Chains' Competitive Efforts Pay Off in First Half

The efforts of the nation's largest public supermarket companies to differentiate themselves and strengthen their formats against competitive threats drove strong top- and bottom-line results in the first half of the year, although analysts said it's not clear whether the second half will be as robust.

Continuing the upswing of the prior 12 months, financial results for the half were strong among the industry's 10 largest chains that have public equity or public debt:

• Sales grew 3.6%, on top of a 5.2% increase in last year's first half (excluding results at Supervalu, whose acquisition of Albertsons in June 2006 would have boosted overall sales gains to 16.8% for the half, making for less meaningful comparisons).

• Adjusted EBITDA (earnings before interest, taxes, depreciation and amortization, or operating cash flow, exclusive of one-time and other special charges) for the remaining nine companies increased 5.7%.

• Same-store sales during the first quarter of the calendar year rose an average of 2.1%, following a 3.3% jump in the first half of 2006, and gained an average of 2.7% in the second quarter of the calendar year, compared with a 3.6% increase in the year-ago period.

“The first half was the apogee for supermarkets, with the industry enjoying its best performance since 1998,” Gary Giblen, executive vice president at Goldsmith & Harris, New York, told SN.

But midway through the second half, “things are turning south,” he said, “though it's still hard to say if the downward shift is sharp or slight.”

Giblen said he attributed the industry's first-half performance to several factors.

“The consumer was still very flush during the first part of the year, and most supermarkets had figured out how to compete better against Wal-Mart, with Kroger and Food Lion leading the way.

“You also saw better sales and earnings at chains undergoing format initiatives, like Safeway with its lifestyle stores, and Sweetbay; at companies that improved operations through restructurings, like Winn-Dixie and A&P; and at chains that cracked the code on doing a better job with natural foods to compete more effectively against Whole Foods.”

Giblen said he expects the industry to find itself on middle ground during the second half. “Things are still OK, but not as good as they were earlier in the year, now that the consumer finds himself in an extremely grave condition as the housing market continues to dry up and people see their financial bubbles bursting, and there are some early indications of trading down.

“We're also seeing perishables inflation reaching double-digit levels, and combined with other pressures on consumers, retailers can't simply pass on all the increases, so margins are being squeezed.

“Further, a strengthening by BJ's Wholesale Clubs of its food offerings has hurt supermarket operators in New York, New England and the Southeast; and with Wal-Mart failing in apparel, it's become more aggressive on food pricing,” Giblen said.

Karen Short, an analyst with Friedman Billings Ramsey, New York, said first-half operating performance was strong, “with a lot of retailers fully realizing the benefits of several years of initiatives.

“As we moved into the second quarter there were a lot of built-in expectations of immediate benefits from what was perceived as broad-based inflation, and there was some disappointment the numbers were not stronger than they were,” she said.

“But that judgment was a little hard, and as the industry moved into the second half, it seemed likely inflation would help.

“And there's no reason to believe operating performance will change dramatically in the second half, especially with the likelihood of more inflation,” Short added. “Investors are looking anxiously for signs of consumer changes in anticipation of a recession, and while there may be some trading around within categories, I don't see consumers changing their habits or any drop-off in sales.”

Andrew Wolf, managing director for BB&T Capital Markets, Richmond, Va., said he is leery about the impact retail food inflation could have on second-half results.

“Inflation accelerated from the first to the second quarter,” he said, “and although many of the chains had healthy same-store sales growth, inflation was at 2.8% during the first quarter and at 3.8% during the second, so not all the growth they enjoyed came from improved volume.”

With 40% of the U.S. population earning less than $35,000 a year, “there's a large segment of consumers being hurt by food inflation,” Wolf said, “and if the economy gets worse in the second half, it could have a negative impact on retail business.”

Jonathan Ziegler, a Santa Barbara, Calif.-based analyst for Dutton Associates, El Dorado Hills, Calif., was enthusiastic about first-half performance but also a bit apprehensive as he looks ahead. “Despite numbers that were up against relatively strong comparisons, it was a darn good first half,” he said, “with EBITDA up dramatically because of positive sales along with better cost controls.”

He said the industry's financial performance also reflected improved merchandising; some inflation in retail pricing to reflect higher commodity costs; and higher gas prices, which forced more consumers in the mid- to lower economic strata to eat at home more often. He said the industry's second-half financial performance should benefit from some of the same factors.

In addition, he also anticipates further inflationary pressures from the impact of ethanol on commodity prices and challenging comparisons with the second half of 2006, “which was a strong operating period.”

For Bryan Hunt, managing director for high-yield research at Wachovia Capital Markets, Charlotte, N.C., the industry's first-half financial performance was “strong but slowing,” with sales increases propelled by significant increases in perishables prices and escalating gas prices, which prompted more consumers to eat at home more often.

“But at the same time, you also saw increased penetration of private-label items and the greater incidence of discounting of generic drugs, which helped boost earnings,” Hunt pointed out.

Chuck Cerankosky, managing director at FTN Midwest Securities, Cleveland, said the first half was “pretty good overall,” with Safeway, Kroger and Harris Teeter showing a lot of momentum and Wal-Mart showing somewhat weaker results.

“The companies that did well benefited disproportionately on the earnings line by getting operating leverage from the sales increases or from their ability to take additional market share,” he pointed out.

Cerankosky said he anticipates few changes in the second half. “There will be some impact from inflation pass-through, though that will take awhile to work through the system. But the companies with the most momentum in the first half will continue to show similar trends through the balance of the year,” he said.

Following is an analysis of the financial performance of each company:

• KROGER CO., Cincinnati, whose first-half sales rose 6.7% to $36.9 billion, with comparable-store sales up 5.4% in the first quarter and 5.3% in the second, while EBITDA rose 5.6% to $1.9 billion.

  Kroger's first-half results reflect the success the chain has enjoyed for the past several years, analysts said.

  “Kroger's results are strong relative to most of the other public chains, because it has a better go-to-market strategy that combines merchandising and store ambience with more compelling prices — a combination that resonates with customers,” Wolf said.

  Giblen offered a similar assessment. “Kroger has found a delicate balance between pricing and margins, and that's a good place to be. And because consumers are smart and they recognize that balance, it builds upon itself for good results on an ongoing basis.”

  Cerankosky said Kroger is also benefiting from using loyalty-card data to shape each store to the neighborhood in which it operates — not simply by operating different formats, but also by gearing Kroger-banner stores to local needs.

  “I'm constantly impressed by the way individual locations are merchandised to the local market,” he said. “The company is learning all the time how to do that better, and it gives them a huge advantage over operators with a one-size-fits-all philosophy.”

• SUPERVALU, Minneapolis, whose acquisition of the premium operations of Albertsons in mid-2006 helped boost sales 126.4% during the first half of the calendar year to $23.6 billion, with comps up 1.2% in the fourth quarter and 1.4% in the first, and EBITDA climbing 210.6% to approximately $1.5 billion.

  Giblen said Supervalu's financial performance in the half benefited from the company's ability to work on “a lot of low-hanging fruit” among the acquired stores. “The first six months after an acquisition are the best time to get the easiest gains, and Supervalu has achieved that by doing a better job operating those stores,” he noted.

  Supervalu also got some extra momentum at its Shaw's chain in New England while Ahold's Stop & Shop division was distracted by some of the challenges involved with combining administrative operations with Giant Foods of Landover, Giblen pointed out.

  The company also benefited during the half from the fact so much of its wholesale customer base is in the Midwest, Giblen added. “In areas where agriculture is a big part of the economy and where ethanol prices are rising, Supervalu has a real cushion in its favor,” he explained. “And with escalating gas prices, more consumers are shopping at independent stores that are closer than supercenters.”

  Cerankosky said he was disappointed that same-store sales numbers weren't stronger. “Albertsons, which is the biggest part of Supervalu's retail component, was having sales momentum issues before the sale, and that's one of the reasons it was sold. Now Supervalu is working on those challenges, and it's just a matter of time before it puts it all together and begins achieving the same kind of sales gains as the other major chains.”

  However, sequential same-store sales showed signs of weakness late in the first half, Wolf pointed out, “because of Supervalu's broader store mix, which encompasses Sav-A-Lot, which appeals to a lower-income segment that's affected more by changes in the economy.”

• SAFEWAY, Pleasanton, Calif., which saw sales grow 4.8% to $19.2 billion for the half; comps increase 4.8% in the first quarter and 4% in the second; and EBITDA rise 8.9% to $1.3 billion.

  “Safeway continues to ride the rollout wave of its lifestyle remodeling program,” Cerankosky said. “And even at stores that aren't operating with the lifestyle format, Safeway is using a lot of elements from that format, such as better prepared foods and a wider variety of high-quality perishables, and consumers like that.

  “Safeway is also doing a good job getting its price message across, as it's found a way to combine a merchandising program that emphasizes perishables quality with great Center Store pricing.”

  Giblen also said Safeway's gains are a direct result of its continued success with lifestyle stores. “Lifestyle not only builds sales, but with the emphasis on perishables, it also builds higher-margin sales,” he pointed out.

• AHOLD USA, Quincy, Mass., whose first-half sales increased 4.3% to $11.3 billion, with comps up an estimated 1.5% in the first quarter and 1.6% in the second and EBITDA dropping 17.1% to $871 million.

  While same-store sales at Giant Foods-Carlisle jumped 6.3% during the first quarter and 4.4% during the second, those gains were offset by weak comps at Giant Foods-Landover, which saw declines of 0.8% in each quarter, and moderate comp gains at Stop & Shop of 0.7% in the first quarter and 1.7% in the second.

  Several factors influenced Ahold's U.S. results, Patrick Roquas, an analyst with Rabo Securities, Amsterdam, said, including robust market growth in the Northeast, implementation of a cost-saving program and “the first signs of a successful implementation” of the company's Value Improvement Program at Stop & Shop and Giant-Landover.

  VIP involves lowering prices and cutting back on assortments.

  Giant Foods-Carlisle continued its strong sales momentum, Roquas noted, with exceptionally strong EBIT margins during the second quarter due to less promotional activity.

  Giblen said the numbers at Giant-Carlisle were so strong “because it is a good operation without the problems of the other two Ahold chains, and it goes up against less competition than Ahold's other U.S. operations.”

• DELHAIZE AMERICA, Salisbury, N.C. — encompassing Food Lion in the Southeast, Sweetbay in Florida and Hannaford Bros. in New England — which saw first-half sales grow 4.9% to $8.9 billion, with comps up 1.4% in the first quarter and 2.8% in the second and EBITDA up 11.7% to $492.6 million.

  Sales and earnings were driven mainly by market renewals and customer segmentation initiatives at Food Lion and by the further rollout of organic concepts at Hannaford, Roquas told SN, “though results at Sweetbay lagged expectations due to highly competitive market conditions.”

  Giblen said each of Delhaize's three business segments showed improvements during the half, with Food Lion developing a more vibrant competitive format; Hannaford continuing to weather Wal-Mart's entry into its operating area and benefiting from distractions at Stop & Shop; and Sweetbay benefiting from store closures by Winn-Dixie and Bi-Lo, as well as from its new format.

• A&P, Montvale, N.J., whose sales fell 0.2% to $3.6 billion for the half, while comps fell 1.5% in the fourth quarter and rose 1% in the first, and EBITDA dropped 11% to an estimated $79.2 million.

  With the sale of A&P's Farmer Jack stores in the Midwest late in the company's fourth quarter, overall performance improved, with analysts pinpointing first-half sales in the chain's Northeast core up an estimated 1.7% to $2.9 billion, fourth-quarter comps in the Northeast up 0.9% and EBITDA for the half up 13.6% to $75 billion.

  A&P officials were unable to confirm a precise EBITDA number, explaining, “In light of our ongoing divestiture of non-core operations, the [EBITDA] figures are being revised to align, for the sake of more accurate comparison, with results of continuing operations.” Until those revised numbers have been filed with the Securities and Exchange Commission, a chain spokesman told SN, “A&P is not at liberty to disclose them.”

  Short said A&P sales and profits are benefiting from the chain's decision to upgrade its stores to a more fresh orientation — “on a caliber with Safeway's lifestyle remodels,” she noted.

  With close to 40 stores having undergone major remodelings by the end of the first half of the calendar year, and elements of those upgrades installed at other locations, “A&P's overall same-store sales are up 10%,” she said. Improvements in EBITDA in the Northeast core are the result of the higher-margin fresh mix around the stores' perimeters, she pointed out, “and we're also seeing a more aggressive move toward lowering Center Store pricing to improve the chain's image. Eric Claus [A&P president and chief executive officer] has instigated a small revolution by sticking with the chain's strategy and not worrying about what the competition is doing,” she added.

  According to Giblen, A&P started to see benefits late in the first half from shutting down its Midwest business and pulling back its operations exclusively to the Northeast, “which is its strongest area.”

  Giblen also had kind words for Claus. “He's really been able to get A&P back to basics,” he pointed out.

• WINN-DIXIE STORES, Jacksonville, Fla., which saw sales in the half rise 1.5% to $3.3 billion, comps rise 1.3% in the third quarter and 1.7% in the fourth, and EBITDA turn positive, to $95.6 million.

  Cerankosky called Winn-Dixie “an exciting, classic turnaround where sales per store needed to increase. It went through a period where previous managements tried to find ways to operate a large, geographically diffuse chain, but none of that worked.

  “Now it has a strong merchant, Peter Lynch, as CEO, and the company has found a critical mass of stores it can develop to increase sales per store and improve its market share — though it still has to go up against Publix.”

  According to Giblen, “It's wonderful what happens when you can dump the bottom half of your store base during a bankruptcy and restructure so you're left with your better stores only.”

  In its favor, however, Giblen said Winn-Dixie is doing “fewer things wrong. Lynch is a stronger leader than some of his predecessors, and he knows how to run a tight ship.”

• WHOLE FOODS MARKET, Austin, Texas, whose sales jumped 12.4% in the half to $3 billion, with comps up 6% in the second quarter and 7% in the third, and EBITDA up 0.8% to an estimated $238.5 million.

  “The relatively low EBITDA gain is a result of the company putting too much effort behind getting new stores open, which takes a lot of money,” Cerankosky pointed out.

  “Pre-opening expenses have been higher than expected, but that goes with a rapid expansion. The real estate selection is as astute as in the past, however, so the new store start-up expenses will look like a smart investment down the road.”

  In terms of sales, Whole Foods “continues to be a retail juggernaut,” he said, that attracts a strong consumer response to the freshness, wholesomeness and quality of the offerings around the perimeter, “though it's clear people are not there for Center Store merchandise.”

  According to Wolf, Whole Foods is a growth company, “with square footage growing in the low-double-digit range. And when you grow your store base, sales grow.”

  He said comp-store sales were decent — at the low end of Whole Foods' historic range — “and they stabilized during the latter part of the half as the business overall firmed up.”

  “The numbers are not good,” Giblen said. “The first half of the year has been a turning point where Whole Foods encountered real competition, both from traditional operators and from Wild Oats before Whole Foods acquired it.

  “It was also evident that Whole Foods was enormously distracted by its fight with the Federal Trade Commission [over whether it would be allowed to buy Wild Oats] and by the Web posturings of its CEO, John Mackey, which denigrated Wild Oats while he was trying to buy it.”

• PATHMARK STORES, Carteret, N.J., which saw sales decline 0.2% to $2 billion during the half, comps drop 0.3% in the first quarter and 0.2% in the second, and EBITDA jump 22.5% to $68.7 million.

  With its sale to A&P expected later this year, “Pathmark is running on automatic pilot right now,” Giblen said.

  According to Short, “Knowing the sale is pending and knowing many of the Pathmark people could lose their jobs, simply keeping enough focus to run flat sales is a positive accomplishment.”

  Among other factors affecting results, she said, were ShopRite's more aggressive positioning in the market in anticipation of Pathmark's sale to A&P, “and Pathmark's very concerted effort to sustain profitability while not putting as much emphasis on promotions.”

  Hunt said Pathmark's EBITDA was up “because the company had been remerchandising the stores a year earlier and marking down a lot of products, which meant gross margins were weaker than normal in terms of the comparison.”

• STATER BROS. MARKETS, San Bernardino, Calif., whose first-half sales rose 1.5% to $1.8 billion, while comps rose 1.5% in the second quarter and 1.7% in the third, and EBITDA climbed 41.1% to $113.3 million.

Hunt said Stater benefited from a lessening of promotional activity in Southern California during the half while its major competitors were distracted by labor talks, “which meant it was able to manage the business for cash flow rather than top-line growth.”

Stater itself was not distracted because it opted to sign an early agreement with the union, he pointed out.

2007 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 table represents sales, EBITDA and same-store sales for the two quarters most closely paralleling the first half of the calendar year, encompassing the first and second quarters for Kroger Co., Safeway, Ahold USA, Delhaize America and Pathmark Stores; the second and third quarters for Whole Foods and Stater Bros; the third and fourth quarters for Winn-Dixie; and the fourth and first quarters for Supervalu and A&P.