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Headwinds, opportunity for grocery stocks

Headwinds, opportunity for grocery stocks

“I think there’s a healthy level of skepticism [about conventional supermarket stocks] across all investors, because they had performed so well in 2013. People look at the performance of Safeway or Kroger or Supervalu, and they say there is absolutely no reason for the change in valuation.” — KAREN SHORT     Deutsche Bank analyst  

Despite indications that the economy is continuing to improve, some analysts question whether the robust gains that food retailing stocks enjoyed last year can be sustained in 2014.

Seventeen of the 23 North American food retailing and wholesaling stocks tracked by SN notched double-digit gains in share price in 2013, and only three stocks lost value during the year, despite little change in the fundamental performances of most companies.

“I think there’s a healthy level of skepticism [about conventional supermarket stocks] across all investors, because they had performed so well in 2013,” said Karen Short, a New York-based analyst with Deutsche Bank. “People look at the performance of Safeway or Kroger or Supervalu, and they say there is absolutely no reason for the change in valuation.”

While Pleasanton, Calif.-based Safeway showed some improvements in its financial performance, Supervalu, Minneapolis, is still in the early stages of a turnaround effort, and Kroger, Short noted, “has been steady as she goes.”

Click on the sortable SN Composite stock market results for 2013

“It’s not that the whole industry became dramatically different in 2013, it’s just the multiples expanded,” she said.

Andrew Wolf, a Boston-based analyst with BB&T Capital Markets, said that in 2013 supermarket stocks seemed to shift in the way they were viewed by investors.

“If stocks are being valued as though earnings will continue to go down, that’s one valuation, which was the case say a year ago,” he said. “If the stock is revalued for earnings to be essentially flat, that’s a different value, and that’s essentially what occurred.”

Now, he said, in order for industry stocks to continue to enjoy the kinds of gains they saw in 2014, they will have to show earnings growth.

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“They need to show good fundamental performance,” Wolf explained. “Now that the economy is ostensibly getting even stronger, investors will be looking for the fundamentals to get even better, and for same-store sales growth to turn into cash flow growth.”

Two of the potential near-term headwinds in the current environment, he said, include minimal inflation, which in small doses could normally be counted on to drive same-store sales, and the reduction in benefits through the Supplemental Nutrition Assistance Program (SNAP).

The latter could end up driving some lower-income customers “back to Walmart,” he noted.

In an improving economy, Wolf said, a small amount of inflation was like “free money” to supermarket operators, as customers aren’t as likely to change their shopping patterns over small price increases or decreases as they are in a difficult economy.

Lower fuel prices may be helping to boost consumer spending to some degree, he noted, and overall, consumers appear to be trading up to higher-ticket, higher-margin items in the store.

Improving economic conditions, stronger consumer confidence and employment levels could help supermarket operators heading into 2104, he noted.

“I think the big positives will more or less offset the inflation and the benefit cuts,” he said.

Supervalu leads Gainers; Roundy's takes risk

Supervalu led all stocks tracked by SN in 2013 in terms of percentage gain in share price, as the company stepped back from the brink of bankruptcy with its sale of the Albertsons, Jewel-Osco, Shaw’s/Star Market and Acme banners to Cerberus. The company’s share price nearly tripled to close at $7.29 from its low opening price, an increase of more than 195%.

In addition to improving its outlook and shedding debt through the sale of its legacy Albertsons assets, Supervalu’s stock was aided in 2013 by the fact that some prominent investors, including Cerberus, took a stake in the company, Short pointed out.

John Heinbockel, an analyst with Guggenheim Partners, New York, said in a recent report that he expects continuing improvements in the performance of Supervalu, driven by growth at the limited-assortment Save-A-Lot banner.

“Supervalu’s turnaround remains a work in progress, especially in the under-earning traditional food retail segment,” he said, citing the need for the company to invest in pricing to drive same-store sales growth.

“Save-A-Lot is the key to long-term value creation,” he said, citing the recent growth in same-store sales at the corporate Save-A-Lot stores, driven in part by the rollout of an in-store meat-cutting program, and the potential for that to be leveraged across the chain eventually.

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Sam Duncan, president and CEO, Supervalu, said that in addition to the meat-cutting program, the company has also ramped up quality control in its perishables distribution and is making changes to center store as well, which he described as “nearly complete.”

“Customers are now enjoying cleaner, horizontal sets that are much easier to shop, and more appealing to the eye,” he told investors in a recent conference call. “The new sets also have greater space given to those items that turn quicker, which improves our in-stock position.”

The chain also introduced an “image wall” around certain endcaps, which allows the chain to merchandise special buys or tie-in items.

In the second fiscal quarter, Supervalu said its corporate Save-A-Lot stores had identical-store sales growth of 4.6%, while the company’s traditional supermarket banners saw ID sales decline 0.9%.

Milwaukee-based Roundy’s was the No. 2 stock tracked by SN in 2013, with a gain of 136.45% for the year, to close at $9.86.

The stock was driven by the performance of the Mariano’s Fresh Market banner and the potential for expansion of that successful format, analysts noted. Late in the year the company unveiled plans for the acquisition of 11 Dominick’s stores in Chicago, which it is converting to the Mariano’s banner.

With the 13 stores it already has and the planned opening of five new locations in 2014, the banner could finish the year with 29 or more locations.

Short of Deutsche Bank noted that the company is taking on a lot of debt to fund the expansion — but investors haven’t seemed concerned, even as the company eliminated its dividend. The dividend previously had been a draw for institutional investors, she noted.

“It was very interesting to see how the stock reacted to making the purchase of the Dominick’s stores,” she noted. “A high percentage of the holders were in it for the dividend yield, but obviously, growth trumped the dividend.”


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Roundy’s is refinancing its debt with a new sale of $200 million in notes, $36 million of which would be used to pay for the acquisition of the Dominick’s stores, with $150 million refinancing existing debt.

“They are betting a lot on this,” Short said. “It’s not that I don’t think [Roundy’s Chairman and CEO] Bob Mariano can execute — I think Mariano’s is a great store — but they are meaningfully increasing their leverage, and I just think they are putting a lot of eggs in one basket.

“And they clearly never opened that many stores at once.”

Investors attracted by the successful performance of Mariano’s — new stores are expected to generate close to $850,000 to $950,000 a week in sales — have begun looking at the company like Whole Foods Market in terms of its stock valuation, Short said.

Wolf of BB&T noted that with the lower rents at the acquired stores, projected EBITDA margins of 6% as the converted stores mature over the next three years would exceed the 5% EBITDA at other Mariano’s locations.

The acquired stores are not expected to boost Roundy’s earnings in 2014 due to remodeling costs, but are expected to contribute positively in 2015, the company said.

Kroger steady; Safeway trends improve

Kroger, meanwhile, continued to execute among the best in the industry, and saw its share price rise nearly 55% in 2013, to close at $39.53. The stock had already been performing well before the July announcement of the company’s plan to buy Harris Teeter Supermarkets for about $2.5 billion, a move that brings the company into some new, high-growth markets with a new vehicle to expand there.

Despite Kroger’s cautious tone in its latest earnings report — the company cited consumer uncertainty around the Affordable Care Act and a potential impact from SNAP cuts — some analysts were positive on the stock’s performance.

“Long-term, Kroger is taking share, accelerating growth and remains focused on returns, all of which should drive the equity price higher,” said Scott Mushkin, an analyst with Wolfe Research, New York, in a recent report.

Others, however, have begun to take a more cautious look at the company, which is also in the midst of a management transition as longtime CEO David Dillon steps down and successor Rodney McMullen takes over in 2014.

“Despite Kroger’s solid and consistent ID sales trends, our view on Kroger shares is tempered by a still uncertain long-term outlook for operating margin expansion after years of secular declines due to intense industry competition,” said Kelly Bania, a New York-based analyst with BMO Capital Markets, in a recent report. Bania maintained a “Market Perform” rating on the shares.

Safeway was one of the top-performing food retail stocks of 2013, as the company shed its Canada division, exited from the Chicago market and was the subject of buyout rumors. The company’s shares gained 85.27% during the year, to close at $32.57.

It also showed some improvement in its performance, analysts noted. In its most recent quarter, Safeway reported ID sales gains of 1.9%, excluding fuel, and noted at the time that fourth-quarter IDs were trending even higher, at about 2.2%, excluding fuel, early in the period.

“While we did not find the quarterly results entirely satisfactory, we achieved some significant milestones during the quarter,” said Robert Edwards, the company’s first-year president and CEO, in a conference call with analysts. “Through the actions taken, we have established a strong foundation and momentum, which should allow us to achieve our goal of increasing sales and profitability, and continue to demonstrate our commitment to creating shareholder value.”

As reports surfaced that Safeway could be acquired by private equity, Wolf of BB&T estimated that a “sum-of-its-parts” calculation could lead to a $47 per share value for the stock.

Whole Foods lags

Perennial stock-market leader Whole Foods Market, Austin, Texas, found itself in the bottom half of the list in 2013, with share up a mere 28%, to close at $57.83. The company cited some consumer weakness in its most recent quarter.

While analysts remained mostly positive on the long-term trends of the stock, they expressed some different views about what was impacting the company’s historically industry-leading results.

“Whole is going to be a great investment, and it has been the best company in terms of wealth generation over the last five years,” noted Wolf. “When you are that player, and your fundamentals slow a little, that’s what happens.”

Analysts said there is a perception on the part of investors that the natural and organic market is getting increasingly crowded, with the growth of companies like Sprouts Farmers Market, Natural Grocers by Vitamin Cottage and others.

Wolf suggested that Whole Foods also could be feeling the impact to some degree of the rapid growth in the sales of natural and organic products at conventional grocers like Kroger and Safeway, particularly as those companies expand their natural and organic private label lines.

“Safeway is growing its sales of natural and organics by at least double digits, and Kroger is growing its natural and organic sales in double digits, and that’s a bigger problem than Natural Grocers growing sales by 15%, because the sales base in those traditional grocers is so big,” he said.

“Some of the customers at conventional stores who would have crossed over to Whole Foods don’t because now they can find what they are looking for at Kroger or Safeway.”

He said he thinks this will be “a year of digestion” for the Whole Foods stock, especially if the same-store sales trend stays below historical trends, and the gross margin does not improve.

That said, Wolf added that he still believes Whole Foods is still “the best in the entire industry.”

Short of Deutsche Bank disagreed that conventional stores were having a significant impact on Whole Foods’ sales, and noted that some of Whole Foods’ recent weakness could be attributed to cannibalization.

“I think cannibalization might be a bigger issue than people realized,” she told SN. “I don’t think they are saturated — far from it — but I do think there was unique set of openings recently that caused cannibalization, and they are continuing this quarter.”

In a recent report on this topic, she outlined the unique situation the company had recently from store openings, particularly from the conversion of the Johnnie’s Foodmaster stores in the Boston area, and detailed her argument that the company still had a lot of room to expand.

In the report, Short noted in California, where Whole Foods does have stronger penetration than other states, there are about half a million people per Whole Foods store. That compares to less penetrated states like Texas, with 1.2 million people per Whole Foods store, and similar numbers for Florida (1 million people per Whole Foods), George (1.1 million) and New York (1.6 million).

Whole Foods could double its store count in each of those states “and still have a lower concentration of stores than California,” she said in the report.

“We believe cannibalization in Q4 and Q1 was an anomaly and as a result, believe the impact will diminish throughout Q2,” she said. “But, most importantly, we believe Whole Foods is significantly underpenetrated nationally and believe the growth story remains intact.”

She agreed that some investors appear to be skeptical about Whole Foods’ ability to continue to grow sales at historical levels because of the expansion of other natural and organic chains, but she said Whole Foods has long competed against Sprouts — and Sunflower Farmers Market, which merged with Sprouts in 2012 — with about a third of its store base in several Western states, including Texas, Arizona and California.

Sprouts up in IPO; The Fresh Market down

Sprouts Farmers Market saw its shares rise sharply it its initial public offering, and analysts remained positive on the company’s prospects in 2014.

Mushkin of Wolfe Research last month upped his rating on Sprouts to “Outperform,” citing the company’s unique mix of value and natural and organic offerings.

“Sprouts is a unique, compelling, high-growth format that is positioned well to capitalize on the movement toward natural/organic/fresh foods and the tailwinds of the Millennial generation,” he said in announcing the upgrade.

After a recent visit with executives at Whole Foods headquarters, Short of Deutsche Bank said Sprouts is implementing several operation improvements, including expanding its assortment in grocery by increasing the heights of its gondolas. She said Spouts has increased grocery SKUs from 4,000 to 5,200 “to make Sprouts a more complete grocery shop.”

Read more: Supermarket stocks ride economy to first-half gains

The higher shelves had been rolled out to about half of the company’s stores by last month, and the company said it plans to install the higher gondolas at all new stores, as well as in 10-15 planned remodels and as many as 10 additional units in 2014. Short said stores with the additional grocery items have maintained their open feel and sightlines by locating the higher gondolas to the sides of the store. The company is realizing an unspecified list in comparable-store sales from the initiative, she said.

Sprouts store remodels also include the introduction of Boar’s Head products in deli departments, and the installation of additional freezer space, Short said.

Remodeled stores around the Phoenix market saw 2% to 4% comparable store sales lifts in 2013.

Sortable table: First-half stock prices, gains

“With Sprouts, I don’t think people fully understand the story,” Short told SN, noting that one of the factors weighing in Sprouts’ favor is its high level of inventory turns in produce — two or more times a week.

“That gives them such a significant competitive advantage,” she said. “If they are turning 25% of their sales 2½ to 4 times a week, compared to a typical supermarket turning their inventory once every three weeks, that’s a tremendous advantage that I don’t think investors fully appreciate is not going to go away.”

Sprouts, which is expanding its store base by about 12% annually, also recently upped its earnings guidance.

In its IPO on Aug. 1, Sprouts raised $333 million by selling 18.5 million shares at $18 during the initial offering — shares that were initially expected to sell between $14 and $16 per share, according to a prospectus. On the public market, the shares opened at $35 and closed the year at $38.43.

Another recent IPO, The Fresh Market, which went public in 2012, did not fare as well in 2013.

The stock was the weakest performer of those food retailers and wholesalers tracked by SN, with a decline of 15.78% for the year, to close at $40.50.

Wolf of BB&T noted that he was cautious on the company prospects early in 2013, largely because of the potential hazards the company faced entering new markets, including Houston and California.

“They went into markets that were unusual for them,” he explained. “Houston is a big market, and they did it with an acquisition.”

He said in such an urban environment, rent is often higher than the suburban markets where The Fresh Market had typically operated, forcing the company to drive better volumes to achieve a return.


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“I think they had to do higher than normal store volumes to make it work, and they are actually lagging normal store volumes,” he said. “Plus, they have a lot of established competition there, with Whole Foods, Kroger, H-E-B and even Randalls.

He also noted that California can be a tough market for retailers who seek to expand to that state from out of the area.

“They are finding that the consumer is a lot different there,” he said. “Their offering is high-end, and has appeal to some Midwestern, Southern and Mid-Atlantic customers. In California, what has appeal are fresh and natural and organic products.”

Craig Carlock, president and CEO, The Fresh Market, described the company’s results as “mixed” in a recent conference call with investors.

He said sales at a store in Palo Alto, Calif., are “ramping better than expected,” while in Sacramento, “it is taking us longer to build traffic.”

In Houston, he said the stores have not generated enough returns for their costs, but nevertheless give the banner a beachhead in the market from which to expa

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