FEELING THE PINCH

It was a tough first half for supermarket operators.A combination of labor strife in Southern California and ongoing encroachment from alternative formats made it difficult for traditional supermarket operators to boost sales or earnings during the first half of 2004, industry analysts told SN, and with retailers from Wal-Mart Stores on down trying to drive sales growth, the quest by supermarkets

It was a tough first half for supermarket operators.

A combination of labor strife in Southern California and ongoing encroachment from alternative formats made it difficult for traditional supermarket operators to boost sales or earnings during the first half of 2004, industry analysts told SN, and with retailers from Wal-Mart Stores on down trying to drive sales growth, the quest by supermarkets to hold onto market share will continue to squeeze financial results through the balance of the year, they said.

"This is the worst time ever for supermarkets," Gary Giblen, director of research for C L King Associates, New York, told SN, "because the solutions that solved problems in the past are no longer working.

"Food inflation didn't help the industry in the first half because of the more intense competitive environment created by alternative formats; private-label sales are approaching saturation and didn't produce the large increases of the past. And health care costs in union contracts were increasing rapidly.

"Looking ahead, I don't see any bailout from food inflation. And private-label sales, while positive, are not increasing. Given the consumer meltdown the industry experienced in June and July, the second half could be worse than the first," Giblen said.

Bryan Hunt, an analyst with Wachovia Securities, Charlotte, N.C., also took a pessimistic stance on the outlook for the second half. "With fuel costs likely to rise and a general weakness among retailers on back-to-school sales, the overall retail environment doesn't look very robust for the second half," he told SN.

"Supermarket sales are likely to soften somewhat during the balance of the year, and while margins could improve slightly as commodity price increases ease up, I don't see the operating margin environment improving, with the cost reductions in health care or worker salaries unlikely to kick in until sometime in 2005."

Edouard Aubin, an analyst with Deutsche Bank Securities, New York, expressed disappointment that it's taking so long for the reduced labor rates to kick in.

Contracts negotiated around the country during the first half of 2004 did not produce improved results, Aubin said, "because virtually all the contracts that expired during the half were extended, so the positive impact of any cost reductions the chains might enjoy did not manifest themselves during the half."

He said the first half was "a little bit disappointing. And in Southern California, though the three major chains were able to extract significant concessions from the union, the turnover rate among first-tier employees has been very low as many of them cling to their jobs to maintain the benefits they have. So it will take some time for the benefits for the chains to kick in and have much impact on financial results," Aubin added.

He said he expects some improvements in second-half financial results, "as the industry benefits from improvements in the economy."

"The trend of the last few years was evident again in the first half of 2004, with financial results continuing to be disappointing," said Jonathan Ziegler, principal with PUPS Investment Management, Santa Barbara, Calif. "Top-line sales growth was sluggish at best, with retailers generally feeling the need to drive sales by lowering gross margins, which resulted in negative earnings trends, and commodity inflation proved to be inelastic and could not be passed on to consumers."

Ziegler told SN he's not sure if supermarkets will fare any better in the second half. "We need inflation to creep back into selling prices for retailers to make a good living. But with the same pressures facing all retailers, supermarket operators will probably continue to go after market share with price while opting to sacrifice margins," he said.

On the plus side, Ziegler said he believes retailers are getting their arms around cost structures in the new contracts they're negotiating, "which will put them more in line with discounters."

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., said real identical-store sales -- sales adjusted for inflation -- were weak during the first half, "as they have been for the last six quarters." As a result, while nominal comps have generally increased, comps with inflation factored in were actually 2% to 4% lower during the half, he explained.

Sounding an optimistic note, Wolf said an easing of commodity inflation and an upswing in the price of manufactured goods should leave supermarket retailers in better shape during the second half.

According to Chuck Cerankosky, an analyst with McDonald Investments, Cleveland, second-half results should be better as the chains go up against weaker sales comparisons.

The big event for the industry in the first half was the labor dispute in Southern California, which ended in early March "and which was followed by a sales recovery effort by the three major chains that proved to be very costly."

During the half, several chains both in and outside of California sought to gain share by spending more on promotions in certain markets than they actually needed to spend or where they weren't getting the paybacks they needed, and earnings suffered as a result. "But that kind of margin investment could have positive long-term implications because it has been integral to the consolidation process," Cerankosky said.

The analysts commented on the individual first-half financial performance of each of the top 10 chains with public equity or debt. Their observations follow:

KROGER CO., Cincinnati, which saw first-half sales rise 4.4%, operating income drop 25.5%, and comparable-store sales for the first and second quarters rise 0.3% and 0.6%, respectively (excluding fuel and including Southern California results).

Wolf said Kroger had better sales traction than the other two national chains, "but income was down because it chose to invest more to get better sales." He said same-store sales benefited by about 2% from square footage growth and another 1.5% from fuel sales.

Cerankosky said the biggest detriment to Kroger's first-half results was the recovery costs from the work stoppage in Southern California. "With the combination of the lockout [at Kroger's Ralphs stores] and the investment in market-share growth, it was not a good first half for Kroger," he explained.

"Kroger has two negatives it must cope with," Aubin said. "Given the geography of its store network, Kroger is disproportionately affected by the growth of competition from discounters in the Midwest and Southeast; and because it's been more disciplined over the past few years in terms of controlling costs, there's less low-hanging fruit for Kroger to pick off than for Safeway and especially Albertsons."

ALBERTSONS, Boise, Idaho, with first-half sales up 5.6%, operating income down 30.3% and negative comps of 3.7% and 1.3% for the first and second quarters, respectively (excluding fuel and including Southern California results). First-half results included second-quarter sales from Shaw's Supermarkets, which Albertsons acquired in April; however, comp-store sales did not include results from Shaw's.

"The total sales increase for the half was not meaningful," Wolf said, "because Albertsons' sales fell 28% in the first quarter due to the Southern California labor dispute and rose 12% in the second quarter due to the acquisition of Shaw's."

Cerankosky said the drop in operating income was due totally to the lockout and would have been up without that event. "While Albertsons can still stand some improvements in its top-line momentum, the systems it is installing are improving its overall cost structure," he said.

Albertsons exited the Omaha, Neb., and New Orleans markets during the half, Cerankosky added, "which reinforced the chain's return-on-investment focus and its striving for critical mass in the marketplace -- something it will continue to work on."

SAFEWAY, Pleasanton, Calif., whose first-half sales fell 1.8%, operating income fell 35%, first-quarter comps fell 0.8% and second-quarter comps were flat (excluding fuel and Southern California results). Safeway took the hardest hit in the Southern California labor dispute than either Kroger or Albertsons because Vons, its Southern California division, was the strike target.

Giblen said Safeway sales declined because of the impact of the strike and Safeway's subsequent effort to rebuild volume, which resulted in a plateauing of comps in the second quarter. "But Safeway's acquired operations -- Randalls, Genuardi's and Dominick's -- continue to exhibit generally lackluster performances, and Dominick's in particular remains in transition while Safeway attempts to resolve labor issues there."

Aubin said the drop in Safeway's operating income in the half was the result of a goodwill impairment charge from Dominick's, which had been classified by Safeway as a discontinued operation and then reclassified as a continuing operation after the company decided late last year not to sell it.

AHOLD USA RETAIL, Chantilly, Va., with first-half sales down 10.3%, operating income down 28.3%, and comps down 1% in the first quarter and up 0.9% in the second.

The drop in Ahold's U.S. retail sales resulted from the company's decision to list the Bi-Lo and Bruno's chains in the Southeast as discontinued operations while it attempts to sell them, thereby weakening the comparison with year-ago revenues, Giblen pointed out. Operating income in the half was hurt by greater-than-anticipated challenges as the company tries to integrate its Stop & Shop and Giant divisions, he added.

Aubin said the declines in Ahold's first-half results were also due to the parent company's taking its eyes off its U.S. operations while dealing with financial issues overseas, "resulting in less capital spending, which caused traffic to suffer across Ahold's entire U.S. store base."

DELHAIZE AMERICA, Salisbury, N.C., which saw first-half sales jump 6.6%, operating income rise 32.9% and comps increase 2.5% in the first quarter and 1.4% in the second. The chain, a division of Delhaize Group, Brussels, Belgium, encompasses Food Lion in the Southeast, Hannaford Bros. in New England and Kash 'n Karry in Florida.

Analysts agreed the chain's strong performance in the half resulted in part from weak comparisons in the prior year, including an accounting change that boosted income, as well as the weak showing by competitors Winn-Dixie and Ahold's Bi-Lo and Bruno's chains.

Ziegler said Delhaize America benefited from best practices derived from Hannaford and others imported from Europe by the chain's parent company, plus the everyday-low-pricing program at Food Lion, "which makes Food Lion stand for something in markets where it competes with Wal-Mart."

Hunt said other factors that helped improve first-half results included the acquisition late last year of Harvey's, a 43-store chain operating in southern Georgia and northern Florida; extensive remodeling activity of the Food Lion stores in Raleigh, N.C.; and extensive remerchandising in health and beauty care, wine and beer, and deli categories that enabled Food Lion to expand margins.

A&P, Montvale, N.J., whose sales rose 7% for the first half of the calendar year, operating cash flow fell 1.4% and comps rose 1.5% in the company's fourth quarter and 1% in the first.

Hunt said the strong jump in A&P's first-half sales reflected the weakness of the Canadian dollar and the benefit of an extra week in A&P's fourth quarter. "But A&P has done a nice job stabilizing profitability over the last three quarters through a series of cost-saving efforts, getting a positive return on new point-of-sale merchandising systems, and reformatting its Farmer Jack stores in the Midwest.

"But offsetting those gains were fallout from the extremely competitive nature of the Northeast marketplace and a more competitive Canadian market over the last couple of quarters," Hunt added.

Giblen said the extra week in the fourth quarter added approximately 2% to A&P's sales increase, while the positive comps came mostly from the chain's Canadian operations, where competition was more relaxed during most of the six-month period. "But U.S. comps remained flat because of chronically poor performance," he said.

Operating cash flow in the half was hurt by A&P's investment in gross margin to drive sales at Farmer Jack, "though even that effort did not help comps," Giblen added.

WINN-DIXIE STORES, Jacksonville, Fla., with sales dropping 1.3% for the first half of the calendar year, an operating loss of $3.7 million and comp-store declines of 6.4% in the company's third quarter and 4.3% in the fourth.

Winn-Dixie has achieved stability in its cash flow, Hunt told SN, with operating cash flow rising from $6 million to $17 million in the March-to-June quarter as a result of the company's decision to close underperforming stores and invest in pricing over the past year. But that investment resulted in an operating loss, he pointed out.

"During the first half of the calendar year, same-store sales were worrisome, and the chain still needs to work on building its average basket size and/or customer counts to leverage its fixed cost structure," Hunt explained.

PATHMARK STORES, Carteret, N.J., whose first-half sales rose 0.4%, operating income dropped 41%, and comps fell 1.4% in the first quarter and rose 1.3% in the second.

Giblen said good earnings results but poor comps in the first quarter prompted Pathmark to attempt to rebuild comp sales in the second quarter, "but that effort cost Pathmark a great deal of margin investment and only hurt earnings."

Hunt said Pathmark committed itself to cutting prices, "but its pricing did not generate enough demand to compensate for the margin investment, so profitability was down. The company has done a good job pulling off low-hanging fruit, but there's not much left, and with the Northeast economy hurting and more aggressive promotions by ShopRite in the second half, it will be difficult for Pathmark to continue down that road."

Pathmark is also feeling the effect of opening few new stores in a growth market, Ziegler pointed out. "It has no supercenters to worry about, but it faces serious competition from ShopRite, which is a very aggressive operator."

WHOLE FOODS MARKETS, Austin, Texas, with sales for the first half of the calendar year up 23.4%, operating income up 27.2%, and comps up 17.1% in the second quarter and 14.1% in the third.

Whole Foods continued to benefit during the first half from the increasing acceptance of natural and organic foods among the general public, Wolf said, "particularly when scares like mad cow disease raise public awareness -- and demand -- because organic beef doesn't carry the same risks as conventionally raised beef."

Even without the benefit of the strike-lockout at its 18 Southern California stores, Wolf pointed out, Whole Foods' overall comps were up 16.4% in its second quarter (the first quarter of the calendar year) -- double its historic norm of 8% comp increases.

However, Wolf said earnings slowed during the half -- growing at a rate of 35% in the company's second quarter and only 10% in the third -- as Whole Foods began to expand the rate of new-store openings.

"Sales remained strong, but the impact of the new stores impacted earnings because of the lower profits generated by those stores," he explained.

"Whole Foods' top-line performance is outstanding," Cerankosky said, "and even without the benefit of the Southern California labor dispute, it's doing a great job differentiating its retail food format from anyone else's. The result is a good sales trend, good in-store merchandising and the ability to control overhead costs.

"Consumers are going to Whole Foods specifically for quality merchandise, and the chain has really pulled itself away from the price and promotion jam that retailers in all segments are contending with."

STATER BROS. MARKETS, Colton, Calif., whose sales jumped 34.5% for the first half of the calendar year, operating income rose 200.6% and comps were up 42.2% in the second quarter and 17.1% in the third.

According to Hunt, the volume Stater Bros. picked up during the Southern California strike-lockout is going to stay with Stater. "The strike changed Stater's business forever," he said, "because it's continued to hold a significant portion of the customer base it picked up despite price investments by Kroger, Albertsons and Safeway."

Ziegler said Stater is also benefiting from its everyday-low-pricing program, "which differentiates it from the other operators in Southern California."

2004 First-Half Financial Results

Below are financial results for the 10 largest supermarket chains with public equity or public debt. Although reporting periods vary, the chart represents sales, operating income and same-store sales for the two quarters most closely paralleling the first half of calendar year 2004.

Name: Sales (In Billions $); Change; Operating Income (In Millions $); Change; 1Q Comps; 2Q Comps; Dates

Kroger Co.: 29.9; +4.4%; 645.9; -25.5%; +0.3%*; +0.6%*; 2/1/04-8/14/04

Albertsons: 18.8; +5.6%; 524.0; -30.3%; -3.7%*; -1.3%*; 1/30/04-7/31/04

Safeway: 16.0; -1.8%; 472.2; +0.6%; -0.8%**; 0**; 1/4/04-6/19/04

Ahold USA Retail: 11.8; -10.3%; 536.0; -28.3%; -1.0%; +0.9%; 12/29/03-7/11/04

Delhaize America: 7.9; +6.6%; 428.4; +32.9%; +2.5%; +1.4%; 1/4/04-7/3/04

A&P (b): 6.0; +7.0%; 117.5 (a); -1.4%; +1.5%; +1.0%; 12/1/03-6/19/04

Winn-Dixie (c): 5.2; -1.3%; (3.7); --; -6.4%; -4.3%; 1/8/04-6/30/04

Pathmark: 2.0; +0.4%; 27.3; -41.0%; -1.4%; +1.3%; 2/1/04-7/31/04

Whole Foods (d): 1.8; +23.4%; 113.5; +27.2%; +17.1%; +14.1%; 1/19/04-7/4/04

Stater Bros. (d): 1.8; +34.5%; 101.0; +200.6%; +42.2%; +17.1%; 12/29/03-6/27/04

*Same-store sales including Southern California results and excluding fuel.

** Same-store sales excluding Southern California results and excluding fuel.

(a) Earnings before interest, taxes, depreciation and amortization.

(b) A&P results are for the fourth and first quarters.

(c) Winn-Dixie results are for the third and fourth quarters.

(d) Results for Whole Foods and Stater Bros. are for the second and third quarters.