Weathering the Storm

Financial results among supermarket operators during the second half of 2007 continued their upswing, despite intense pressure from the slumping economy and accelerating inflation in food prices, analysts told SN. The second half was an extraordinarily challenging environment for supermarkets, with the double blow of inflation and a falling economy, and yet they did well, Gary Giblen, executive vice

Financial results among supermarket operators during the second half of 2007 continued their upswing, despite intense pressure from the slumping economy and accelerating inflation in food prices, analysts told SN.

“The second half was an extraordinarily challenging environment for supermarkets, with the double blow of inflation and a falling economy, and yet they did well,” Gary Giblen, executive vice president of Goldsmith & Harris, New York, told SN.

For Bryan Hunt, a high-yield analyst with Wachovia Securities, Charlotte, N.C., the combination of enhanced merchandising by conventional supermarkets, more food-at-home spending and a reduction in the number of supercenter openings by Wal-Mart “created a great window of opportunity for the industry. The last two years have been very good for supermarkets, and that should continue going forward.”

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., said second-half results indicate that supermarkets have weathered the economic storms well. “Given the challenges the industry faced, there was still good sales and earnings momentum — just somewhat less than in the same period in the prior year.”

Composite results for the 10 largest chains with public equity or debt during the second half include:

  • A jump in total sales of 2.5%, compared with an increase of 2.1% in the back half of 2006.

  • An average increase in comparable-store sales of 3.4% in the third quarter of calendar year 2007, compared with an average increase of 3.3% a year earlier, and an average increase of 3.5% in the fourth quarter, compared with 1.9% in the prior year.

  • A rise in operating income of 2.2% for the half, compared with a gain of 11.4% in the second half of 2006.

Wolf said vendors passed on product cost increases as high as 6% during the half, while supermarkets only passed through increases of 4.4%, which impacted sales and margin gains during the half.

“But while the combination of increased product cost inflation and the shaky economy caused bottom-line growth and margin expansion to slow somewhat, top-line growth was still pretty good, though it, too, wasn't maintained at the same pace as in the prior year,” he explained. “What also helped the industry was the slowdown in midweek restaurant dining, which boosted demand at the supermarket.”

Carla Casella, a high-yield analyst with J.P. Morgan Securities, New York, said the industry spent the second half of last year “trying to figure out how to market to a consumer whose pocketbook was being picked by high gas prices and food inflation.

“Usually, food inflation is a good thing for supermarkets, but this round hasn't been great, because there's been so much of it that it's really hurting the consumer — and that in turn hurts the retailer.”

According to Hunt, the industry spent the second half of 2007 playing catch-up on manufacturer price increases, “with some companies not putting all the increases through, particularly on commodities like milk and eggs. And the companies with gas stations, which tend to use gas as a loss leader to drive volume through the stores, took an additional hit on margins as well.

“But despite all that, we saw expansion in operating income because of the tonnage gain from the drop in restaurant patronage.”

Jonathan Ziegler, a Santa Barbara, Calif.-based analyst for Dutton Associates, El Dorado Hills, Calif., said tonnage was certainly not up as much as dollar sales, “but inflation in commodity costs that were passed to retailers by vendors were certainly reflected in shelf prices.”

For companies that sell gasoline — a small component of the 10-chain base — the rapid inflation in fuel prices, amounting to about 2.5%, accounted for most of the top-line gains, Ziegler pointed out.

According to Giblen, the spike in inflation came just as supermarkets had found the right mix of price, quality and service. “But in this challenging economy, even consumer spending at the supermarket was affected, and inflation only exacerbated the challenge to consumers, who found themselves faced with serious sticker shock at the store shelf.”

With food inflation running anywhere from 2% to 3% during the half — a little higher than the inflation rate in the second half of 2006 — Giblen said the industry's generally positive results were undercut by the economy.

“Consumers were actually trading down and eliminating many discretionary purchases, and a lot of the mix was driven by inflation and big increases in gas prices, more so than tonnage increases,” he said. “So it was difficult for the chains to pass on all their inflationary costs. And while there was not a margin squeeze in the second half, there was spor-adic margin pressure, and it took a great deal of effort to keep margins healthy.”

MORE OF THE SAME

Looking ahead, analysts said they do not anticipate much change through the first half of 2008.

“You'll see steady, decent fundamentals overall, but with rapid product cost increases continuing, and a tough economy that should continue to marginalize fundamentals,” Wolf said.

Ziegler said increasing costs from CPG vendors, combined with rising gas prices, “will continue to keep the consumer very price-conscious, and we will see more of that reflected in financial results during the first half of this year.

“The key going forward will be a trade-in on eating away from home in favor of eating more at home — which reverses a trend of the last several years that has favored the family dining industry over supermarkets — and a trading down in what consumers choose to buy, which may make companies a bit more aggressive as they try to maintain some pricing as long as they can before taking a margin hit.

“However, the first half should be mildly positive. The consumer is stretched, and the move to trade down from higher-priced goods will be a mixed blessing, because it will enable retailers to achieve strong margins in private-label goods, though it will hurt them if shoppers switch from steak to pasta.

“I think we'll also continue to see higher sales that reflect increased prices more than tonnage, and I think consumers will be on the lookout for more promotional pricing that has a mitigating impact on high shelf prices,” he said.

Chuck Cerankosky, an analyst with FTN Midwest, Cleveland, said he expects food inflation to have a negative impact not only through the first half, but also through the balance of the year. “I'd be very surprised if it became tepid in the second half of this year,” he told SN.

Casella said she believes the first half “could be worse than last year, because food inflation is not getting better, and the consumer is already weakened from the economy.”

Giblen said the economy shows signs of getting worse, especially outside the supermarket industry, “where even high-income consumers are starting to cut back and spend less. And inflation shows no signs of abating.”

Analysts' observations on second-half results for each company follow:

  • KROGER CO., Cincinnati, saw second-half sales rise 5.8% to $33.4 billion, with comparable-store sales, excluding fuel, up 5.7% in the third quarter and 5.3% in the fourth, while operating income fell 6.1% to just under $1.1 billion. (Adjusting for an extra week in the prior year, Kroger's sales for the second half were up 10% and operating income was up 1%.)

    Kroger had a tough third quarter, Giblen pointed out, because it was unable to pass through all vendor increases, “and it found itself in a margin squeeze. But it rectified that in the fourth quarter.”

    Giblen said Kroger is the most price-competitive of the major chains — “the right positioning in this economy,” he noted — “because it is simply doing a good job. Plus, it benefited from limited exposure to the bust in the housing market, except in Southern California, where it operates Ralphs.”

    According to Karen Short, an analyst with Friedman Billings Ramsey, New York, a third-quarter tax rebate prompted Kroger to accelerate margin investments — something it might not have done without knowing the rebate was coming, she noted.

    Kroger gained share during the half, “because it was actively reinvesting in price, and consumers noticed — and as a result, Kroger was able to capture share from a wide range of sources. And besides narrowing the price gap with Wal-Mart and other discounters, the quality of its offering was strong — and it was aided by the fact high gas prices provided less incentive for shoppers to travel long distances to save money.”

  • SAFEWAY, Pleasanton, Calif., saw second-half sales increase 5.6% to $23.1 billion, with comps rising 3.2% in the third quarter and 2.8% in the fourth, excluding fuel, and operating income going up 9.9% to $988.7 million.

    Although sales momentum slowed, Wolf said Safeway benefited from shrink reduction management “that allowed it to expand gross margin modestly — though its pricing is still less aggressive than Kroger's.”

    Giblen said comps were constrained by the upscale nature of Safeway's lifestyle stores, “and in California, where 40% of Safeway's store base operates, it was hurt by the housing situation.”

    According to Short, Safeway was also dealing with tough year-over-year comparisons during the half, because it had gained significant share during the prior year at the expense of Albertsons, which was going through a change of ownership in late 2006.

  • SUPERVALU, Minneapolis, saw retail sales for the half fall 6.5% to $15.8 billion, while comps, excluding fuel, rose 0.5% in both quarters and retail operating income increased 5.7% to $727 million.

    Giblen said sales slipped in the second half of 2007 as Supervalu dealt with the Albertsons stores it had acquired in mid-2006. “The second-half results reflect the fact the Albertsons stores need a lot of work, and those stores are taking Supervalu's attention away from other retail stores.”

    “Supervalu has been trimming the number of stores as it absorbs the acquired Albertsons business,” Cerankosky said.

    Short said the modest comps “reflect management's efforts to get a handle on the acquired business and to decide which promotional programs it wants to install. Right now the company isn't positioned to be as aggressive as some of the other leading retailers.”

  • AHOLD USA, Quincy, Mass., saw second-half sales drop 5.8% to $9.7 billion following the sale of 71 Tops Markets in early December. Operating income declined 10.6% to $355 million, and comps increased an estimated 0.7% in the third quarter and 2.3% in the fourth. (Excluding the Tops stores from the year-ago comparison, Ahold's U.S. sales were up 3.2% in the second half of 2007.)

    Identical-store sales fell 1.8% at Giant-Landover in the third quarter and 0.5% in the fourth, while comps, excluding gas, rose 1% in the third quarter and 1.2% in the fourth at Stop & Shop and 2.3% in the third quarter and 3.8% in the fourth at Giant-Carlisle.

    Casella said the sales decline resulted primarily from the divestment of the Tops chain. However, while Giant-Carlisle did very well, Giant-Landover suffered from competitive pressures during the third quarter, although an extensive store remodeling effort that began earlier in the year helped improve results in the fourth quarter, she said.

    The drop in operating income resulted from the ongoing impact of the company's Value Improvement Program — involving reductions in pricing and inventory levels in produce, frozen foods and several packaged goods categories — at Shop & Shop and Giant-Landover, an effort that began in late 2006, she said.

    James Anstead, a London-based analyst with Citigroup, New York, said the accelerated rollout of VIP was eroding margins, “though the fact customer price perception is still improving more than a year after the price investment was made [in produce] is a key [positive] point,” he said.

  • DELHAIZE AMERICA, Sal- isbury, N.C., saw sales in the half rise 5.3% to $9.3 billion, with comps climbing 4.6% in the third quarter — the highest comp in the last seven years — and 3.7% in the fourth, while operating income increased 1.9% to $529.8 million.

    Anstead said results were driven “by good performance from all three U.S. banners,” encompassing Food Lion in the Southeast, Hannaford Bros. in New England and Sweetbay in Florida, though he singled out Sweetbay in particular, “[where] all the Kash n' Karry conversions have been completed, and [where] price investments resulted in the highest comp-store sales at Sweetbay since the conversions began.”

    However, he said he was concerned that the company took a fourth-quarter asset writedown on 25 underperforming Sweetbay stores, “though the potential for a turnaround means it is one of the few obvious opportunities for margin accretion [by Delhaize America].”

    Giblen said the company's strong comps reflect the low pricing at Food Lion, “which is positioned right for the current economy,” and weaker competition at Hannaford Bros., “where supercenter expansion has stopped and Shaw's pricing is high.”

    According to Casella, improved sales and comps resulted from the positive impact of marketwide remodeling activity in several Food Lion regions; and to traction gained by Sweetbay in Florida and Bloom in the Southeast.

  • WHOLE FOODS MARKET, Austin, Texas, saw second-half sales rise 32.5% to $4.2 billion following the acquisition of Wild Oats Markets in August; comps increased 8% in the fourth quarter and 9.3% in the first, and operating income dropped 9.6% to $132.9 million.

    Cerankosky said Whole Foods' sales continue to be “very impressive on a comp-store basis, while the costs of assimilating Wild Oats and of launching a large number of new stores put a great deal of pressure on earnings.”

    According to Wolf, “The good news for Whole Foods is that sales momentum has strengthened from a year ago, when the chain was in the midst of dealing with increasing competition from conventional grocers. But that has pretty much cycled through.

    “Sales momentum was also spurred during the half by the pricing spread with conventional chains, as the rapid inflation in conventional food prices made Whole Foods' prices look better on a relative basis.”

  • WINN-DIXIE STORES, Jack- sonville, Fla., saw sales for the half go up 0.7% to $3.9 billion. Comps were up 0.2% in the first quarter and 0.5% in the second, and adjusted EBITDA came in at $41.5 million, compared with a loss in the same period the prior year. (On a non-adjusted basis, EBITDA was $50.7 million compared with a loss.)

    According to Short, Winn-Dixie showed “significant improvement.”

    But in the second half of 2006, shortly after it emerged from Chapter 11, the chain became very promotional, “and it was attracting a lot of cherry-pickers,” Short pointed out. “In 2007, it scaled back on promotions and tried to retrain customers to do less cherry-picking and become more loyal.”

    Giblen said it's been tough for Winn-Dixie to gain traction, “because the Southeast is such a tough area to compete in, and it's been the hardest-hit area for blue-collar workers — plus, there is plenty of Wal-Mart and Food Lion activity there to appeal to the customer looking for low prices.”

  • A&P, Montvale, N.J., saw sales in the second half drop 19.4% to $2.5 billion following the sale of its 19 New Orleans stores in September, while comps in its core Northeast region rose 3.2% in the second quarter and 3.1% in the third. EBITDA jumped 28.2% to $47.3 million. (Excluding the divested stores, A&P sales in the second half were up 3.1% in the Northeast. At the end of the third quarter, A&P acquired 140 stores from Pathmark.)

    “A&P is doing well,” Short said, “as it starts to see momentum from the initiatives it started early in 2006. But businesses are slow to turn around. However, it has the momentum, and that's reflected in the accelerating numbers, and the business trajectory is very strong.”

    A&P has not accepted all manufacturer price increases, she added, “so it's been able to hold prices in many cases, and as a result, A&P had its strongest comps in years.”

    Giblen said A&P has made great strides in its Northeast core area. “Given the problems at Pathmark before A&P acquired it, and at Stop & Shop, it's enjoyed a pretty benign competitive environment, and that has helped.”

    He said the improvement in EBITDA was due to operating improvements that affected margins.

  • STATER BROS. MARKETS, San Bernardino, Calif., saw second-half sales jump 7.8% to $1.9 billion; comps rose 2.2% in the fourth quarter and 3.3% in the first; and operating income increased 0.4% to $56 million. (Adjusted for an extra week in 2007, the sales increase was 3.9%.)

    Hunt said the increase in Stater's sales resulted from inflation and from two new-store openings. “Stater also benefited from increased tonnage in food-at-home that formerly went to food-away-from-home, which became less viable for consumers in the Inland Empire because of concerns over fuel and housing prices.”

    The modest increase in operating income resulted in part from expenses related to the start-up of the company's new distribution center, Hunt noted, but it came primarily from a substantial drop in gross margin during the company's first quarter (the September quarter on the calendar), “when a promotion resulted in more margin deterioration than forecast.”

    “As more consumers got their pocketbooks picked, Stater was able to attract a growing number of customers with its highly promotional everyday-low-price marketing program,” Casella said.

  • HARRIS TEETER, Matthews, N.C. — a division of Ruddick Corp., Charlotte N.C. — saw sales in the half rise 13.6% to $1.8 billion, with comps up 5.9% in the fourth quarter and 4.4% in the first, and operating income up 29.2% to $84.8 million.

Wolf said Harris Teeter's large gain in operating income was driven by sales growth, new stores maturing more profitably, and operating leverage at existing stores driven by strong same-store sales results.

“Sales are so good because the company is well positioned to merchandise in between a Whole Foods and a conventional grocery competitor,” he explained. “Yet, although it has achieved high-end merchandising status, the price perception at Harris Teeter is in line with that of conventional grocers.”

Cerankosky said Harris Teeter is benefiting from a long-term growth plan “that's been making excellent real estate selections. Each store is built to serve a specific market — there's no single prototype — and the sales response has been good.”

SUPERMARKET PERFORMANCE IN SECOND-HALF 2007

Below are financial results for the 10 largest supermarket chains with public equity or debt. Although reporting dates vary, the chart represents sales, operating income and comparable-store sales for the two quarters most closely paralleling the last six months of calendar 2007, encompassing the third and fourth quarters for Kroger, Safeway, Ahold USA and Delhaize America; the first and second quarters for Winn-Dixie Stores; the second and third quarters for Supervalu retail and A&P; and the fourth and first quarters for Whole Foods Market, Stater Bros. Markets and Harris Teeter.

COMPANY SALES CHANGE OPERATING INCOME CHANGE 3Q COMPS 4Q COMPS REPORTING PERIOD
Kroger Co. $33.4B +5.8% $1.07B -6.1% +5.7%* +5.3%* 8/19/07-2/2/08
Safeway $23.1B +5.6% $988.7M +9.9% +3.2%* +2.8%* 6/17/07-12/29/07
Supervalu (retail) $15.8B -6.5% $727.0M +5.7% +0.5%* +0.5%* 6/17/07-12/1/07
Ahold USA $9.7B -5.8% $355.0M -10.6% +0.7%(e) +2.3%(e) 7/16/07-12/30/07
Delhaize America $9.3B +5.3% $529.8M +1.9% +4.6% +3.7% 7/1/07-12/29/07
Whole Foods $4.2B +32.5% $132.9M -9.6% +8.0% +9.3% 7/2/07-1/20/08
Winn-Dixie $3.9B +0.7% $41.5M** +0.2% +0.5% 6/28/07-1/9/08
A&P $2.5B -19.4% $47.3M** +28.2% +3.2% +3.1% 6/17/07-12/1/07
Stater Bros. $1.9B +3.9% $56.0M +0.4% +2.2% +3.3% 6/25/07-12/30/07
Harris Teeter $1.8B +13.6% $84.8M +29.2% +5.9% +4.4% 7/2//07-12/30/07
* Excluding fuel. ** Earnings before interest, taxes, depreciation and amortization. (e) = estimate