Margins Squeezed as Deflation Subsides

Food retailers have been waiting for inflation to make a comeback, but some say it may be awhile before cost increases can be fully passed along to consumers. Some operators that are in the midst of price-reduction initiatives, including Pleasanton, Calif.-based Safeway and Food Lion parent Delhaize Group, said they will sacrifice some margin in the short term, and analysts said it could take a few

Food retailers have been waiting for inflation to make a comeback, but some say it may be awhile before cost increases can be fully passed along to consumers.

Some operators that are in the midst of price-reduction initiatives, including Pleasanton, Calif.-based Safeway and Food Lion parent Delhaize Group, said they will sacrifice some margin in the short term, and analysts said it could take a few quarters for retailers to adjust shelf prices.

Pricing in the last few years has deviated from historic patterns, with the Consumer Price Index for food-at-home increasing by only 0.5% between 2008 and 2009 — the lowest annual increase since 1967 — and declining for the six-month period from September 2009 through February 2010 — a phenomenon not seen since 1959, according to the Economic Research Service of the U.S. Department of Agriculture.

Food-at-home prices increased 0.2% in March — below the increase of 0.7% last March. The CPI for food-at-home is projected to increase 2.5% to 3.5% this year, “slightly above the long-term historical average,” the USDA said.

Steve Burd, chairman, president and chief executive officer of Safeway, said his company is unlikely to boost prices to recoup inflationary cost increases until later in the year.

“Because we're still in a relatively slow economy, we have not been able to immediately pass on [inflation in the cost of goods] in the form of higher retails,” he said in a conference call with investors. “I think it's a temporary phenomenon, and I think the second half will clearly have inflation in it.”

As for gross margin pressures, Burd said Safeway is taking some hits, particularly in commodity prices. “There's been some sacrifice in the first quarter, and there's been a bit more in the early part of the second quarter,” he noted.

“If you think about it, the commodity areas — milk, eggs and meat — are the ones that have just enormous volatility. Couple that volatility with a little sensitivity on the part of retailers to not scare away volume, and you end up [reacting] just a little bit gingerly on the retail side. But at the end of the day, you've got to recoup it.”

In reporting first-quarter results last week, Brussels-based Delhaize said food-cost inflation was basically flat for the period, but its new pricing initiatives, which began in January at Food Lion, helped narrow the gap between costs and shelf prices by 160 basis points.

“Whether there is gap between or no gap between price and cost inflation will be the result of price strategy with Wal-Mart more than anything else,” said Stéfan Descheemaeker, executive vide president and chief financial officer, Delhaize.

The company said it expects cost inflation to gradually return as the year progresses.

Mark Wiltamuth, an analyst with Morgan Stanley, New York, said it could be a while before retailers are ready to raise prices.

In 2004 and 2007 — both periods during which inflation returned — he said sharp increases in commodity prices at those times “played a role in grocers having difficulty passing them through.”

“Grocers tend to have one or two quarters of margin pressure from inflation and then eventually pass through the higher costs,” he said. “We've lived through re-inflation waves in the past, and we haven't found one yet that worked for the grocers. With consumers currently focused on low prices and price discounting, we see risk of margin shortfalls as inflation returns.”

Grocers struggle to perform when prices are rapidly changing in either direction, he said. “The best operating environment for grocers is one with low levels of steady inflation — something at a 1% or 2% level, where grocers can pass through pricing without causing sticker shock for consumers.”

Wiltamuth also noted that it's easier for grocers to pass through inflation on CPG items than on commodities. “Commodity inflation can cause margin problems for grocers [because] inflation in the perimeter can often be rapid and it can trigger declines in volume and demand as the consumer reacts to the higher prices.”

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., said pricing should “turn more rational” as consumer confidence returns.

“My best guess is, inflation will be reflected item by item,” he said. “Retailers will see how long they can continue to make money with prices where they are now, and when they decide they can't, that's when they'll increase them to reflect the higher cost of goods.”

Wolf said he believes it will be the non-price leaders in a market that initiate price increases, “and if they are successful, then others will follow, and if they are not, then everyone will pull back.”

SOME COST INCREASES

Michael Schlotman, executive vice president and chief financial officer for Kroger Co., Cincinnati, recently said the company has seen inflation in some fresh items.

“Milk has gone up a little bit, and if you look at meat and produce, there's certainly been some inflation there,” he said in a recent presentation. “But it's not always a good-news item when produce is inflationary.

“Typically, produce gets inflationary when there's been a bad growing season, which is what we experienced with Florida, and then the disruptions from the earthquake in Chile. But now we are transitioning more to fields in California and Mexico, so the supply is coming back.

“The big thing in produce is the quality of the product. Typically when you have inflation, you have low supply and bad product, so you have consumers paying more for a product they don't like to buy and we don't like to sell. So we're looking forward to this continued transition to other fields to have better-quality products.”

Brian Cornell, president and CEO of Sam's Club, Bentonville, Ark., said in a recent presentation to investors that the chain will make decisions on passing along price increases on a category-by-category basis.

“Clearly, we had significant deflation last year, almost across the board in various categories. What you're seeing this year is some abatement of that deflation and a little bit of inflation in some categories,” he said. “Whether we go into inflation in the second half of the year is anyone's guess, but it's probably moving more toward that direction.”

Frank Forward, executive vice president and chief financial officer for BJ's Wholesale Club, Natick, Mass., said business is getting stronger as the economy cycles through the deflationary trend of 2009.

“Certainly, the beginning of the year has been pretty much how we thought it would be in terms of price deflation, but we thought it would have pretty much cycled through by the end of this [first] quarter and beginning the next quarter, and that's been pretty much how it's coming on.

“So we've been pretty pleased with that and with our ability to get some pretty strong gains at the same time.”

Ron Freeman, CFO for Ingles Markets, Asheville, N.C., said deflation appears to be leveling off. “I certainly don't have a crystal ball on food deflation,” he noted. “But after some pronounced deflation, things seem to have settled a little bit, and that's pretty much broad-based outside of gasoline and milk.”