Optimists' Club

The inflation that's been impacting supermarkets through the summer may be just a blip on the radar screen, or it may have legs long enough to keep margins under pressure, a panel of industry analysts said during SN's 12th annual Financial Analysts' Roundtable. Of the seven participants, five came down on the side, while two said they believe inflation could hang on as a serious industry challenge

The inflation that's been impacting supermarkets through the summer may be just a blip on the radar screen, or it may have legs long enough to keep margins under pressure, a panel of industry analysts said during SN's 12th annual Financial Analysts' Roundtable.

Of the seven participants, five came down on the “blip” side, while two said they believe inflation could hang on as a serious industry challenge for a while.

On other topics during the roundtable discussion, which was held at SN's New York City headquarters, analysts said:

  • Of the three major chains, Kroger has the most sustainable long-term strategy; Safeway's lifestyle format may lose its edge by the time all stores have been converted; and Supervalu's variety of banners should serve it well, as long as it's able to execute properly.

  • The impact Tesco has on conventional operators may be hard to judge for three years or so, although supermarkets are likely to adjust to and co-opt some of the fresh meal programs Tesco offers.

  • The cutback in supercenter openings by Wal-Mart may be a mixed blessing, resulting in a short-term easing of competitive pressures followed by a stronger merchandising and pricing position after Wal-Mart resolves marketing issues in categories other than food.

  • Supermarkets have done a good job of paying down debt, though current market conditions do not lend themselves to debt financing.

Although the analysts said there's been some evidence of trading down among consumers due to inflation, “food retailers are the beneficiaries of a reluctance by consumers to get into their cars and drive any distance at all to spend money they don't have to spend,” Mark Husson, New York-based managing director and global head of consumer research for HSBC Securities, London, said.

“But I think this whole inflation thing will have blown over in three months' time and things will be back to normal again.”

Mark Wiltamuth, executive director at Morgan Stanley, New York, offered a similar outlook. “The consumer is under some pressure, [but] I think food retailers are going to be a little less impacted than the broader retail market, because when people [are] looking to economize, they end up going to the grocery store more often.

“We have a bit of headwind right now with food inflation, but comps are still good and companies are delivering pretty good numbers, so I don't think inflation is going to be as dour as some have suggested.”

Chuck Cerankosky, managing director at FTN Midwest Securities, Cleveland, said the tight labor market should help the industry avoid inflationary challenges. “There's going to be some trading down in certain demographics, [but] if wages can catch up a bit with some of the higher costs we see in food and fuel and general merchandise items, then demand could be a little bit more stable than people might expect,” he noted.

Two high-yield analysts were also upbeat about the outlook for the economy.

“I'm a little bit more on the bullish side,” Carla Casella, managing director of high-yield research at JP Morgan, New York, told SN. “My view is consumers are actually going to hang in there a little bit better than people think because of the strong wage and unemployment numbers.”

According to Bryan Hunt, managing director of high-yield research at Wachovia Capital Markets, Charlotte, N.C., “Unemployment is very low, wage growth has been good and retail sales have been decent, [and while] certain categories have definitely softened up, the consumer is feeling good about [supermarkets],” based on the merchandising changes taking place in such areas as private label and perishables, “and the receptiveness [by consumers] to those changes.”

Taking a more pessimistic outlook, Gary Giblen, executive vice president at Goldsmith & Harris, New York, said concerns expressed by some of the major chains could signal “extreme consumer price resistance and trading down, or it could be a blip.

“Given the many pressures in the economy, I think it's more than a blip, [and] we could see a pretty severe consumer downdraft that would affect even supermarkets.”

Andrew Wolf, managing director at BB&T Capital Markets, Richmond, Va., said inflation is likely to be around for a while because of a doubling of corn prices. “A lot of inflation [is] resulting from what's going on with ethanol,” he explained, with prices at the production level inflating faster than what retailers can pass through.

“The bottom line is, inflation probably has got some legs, and that could be pretty worrisome for retailers, because it could mean prices will be out of whack for a longer time than just a normal commodity-cycle period, and at this point it looks like it's impacting retailers' gross margins negatively.”

The full text of the first part of the roundtable discussion follows. Additional topics will be covered in upcoming issues.

SN: Can you give us an overall sense of the economy going forward and how it's going to impact supermarket operators?

GARY GIBLEN: I think we're seeing the beginning of consumer weakness, which is translating not only into sales weakness but also margin weakness because of consumer resistance to perishables inflation, and inflation tends to be high in perishables these days because of energy prices.

Safeway and Supervalu and some other data points have indicated the beginning of softness, and if it goes to the ultimate extreme, then we could be revisiting a scenario like the late 1970s, where there was extreme consumer price resistance and trading down. Or it could be a blip. I think it's more than a blip, and given the many pressures in the economy — depletion of the piggybank from home equity loans and so forth — we could see a pretty severe consumer downdraft that would affect even supermarkets.

MARK WILTAMUTH: The consumer is under some pressure. Looking at results in the restaurant group that I follow, we've seen same-store sales declines of 1.5% in the casual dining group. That's been going on for some time, and it's all traffic-driven. And we're seeing softness in the Florida and California markets in particular, where the rising adjustable-rate mortgages and weakening home values have played some role in impacting the consumer.

Having said that, I think food retailers are going to be a little less impacted than the broader retail market, because when we did our surveys with the restaurant companies last year, we found that when people were looking to economize, they ended up going to the grocery store more often.

MARK HUSSON: Consumer confidence is good, employment numbers are pretty good and average wages are pretty good. It's like the running of the bulls at Pamplona — every now and then somebody gets knocked over, but most people seem to get through to the stadium and have a pretty good time.

I think that's where the consumer is right now. There is some trading down, with consumers actually avoiding eating out more and eating at home a little bit more, which is exactly the reverse of 2002, when I think this panel said it would be the end of supermarketing as we know it, which turned out not to be the case. And the restaurants at the time were in a very strong period.

So I think there is some behavioral shift here, and I think food retailers are the beneficiaries of a reluctance by consumers to get into their cars and drive any distance at all to spend money they don't have to spend.

CHUCK CERANKOSKY: The other side of inflation is that we're seeing a pretty tight labor market, and if wages can catch up a bit with some of the higher costs we see in food and fuel and general merchandise items, then demand could be a little bit more stable than people might expect. There's going to be some trading down, no doubt about it, in certain demographics, but some of the work we've done indicates the labor market is very tight.

ANDREW WOLF: The industry is definitely very much improved from what it was, though I did downgrade my opinion of the group late in July from overweight to neutral as a result of a combination of some of the things Gary was talking about concerning inflation and some of the trouble supermarkets are having passing those product-cost increases through.

There's also a political component to it, with a lot of inflation resulting from what's going on with ethanol. The price of corn has nearly doubled, and corn is a highly subsidized crop, which is one of the reasons that any products related to corn — which end up being a lot of what we eat in the U.S. — are relatively cheap. But now that the price has doubled, most of the inflation indices I look at are tracking higher, with the major sub-indices tracking higher on the production side than the consumption side.

In other words, prices at the production level are inflating faster than what the retailers can pass through. That was really the basis of my downgrade. At some point it will straighten itself out on the agriculture side, but the bottom line is, inflation probably has got some legs, and that could be pretty worrisome for retailers because it could mean prices will be out of whack for a longer time than just a normal commodity-cycle period, where it's kind of self-correcting in fairly short order.

Looking at produce in particular: There was a big freeze in California in January, with produce inflating 30% year-over-year in the early winter months, and now it's come down, and by the end of the year it'll probably be back to normal. That's an example of a normal supply-side problem that fixes itself through a combination of market forces and nature.

But the inflation that's driven by ethanol has a lot longer legs, because it's driven by the price of its main ingredient, corn, which has essentially doubled. I think it's going to take longer than people might think to really work its way through the complete supply chain, and at this point it looks like it's impacting retailers' gross margins negatively.

CARLA CASELLA: I'm still trying to get over the fact that inflation is hurting supermarkets. I cover a broader universe of retail and consumer products, and supermarkets are the place to hide whenever you're worried about the economy and the impact on the consumer, because historically it's been a more defensive investment than apparel and other retailers. So I tend to agree with a lot of what's being said, and it's my view that consumers are actually going to hang in there a little bit better than people think because of the strong wage and unemployment numbers. I guess I'm a little bit more on the bullish side than the bearish side that's been voiced around the table.

BRYAN HUNT: I'm going to voice more of a positive tone with regard to the economy. First, unemployment is very low; second, wage growth has been good; and third, retail sales have been decent and holding on. There are certain categories that have definitely softened up recently, including apparel. But the consumers' largest balance-sheet item is financial assets, and with the Dow hitting an all-time high during July, consumer buying psychology should have a positive tone.

As it plays out in supermarkets, there have been dramatic increases in tiering of private-label goods and a larger and more exotic selection of perishable items that are enticing consumers to spend more money on new items, and that has been very successful. So I would say, based on the merchandising changes taking place at supermarkets and the receptiveness to those changes by the consumer, that the consumer is feeling good about this channel of retailing.

GIBLEN: In terms of industry impact, let's not forget that gasoline is increasingly significant for many of the chains, and the problem with gas is that it's the most price-sensitive item. You have large signs outside the stores advertising your pricing, and gas accounts for a good part of the household budget, so the public companies that do major amounts of gasoline retailing — such as convenience store chains — have all had to guide their numbers down quite a bit. When wholesale gas prices are high and going up, you cannot pass on your retails fast enough to recover the wholesale inflation. And that's certainly important for Kroger and for all the Albertsons stores that have fuel and, increasingly, for Safeway. So gasoline will pressure earnings for some time, even if it is not a segment reported per se by supermarkets, whereas convenience stores disclose their gas numbers clearly.

CERANKOSKY: Certainly, gasoline is much more expensive per gallon than it was a couple of years ago, but we are cycling $3 gas now vs. a year ago — people have seen it before and they've lived through it. It's not a good thing, but I don't think it's going to be as bad a hit as it was last year. As for supermarkets that are selling it, some have done an extremely good job of tying it into loyalty programs, so while consumers are seeing gas go up, they're also seeing a discount based on what they spend in the store.

In Cleveland, Giant Eagle has run Tops out of town using gasoline, as it's developed a tremendous loyalty for its GetGo gas program. It works well, and it's interesting how it's just about displaced all other promotional and loyalty merchandising. It's been a great program for Giant Eagle — not just because it's pricing gas extremely cheap, but because it's built the loyalty program around how much money you spend in the store.

WILTAMUTH: I think I probably start off a little more sanguine than some. If you stop and look at what the industry has done over the last several years, a lot of corrective measures have taken place across the industry. We've had three years of price reductions from some of the major grocers that have really narrowed the pricing gap with Wal-Mart, plus we're seeing solid same-store sales performance across the industry majors, and now Wal-Mart is actually slowing its supercenter expansion down. So I feel a lot better about the industry than I did two, three or four years ago.

We have a little bit of headwind right now with food inflation, but comps are still good and companies are delivering pretty good numbers, and I don't think inflation is going to be as dour as some have suggested.

WOLF: Of the big three, Supervalu was the only retailer that said sales were slowing, though like most retailers, it didn't know exactly why. A retailer has to look at things in the environment and make guesses, just like anyone else, and it's a fact that if you look and see higher rates of inflation in your product costs, it's clear the economy is going to govern the degree to which inflation can be passed through or the time it will take to be passed through. So first, you've got to look at whether inflation is going to continue to accelerate on the buying side or whether it's going to come down; and second, you have to look at what's going to happen with the economy. If the economy softens further and if consumers have less disposable income, then I think the competitive environment will heat up and it will be harder to pass through food inflation; whereas if the economy rebounds smartly and there is more control of commodity inflation through supply or some other means, then competition will ease and product costs will flow through far more easily.

WILTAMUTH: All three grocers talked about inflation on their most recent investor calls, so it shouldn't have been news by the time Supervalu mentioned it. I've been amused that investors have always viewed inflation as a positive thing. You have to recognize where the inflation is. There's good inflation and bad inflation. Same-store inflation is good inflation, and the inflation in commodity and perishables prices is bad inflation, but I think a lot of investors are on the wrong side of that. That's what caused some of the valuation corrections we saw during July.

CERANKOSKY: I follow a company in Cleveland called Sherwin-Williams, which has over 3,000 paint stores. Last year, when oil prices spiked, everybody was concerned the stock was going to get crunched because there are a lot of oil-based chemicals in coatings. But Sherwin-Williams passed through the inflation very slowly — it made it clear it was not going to be an overnight thing and that it would take a little while, and the stock price has been fantastic.

So passing inflationary price increases through is a strategic effort that you don't do overnight when you're dealing with thousands of SKUs, and whatever the promotions companies have been working on may delay passing prices through promptly.

HUNT: If a retailer hangs a sign up that says “Milk, $5 a gallon,” and you explain why milk is $5 a gallon, the consumer will understand and is likely to be sympathetic and make the purchase. Retailers can't just raise prices 30% to 40% without any explanation and expect consumers to have a positive reaction.

WILTAMUTH: I was just in a Stew Leonard's recently that had a sign up explaining the link between corn, ethanol, cows and milk.

HUNT: What we're really missing here is that we're in a global economy, and the reason dairy prices are so high is not just corn — there's been a three-year drought in Australia, and Australia is a major exporter of whey and nonfat dry milk. So the world is now coming to the United States for those products, and with prices being so high for whey and nonfat dry milk, you've got dislocation.

HUSSON: I agree with Mark [Wiltamuth] entirely, that this whole inflation thing will have blown over in three months' time and things will be back to normal again.


SN: There's been a lot of industry buzz about Tesco coming into the U.S. with 100 Fresh & Easy stores in the next year or so. What's your take on the threat Tesco will pose?

HUSSON: Tesco didn't send Tim Mason [chief executive officer of the U.S. operation] over here to open a couple of hundred stores, see if they work, and then suck it up and leave. He's got a budget to open several hundred stores a year for several years, and the company is building a whole infrastructure, with a big distribution center, a heavyweight management team and a group of vendors coming over from the U.K. to make fresh food because Americans can't cook from scratch.

Cumulatively, when you look at the amount of space Tesco is moving into, it's a market roughly the size of France, and if you think about opening up a few hundred stores, or even a thousand stores, in the greater scheme of things, it's going to be hard to see that impact before 2011 or 2012, which is roughly the time Tesco figures it's going to take to break even.

But I think it's going to be difficult to isolate the impact the Tesco stores will have on supermarkets, because they are going to take business from family and casual dining restaurants, convenience stores, drug stores, non-traditional supermarkets like Trader Joe's and other operators like that as much as it will from Vons and Ralphs. And once the dust from the openings has settled, it'll be hard to find a supermarket retailer who will say he's noticed any significant difference in sales.

WILTAMUTH: I think that's a good point. It'll probably be more of a valuation concern for investors than an actual earnings impact for grocers on the West Coast.

As to whether or not Tesco will be doing acquisitions, I think the last thing Tesco wants to do is start buying legacy grocery stores with union infrastructures. I think it's probably going to stay focused on its new and innovative Fresh & Easy format that is not encumbered with labor contracts.

CERANKOSKY: And I think the Big 3, at least out on the West Coast, are going to learn from Tesco and incorporate some of the best parts of its operation into what they're doing now, especially in the prepared foods area. In fact, they're probably already doing it.

HUSSON: It's going to be hard for Tesco to stop people from cloning it.

WOLF: I only know Tesco management by reputation, which is obviously excellent. But what I do know, hypothetically, is that if it can add a price element to a strong offering in a category like ready meal solutions — a category for which there really is a lot of demand — and if the execution is done well, then I think the business will really be there.

HUSSON: Tesco's demographic appears to be very variable. When you're looking to open this number of stores, it's got to be varied. The thing that unites it, if there is a uniting feature, is that the demographic is very young, and most of your Gen Y-ers and so on have never had to cook and never learned, which should be a positive for Tesco's business.

HUNT: I think the demographic appeal for the Tesco stores will be more widespread than the younger generations, especially if you look at where the big boxes have fallen down — with the older demographic. Walking through a 200,000- or 250,000-square-foot store and having to traverse the parking lot just to get into a supercenter has no great appeal for the older demographic. But if you are not looking to stock your pantry, and if you can park curbside, get through a 10,000-square-foot store quickly and get a single-meal solution, I believe the smaller Tesco format will have great appeal to retirees.

HUSSON: Tesco's strategy, like Kroger's strategy, is to find an adequate return on capital and keep it there. You don't grow it, because if you allow it to expand, competitors will cut you off at the knees.


SN: Will the supermarket industry see any benefits from Wal-Mart's decision to slow down supercenter expansion?

WILTAMUTH: Wal-Mart is going to go from opening 270 supercenters a year to opening 170 in 2008 and beyond, so wiping out 100 new supercenters every year will mean less competition for grocers and less price cutting. We've estimated those 100 supercenters represent about $2.5 billion dollars in expansion pressure that will not be there for the industry, and that's about 19% of the industry growth in a year, which is significant.

HUSSON: On the other hand, the supercenters Wal-Mart does open will still have comparable-store sales in the mid-single digits, which is not quite as good as three or four years ago, though now it is a much bigger company. It's taken something like $9 billion in retail sales out of the supermarket industry this year, which is pretty much the same as last year and the year before. So while the impact on supermarkets seems to have slowed down in terms of percentages, it hasn't really changed in terms of constant dollars, and it's actually having the same impact as it had in 2002 and 2003, when it was supposed to be the end of the world. So while the pressure is not getting worse, it's still going to be at least the same as it has been in recent years.

WILTAMUTH: Where Wal-Mart would have been seeing 12% sales growth last year, now it may grow only 9% to 10%, and on the scale Wal-Mart traditionally grows, that pullback is still meaningful.

CERANKOSKY: And it's putting pressure on weaker operators, so you're seeing Ahold getting smaller, and you saw A&P leave Detroit — and Wal-Mart's still got a lot of stores in Michigan. You're seeing consolidation taking place throughout the industry, and whoever's opening strong stores is putting more pressure on the weaker operators.

HUSSON: Supervalu's worst markets are probably the Wal-Mart markets.

WOLF: Wal-Mart is focusing internally, as it should, and that in itself is a negative for anyone who competes with it, because if it gets better — given its sheer size — and if its comp numbers go up, that's a huge amount of market share that's at risk if it can execute on a good strategy.

Wal-Mart said last spring it was going to get more price-competitive going into July 4th, which it did with a food promotion that worked well. It apparently did rollbacks on 15,000 food items in June, compared with 10,000 in the year-ago period — well above plan, since it was planning food rollbacks on about 13,000 items — so it's really ratcheted up its game in terms of how it promotes, which is generally through rollbacks.

The company has not been doing well for a while, but it appears it's starting to come out of that, and Wal-Mart remains a threat to anyone who competes against it, not just supermarkets.

CASELLA: And all of Wal-Mart's pain has not come from just the food sector. It continues to do fairly well in food, and that's what's keeping it as stable as it has been. It's in apparel and other areas where it needs to do more work, and it can only benefit food when Wal-Mart starts to turn those other categories around.

GIBLEN: Wal-Mart's plan just a year ago was to really go strong on apparel and basic fashion to regain market share from Target. Now that's out the window, because Wal-Mart encountered serious challenges accomplishing it, and it's back to a commodities and price message. Sure, it's good that Wal-Mart's footage growth is slowing down, but the other side of the coin is not very pretty, as Wal-Mart is laser-focusing on further improving the grocery offering and low-price positioning as well.

CERANKOSKY: Wal-Mart always seems to defer to a price strategy.

The Big 3: Kroger

SN: Turning to the conventional formats, Kroger has run excellent numbers for the past couple of years on a simplified strategy of cutting expenses and plowing the savings back into retail. How sustainable is that strategy?

WILTAMUTH: I think it's a sustainable strategy. If you look at the consistency of its execution, the magnitude of its comps over the last two years, all the work it's done with Dunhummby to get back to what consumers want, it's just plain old-fashioned retailing

What Kroger is doing is trying to keep margins flat to slightly up by plowing excess margin back into lower price so it can keep the same-store sales momentum going. In an environment where you're competing against Wal-Mart and other price-focused formats, that's a strategy that holds together, because if you keep investing in the store experience and keep the same-store sales line at a low hum, that'll give you a lot of growth, and healthy growth at that.

WOLF: Kroger has been plowing capital expenditures into the existing store base as its numbers of core stores have been shrinking slightly. That's critical to what it's doing, because at the same time it's getting sharper on price, it is also increasing the store ambiance and the merchandise, all of which determine the value per dollar, or the reason to shop there, which is going up. And it's been a very strong proposition.

GIBLEN: Kroger also does a good job forging harmonious relationships with the union and its front-line employees. That results in direct benefits in terms of productivity and service offerings — for example, a pleasant checkout experience and so forth. So if there's going to be a middle-of-the-road winner — a last chain left standing, so to speak — it's going to be Kroger, which is clearly and effectively positioned.

WOLF: One very important aspect to mention is that Kroger flipped back in philosophy when Dave Dillon took over [as chairman and CEO]. The message now is to drive market share, not lose market share — sort of an old Kroger standard philosophy I think the company abandoned to some degree under Joe Pichler [Dillon's predecessor] to sustain earnings growth.

I think Kroger has the most sustainable strategy, long term, of the Big 3. I believe Kroger will continue to manage for market share and volume in almost any environment, and there are going to be some environments where that's great for earnings and others where it isn't as good. But I think Wall Street investors should understand that's what Kroger's operating philosophy is going to be. The company will try to fine-tune it and get it all. But don't get me wrong: At the end of the day, if Kroger puts a stake in the ground, it's going to go after volume to maintain its market share and try to grow that share. The company has said it, and I think it actually means it. And as others have pointed out, Kroger has proved it. It has the industry-leading share, and it's probably doing better than anybody in the mix. Kroger is definitely in the top echelon of same-store sales growth in this industry.

GIBLEN: To add to your point, gross margin level was not quite what Wall Street wanted in the last quarter, as Kroger saw the need to crank up price investments to maintain robust sales momentum.

CERANKOSKY: I'd like to see Kroger get more into general merchandise than it has been. It's going to be opening more Marketplace stores, and that's a very interesting opportunity. It's already announced Marketplace locations in Louisville and Wichita, and I guess there are some others under way, but it's a way to pick off that general merchandise item that clearly isn't big-ticket but that allows customers to make a sort of treasure-hunt purchase when they see a nice piece of houseware merchandise they might not have bought at another store. Expanding Marketplace is not a big strategy for Kroger, but it is adding a number of those stores.

HUSSON: I agree, the Marketplace format is very interesting, but it's still small potatoes. What's really depressing to me is that Kroger says it's getting return on capital to the point it can start rolling these stores out now, and yet its idea of a rollout is to open an extra seven stores, while we're talking about Wal-Mart going from 270 openings a year to 170 as a dramatic deceleration. I think Kroger lacks aggression when it comes to this area, and I think it ought to be a bit more aggressive than it is.

WILTAMUTH: Is it lack of aggression, or discipline on return on invested capital? I think one of the errors the industry made over the last decade was focusing too much on expansion, rather than on return on invested capital.

HUSSON: Kroger says it's solved the problem of return on investment, so it's not that. Maybe it's just a comfort zone for each division — that it can manage maybe just one or two of these a year without getting all sweaty. But actually I think Kroger is just being lazy.

CERANKOSKY: May I make it a little more complicated? I would suspect these market-by-market announcements [of Marketplace openings] parallel work by Kroger on deals with the union to have the right wage scales in the nonfoods operations. I think that plays a role, because Kroger is competing against purveyors of that type of merchandise that are all non-union, and Kroger has got to make sure it's not way out of line on the staffing for that part of the store. I don't know if that's the case, but I suspect it is.

HUSSON: I think the locations for the Marketplace stores tend to be more downtown than its non-union competitors. They're not stuck way out in the sticks in semi-rural markets, which means Kroger doesn't have to be directly competitive with Wal-Mart in terms of having to have Tide or Bounty at exactly the same price, in the same way Target does. I think it can be a little bit more commercial and more creative than that. Kroger doesn't have to be the same — it just has to get the job done.

CERANKOSKY: Kroger's goal with the Marketplace stores is to generate some impulse buys and get more of that discretionary dollar that might otherwise go elsewhere.

WOLF: One thing Kroger has done in some market areas is to add elements of the Marketplace store in a regular-sized supermarket — putting in a half-aisle or so of items that weren't there before, like kitchen utensils, cookware, wine glasses and other food-related merchandise. These items are geared to be impulse buys, and it's something Kroger is capitalizing on in a logical way, with its internal expertise in general merchandise that enables it to add these items to existing supermarkets.

WILTAMUTH: But it's got to pick its categories carefully. You don't want to see Kroger heading down the consumer electronics gauntlet and trying to outdo Best Buy and some of the other players in that arena. It should stay with adjacencies that fit with grocery retailing.

The Big 3: Safeway

SN: What do you see ahead for Safeway?

GIBLEN: At Safeway, the three most important themes are lifestyle, lifestyle and lifestyle — all the time. Safeway's conversion to the lifestyle format and approach has been successful.

To me, the big question is whether Safeway has picked the easy fruit and the easy stores and will therefore get diminishing returns from ongoing lifestylizing, because you can't do it in every single demographic. But certainly that approach has been the right thing for Safeway to do, given its geographies, and I think it's probably getting a little benefit from the turmoil at Whole Foods. In fact, in some internal communications with Whole Foods management that came out during the Federal Trade Commission's discovery process, management acknowledged that lifestyle is gaining some share from even the formidable Whole Foods.

While it remains to be seen just how universally rollout-able lifestyle stores are, I'd give it at least a 50-50 shot for success.

WILTAMUTH: The lifestyle strategy is going to run out around 2009 or 2010, though, as Safeway runs out of stores to remodel. And in contrast to Kroger's long-term strategy, Safeway tends to gun for a much higher earnings growth rate — in the 12% to 15% range. To get there, it's been augmenting its core growth with non-grocery efforts, such as its third-party gift card business, the Blackhawk Network. I'm recommending Safeway stock right now because I think the Blackhawk Network is not getting fully valued. But in terms of the sustainability of the strategy, it'd probably be safer to focus more on a Kroger type of reinvestment in a same-store sales growth strategy.

CERANKOSKY: I think Safeway's going to hit the gas pedal on acquisitions — not so much buying whole companies, but doing quite a bit more in buying selected castoffs, as Kroger has done in a number of markets where it aggressively competes with a player and then buys some of those stores at less than replacement cost, as it did in Detroit with Farmer Jack. What's going to be interesting to watch is what happens with the overlap between Safeway and the Cerberus-controlled Albertsons units.

HUSSON: With regard to Blackhawk, isn't it clever that Safeway was the company that realized all that traffic coming through the supermarket every single week was something it ought to be able to do something with, and they're the ones who put together the strategy and invested the money?

So it's not only about lifestyle at Safeway. Lifestyle is a manifestation of a broader move that Safeway made — and a broader understanding it has — that good retailers ought to have a brand personality and a point of view. Thirteen or fourteen years ago, you could have taken the signage off the front of any supermarket and put another sign on, and it's conceivable customers wouldn't have noticed any difference, nor would they have had a different set of expectations about the store. I think what Safeway has done is differentiate itself from its local competitors.

More importantly, on the branding side, I think it understands that each category is a personality, and Safeway has a point of view about some of those categories. I think O Organics is a start, and Eating Right is the next stage in that branding evolution. To say that lifestyle runs out in 2010 may or may not be true, but it ignores the fact there are lots of branding initiatives coming along behind that. That was just the most successful one.

CASELLA: To me, there's a little bit of a law of diminishing returns at work here as well. But there are operators in some markets who are trying to emulate what Safeway is doing, or something close to it, though it may not exactly be a lifestyle concept.

HUSSON: I think there are first-mover advantages in the lifestyle approach, and that's certainly true with Blackhawk.

WILTAMUTH: Although Safeway has more sales initiatives and more marketing initiatives, cap-ex dollars aren't going to be thrown at remodels forever, so I think the question is, what is Safeway going to be doing with that free cash flow when it gets to 2010? Is that money going to go to acquisitions, or is the company going to return that capital to shareholders?

CASELLA: Or use it to pay down more debt to be sure it keeps its investment grade rating?

WOLF: I very much concur with Mark [Husson's] take on Safeway. It does see branding as a key to its future, and lifestyle is a major part of it. Too bad it lost Brian Cornell, who appeared to me to be one of the architects of the whole strategy.

I also think, in a bigger context, that Safeway needs this to work, given the spreads between its retail prices and those of a Kroger to a Wal-Mart. Safeway's strategy is to upscale the stores and bring more value to them so it doesn't have to lower its retails in the marketplace. And that's working, obviously, in an economy where the demand for supermarkets has been very good, with restaurant traffic moving to supermarkets for various reasons, as Mark [Wiltamuth] noted.

But in a not-so-good, flat-to-down economy, I still think Safeway has more risk on the sales side with its retail strategy than a Kroger, let's say. And I think that's probably the reason for the greater caution about inflation Safeway executives expressed on the last conference call.

CERANKOSKY: The flip side of that could be that Wal-Mart might be the great counter-cyclical retailer, with people trading back to Wal-Mart if the economy goes in the dumper because of its emphasis on price rather than quality.

HUSSON: Or you could see Whole Foods customers trading down to Safeway.

The Big 3: Supervalu

SN: What will Supervalu stand for over the next few years?

CASELLA: I think Supervalu will stand for a little bit of everything. When a company has something for every market, as Supervalu does, I get the sense it's not going to try to consolidate the brands — and further down the road, I believe it wants to really make its space by differentiating its operations.

WILTAMUTH: I think Supervalu's scheme is going to be plain old retail execution without disruptions. Its whole focus the next few years is going to have to be on stitching this [Albertsons] merger together and not having any blow-ups, so I don't think it's time for it to focus on any particular point of view in its retail presentation. Rather, it's time to focus on the nuts and bolts of retail.

HUNT: Supervalu has a great opportunity for community and store optimization, because it has a peg for every hole, demographically, with Sav-A-Lot, Cub and even Sunflower, so it can address every market opportunity and channel. I would agree with Mark [Wiltamuth] that Supervalu's near-term success is tied more to execution and cost synergy execution than to innovation.

HUSSON: I think Supervalu would agree it's further down the evolutionary tree than the other major retailers are right now. It doesn't have anything that looks remotely like central procurement, and for a retailer with that kind of scale, that's sort of shocking. But that's the opportunity. It's saying, “We're just crawling out of the primeval slime right now, and though we don't look very pretty, see what those hairy guys running around look like? We're going to be doing that soon.”

WOLF: On the other hand, though, if the economy goes bad, Supervalu could be the first to bend, more so than companies with higher asset quality, which it has acknowledged.

CASELLA: One thing that will be interesting to watch will be how Supervalu uses the wholesale side of its business — whether it uses it to its advantage or would ever consider getting rid of it, and how competition develops on the wholesale side. That will be an interesting development to watch, with Target expanding and figuring out what to bring in-house to try to distribute itself, with C&S expanding, and with Wakefern starting to sell to external customers. So I think the wholesale side will be as interesting as the retail side.

WILTAMUTH: One thing Supervalu excels at is a basis-point mentality — squeezing more and more efficiencies out of the system — and with its wholesale business now combined with a bigger retail engine, it's got a lot of opportunities nationwide to squeeze out supply-side costs.

HUSSON: If you look at Supervalu's retail operation — which is a profitable business, albeit with only so-so returns — and then at the wholesale business, Supervalu has got better returns on invested capital on the wholesale side than the core retail business has, and yet retailing is where Jeff Noddle [chairman and CEO] has started his major push in terms of assets. I don't think he would have committed capital to the acquired Albertsons businesses unless he had a very detailed plan of how he was going to get the returns, and I think he spent a lot of time studying the Kroger-Fred Meyer deal, which he realized was the way to do an integration, and the Albertsons-American Stores deal, which was the way not to do it. So actually, even though Supervalu is relatively un-evolved here, it will be another three years before the end of this story is written.

The Northeast

SN: Once the A&P-Pathmark merger is completed, what further steps do you see in efforts to consolidate the Northeast?

CERANKOSKY: Once that deal is done, there are going to be a lot of stores tossed out of that combination and spun off that other operators will buy, so it's a marketing area that has a lot of room for further consolidation. And it's not clear what might happen with the Ahold pieces.

GIBLEN: Weis Markets is kind of sitting there, with $2.2 billion in annual volume but no clear future, so it could be of real interest to some potential acquirers.

HUSSON: Ahold has spent a lot of money on price awareness at Stop & Shop, and my guess is, having made that investment, it wants to stand a chance at least of harvesting something out of that before considering further divestment opportunities.

WILTAMUTH: As we've seen from Kroger and Safeway, it takes time for those kinds of efforts to really start kicking in and get recognized in consumer price perception, so it may take some time before it starts showing up.


SN: The fortunes at Delhaize seem to be going well at Food Lion, Hannaford and Sweetbay. What do you see in their future?

HUNT: I think there are opportunities for Delhaize to do limited acquisitions, given that it looks like Bi-Lo [in South Carolina] is for sale again, and some stores may become available as it exits certain markets. With the conversion of the Kash 'n Karry chain to Sweetbay completed, it's possible we could see Sweetbay picking up some of the Cerberus-run Albertsons stores in Florida. Delhaize has addressed short-term debt maturities on its balance sheet, and as a result it is positioned on the balance sheet to make acquisitions.

GIBLEN: Some of the Bruno's store base could go to Delhaize. That would be a natural thing — to finally fill in that pocket — since Delhaize has actually steered clear of Alabama to some degree in the past because of Bruno's presence there.

CASELLA: Delhaize could certainly look at all those companies that have been mentioned — Bi-Lo, Albertsons, Bruno's and I'd add Winn-Dixie — but I think it was stung a bit by how hard it was to integrate Hannaford, and I think that's why it's stepped away from buying large chains and has stuck to buying a 10-store operator here or a 20-store operator there. So I think it would be more likely to cherry-pick from all of those operators.

HUSSON: I think the integration of Hannaford Bros. was hard for Food Lion, but ultimately that process forced Food Lion to modernize itself. It knew where it was going, but it was evolving slowly, and it was sort of caught in the wrong weather. And now that it's learned how to merchandise fresh food, it's got a pretty impressive meal replacement program going and more than trebled the SKUs in produce, so I think that's actually gone extraordinarily well.

I think the first challenge for Delhaize, before it thinks about buying anything else, is to enjoy being investment-grade for a little bit. The second thing is to try to make some money out of Sweetbay — I think the sales are there, but the profitability isn't yet. The third thing is to try to find something to acquire that doesn't have difficult union relationships. From Delhaize's point of view, one of the reasons it's been able to do well in an environment where it was carrying a lot of debt is that none of its operations have been significantly unionized. A potential problem with the Ahold assets is that they're all union operations, and that's something Delhaize is really not used to managing.

HUNT: Delhaize tried to buy Pathmark back in the day, and it was unionized.

GIBLEN: The question of whether Delhaize would look for an acquisition presupposes there are no Federal Trade Commission barriers to acquisitions. Logically, there shouldn't be in some of these combinations we've been talking about, but it is possible that, given the political aspect of the FTC now and some regrets over past deals that were allowed that were not as pro-consumer as initially conceived — as well as the Whole Foods-Wild Oats situation poisoning the well for the industry — you can't rule out that it may not be possible to do many acquisitions of any size in the industry.

Whole Foods

SN: What prospects do you see for Whole Foods?

WILTAMUTH: The key thing to focus on at Whole Foods is what's going on with the core earnings engine. The company has had some real challenges with pre-opening expense — that's been a completely unpredictable line in its income statement — so it really has to address expenses and get the business back on track in terms of delivering 20% earnings growth. If it doesn't, the stock's going to be challenged for a while.

HUSSON: I think gross margins at Whole Foods will go down, though they haven't gone down in the last two or three years. The problem with the company's sales growth is one of cannibalization, I suppose, and although Whole Foods is opening a lot of square footage this year — something like 1 million square feet — Safeway, with its lifestyle stores, will open and remodel about 10 million square feet, so the competition isn't standing still.

GIBLEN: The Whole Foods model is very volume-sensitive, because the company spends a large amount of money per location to get a beautiful and unique store, and if comps are somewhat slower or consumer behavior is a little bit sloppy, that hurts its internal profitability. I think the Street knows Whole Foods is in for a rebuilding year this year and most of 2008, and it could extend beyond that.

WOLF: As far as Whole Foods' margins are concerned, price studies I've done indicate its dry grocery pricing is at or below market compared with conventional operators. In Washington, D.C., for example, when Wegmans brought price points down in natural foods, Whole Foods actually went down with them, according to my price study, and it was the market leader in branded dry grocery and natural and organic foods, with a spread of about 15% between Whole Foods and Harris Teeter, about 20% between Whole Foods and Safeway, and about even with Wegmans, as it matched their lower prices. It has that opportunity because it's the biggest buyer in the category. So I don't believe the risk lies with gross margin, if it lies anywhere. And, with respect to the gross margin being 5% to 10% higher than at other supermarket chains, the key difference is that Whole Foods is in the restaurant business, and gross margins in restaurants are 70% before the labor component, so it's not exactly an apples-to-apples comparison vs. a conventional grocer. In fact, it's quite different because of all the food prep in the stores.

GIBLEN: Besides the merchandise element, Whole Foods includes occupancy costs in its gross margin, and those costs get de-leveraged mighty quickly if you lose a few percentage points of sales growth.

HUSSON: Gross margins are dynamic, and a pricing study is not a static piece of data. Our job is to try and look forward, and if you look at the natural and organics business in other markets, where it's been part of the mainstream longer, you can see the price premium that organics and quality food have over conventional items is shrinking all the time. For example, the finance director at Sainsbury's [in the U.K.] has said he's looking to get gross margins on the natural and organic side of his business to be exactly the same as those on the dry grocery side, which is a pretty scary number if you're a Whole Foods buyer.

High-Yield Debt

SN: What current trends do you see in the debt market?

HUNT: Over the last 18 months, Ahold and Delhaize have both become investment-grade players, and we've seen dramatic improvements in balance sheet conditions for companies like Stater Bros., Pathmark and Ingles. Looking at how these players have performed in the credit markets, they've been very good stewards of their capital and very good managers of their balance sheets. And if you look at just the leverage points, Stater Bros.' leverage dropped from 4.8 to 4.0, Pathmark moved from 5.3 to 4.2, and Ingles from 3.7 to 2.9 over the last 18 months. That has been a function of both pure debt reduction — the use of free cash flow to pay down debt — and profitability growth. So the supermarket sector has performed extremely well from a debt perspective.

CASELLA: I would completely agree with that. One fear we've had on the high-yield side is, would these companies be able to hold an investment-grade rating? I think both Safeway and Kroger have shown that, even with a combination of expansion, shareholder-friendly activity and heavy investment in stores, they're able to keep their balance sheets strong enough to hold that rating and to keep the rating agencies happy. And now we're seeing Delhaize and Ahold moving out of the high-yield debt market, with each now having one leg in the investment-grade door. So our universe is dwindling, with those two companies moving back up and A&P merging with Pathmark, so there are fewer high-yield supermarkets.

WOLF: Is there a supply-and-demand aspect by the issuers that actually helps pricing? And if so, then if these guys lever themselves back up and slip into high-yields, would pricing for other supermarket issues go down just because of the excess supply?

CASELLA: It could.

HUNT: It would depend on how large the slide would be. A lot of investors want to hold the index credit in a given sector, so if somebody like a Delhaize were to slide back into high-yield, it would pull capital away from the smaller issuers, which is what happened when Supervalu moved from investment grade into high yield.

CASELLA: A key to our markets, from the equity perspective, is that, right now, the markets are very choppy, so any company that needs financing is at risk. I think the largest operators are smart enough to avoid doing something crazy that requires them to tap the debt markets right now, because the debt market is a lot more expensive than it was two months, six months or a year ago.

HUNT: Because of current market conditions, it's precarious for any operator that would need a large amount of capital, and especially debt financing. Whether it's loans, CMBS [collateralized mortgage-based securities] or any other type of secured financing, it's going to be tough right now.

CASELLA: So the market is looking for a good deal.

HUNT: A&P wants to issue $800 million or so worth of senior secured bonds to finance the Pathmark deal, but in today's environment, it's going to be more expensive, and the impact on net income will be evaluated by all of you on the equity side when you do your analysis.

GIBLEN: Is there any greater reluctance to accept synergies in the projections?

CASELLA: Yes, there's a reluctance to anything that is not straightforward or that has a red-flag risk to it. But for deals where you have to assume there's a really big synergy — if there's a big add-back to get to a decent leverage number, or if it's not clear the deal is going to generate a lot of free cash flow from day one, or year one — those aren't getting done.

GIBLEN: But those were OK three months ago.

CASELLA: Yes, but what changed is, the market had gotten too frothy, and deals were getting done too aggressively, without very many covenants, and investors had to accept it because they were sitting on cash, and if they didn't buy it, someone else was going to buy it — it was going to get done, and they would be behind the market.

HUNT: Competition for private-equity-group business is very expensive and can represent more than 50% of deals in a capital cycle. During the recent cycle, investment banks kept stepping up how much leverage they were willing to backstop, and as those guaranteed financings continued to escalate, it led to the market getting indigestion.

CASELLA: Right. Once the banks realize they can't get a few done, they have to hold that paper on their books, and they get more and more conservative about what they'll commit to when they're out there talking to operators.