor allowances inappropriately or something like that. But at the end of the day, it's just not that hard for supermarkets, and there aren't that many places to hide things. So I think investors in general can have a higher level of confidence in the earnings quality and the numbers coming out of supermarket companies than out of a lot of other companies. They might not be happy with the numbers they see, or it might not be sexy and exciting, but I think as a general proposition, the earnings quality is probably better than other industries.

GIBLEN: I differ somewhat with that because there are some areas that supermarkets have rich ground to play around in. Most of them have mature pension funds, so they can change their pension assumptions, which we saw Safeway do a few years ago. In addition, you have vendor allowances, which can be significant, and those are very unregulated, and you can prematurely recognize them, you can over-recognize them, you can never earn them -- you can play a game with a house of cards where you're always borrowing from the future year until the vendors get really mad and you have a Kmart situation. The Supervalu matter was no big deal in that retail pharmacy [where the accounting error occurred] is an infinitesimal part of the business, truly not central to nor typical of their operation. But I think it's conceivable you'll see more things coming out about vendor allowances, and those can be significant because that can shift a company's whole profitability. I hate to get back to A&P all the time, but the reason why maybe its future guidance disappeared is because it had to change its accounting, and maybe it can't achieve the margins going forward that it could by virtue of lawful but aggressive use of vendor allowances.

BERNSTEIN: I'd agree that vendor allowances is certainly a significant issue. My only point is that it's not like all your sales are in accounts receivable or like you've got jillions of dollars of payables. There are far fewer ways to create fictitious accounting in supermarkets than there are in other industries. That's all I'm saying. There certainly are ways to defraud people in any industry, but I think that short of something like that, it's a lot harder to do in supermarkets.

ZIEGLER: But our companies have found every way to do it that they can. I can think of only two companies that have not reported non-recurring charges since I've been following the space. And when companies start closing stores and taking them as non-recurring charges, it sort of gets my blood boiling a little bit.

MURPHY: I think it's inevitable, over the next couple of years, that there'll be more of this stuff because anybody that has something that might have been borderline in the 1990s isn't borderline anymore. It's got to come to the fore. I just think there's going to be a lot more pressure, and I think it's already happening.

CURRIE: It's not just the companies that are exerting pressure but also the auditors as well. We haven't really seen the end of 2002 yet, whereby we'll have a lot of auditors who may not sign off on a set of accounts that aren't quite right.

CERANKOSKY: I think we have to differentiate between accounting standards and these non-recurring things, where you're trying to push something that's operating in nature below the line. The point is, with comps being sluggish, the market is saying it doesn't care whether an item is non-recurring or not -- the comps are lousy and it wants to see better earnings. But even if they do all these add-backs, earnings still aren't going to be up to expectations. Everything's got to be driven by better revenue growth. However you get to those better sales -- whether the industry consolidates or you cut prices -- you're not going to footnote your way to better results or a better stock price. It's got to be driven by the top line, let alone somebody committing accounting fraud.

CURRIE: But there's a difference between accounting fraud and disclosure. When you think about those issues with Safeway a couple of years ago -- the pension benefits, the insurance gains, the property, profits and real-estate gains -- they were all there for us to see. So maybe it's up to us as analysts to not take what the company says is an ongoing profit and to become a bit more aggressive and say this is what we think the real profitability is. It gets my blood boiling as well when they take charges for closing stores, which is what these companies do year-in and year-out. So maybe it's up to us to give our own opinions of what we think the pre-exceptional earnings are rather than just listening to the company's definition of it.

CERANKOSKY: The interesting thing here is the conflict between research and investment banking. When I got into this business 20-some years ago, I was with a boutique firm in Cleveland that made a very clear statement as part of its marketing that it did no investment banking -- that it was just a research boutique and money management operation. So it makes my blood boil to suddenly see this as an issue in the media, when it's been going on for years and years and years. And it's only become an issue because the stock market went down and people weren't doing their own due diligence or were just listening to their neighbors. Everybody wanted to own IPOs in companies like Webvan and other garbage, but when the stocks went down, they said it's somebody else's fault. I wonder how many people read prospectuses and looked at the 12 pages of risk that were typical in a lot of these deals. But after the value drops, they blame management, they blame the broker, they blame the analyst. And there are a lot of guilty parties here, but you don't hear anybody complaining about Wall Street on the way up.

GIBLEN: I think the market is responding in the way you're suggesting because the companies that do take excessive charges now are used to getting high valuations and now they're getting low valuations, and it seems that no amount of good news can move those companies because they're tainted. So the market is getting to be a lot more efficient, and those companies will have less ability to raise capital and charge high prices and do things that perpetuate the bad practices.

CARTWRIGHT: That's right. The market is looking at cash flow and at return-on-invested-capital and at long-term growth prospects, not near-term earnings. That seems pretty clear.

WHAT ARE AN ANALYST'S RESPONSIBILITIES?

With fewer companies providing earnings guidance, analysts said they will have to be more aggressive in making predictions on their own -- though they anticipate flak from managements that blame the analysts' negative outlooks for their company's underperformance.

SN: Given all these accounting issues, will the role of the security analyst have to change?

CERANKOSKY: I think investors expect us to pick stocks that go up and avoid those that go down. And with the way the industry has acted in the past year, that's been tougher within our sector.

ZIEGLER: It's my understanding that more and more companies are going to stop giving earnings guidance during quarterly conference calls, which is going to make for a lot more volatility, which means we're going to have a wider dispersion in our estimates of sales and earnings growth.

GIBLEN: It's going to make us analysts.

CARTWRIGHT: Exactly. We shouldn't be recommending these stocks based on what the investor relations person tells us every month. That is over.

MURPHY: The benefit of guidance is not that, though. It's to force the company to make a better budget and actually hit it. And the problem is that supermarket companies that are no longer giving guidance are thinking that Walgreen doesn't give guidance. But these companies are not Walgreen-style companies -- they don't have the earnings consistency or quality. So I'd like to see them continue to give guidance because I want to be able to see whether or not they have their arms around the business.

CARTWRIGHT: I think the days are over of calling up companies and asking what the interest rate is going to be and what comps will be to figure out earnings. There's no doubt we're not doing that anymore. What we can do is look across all companies' results and extrapolate. I think it was key when Joe Pichler said this is the most competitive environment he'd seen in years because at that point, I downgraded everybody because if it's bad for Kroger, it's going to be bad for everyone.

ZIEGLER: But we saw that coming before Joe said it. Wal-Mart was out there forever pressuring the space.

CARTWRIGHT: It was also significant when Safeway missed its same-store sales target last July [2001]. That's when I downgraded them. Because when you start to miss your targets, generally more misses are to come. You never see these companies turn things around in one quarter. It just doesn't happen.

GIBLEN: The other litmus test was when Safeway, which has been the best-managed company, lowered its guidance on its growth rate last fall, right after Joe Pichler's "shot heard 'round the world." That said to me the story was over for the industry. Clearly, you would have to extrapolate all the bad stuff from there, which different companies recognized at different times. Pathmark had bad numbers in the quarter that came out in April, and I was guilty of thinking that Jim Donald [chairman and CEO] was being too pessimistic, but really, he was just seeing things faster than companies that are only now coming to grips with reality.

CARTWRIGHT: I myself was guilty of not really paying as close attention to those pension write-offs and similar types of things as I should have been and now, going forward, I do pay more attention.

GIBLEN: But I think that as analysts, we're really not guilty because we have many masters. I think most of us have the integrity where, at least to varying degrees, we have resisted banking pressures, but ultimately we have to do what investors care about, and there have been times when I've had the experience of bringing out some of these issues when nobody cared much about them. At least I've gone from being penalized for bringing them up to being rewarded for discussing those issues.

ZIEGLER: So what do you think is the No. 1 concern of investors right now? I think Chuck hit it earlier when he said there's no top-line growth in this space.

GIBLEN: I think quality of earnings is also important, but we're responding to our audience, and that audience didn't want to hear about that before so what could we do?

CARTWRIGHT: Any time your results are not great, the inclination is to give out less information and to be more inwardly focused. I think that's only natural.

BERNSTEIN: With respect to company managements who are upset with what equity analysts might be saying, they have to understand that they're the guys running their company, it's their company -- you guys aren't stocking the shelves, and it's your job to call 'em like you see 'em. I know life isn't that easy, but a lot of these questions revolve around professional responsibility. I think Neil's comments about investors goes for management teams, too. They have to be willing to step up to the plate, and if results are not good, it's not because analysts have gotten negative on the stock -- results are not good because the company had a tough period.

CARTWRIGHT: Unfortunately, though, there's the perception in some cases -- which I don't think is right -- that if too many analysts are too negative, then we perpetuate the problems with the stock price. I mean, that was actually said to me. I was arranging to take management through cities to visit investors, and I was told by the company it had decided not to visit investors with me because of my rating on their stock. This is a major company. And I told them I was trying to be objective, and they said I was helping to perpetuate the pressure on their stock. And I think that's the view. And this is not the first time that has happened.

BERNSTEIN: Turn in good numbers and the stock price will take care of itself.

CERANKOSKY: Over the years there have been instances where I've had negative opinions on stocks but I've had amazingly good relationships with the managements afterwards. It's the institutional owners who get upset.

CARTWRIGHT: I've never had a problem getting calls returned or being on the quarterly conference calls. This person was perfectly nice and said, "I've enjoyed working with you over these seven years, but we have to pick and choose, and if you change your rating, then maybe we'll reconsider."