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Bleak Expectations: Financial Pressures Worry Supermarket Analysts

Bleak Expectations: Financial Pressures Worry Supermarket Analysts

The sluggish economy and other factors will continue to challenge many traditional supermarkets, according to participants in the 2012 SN Analysts Roundtable Part 2 of the Roundtable: Is Kroger All It Can Be?

NEW YORK — The economy is not likely to get better in the foreseeable future, putting ongoing pressure on middle-class consumers and the supermarkets at which they shop, according to participants at SN’s 17th annual Analysts Roundtable here.

The analysts also said they expect Supervalu to sell most of its conventional assets as it tries to retrench.

John Heinbockel, managing director at Guggenheim Securities, New York, said he sees a return of inflation and “very, very tepid growth” for the economy in 2013, which will mean “another challenging environment [where] supermarket companies that have the best value propositions will continue to be the winners.”

He said he does not anticipate an economic turnaround in the near term. “I am very concerned that we are on a long, steady path downward,” Heinbockel noted. “I think we have a long-term trend here where we have to be smarter about what we spend and learn to live with less.”

Meredith Adler, managing director for Barclays Capital, New York, said the accumulated impact over several years of increasing prices for food and gas can become “really scary [for] people who don’t have a lot of money.”

According to Scott Mushkin, an analyst with Jefferies & Co., New York, “That’s been more or less the story of the middle class for years, and it will probably destroy the supermarket industry as we know it if we continue down this path. It’s really kind of that simple.

 “The middle class is still under a tremendous amount of pressure, and it feels like [the economy] is muddling along because nothing is happening very quickly. Income is actually going down, [and] people are simply buying less of everything.”

Adler said the ongoing pressures have changed the way people spend money. “I think the financial crisis has changed the way we think about keeping up with the Joneses, which people are doing a little bit less.”

Andrew Wolf, managing director for BB&T Capital Markets, Richmond, Va., said he believes people still want to keep up with the Joneses. “I don’t think America’s going to stop being consumer-driven,” he said. “If the economy turned better, consumers would spend money.”

Mushkin also said he believes consumers still want a lot of things, “so it’s not about keeping up with the Joneses but more about pent-up demand.”

But with consumers watching the price of food and gas continually going up, “there is no cushion in their budgets to deal with rising prices,” he said. “Gas goes up or food goes up, and they find themselves having to make really tough choices.”

That goes for supermarket operators as well, he added. “They will face a tough choice on how much of the price increases to pass through, and given the current macro climate, it’s hard to see how meaningfully higher input costs will not pressure margins.”

Until the economy recovers, however, even value-priced stores are likely to see “a very strained consumer [who] continues to think about every dollar she spends,” said Deborah Weinswig, managing director, Citigroup, New York.

Gary Giblen, an independent analyst, questioned whether “you will see a meaningful weakening in expenditures at Whole Foods and Fresh Market and in the upper end of conventional grocers” if upscale consumers also begin to experience economic pressure — a prospect suggested by sales trends at high-end retailers in other industries.

Mushkin said the best hope for supermarkets might come from Millennials — consumers still under the age of 25 — who have been slow to form households. “It’s possible we’ll see a renaissance of the food-at-home industry sometime next year, driven by the Millennials as they begin forming new households,” he said.

Turning to a discussion of Supervalu, most analysts said they expect the Minneapolis-based distributor to shrink its size by selling off assets.

“Supervalu needs to seriously consider strategic alternatives to protect the [store-level] employees,” Mushkin said. “It’s better for all constituencies to see assets move now and shrink Supervalu to a core retailer-distributor in the Upper Midwest and the Intermountain area.”

Potential buyers mentioned by the analysts included Ahold, Delhaize and possibly even BJ’s Wholesale Club for Acme or Shaw’s in the East; some combination of Kroger, Safeway and Stater Bros. for Albertsons in Southern California; and Kroger for Jewel in the Midwest.

“Kroger should be the dominant operator in Chicago — [Jewel is] Kroger’s missing link in the Midwest,” Heinbockel said. “If I were Kroger, I’d offer Supervalu a very, very low price and say, ‘Take it or leave it. And if you don’t take it, we don’t need it.’”

If Supervalu does do an asset sale, Heinbockel said he believes it’s likely the distributor will end up with its value-oriented banners — Cub Foods, Shop & Save, Shoppers Food Warehouse “and little else.”

Most of the analysts said they believe Save-A-Lot would be an attractive asset to sell. Heinbockel suggested it could sell for $1.5 billion to $2 billion, and Adler said the sale of that chain “would give Supervalu a lot of breathing room so the company could continue to operate the rest of its banners.”

As for the prospects for Supervalu’s financial performance going forward, Heinbockel said the company should have become more aggressive on price two years ago. “Doing it now is a little better than doing it two years from now, but the timing was very ill-conceived,” he said.

He said he expects comparable-store sales to fall as low as negative 6% before any recovery, “but they won’t be positive for quite some time.”

Part 1 of the roundtable follows:

The Economic Impact

SN: How will the economy impact the supermarket industry over the next few months?

John Heinbockel: A year ago we were pretty bearish, and I think very little has changed. If you look out to 2013, income will be under more pressure as we cycle the payroll tax cut, assuming the rest of the fiscal cliff is dealt with appropriately. I don’t think the labor market is that much better than it was, and inflation is coming back, which I think on balance is a bad thing for consumers but not for retailers. But income is the most important factor to most people, and it will remain under a fair bit of pressure, and I don’t think that is going to change. So the expectation has to be that we are going to see a non-recessionary economy in 2013 with very, very tepid growth. It will be another challenging environment, and I think the supermarket companies that have the best value propositions will continue to be the winners.

Deborah Weinswig: Looking ahead, I think the top 25% of the population — those whose incomes are tied to the stock market and who are less concerned about the value side of shopping — will continue to see some upside. And the companies they shop at — like Whole Foods and The Fresh Market — are the ones that will see the best performance in comps and the ones that will outperform the rest of the industry. For those shopping on the value side, however, we will continue to see a very strained consumer. These are the people for whom Wal-Mart has really gained a huge amount of mind-share because that consumer continues to think about every dollar she spends.

Meredith Adler: There’s a big mystery right now about what’s happened to volume. The data that’s coming out of CPG companies suggests volumes are down 2% to 3%, which leads me to wonder where people are eating. It’s not at restaurants. So are they eating less? The CPG data doesn’t count perishables, so could people be eating more perishables? In a previous recession people ate a lot of potatoes, and sales of potatoes went up a lot. But right now it’s still a mystery to me.

Andrew Wolf: The growth in perishables was especially strong during the second quarter of this year. An executive at a large foodservice distributor asked me the same question — where are people eating? He wondered how people could raid their pantries for so long. But he also noted that the produce business was up in double digits. There has certainly been a lot of deflation in produce, so I think people are eating where they can get the best value, and lately that has been in produce.

Gary Giblen: Produce consumption sure is up, and that’s likely to continue because we have another big round of packaged food inflation coming due to the drought, and that will impact cereal and a lot of other foods that depend on corn and grain input costs — so that’s sadly one more challenge ahead for the industry, just as an earlier wave of food inflation wreaked havoc but eventually got digested.

What will be interesting to see is whether high-end businesses continue to hold up. I keep an eye on data-points outside the food-at-home retail industry per se, and there are signs of chinks in the armor at the upscale end. For example, Nike and Ralph Lauren, which are awfully strong, fashion-driven brands, are seeing some weakness; and Tiffany and Coach are affordable luxury accessories that had been resilient and then all of a sudden showed weakness.

Even food-away-from-home has to give you pause. For example, Starbucks saw a shockingly precipitous drop in its U.S. business starting in June; and low-cost restaurants like Chipotle, Buffalo Wild Wings and McDonald’s, which typically weather economic storms, are also softening. So it could well be the shoe will drop on the more upscale supermarket customer, and you will see a meaningful weakening in expenditures at Whole Foods and Fresh Market and in the upper end of conventional grocers.

Scott Mushkin: I’ve spent a tremendous amount of time trying to figure out some of the trends affecting this industry, and one of the things we’ve seen is a move to fresh. In a study comparing Baby Boomers and Millennials, we found that fresh transcends generations, which bodes well for companies like Whole Foods.

Giblen: Color me cynical, but I’ve observed that people typically give up their ideals to save a buck or to avoid inconvenience when the need arises. They talk idealistically but act on their pocketbooks. The politically correct sentiments Millennials are expressing now about natural foods could prove as frail as the next missed bonus or an increase in the college tuition bill, let alone the next pink slip that hits the family.

Mushkin: In a study we did about U.S. demographics, we found the people that spend the most money on food-at-home are between the ages of 35 and 54, whereas there is a lull among Millennials to form households — it’s actually running at one-third the rate you would normally expect. And when we quantified that data, it indicated a drag of 50 basis points on the industry, though that should reverse itself over time. In essence, if we could speed up household formation, there are enough Millennials now over 25 to overwhelm a 35 to 54 population lull, so that by 2016, you’ll actually have growth in the 35 to 54 population for the first time since 2008, which was the first time volume went negative in the industry. And I think it’s possible we’ll see a renaissance of the food-at-home industry sometime next year, driven by the Millennials as they begin forming new households.

Weinswig: So you think part of the economic decline is due to a lack of household formation among the younger generation?

Mushkin: Oh yes, totally. According to the Pew Research Center, the number of people 25 to 34 living in multigenerational households is 21.6% — the highest it’s been since the 1940s. There are also cyclical factors at play — at least I hope they are cyclical. If you look at median incomes in the U.S., the years that supermarkets outperformed the market were between 2005 and 2007, which were the only years median incomes actually rose since 1999. Supermarkets are middle-class shops, and it’s the middle class that’s under tremendous pressure.

Adler: The data we look at indicate that just about 20% of U.S. households are part of the government’s Supplemental Nutrition Assistance Program — a number that was up 5% in the last set of data — and it hasn’t leveled off yet …

Mushkin: … which is a huge problem because what that indicates is, the middle class is still under a tremendous amount of pressure.

Adler: What are the chances the economy just keeps muddling along?

Mushkin: It already feels like we’re muddling along because nothing is happening very quickly. If you look at the income data, it’s actually going down, and it has been for the past few years. Things are slowly decelerating, and that’s been going on for years. There was a study done that indicated tonnage is actually down throughout the whole economy, not just in food. People are simply buying less of everything.

Wolf: People are de-leveraging. You don’t spend as much when you are not borrowing money from the bank or loading up your credit card.

Weinswig: When Europeans come with us on store tours, they say, “You Americans have so many things.” There’s this growing idea of having fewer, better things and that it’s cool to be frugal.

Adler: I think the financial crisis has changed the way we think about keeping up with the Joneses, which people are doing a little bit less.

Wolf: But we don’t know if that will be permanent or not.

Adler: Everything goes in cycles. I think it’s been going on longer than we think, maybe since 1986.

Wolf: I think people still want to keep up with the Joneses, and I don’t think America’s going to stop being consumer-driven. If the economy turned better, consumers would spend money.

Heinbockel: Look, I’m pretty bearish socially. The Boomers haven’t saved nearly enough, and they are going to have a lot less to spend going forward. And I think the Millennials aren’t going to have anything near the standard of living that we have had, so I think we have a long-term trend here where we have to be smarter about what we spend and learn to live with less. That’s why I am so bullish on anything value-oriented, anything that speaks to frugality, and I don’t see a way out of that. We could start to see our way out of it with the election, if we start to deal with the deficit. But I am very concerned that we are on a long, steady path downward.

'Could See Some Social Unrest'

Mushkin: We can’t afford to continue down this path we’re on. There is a massive wave of Millennials that are 22 years old, and the unemployment rate for people ages 25 to 34 is already really high. That’s why we could see some social unrest unless we get this economy kick-started in the next year and a half. If we do, then pent-up demand is going to be there. So it’s not about keeping up with the Joneses but more about pent-up demand.

Wolf: I think a lot of what has been pressuring middle- and lower-income consumers is gas inflation. The price of gas went up a buck a gallon last year — about $75 a month for an average household. Depending on who you are, you’ve cut back on a lot of spending — and then in 2011 there was a big ramp-up in food inflation, which resulted in a lot of sticker shock that’s more visceral. You go to a supermarket and the price of Wheaties is up, and you’re already hurting because you’re paying so much for gas. I think a big part of consumer behavior is inflation-fatigue, which has really impacted consumers’ budgets for necessities, so they are going to shop at a cheaper store out of necessity.

Weinswig: Kroger was saying that, despite the drought, it doesn’t feel manufacturers will necessarily push along everything that is coming through. Right now you can actually see beef being slaughtered early because of the demand destruction that happened last time we were in this situation. So we are experiencing a very different pace of inflation coming through this time.

Adler: Except that the herds have already been culled, and I don’t think there is as much to cut.

Mushkin: If you look at the percentage of spending on food and fuel among the first, second and third quintiles, it’s much greater than the spending among the fourth and fifth quintiles. These consumers tend to be very heavy users of the food-at-home channel. At the same time, they are seeing their incomes under pressure, meaning there is no cushion in their budgets to deal with rising prices. Gas goes up or food goes up, and they find themselves having to make really tough choices. For the supermarket companies, they will also face a tough choice on how much of the price increases to pass through, and, given the current macro climate, it’s hard to see how meaningfully higher input costs will not pressure margins.

Heinbockel: Some people make way too much of a fuss about gas prices. When you think about it on a macro level, unless it’s up big or down big, you’re talking about a $10 billion to $15 billion swing, and I think this is noise. A lot of it comes back to income, and we saw a substantial drop in income between December and January as we cycled the payroll tax cut. Personal income growth slowed to 3% from 4%, and we will see another 100 basis points of moderation this coming January as the payroll tax returns to 6.3%.

With regard to inflation, I don’t think we will see what we saw two years ago. Inflation is not going to be up 6% — I think it will be more in the ballpark of 3% to 3.5%, and that’s a manageable amount for most households. People will just cut back more on their discretionary spending, and that’s less of a problem for pure food retailers.

Adler: Except that if there had never been any deflation — putting produce and meat aside because they are unusual — then you’re talking about putting 3.5% on top of 4.5% to 6%.

Heinbockel: That’s fair, but you have to cut back elsewhere.

Weinswig: When gas prices are down 7% in a week, I think the consumer has 7% more money in his pocket, and he spends it at the grocery store. If your household income is $40,000 a year, which is what Wal-Mart’s average customer earns, then Wal-Mart sees it immediately in its average ticket because people just have more money to spend.

Wolf: I really think gas inflation is meaningful. You said if it doesn’t move a lot, then it’s just noise. But it moved 26% last year, and it moved 18% the year before. That’s not noise.

Heinbockel: On a year-over-year basis, it’s been flat in 2012.

Adler: I don’t think people on a limited budget are thinking about how much money they had last year or what gas prices were last year. The only thing they are thinking about is what is coming in and what is going out.

Mushkin: For households earning $25,000 a year, $3.50 a gallon used to be the sensitive area, but our surveys indicate people are beginning to get desensitized to that number, and it looks like the sensitive level is shifting to $4. We were kind of caught off guard a little bit when gas prices fell below $3.50 — we thought it would be more important than it has been, and if it had moved below $3.50 a gallon two years ago, it would have been much more important. But I think it’s psychological —$4 a gallon is a lot, and I think it makes people get really nervous.

Heinbockel: I don’t think they feel better at $3 — I just think they feel worse at $4. All regression work we have done comparing the absolute level of gas prices — you can’t look at just the percent changes — to individual company comps consistently shows a surprisingly low correlation. Gas prices get a lot of publicity, but I think they are a very overrated factor unless they hit magical levels like $4 a gallon.

Adler: What’s really scary is when you think about all those factors accumulating and piling on people who don’t have a lot of money.

Mushkin: Yes, it’s very disturbing, and that’s been more or less the story of the middle class for years, and it will probably destroy the supermarket industry as we know it if we continue down this path. It’s really kind of that simple.

Weinswig: If you go back to 2009, there has been a direct correlation between gas prices and traffic at Wal-Mart every quarter.

Adler: People are choosing where to shop based on gas prices, but I think we are also talking about how much money is in their pockets.

Giblen: Here’s a real-life example of how food consumers have adjusted to and tuned out higher gas prices. For the last two years, the only promotional effort at Ahold’s Stop & Shop in Connecticut was a tie-in with Shell gas, where you could accumulate points for dollars spent and get a discount on purchases at Shell, which is an expensive gas. That seemed to be working for Stop & Shop, which otherwise had very high prices. However, the chain recently began bombarding people with hotter front-page specials and offering $5 off purchases of $30 at the same time it de-emphasized the Shell program, which I think indicates people care less about gas — they simply assume it’s at a high level and that’s that.

Wolf: I think another thing going on with the economy is that people are slowing down until they see where the dust settles in the European economic crisis. If that ultimately puts us into a recession, they want to save some money for it, so they are acting very rationally.

Adler: For businesses, that’s an even bigger issue. In terms of jobs, businesses are all on the sidelines waiting for the worst to happen.

Wolf: I agree — there are a lot of negative headlines around, and people are picking up on that.

Stock Prices

SN: What impact are these factors likely to have on retail food stocks over the next year?

Adler: The winners will continue to win and the losers will continue to lose, and Kroger will be somewhere in the middle.

Mushkin: That’s been the situation for years now, and you wonder how much longer that’s actually going to be the case. Valuation is a good thing to think about, though it is not exactly parallel with stock prices, but if you look at Safeway’s stock, which is priced at four times EBITDA and Whole Foods at something like 13 times EBITDA, it’s very hard for that to continue for a long period of time for socio-economic reasons. One of them is going to actually come up or one of them is going to go down and narrow the gap, even though one is a clear winner and one is having a hard time. The fact the gaps are so wide right now reflects what is going on in the macro environment.

Adler: On top of that, there are also a lot of technical factors. The stocks don’t always reflect the industry or even the chains’ prospects of earnings, so both Supervalu and Safeway are trading the way they are in part because of their leverage and their liquidity, and those are company-specific.

Mushkin: Safeway’s leverage, which is really not all that high currently — even after it borrowed money to buy back stock — is only a big problem if EBITDA dollars continue to fall.

Wolf: The stocks are definitely priced with the expectation EBITDA will continue to go down. I think conventional chains are going through a long process, which started with Kroger, of getting a new price equilibrium compared with the discounters — whether it was forced by the tough economy or simply exacerbated by the economy. Everybody is going through that, and there is not yet equilibrium because gross margins keep going down.

Adler: The market thinks all of this is structural. Several people asked, when commodity prices started going up, who is going to be hurt the most, and my answer was, the consumer. There is no understanding by investors that the pie is shrinking.

Mushkin: The pie is shrinking, and it has been since 2008, according to our data. It’s amazing to think that the pie is shrinking in the food-at-home vertical.

Adler: Especially since food-away-from-home is not growing.

Mushkin: Some of it is demographic, and some is economic, but it is shrinking.

Adler: Even when Wal-Mart started struggling in 2009, people asked, where is its market share going? The share didn’t go anywhere — people simply stopped buying things they didn’t need. I find investors have a hard time with that concept because they don’t see spending going down.

Weinswig: There was pantry de-stocking, and people just never reloaded. They decided they didn’t need to replace all of the stuff they had.

Adler: I have a theory that they actually reloaded last year following a lot of promotional activity, and now they are de-stocking again.

Wolf: Until gross margins stabilize, I think you’re going to see a lot of problems for companies like A&P and Winn-Dixie — and what’s going on with Supervalu — that’s going to get exacerbated if the economy stays sluggish and inflation returns.

Adler: When you look at individual companies, a lot of what happens with their stocks will be dependent on what happens to the Supervalu assets.


SN: How does the situation at Supervalu look to you?

Heinbockel: The lower comps at Supervalu are not a surprise because of the dis-inflation this year. What does surprise me is, Supervalu hasn’t protected profits better, which is due to not having cut costs fast enough. And I was a little surprised that it’s finally decided to get more aggressive on price now. That should have been done two years ago. Doing it now, I guess, is a little better than doing it two years from now, but the timing is very ill conceived.

Mushkin: I think almost all of what Supervalu is doing is positioning — getting a line of credit that’s asset-backed, which allows it to compete on price. It may not be rational, but it lets the company be a threat to everyone else in its markets, whereas 2,500 layoffs at Albertsons in Southern California is not doing anything for its business.

Weinswig: We were told that the new CEO [Wayne Sales] has experience in turnarounds. Why bring in a CEO who has turnaround experience if you’re not planning to turn it around?

Heinbockel: I think the strategic review is going to be disappointing and that not much will come out of it. Having said that, I think Supervalu will not perform poorly enough in the next year or two to encounter any real financial problem, and I would be shocked if the comps were positive a year from now, even if inflation meaningfully accelerates. I think comps will trough at negative 6% or so and gradually get better, but they won’t be positive for quite some time.

Mushkin: Supervalu should shrink to a defensible core. In my opinion, there is a good chance the West Coast and Save-A-Lot will be monetized in one fashion or another, and I actually think there is the potential to see asset movement before the end of the year. Perhaps the strategic review is just checking the box for shareholders, which I think is a big mistake. We’ve been saying since October 2009 that Supervalu needs to seriously consider strategic alternatives to protect the employees, first and foremost. And from time to time it seems it has tried to right-size the organization. In fact, our sources suggest there were fairly serious attempts to sell both Acme and Shaw’s a few years ago.

Heinbockel: But nobody wanted Shaw’s.

Mushkin: Yes, but now with the threat of a price war, Supervalu appears to be trying to force people’s hands a little bit.

Adler: I heard there were potential buyers for Shaw’s.

Mushkin: There were, two years ago, but they just couldn’t agree on distribution.

Adler: I heard the issue was that Supervalu wouldn’t break Shaw’s apart — that it wanted to sell the chain as one company, and there was no interest for that. If Supervalu had been willing to break it apart, it could have gotten a decent price, but it just wasn’t willing to do that.

Mushkin: It was the same with Acme. Supervalu had a deal for Acme, but it wanted a five-year distribution contract, so the prospective buyer just walked away. But I do think there are potential buyers out there.

Weinswig: We have heard from a lot of real-estate experts that Shaw’s has some of the best actual physical locations. That is the thing about these Supervalu boxes — most people will tell you they are in great locations.

Adler: But they’re only great locations if they stay a supermarket. It’s not so economical if you have to convert them to something else. It’s not the real estate per se — it’s their value as a supermarket.

Wolf: The highest and best use for most of those locations is still as supermarkets. But at the end of the day, I think Ahold and Delhaize could show up — I think they’re probably more likely buyers on the East Coast than Kroger would be.

Weinswig: That could happen, but so could several other scenarios. For example, maybe BJ’s buys some of the assets — it would give it a great position in the Boston market. BJ’s is a great operator with a great CEO in Laura Sen, and I think she would be able to operate traditional grocery. Her background is in merchandising, and she is very insightful on the technology side, which is where Supervalu is lacking.

Mushkin: When it comes to Supervalu’s assets on the West Coast, something has to happen there — there’s no way the union and the company don’t recognize that. But you’ve got several issues there, including underfunded pension liabilities, which you know the union is going to deal on right now, so you’ve got to strike while the iron is hot. Another issue is market share — that market is such a mess. But I do think those stores will trade. Some pretty good West Coast sources are saying if Supervalu could fold the Albertsons into the current distribution and infrastructure of an existing competitor — maybe a Stater, a Safeway and a Kroger — it could just split that whole Southern California division.

Heinbockel: Do you think California’s attorney general would allow those stores to go to Kroger and Safeway?

Crunching the Numbers

Mushkin: I actually think Supervalu could break it up in a way that would avoid antitrust concerns. The trouble is trying to understand how people are going to look at the underfunded pension liabilities at Albertsons and what the tax implications are. We could look at what Safeway sold Genuardi’s for on a per-store basis and do the math pretty quickly, but the question is, what else is there? That’s what’s so hard to figure out.

Adler: I heard that Genuardi’s stores went for an unusually big price — $6 million a store — because Giant of Carlisle didn’t have to take the worst stores, and it thought it could turn the rest around in a heartbeat. Giant has a unique format, very similar to Hannaford. But I’m not sure what Ahold paid Safeway for the Genuardi’s stores would be the right price.

Wolf: Good locations are worth a lot more, especially if you don’t have to take the bad ones.

Mushkin: It costs at least $15 million to build a store in Southern California, according to the people I talk to. So if someone can get those Albertsons stores, even with the pension liabilities, for $7 million each, you’ve saved half your building costs.

Adler: If I’m Kroger and I’m already in the same pension plan and I’m taking some of those Albertsons locations, why would it be any different? Could Kroger cut a deal?

Weinswig: Kroger could cut a deal. And it’s in a unique situation now because of the competitive environment.

Mushkin: I think there is a very significant interest among multiple parties for Supervalu to get its house in order, and I would bet the union feels the same, especially after what just transpired at Albertsons, with 2,500 people laid off.

Wolf: It would be a good thing for the industry to see the unions finally get real about the dilemma the employers face.

Mushkin: The union would rather have those stores in stronger hands, and it knows Kroger and Safeway would be stronger than Supervalu.

Wolf: On the other hand, the union could say that every time it gives employers something, they bring it to their bottom line. So it’s not like the union is totally at fault for not trusting the companies.

Mushkin: But you have to play the game that’s in front of you, and the game right now is Supervalu threatening a price war — and even if it’s not anytime soon, the company could wind up putting itself in Chapter 11 and in the process weakening the heck out of Safeway and Ahold, and even making things a little more difficult for Kroger. So clearly, to me, it’s better for all constituencies to see assets move now and shrink Supervalu to a core retailer-distributor in the Upper Midwest and the Intermountain area.

Heinbockel: Basically going back to what Supervalu was.

Mushkin: Plus Jewel, and keeping Boise.

Wolf: There is a Catch-22 with Supervalu, and it’s obvious: The company is bleeding market share because its prices are out of whack. How do you sell an asset like that?

Mushkin: That’s why it’s threatening a price war. That’s why it wanted to get an asset line. In my opinion the bankers told the company that if it gets an asset line, it can take prices down for a long period, and that threat may get people back to the table.

Wolf: We’ll have to see how it plays out. You can’t just say asset purchases are great and then have someone cherry-pick all the good stores. Supervalu has to sell the entire chain for equity investors to potentially realize value.

Adler: One of the arguments against Supervalu shrinking down to a core is, it would lose clout with its vendors. Even if the company is doing poorly, it is still a big player now.

Heinbockel: That’s one of the reasons I don’t think spinning off distribution is a good idea.

Mushkin: When you look at a company like Publix or H-E-B, if you’re really strong and not shedding share, the CPG companies will want to deal with you.

Adler: And if you’re No. 1 in Chicago, as Jewel is, you’re still going to get some support.

Heinbockel: Whatever it shrinks to, Supervalu would have to be incredibly powerful and incredibly strong so that it’s not ceding share. That means the business would be comprised largely of the discount brands — Cub, Shop & Save, Shoppers and little else. But that would be a business that lacks the scale of its biggest rivals.

Mushkin: That’s what I see as the only option for Supervalu — shrink to where it’s powerful and hopefully be able to sell all its other assets off so it doesn’t go bankrupt.

Wolf: Winn-Dixie went out at four times EBITDA, and Supervalu overall is a better asset than Winn-Dixie.

Heinbockel: Winn-Dixie was small and focused.

Wolf: And its market share had stopped going down. So a mediocre-to-poor asset can trade at four times EBITDA once its market share stops going down, but what is EBITDA in two years if your share is going down? That’s the dilemma — even if the stores are more productive and of better quality, it is much harder to value a chain that is losing a lot of market share.

Heinbockel: Supervalu has assets that can trade at more than four times EBITDA. A year and a half ago, I was shocked at how badly Jewel was performing. At one point I thought it was worth seven times EBITDA, but who would pay that now, particularly if there’s little competition for it, which there probably is? I don’t think private equity wants any part of Supervalu’s traditional business because it doesn’t know where margins will be in two or three years and it won’t have a credible exit strategy, so investors might be stuck with the asset forever.

Mergers and Acquisitions

SN: What’s the outlook for industry consolidation in the year to come?

Adler: Well, because there’s the potential for Supervalu — a big asset — to sell, the outlook for consolidation is probably stronger than it’s been for a long time.

Weinswig: I agree with that. Winn-Dixie merged last year with Bi-Lo, which was deemed successful, and there are still a lot of weak, smaller players.

Adler: I don’t know that it’s necessarily true that the small players are weak. You can look at Demoulas Market Basket — its market share has been unbelievably good, and it’s taken a lot of share from Shaw’s. The ones that are hurting the most are the ones about which Kroger has said, “It’s not fair to our shareholders to be responsible for lowering someone else’s prices. Their shareholders should take that pain, and then we’ll think about buying them.”

Weinswig: Kroger has been unbelievably disciplined.

Mushkin: Too disciplined about acquisitions, I think. Sometimes I wonder, to tell you the truth. My guess is that Kroger could have had Roundy’s at 4.5 or 4.6 times EBITDA. The pricing wasn’t there, but the purchasing synergies alone should have made it a good deal. Kroger has said Roundy’s assets needed a lot of work, but I’ve been in a lot of those assets, and I don’t agree with Kroger on that.

Heinbockel: I don’t think we’re going to see a lot of M&A activity because if I’m right that the macro environment is going to remain challenging, then a lot of these guys are going to have to take care of their own houses first. It’s the same answer I gave last year — it’s a buyer’s market, so why take on risk when you don’t have to? It has to be something that’s truly transformational — either remaking a market competitively, which an Albertsons transaction in Southern California might do, or something like the Kroger-Fred Meyer deal, where you wind up with something you didn’t have before.

Wolf: Like Jewel?

Heinbockel: Kroger should be the dominant operator in Chicago — that’s Kroger’s missing link in the Midwest. Having said that, if I were Kroger, given the situation that Supervalu is in and the fact that I’m the likely buyer, I’d offer Supervalu a very, very low price and say, “Take it or leave it. And if you don’t take it, we don’t need it.”

Giblen: I’m going to reiterate something I said last year — that I thought there would be a transformational deal in the food/drug/mass segment fairly soon. That did happen, albeit in the drug store industry, with Walgreens and Alliance/Boots getting together. But given all the problems in the retail food industry, wouldn’t a Kroger-Tesco tie-up of some kind enable Kroger to break out of the problems we’re discussing, just as Walgreens/Boots did — with an end-run around deeply-rooted drug store industry challenges? The advantage of Kroger and Tesco getting together is, the merged company would draw from the best practices of each and would get closer to solving the Fresh & Easy snafu haunting Tesco — plus, over time, procurement synergies would accrue.

Mushkin: A merger of equals.

Giblen: In a realistic sense what typically happens in an industry when things get really bad is you get these transformational deals that aim to start a new era with a clean slate.

Adler: You could ask the question why the drug store industry is so much more consolidated than the supermarket industry since competition in the supermarket industry is a lot tougher?

Heinbockel: What forced massive consolidation in the drug store industry was margin pressure in pharmacy as third-party penetration dramatically increased and profit margins came under pressure. You really haven’t had the same type of broad tectonic shift over such a short period of time in food retail.

Adler: It was about lumpy pressures, as opposed to one-customer-at-a-time pressures. But it’s interesting to think that the pressure Wal-Mart put on the supermarket industry has left it about as fragmented as it always was. I get people calling me all the time saying, “It’s never been more competitive,” whereas actually it has been. When Wal-Mart was in the midst of its major square-footage growth, it was particularly tough.

Giblen: In food retail, a big barrier to consolidation is the unions. It’s pretty much unthinkable for a non-union operation to become labor-organized via a buyout.

Wolf: If the unions somehow got involved in this proactively, that would be hugely transformational, and big things could happen in terms of consolidation — but it’s tough to give up real benefits. For a lower-middle-class family, a good health plan is the one thing you have.

Heinbockel: I strongly believe consolidation creates very little value in most cases and does little to rectify a tremendously overstored operating environment. The problem is that you’ve got 2 billion square feet of consumables space out there, and that doesn’t even include companies you wouldn’t think are consumables players. I was in a Costco once looking at water, and a customer came up to me and said, “You don’t want to buy your water here. You want to buy your water at Staples. They’ve got the best prices on water.” So at the end of the day, the question is, how do we begin to purge some of that 2 billion square feet? One or two deals is really just a drop in the bucket.

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