Food Retail Stocks: A Few Bright Spots in '08

In a year in which the Dow Jones Industrial Average lost about a third of its value, supermarket stocks actually didn't fare too poorly by comparison.

Although more than half of the 24 North American food retailing stocks tracked by SN had double-digit losses in 2008, only a handful — four, in fact — fared worse than the market overall, as measured by the Dow. The DJIA fell almost 34%, and the Standard & Poor's 500 Index was down about 38.5% for the year.

The SN Composite Index, weighted by market capitalization, fell only 4.26% during the year — a return many investors would have welcomed. The index was buoyed by the respectable performance of some of the largest companies on the list, including Wal-Mart Stores, which was up 17.95% for the year, and Kroger Co., which slid only 1.12%.

“If you were looking for major large-cap stocks to hide in, Kroger and Wal-Mart would have rewarded you, but all of the others would not have been good to hide in,” said Andrew Wolf, a Richmond, Va.-based analyst with BB&T Capital Markets.

The food retailing sector, he said, “showed overall that it was defensive,” but it was also more sensitive to the pressures of inflation than many observers had expected. While a moderate amount of inflation is generally considered a boon to food retailers, in 2008 food-cost inflation of an estimated 5%-6% came amid an economic recession in which consumers drastically curbed discretionary spending.

Low prices became the most critical attribute for all food retailers, and many operators seemed to struggle to find the right balance between promotion and margin.

“If you are raising prices into a bad economy, it's not a good prescription to help demand, and as a matter of fact it is a prescription for disaster,” Wolf said.

He said the lack of real sales growth — sales adjusted for inflation — kept more pressure on many supermarket stocks than there might have been in a less inflationary environment. Both Pleasanton, Calif.-based Safeway (down 30.52% for the year) and Minneapolis-based Supervalu — one of the biggest losers of the year with a decline of 61.09% — struggled to drive same-store sales despite inflation.

All three, along with Whole Foods Market, the Austin, Texas-based natural foods retailer, which also had a terrible year with a decline of 76.86%, make up the S&P Food Retail Index.

“You had real sales growth slowing all year, and the stocks tend not to perform that well when real sales growth is slowing,” Wolf said. “At Kroger, real sales growth held up the best. At Safeway, real sales growth did not hold up that well, and Supervalu did the worst in terms of real sales growth. And for Whole Foods, it was the same. Those are the fundamentals that caused those stocks to trade down.”

Gary Giblen, an analyst with Goldsmith & Harris, New York, noted that the traditional defensive nature of supermarket stocks gave way to the severity of the economic fallout.

“Supermarkets were getting some trade-down from consumers' falloff in casual dining, but because the economy got so bad, the defensiveness kind of fell through to the discount level of food retailing,” he said.

He noted that Ahold (down about 11% for the year) began to see some success later in the year from its massive effort to revamp its price image at its Stop & Shop and Giant-Landover chains in the U.S., while other companies, such as Winn-Dixie Stores, Jacksonville, Fla., “overdid it on promotion and killed their profitability.”

Montvale, N.J.-based A&P also encountered that situation, Giblen pointed out, when the company “did the right thing to get pricing in line, but then they didn't buy properly, which hurt them for a quarter.”

“The other monkey wrench in the scenario was these companies struggled to fully pass on food inflation,” Giblen said. “In a moderately soft economy, food inflation can be passed on, but in a catastrophic economy, which I think it is safe to say we are in, then you can't sticker-shock the consumer, and the retailer ends up eating some of the margin.”

TOP-LINE GROWTH

Kroger fared better than its peers, Wolf of BB&T said, primarily on the basis of its top-line growth. The company had among the highest same-store sales in the industry consistently throughout the year as its sharp focus on pricing drove traffic to its stores.

“They had volume growth, which is a proxy for market share, so investors are going to go with the company that has the best market share growth,” Wolf said.

Real sales growth will continue to be a factor in 2009, Wolf predicted, as companies will continue to face some inflation.

“The stocks had a good fourth quarter, but generally the relative valuation of the stocks — how they are compared to the market — tends to vary with real sales growth. They will perform as real sales growth goes. If it heads back to flat, and inflation moderates, that could be a good thing for the stocks.”

He said he expects the pace of inflation to slowly moderate in 2009, and supermarkets will have to achieve sales growth ahead of that in order for their stocks to become attractive to investors again. As inflation eased late in 2008, the industry's real sales did not appear to be showing much improvement, Wolf noted.

“Those numbers have not been encouraging,” he said. “I think the fact that inflation is slowing is a positive, but I'd like to see positive — or at least less negative — sales growth. We are going to look at a few more data points, so we are not coming to any conclusions yet; we are watching closely.”

TOUGH COMPARISONS

Karen Short, an analyst with Friedman, Billings, Ramsey & Co. New York, noted that the slowing pace of inflation in 2009 could be a negative for stocks, because it will make same-store sales gains harder for operators to achieve.

Competitive pricing was the key to how well the industry's stocks performed in 2008, she noted.

“I don't think it is coincidental that the stocks that performed the best had the narrowest gap with Wal-Mart, and that points to Kroger,” she said.

For some of the stocks that underperformed the market, Short attributed some of the decline to both execution miscues by operators and to the sudden aversion on the part of investors to companies with high debt loads, thanks to the credit crisis.

“There was a real fear of leverage from an investor perspective,” she said, citing A&P, Supervalu and Whole Foods among those companies that had enough debt obligations to scare away investors. “They took on debt on the worst possible time.

“There are names that don't have any liquidity risk, but in this environment, investors are avoiding any names that have any risk of any magnitude,” she said.

Supervalu, she pointed out, has some debt refinancing scheduled this year.

“There is some concern that they may not be able to tap the debt markets in order to refinance,” she said. “They still have their [credit] revolver, which I think they will be able to use, so I don't think there is an issue from that standpoint, but there was some concern.”

Supervalu also struggled from an execution perspective, Short noted, particularly with regard to the acquired Albertsons stores.

“They had been starved of capital, and Albertsons historically didn't really stand for quality, and didn't really stand for low prices,” she explained. “Supervalu is now struggling to make it more consistent across the entire store base, at a time when nobody really has an appetite for levered names, especially exacerbated by a weak performance.”

At A&P, which lost nearly 80% of its stock value in 2008, other factors were at play.

Like Supervalu, it accumulated a heavy debt load with its 2007 acquisition of Pathmark Stores, but it also had attracted a lot of hedge fund investors who were forced to liquidate their holdings during the year, analysts pointed out.

“Given that it's now a small-cap name, from a liquidity perspective, when there is some selling pressure, it really affects the name more than if you had a larger cap,” Short explained. “There were some massive liquidations of A&P, driven by fund liquidation.

“Plus, A&P had some execution-related issues after the acquisition, so they deserved to get hit a little bit.”

Giblen of Goldsmith & Harris also noted that the company had some financing arrangements with Lehman Bros. that raised concerns among investors when Lehman Bros. was dissolved, although A&P quickly sought to quell those concerns.

“I would say the stock decline was 75% driven by the non-operating factors, and then the rest was driven by the fact that they had some problems integrating Pathmark,” Giblen said.

Whole Foods suffered not only from its newly accumulated debt load following the 2007 acquisition of Wild Oats, but also from its high price perception in a weak consumer market and its slowing sales growth.

“This is not an environment where consumers are willing to pay a premium, especially when there is a similar offering at the conventional chains,” Short explained. “If you looked at Whole Foods vs. the conventional chains six years ago, there was a significant gap in quality, and now that has narrowed, but the price gap has not. Why would consumers pay up for something if they can get almost the same quality at a significant discount?”

Giblen described the events of 2008 as a “perfect storm” for the implosion of Whole Foods' stock value, between the Federal Trade Commission's ongoing antitrust case and the sales decline.

“It seems obvious now, but there was a long-held belief that natural foods were impervious and not affected by the economy,” he said. “Whole Foods did all right for a while, but it caught up to them all at once.

“They also had the antitrust case with the FTC, and that raised the prospect that they might have to unscramble the omelet, which could also be very damaging,” he added.

Whole Foods also eliminated its dividend, and that also may have impacted the stock because of the institutional investors who require that a stock pay a dividend.

“The stock decline was severe, and deservedly so, but part of it was things like the dividend being cut and the FTC issues,” Giblen said.

Wolf of BB&T Capital Markets also pointed out that Whole Foods' expansion strategy — which it scaled back during the course of the year — might have turned off the investment community.

“They were accelerating growth into a deteriorating sales environment, and that was really a prescription for major earnings disappointments,” he said. “And as the year went on, the earnings disappointments got bigger.

“That, combined with expanding into England and opening very large stores — too big for what they need — that they thought would accommodate 10% sales growth as far as the eye could see, that is what hurt the stock,” he said. “I don't think it nullifies the concept, though. The consumer will come back to Whole Foods, and they still have the best sales per square foot of anyone in the industry.”

The other natural and organic specialist tracked by SN, United Natural Foods Inc., also had a difficult year, in part because of its close connection with Whole Foods, analysts said, but also because of other issues related to the integration of its specialty products division, Millbrook Distribution.

“United Natural's stock decline was a little more company-specific,” Wolf explained. “Its sales growth started to slow a little bit, but it was still pretty good — they had double-digit internal sales growth. When you take out 5% or 6% inflation, they probably had mid-single-digit real sales growth, which is very strong.

“So it wasn't so much about sales at UNFI, but it was the Millbrook acquisition early in the year when the wheels really came off the track — the earnings disappointments because Millbrook was a lot more dilutive than they originally thought.”

He added that he believes the company has largely gotten past the integration issues with Millbrook and will benefit from the business in the long run.

NATURAL DISASTERS?

Giblen, however, said he believes there may be another shoe to fall in 2009 for United Natural, as independent natural food stores could begin to suffer from the same decline in sales that has impacted Whole Foods.

“The only part of their business that has been robust has been the independent natural foods customer, but I think that has been really falling off the cliff now,” Giblen said, predicting that these companies will see “massive closures” in 2009.

“I think independents are going to have a worse blowup in '09 than Whole Foods had in '08,” he said. “They lack the credit access and financing that Whole Foods has, and also they have high prices — and in this economy, that's a death warrant.”

Safeway, which itself has been shifting to become more like Whole Foods through the rollout of its lifestyle stores, also appeared to suffer from its higher-priced image during 2008.

Short explained that investors might see as a negative the large overlap Safeway has with the more value-priced Kroger stores — about 40% of Safeway's store base competes with Kroger.

“I think investors are looking at Safeway and saying they are going to have pressure on prices for several years,” she said.

However, she pointed out that the majority of Safeway's stores do not compete directly with Kroger, and they have very little overlap with Wal-Mart as well.

“So at the stores where they don't compete with Wal-Mart or Kroger, they don't have to worry about the price gap,” she noted.

Ruddick Corp., parent of the Harris Teeter chain in Matthews, N.C., might have suffered from a similar high-price perception during 2008, Short explained. That stock fell about 20% as the company — which Short described as being positioned somewhere between Food Lion and Whole Foods — became concerned late in the year about sales growth.

In addition, the chain's geographic concentration in North Carolina — long one of the fastest-growing regions of the country — might have become a negative to investors in 2008 as the region's banking industry took a hit, Short explained.

“From an investor perspective, there is the fear that they will lose share in this environment,” she said. “Investors see more headwinds than tailwinds.”

She noted that the traffic trends at Harris Teeter are positive, although customers are trading down.

“That could help gross margins, because they have a strong private-label offering, but it's not good for the ticket,” she said.

CANADA ON TOP

Canadian companies were among the top performers in 2008, with three of the four operators that SN tracks — Metro, Empire Cos. and Loblaw Cos. — showing strong gains for the year, while only one, North West Co., had a decline.

“It has been kind of a year of adjustment for these companies,” said Perry Caicco, an analyst with CIBC World Markets, Toronto, citing both the incursion of Wal-Mart into Canada two years ago and overly aggressive pricing by Loblaw as conditions to which the operators needed to adjust.

“Loblaw got its pricing a little more under control over the last year, and that was the major reason the stocks did a little better in the market,” he explained. “That was the biggest thing that relieved margin pressure on the grocery sector in Canada.”

In addition, he said, investors grew to understand that the major Canadian chains had adjusted well to Wal-Mart's rollout of supercenters in Canada.

The inflation that bedeviled U.S. operators for much of the year was largely offset by the strong Canadian dollar in 2008, Caicco explained, allowing operators to get good pricing on product from south of their border.

Late in 2008, however, the dollar became weaker, and price increases began to set in. That is set against a backdrop of rising unemployment in Canada, particularly in the central region, where much of the manufacturing business is tied to the U.S. auto industry.

North West Co., the one Canadian decliner on the SN list, with a drop of about 19%, was impacted by the fact that it is scheduled to switch from being a trust to becoming a traditional public company in 2011. That could mean a lower payout in the form of a dividend than investors are accustomed to, he explained.

Short of FBR noted that Safeway's Canadian operations — where the company generates nearly 15% of its sales and EBITDA — could come under pressure soon as Wal-Mart continues to expand there.

UPS AND DOWNS

Following are the top five percentage gainers in 2008 among food retailing stocks tracked by SN:

• Metro, Montreal, up 40.42% to $37, rebounding from a 31% decline in 2007.

  The company recently converted the stores it acquired from A&P in the Ontario market, but Caicco of CIBC World Markets said the company might have to make some pricing adjustments in 2009. “I suspect they may be priced a little high, and they are going to have to make some adjustments to be competitive in the marketplace,” he said. “So, for them, the issue is going to be getting their mitts around pricing.”

• Nash Finch Co., Minneapolis, up 27.24% to $44.89, following a 30% gain in 2007.

Why this company's stock performed as well as it did was a mystery to analysts contacted by SN, although Giblen of Goldsmith & Harris speculated that it could have been driven by the belief among investors that an inflationary environment would boost wholesalers. That didn't hold true for Supervalu, although it may have contributed to Spartan's performance for the year — up 1.75%.

• Wal-Mart Stores, Bentonville, Ark., up 17.95% to $56.06, following a 3% gain in 2007.

  “The economy came to them in terms of their positioning,” Giblen said. “But they also did things to build on that — they did a lot of skillful things, such as the [discount generic] pharmacy pricing, to fully regain their price image. They read the consumer better than most retailers, and they just said, ‘price, price, price.’”

• Empire Cos., Stellarton, Nova Scotia, up 13.88% to $48.74.

  Caicco said Empire, the parent of the Sobeys chain, appears well positioned heading into 2009. “Empire is probably in better shape overall in terms of their offering and what they put into the market,” he said.

• Village Super Market, Springfield, N.J., up 12.77% to $57.39, following a 19% gain in 2007.

  “They have maintained good sales, and Village is a superior operation,” Giblen said. “They are the most Kroger-like in terms of striking the right balance.”

• Following are the top five percentage losers in 2008 among food retailing stocks tracked by SN:

  • Target Corp., Minneapolis, down 30.94% to $34.53, following a 12% decline in 2007.

    “Low price trumps all in this economy, and even though Target took a lot of steps to intensify its price message, it was up against Wal-Mart,” Giblen explained. “They did what they could with discipline and intelligence, but they are just stuck, given the economy, and I think investors have recognized this in the stock price.”

  • United Natural Foods, Dayville, Conn., down 43.82% to $17.82, following a 12% decline in 2007.

    The company struggled with the integration of Millbrook Distribution in 2008, and suffered along with Whole Foods as sales at its largest customer slowed.

  • Supervalu, Minneapolis, down 61% to $14.60, following a 5% gain in 2007.

    Highly leveraged from the acquisition of Albertsons and struggling to keep its comps in positive territory, Supervalu got hammered by investors in 2008. “Supervalu did the worst in terms of real sales growth [among the big three chains],” said Andrew Wolf of BB&T Capital Markets.

  • Whole Foods Market, Austin, Texas, down 76.86% to $9.44, following a 13% decline in 2007.

    Whole Foods encountered what Giblen described as a “perfect storm” in 2008, with a combo of declining sales, the FTC antitrust investigation and the elimination of the company's dividend.

  • A&P, Montvale, N.J., down 79.99% to $6.27, following a 22% gain in 2007.

  “There were some non-operating issues that drove that stock,” said Giblen, citing the selloff of positions by hedge funds as prominent among them. But the company also was among those that made missteps in their efforts to balance pricing and margins.

SUPERMARKET NEWS 2008 ANNUAL STOCK PRICE COMPARISON

2008 GAINERS & LOSERS
(RANKED BY PERCENTAGE CHANGE)