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Strategic Initiatives Yield Results on the Bottom Line

Robust financial results in the second half of 2006 reflected the culmination of the industry's efforts to do a better job of merchandising, and the first half of this year should see a continuation of those positive trends, analysts told SN. The only potential threats to the upbeat outlook, they said, are a rise in some commodity prices and the tougher financial comparisons supermarkets will face.

Robust financial results in the second half of 2006 reflected the culmination of the industry's efforts to do a better job of merchandising, and the first half of this year should see a continuation of those positive trends, analysts told SN.

The only potential threats to the upbeat outlook, they said, are a rise in some commodity prices and the tougher financial comparisons supermarkets will face.

“The second half was phenomenal and shows the industry is alive and vibrant and growing,” Jonathan Ziegler, a Santa Barbara, Calif.-based analyst with Dutton Associates, El Dorado Hills, Calif., told SN.

Overall results for the 10 largest chains with public equity or debt during the second half of calendar 2006 showed the following trends:

  • Sales increased an average of 2.1%, compared with a decline of 0.7% in the second half of 2005.

  • Comparable-store sales in the third quarter of the calendar year rose an average of 3%, compared with an increase of 1.5% in the same quarter of 2005.

  • Fourth-quarter comps rose an average of 1.7%, compared with an increase of 2.7% in the last quarter of 2005 — due in part to difficult comparisons for chains impacted by Hurricane Katrina a year earlier and also to bad weather this year in some parts of the U.S.

  • Operating income jumped 11.4%, compared with an increase of 2.1% in the back half of 2005.

Bryan Hunt, a high-yield analyst with Wachovia Securities, Charlotte, N.C., said the upswing in operating income “is a great indicator of how well the industry is doing. It shows that companies are leveraging their sales results and getting stronger gross margins from merchandising improvements.”

He said escalating gasoline prices, along with improved merchandising, were positives for the industry in the second half.

“Supermarkets benefited from increased traffic generated by higher gas prices, which kept consumers shopping closer to home, and also from the evolution in merchandising to more fresh, which means higher margins and also more customer trips to the store because of the perishable nature of the category.”


Looking at the first half of 2007, Hunt said he expects more of the same, “though comps will become more difficult.”

Although second-half financial results included “the best sales numbers we've seen since late 2004,” Hunt said, total sales growth for January and February of this year was up more than 5%, slightly ahead of last year's second-half results, with food inflation accounting for about 2% of the increase.

With commodities like beef, chicken, eggs, orange juice and gasoline experiencing “material inflation,” the first half of the year could see some consumers switching to private-label items or trading down from premium products, Hunt said, “but that's the only possible hiccup in the outlook.”

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., said the second half was very good “because sales remained strong after a good first half, and earnings remained strong and got better, reflecting an upswing in gross margin.

“After several years of rapid commodity inflation in beef and dairy — which retailers are generally unable to pass through — the industry moved into a period where modest inflation in packaged goods was passed through, which helped lift financial results.”

Despite a “little bit” of inflation in beef, “which could last awhile,” Wolf said he sees good financial results continuing in the first half. “The economy is chugging along, which is good for demand, and gas prices are back up, which is generally bad for restaurants and good for supermarkets.”

According to Ziegler, merchandising was the key to the industry's strong results in the second half of 2006.

“Managements have figured out how to differentiate conventional stores from the big-box retailers — to draw more traffic and get customers to spend more — by putting together a more attractive offering and stronger merchandising,” he pointed out.

The only potential negative Ziegler sees in the first half is the continuing escalation of gas prices toward $4 a gallon, “though the adjustment by consumers may be smaller than it was when gas broke the $3 a gallon barrier,” he noted.

In addition, the industry will be going up against strong comparisons with the first half of 2006, “which could create a very challenging situation in which financial results continue to grow but at a slower pace than they did a year ago,” Ziegler pointed out.


Chuck Cerankosky, an analyst with FTN Midwest, Cleveland, said second-half results “looked good, as we saw the well-run chains continue to take advantage of industry consolidation by making small but smart acquisitions of properties within their existing operating areas or by exerting economies of scale to improve market share.

“In addition, the investment community had a better understanding that the grocery industry is quite segmented, with room for conventional grocers with the right product mix and operating cost structure in the middle of the market and for supercenters at the low end and specialty stores like Whole Foods at the high end.”

Cerankosky said he expects escalating gas prices to help the industry during the first half of this year, as supermarkets with gas loyalty cards offer fuel savings based on in-store purchases, “which should be a positive.”

The second half was “pretty solid, for the most part,” said Karen Short, an analyst with Friedman Billings Ramsey, New York.

“In general, the industry began moving past some of the headwinds it's been facing, including the cost of labor and health care,” she said. “And as those costs became less onerous, the chains began seeing better bottom-line results — at the same time they've been doing a better job of merchandising, with improved execution at store level and a higher rate of labor productivity.”

The second half saw the industry benefit from better merchandising, better fresh products and the ability to take share away from quick-service restaurants and Whole Foods, Short pointed out, “and those factors, combined with a sales trajectory around the perimeter, gave chains more leverage to lower Center Store prices to narrow the gap with Wal-Mart and other discounters. And higher gas prices had a negative impact on Wal-Mart while helping supermarkets.”

Short said she expects most of the positive trends to continue into the first half of this year, “though at some point comps will get more challenging. And to the extent we're seeing cost pressures in certain commodities, it remains to be seen how much is passed through in higher price points.”

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

  • KROGER CO., Cincinnati, which saw second-half sales climb 9.8% to $31.6 billion; comparable-store sales, excluding fuel, increase 5.5% in both the third and fourth quarters; and operating income rise 16.2% to $1.1 billion.

    The goals Kroger has been working toward the past several years “all came together and gathered momentum during the half, with strong sales growth and earnings improvements,” Cerankosky said.

    Those results were surprising to investors, who viewed Kroger's initial sales improvements as unsustainable, he pointed out. “But they were sustainable,” Cerankosky noted, “and as the company emphasized, it was not trying to expand margins but to drive the business with revenue growth, margins did expand last year, and Kroger ended up with better-than-expected earnings.”

    Jay Whitmer, an analyst with Cleveland Research, Cleveland, said Kroger's strong financial performance in the half was spurred by its four-pronged strategy that utilizes price, service, assortment and the shopping experience to drive its business.

    “Kroger has been successful over the past five years doing everything it set out to do,” he said. “It's done a remarkable job lining up initiatives that work in harmony to get people into the stores more often while using data from dunhumby [a United Kingdom-based research firm] to target some of its best customers and incentivize them to build bigger baskets.

    “It's also tackled opportunities aggressively, and it's been helped by the more benign nature of the market, as capacity comes out and as Wal-Mart focuses on the ‘leaky faucets’ outside the food area.”

    Wolf said Kroger's marketing strategy continued to be robust during the half, “with increased customer counts and larger basket sizes boosting sales and its ability to offer better merchandising allowing margins to mix out better.”

  • SAFEWAY, Pleasanton, Calif., where sales grew 4.4% to $21.9 billion; comps, excluding fuel, rose 4% in the third quarter and 3.7% in the fourth; and operating income climbed 14.4% to $899.9 million.

    Safeway's financial performance in the half was a result of its up-market strategy, where it puts the emphasis on the product offering and the shopping experience more than price at its lifestyle stores, Whitmer said. “With fewer supercenters in its geography, Safeway is able to pursue a strategy that is less price-based than Kroger's,” he explained.

    Safeway also benefited during the half from the underperformance of Albertsons stores in many of its operating areas, particularly in Northern California, Whitmer noted. “The problems at some of those stores have not been addressed for a while, and that has helped Safeway.”

    Wolf said Safeway's performance was less robust than Kroger's on the sales line, “because it's putting more emphasis on merchandising and product quality than on price, which is a strategy that promotes earnings growth.”

    However, Cerankosky said he believes price is part of Safeway's message. “It's emphasizing quality in its electronic advertising, which talks about ‘ingredients for life,’ but in its print ads it makes a price statement on Center Store categories, especially for customers who use its loyalty card,” he explained. “The goal is that customers who come in for organic apples or Rancher's Reserve beef will be able to find peanut butter at very competitive prices.”

  • SUPERVALU RETAIL, Minneapolis, where the acquisition of Albertsons last June helped boost sales to $16.9 billion and operating income to $688 million, while comparable-store sales were flat in the second quarter and increased 0.6% in the third.

    Comps at Supervalu retail operations excluding Albertsons were down 1% in the second quarter and down 1.3% in the third, while the acquired Albertsons operations saw comps rise 0.3% in the second quarter and 1.1% in the third.

    While Supervalu's legacy stores showed negative comps, the Albertsons stores showed improvements, “which might be telling us that the combination food and drug stores have more critical mass in their markets and greater opportunities than the legacy stores,” Cerankosky said.

    Wolf said the legacy stores Supervalu operated before the Albertsons acquisition were not doing that well, while the Albertsons stores were up only modestly during the second half because the former owners had been running them to preserve profits and cash flow at the expense of sales.

    “Now Supervalu is trying to execute a strategy similar to what Kroger and Safeway are doing, based on quality, better merchandising and becoming more price competitive, but it's taken the market leaders years to build up their programs, so Supervalu is running far behind,” Wolf explained.

    Whitmer said Supervalu has “a lot of good things going for it behind the scenes that give it flexibility for good results going forward.” However, those factors involve long-term programs that did not affect its second-half performance, he noted.

    “During the half, the Albertsons stores weren't keeping pace with Kroger or Safeway, though Supervalu is certainly making directional changes to improve that business,” Whitmer explained.

    “And while everyday execution at the Albertsons stores is top-of-mind today, it will take time — possibly a year or more — for Supervalu to integrate the back-end of the business in terms of marketing and merchandising, so it isn't an overnight effort, nor is it particularly urgent for Supervalu to catch up to Kroger or Safeway in the short term.”

  • AHOLD USA RETAIL, Quincy, Mass., which saw sales flatten out at $10.3 billion in the second half; comps rise an estimated 0.8% in the third quarter and fall an estimated 1.4% in the fourth; and operating income drop 24.9% to $281 million.

    Of Ahold's four U.S. retail operations, comps increased only at Giant Foods of Carlisle, Pa., while falling in both quarters at Stop & Shop, Giant Foods of Landover, Md., and Tops. The numbers listed on the accompanying table are based on averages of the comp numbers for the four chains.

    “Clearly, Ahold does not have a lot of wind at its back, and it's been less able to deal with its retail issues while it's been trying to sell U.S. Foodservice,” one analyst, who asked not to be quoted by name, told SN.

    “The company has made its fair share of mistakes on the back-end installing companywide systems, and it has some really soft spots in its retail operations, especially at Tops [the Buffalo, N.Y.-based chain that is for sale].”

    The positive results at Giant Foods-Carlisle are probably more a function of a safer geography than anything else, he noted, “because New England [where Stop & Shop operates] and Washington, D.C. [where Giant Food-Landover operates], are much more competitive markets. And Ahold's efforts to consolidate the back offices of those chains has, frankly, been a mess.”

  • DELHAIZE AMERICA, Salisbury, N.C., which saw second-half sales jump 4.5% to $8.8 billion; comps rise 3.1% in the third quarter and 2.7% in the fourth; and operating income grow 3.4% to $502.6 million.

    Hunt said the improving numbers at Delhaize America in the second half were a function of ongoing efforts by Food Lion to remodel entire markets; by Kash 'n Karry to complete the conversion of its stores in Florida to the Sweetbay format; and by Hannaford Bros. to generate continuing store growth. “The company did a fantastic job of execution,” he noted.

    The fourth quarter could have been better, he added, “but there was a lot of remodeling activity, and preopening expenses were higher.”

    Sales at Delhaize were good during the half, Hunt said, while profits were moderated by the new-store activity, “though the company will see a payback in 2008.”

    According to another analyst, who asked that his name not be used, Food Lion benefited from doing “creative things using consumer insights” from shopper card data and independent consumer research “to figure out how to break out lifestyle segments and allocate capital budgets accordingly.”

  • WINN-DIXIE STORES, Jacksonville, Fla., where sales increased 0.5% to $3.8 billion, and comps rose 5.1% in the first quarter and fell 0.5% in the second (coming off tough comparisons with strong sales a year earlier following Hurricane Katrina). The chain had a loss of $9.7 million on EBITDA for the half.

    “Winn-Dixie is trying to get back on the map by pursuing a strategy to move up-market, similar to the niche in which Publix operates,” one analyst said, “but given its results as reflected in the second half, that's an approach in which I don't have a lot of confidence.

    “Winn-Dixie needs to build durability — it's not going to be a lay-up as it's emerging from Chapter 11 to be in good shape — and it still has a lot to prove, not only to consumers but to vendors, that it can operate stores worth shopping at that are as attractive as competitors' stores.”

  • WHOLE FOODS MARKET, Austin, Texas, which saw sales rise 13.7% to $3.2 billion in the half; comps increase 8.6% in the fourth quarter and 7% in the first; and operating income go up 30.4% to $146.9 million.

    Despite the increases, Wolf said second-half numbers at Whole Foods represented a deceleration of sales and earnings growth as the chain came off two extraordinarily strong years of growth.

    “Although comps of 7% were the best in the industry, they represented a marked decline for Whole Foods from the double-digit increases it's been reporting. And earnings were impacted because the company has ramped up its new-store growth strategy, which is very expensive and very dilutive.”

    Whitmer said second-half results at Whole Foods showed a clear slowdown after several years of double-digit comp increases, and it's still not clear whether those results represent a long- or short-term normalization of its growth curve.

    “Second-half sales showed the least growth at Whole Foods in a long time,” he pointed out, “and the jury is still out on whether that trend will continue or not. It's not a matter of Whole Foods doing anything wrong — its brand, its operations and its store-level expertise are still there. But other retailers have noticed those strengths and have copied them, and that's clearly having an impact of Whole Foods' results.”

    Cerankosky also noted that there's nothing wrong at Whole Foods, “though people who thought it could continue to expand margins while picking up the pace of new store openings seemed surprised by the lower amount of growth, despite warnings by management that its rapid growth wouldn't last indefinitely.”

  • A&P, Montvale, N.J., where U.S. sales declined 2.1% to $3.1 billion; comps rose 0.2% in the second quarter and dropped 3% in the third (due in part to tough comparisons with post-Katrina sales the year before); and EBITDA was up 20% to $59.3 million.

    Short said A&P's comps were impacted by an aggressive remodeling program in the Northeast, which disrupted sales, as well as by ongoing efforts to strengthen the performance of its Farmer Jack stores in the Midwest.

    Third-quarter sales were also hurt by A&P's decision to stop giving away free turkeys at Thanksgiving, “which helped the bottom line but hurt sales,” Short said.

  • PATHMARK STORES, Carteret, N.J., which experienced an estimated sales increase of 3.6% to $3.1 billion in the half; flat comps in the third quarter and a comp gain estimated at 0.2% for the fourth; and estimated EBITDA of $71.1 million, up 1.7%, for the half.

    Short said Pathmark's sales benefited from an extra week in the year, which boosted volume by about $75 million.

    “Pathmark has never had a massive customer bleed — it just kind of chugs along. But with zero population growth in the Northeast, it either takes share from someone else or surrenders it, and it's been treading water for years,” she said.

    Short also said Pathmark's management team has been “a little bit handcuffed” by rumors of a merger with A&P — speculation that came to fruition earlier this year when the two chains announced they would merge — “and the fact its major investor, Yucaipa Cos., didn't want to invest heavily in capital spending until the A&P deal was worked out. And although that was the right decision, it hurt Pathmark.”

    On a more positive note, Short said, management did roll out the Wild Oats private-label line at Pathmark during the half, installed the Topco line in the fourth quarter and improved the deli offering by testing a program featuring Subway meats, “though none of those efforts really created any material boost to the top or bottom line,” she acknowledged.

    Hunt said Pathmark's sales were weak because of the difficult competitive marketplace where it operates.

    “But if you look at all the changes management made in 2005 to turn the business around — discounting some products to move them out — it's easy to see why second-half earnings comparisons were easy,” he said.

    “Pathmark did benefit in the second half of 2006 from the merchandising changes the company made over the last year. However, although margins were better, sales didn't materialize — either because of customer malaise or competitive activity — so the company didn't get much traction from the changes it made.”

  • STATER BROS. MARKETS, Colton, Calif., where sales rose 4.6% to $1.8 billion; comps climbed 2.9% in the fourth quarter and 1.4% in the first; and operating income jumped 20.1% to $55.8 million.

Hunt said second-half sales at Stater were strong because of the healthy economy in the Riverside-San Bernardino market in Southern California where Stater operates most of its stores and which saw an expansion in the housing market. “And the chain's gross margin improved as promotional activity in the market declined,” he added.

Stater also benefited from layering in more private-label merchandise that brought better results to the bottom line, Hunt said.

Operating income benefited year-over-year because the company stopped giving away turkeys at Thanksgiving in 2006, “and although the sales momentum was not as robust in the last quarter of the [calendar] year, the chain did see increases of more than 10% in prepared Thanksgiving meals over the prior year,” he pointed out.

Without the turkey discounting, Stater had a better margin mix in the December quarter last year than in the prior year, he added.

Supermarket Performance in Second-Half 2006

Below are financial results for the 10 largest supermarket chains with public equity or debt. Although reporting dates vary, the chart represents sales, operating income and comparable-store sales for the two quarters most closely paralleling the last six months of 2006, encompassing the third and fourth quarters for Kroger, Safeway, Ahold USA Retail, Delhaize America and Pathmark; the first and second quarters for Winn-Dixie Stores; the second and third quarters for Supervalu Retail and A&P; and the fourth and first quarters for Whole Foods Market and Stater Bros. Markets.

Kroger $31.6 +9.8% $1,142 +16.2% +5.5%* +5.5%* 8/13/06-2/3/07
Safeway $21.9 +4.4% $899.9 +14.4% +4.0%* +3.7%* 6/18/06-12/31/06
Supervalu Retail $16.9 NA $688 NA 0% +0.6% 6/18/06-12/3/06
Ahold USA Retail $10.3 0% $281 -24.9% +0.8%(e)* -1.4%(e)* 7/2/06-12/31/06
Delhaize America $8.8 +4.5% $502.6 +3.4% +3.1% +2.7% 7/2/06-12/31/06
Winn-Dixie $3.8 +0.5% ($9.7)** NA +5.1% -0.5% 6/29/06-1/10/07
Whole Foods $3.2 +13.7% $146.9 +30.4% +8.6% +7.0% 7/3/06-1/14/07
A&P (U.S. only) $3.1 -2.1% $59.3** +20.0% +0.2% -3.0% 6/18/06-12/2/06
Pathmark $3.1(e) +3.6% $71.1(e)** +1.7% +0% +0.2%(e) 7/30/06-1/27/07
Stater Bros. $1.8 +4.6% $55.8 +20.1% +2.9% +1.4% 6/27/06-12/24/06
*Excluding fuel
NA = Not Available
**EBITDA (earnings before interest, taxes, depreciation and amortization)
*** in millions
(e) = estimate