Financial returns for most leading supermarket chains made it seem like the industry was caught in a pressure cooker during the first half, and the lid is unlikely to come off during the second half, industry analysts told SN.
First-half sales were hurt by the continuing downturn in the economy and strong competition from non-traditional operators, they pointed out, which resulted in a severe drop in operating income as most supermarket operators cut gross margins to boost sales.
"There was a very modest sales recovery in the first quarter but no improvement in the second, with promotional activity ratcheting up as the competitive environment got more intense," said Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va.
"In fact, most of the major companies, including Kroger, Albertsons, Safeway, Food Lion and Winn-Dixie, which would normally blame the economy, actually acknowledged that competition was the reason sales were hurting. And with competition getting tougher and gross margin contracting, they were caught in a profit squeeze."
SN's annual comparison of first-half results for the Top 10 public chains bore out that assessment. Excluding Ahold, which was not scheduled to report results until late last week, and Penn Traffic Co., which reported results for only the first quarter before filing for Chapter 11 protection, the average performance among the other eight was discouraging compared with financial results in the previous year:
Sales for the half among the eight chains rose 2%, compared with an increase of 6.3% during the first half of 2002.
Same-store sales in the half fell an average of 0.6%, compared with a decline of 0.1% a year ago.
Operating income declined 17.6% among the eight companies during the first half.
"Sales were soft in the first quarter because of the impact of the war in Iraq," Wolf said, "and although they picked up a little bit in the second quarter, that had a more positive impact on retailers outside the supermarket industry, as post-war jitters suppressed spending on food.
"Late in the second quarter and moving forward into the third, the big retailers saw an upturn in same-store sales because of tax relief and some inflation, but the competitive environment intensified and expense structures went up as health care and insurance costs continued to rise."
Chuck Cerankosky, an analyst with McDonald Investments, Cleveland, said the first half was characterized early on "by a lot of overcapacity in some markets before some of the chains 'got religion' and moved toward price reductions and more promotions."
Gary Giblen, senior vice president and director of research for C L King Associates, New York, said the first half of 2003 was "minimally better" than the second half of 2002, "with some signs of life in terms of increased consumer spending, the beginnings of more rational operations and less of a price-war attitude, and with most companies adjusting to the new world order in which Wal-Mart has become a credible food retailer."
"For years Wal-Mart's food operations were regarded as pathetic by many traditional retailers," Giblen said, "but by the beginning of 2003 the chains were reordering their cost structures and adjusting their operations to deal with a world in which they could no longer dismiss Wal-Mart as a third-tier food operator."
Giblen said he sees little material change in the second half. "Whatever improvements the industry saw in same-store sales in the second half of last year disappeared in the first half of this year, with those numbers hitting a nadir for many companies, and I don't think the second half this year will be much different. There's certainly a little less deflation in meat and dairy prices, but those drops are disappearing in the intense competitive activity going on throughout the industry."
He also said his outlook was impacted by comments made by Kroger management. "Kroger is generally the bellwether for the industry because it's the best-managed operator and the straightest shooter in terms of assessing the situation," Giblen said, "and the fact management was cautious in its outlook painted in vivid brushstrokes what the second half is likely to be like."
Wolf said he expects promotional activity to remain high in the second half, "which should result in fewer defections to lower-cost shopping alternatives, which is one of the few silver linings in this situation."
He said increases in inflation should boost same-store sales slightly in the second half, but competitive pressures will make it difficult for retailers to pass along higher wholesale prices at store level, which will keep earnings down.
According to Jonathan Ziegler, principal in PUPS Investment Management, Santa Barbara, Calif., "There is still intense pressure on margins going forward, and no one has quite figured out how to win share from non-traditional operators because most supermarket shoppers seem to buy only what's on sale. If people are losing their jobs, they should be eating out less and eating in more, which indicates it isn't the economy that's hurting everyone's business -- it's competitive pressures."
Ziegler said he sees some signs for optimism that the second half will be better. "We've been saying for four years that the second half [of each year] would be better than the first, and the signs for improvement in the economy seem to be there. But unemployment is still high, and the improvements don't seem to be affecting the unemployment numbers. However, while I recognize that competition isn't going to go away, I'm guardedly optimistic."
Cerankosky also said he is cautiously optimistic about second-half results, "because we're seeing some early indications that customers are willing to part with more discretionary money at the supermarket, which should help enrich the sales mix and drive profits up at the same time."
Looking at each of the Top 10 companies individually, analysts had the following observations:
KROGER CO., Cincinnati, whose sales for the half rose 3.7%, with comparable-store sales excluding fuel down 0.5% for the first quarter and 0.4% for the second, and operating income down 7.5%.
Kroger enjoyed better sales gains than most operators during the half because it began lowering prices earlier, Wolf said, noting that gross margins at Kroger declined by only 34 basis points during the half, "while the other two majors were playing catchup," with gross margins dropping 44 basis points at Albertsons and 152 basis points at Safeway during the half.
"Kroger recognized early on that consumers were being more careful with their money, and it became sharper on prices ahead of the others, so it was able to choose its battles and pick up market share," Cerankosky said.
Ziegler said Kroger's sales gains during the half resulted from square-footage growth of 4%, "which is clear from the divergence between increased total sales and declining comps," he explained. He also said fuel sales helped boost Kroger's total.
ALBERTSONS, Boise, Idaho, with first-half sales up 0.7%, comps excluding fuel down 1.6% in the first quarter and 1.3% in the second, and operating income falling 25.5%.
"Albertsons is still struggling to get it right," Ziegler said, "and its first-half results were somewhat disappointing, given that it benefits from all the pharmacies, freestanding drug stores and gas stations it operates. So there's a problem there, and it might be coming from operating in too many markets with marginal market shares."
According to Giblen, Albertsons' comparable-store sales might be as low as negative 2% to 3% if pharmacy volume was excluded. "Albertsons hasn't really found its footing yet," he said. "Its pricing was too high during most of the half, and although it finally adjusted prices downward, it's still the highest of the big three. Albertsons is still trying to price its way to profitability, and that's never been a successful strategy."
Wolf said the first-half sales increase at Albertsons was attributable primarily to square-footage growth, and Cerankosky said Albertsons was hurt by the large number of stores it operates in the high-tech corridor from San Francisco to Seattle, as well as by some lingering integration problems -- particularly in the areas of merchandising, pricing and promotions -- stemming from its 1999 merger with American Stores.
SAFEWAY, Pleasanton, Calif., with sales up 2.7% in the half, comps excluding fuel down 1.8% in the first quarter and 1.7% in the second, and operating income down 29%.
"Safeway has some of the industry's worst comps," Ziegler said, "due to competitive pressures in the economy, particularly in the high-tech corridor between Northern California and the Pacific Northwest that has been hard-hit by the economic downturn. And its efforts to make Randalls in Texas and Genuardi's in Philadelphia more like Safeway and less like the companies they were have also cost it some sales."
Cerankosky also cited the decline in high-tech as one of the reasons for Safeway's problems. "Safeway was the best of the majors at getting traditional customers to trade up during the economic boom in the 1990s, due in large part to a third of its store base being in the high-tech corridor on the West Coast. But when that sector went bad, Safeway had to adjust to a much more cautious consumer and revert back to more promotions and price reductions to maintain its sales mix."
Wolf said Safeway had the toughest time of the big three during the half "because it was the last to get serious about investing in promotions and pricing, and it also had difficulties with centralization that negatively impacted sales during the half."
Giblen said Safeway was also impacted during the half by an overzealous effort by store managers to reduce shrink when their bonuses were threatened, "which led the stores to go too far in cutting shrink and ended up negatively impacting sales patterns."
The chain was also distracted by the situation at Dominick's Finer Foods, Chicago, which it decided to sell late in 2002 and whose sales were excluded from Safeway's results, Giblen added. "And Randalls and Genuardi's continued to perform poorly because of Safeway's attempts to put too much emphasis on cost-cutting at the expense of sales-building," he pointed out.
DELHAIZE AMERICA, Salisbury, N.C., with sales down 0.2%, comps down 2.2% in the first quarter and up 0.7% in the second, and operating income rising 5.4% for the half.
Jerome Samuel, an analyst with CDC Ixis Securities, Paris, said the performance of Hannaford Bros., Delhaize America's New England-based chain, was strong throughout the half, while the performance of Food Lion in the Southeast and Kash N' Karry in Florida were weak, despite the company's efforts to refocus on its low-price image in those two regions. Results were also negatively impacted by the closing of 42 stores in the first quarter, Samuel pointed out.
He said same-store sales were impacted 1.1% by the shift of Easter to the second quarter this year; excluding that shift, comps would have been down 1.1% in the first quarter and down 0.4% in the second quarter, he noted.
"This was the year Delhaize finally completed the integration of Hannaford and Food Lion after four years of pain, which enabled it to achieve some of the synergies it has been seeking," Giblen said. "In addition, the company was able to exploit some weaknesses of its competitors in the Southeast, with Bi-Lo distracted by problems at Ahold [its parent company], and Winn-Dixie operating with a weak store base -- and Food Lion's everyday-low-pricing approach gave the company an edge in an economy where people are looking for low prices."
A&P, Montvale, N.J., with sales up 2.1%, comps up 0.5% in the fourth quarter and down 0.1% in the first, and earnings before interest, taxes, depreciation and amortization down 34.4%.
One analyst, who declined to be named, said A&P's overall sales and comps improved after the company decided to reduce gross margins by about 100 basis points during the last two quarters of its fiscal year that ended in February, then moved downward when it pulled back a bit during its fiscal first quarter.
Giblen said it was clear from the outset of 2003 that "even the limited positive strides A&P had made previously were beginning to erode," with same-store sales in Canada accounting for most of the boost comparable-store sales enjoyed during the first half of the calendar year.
WINN-DIXIE STORES, Jacksonville, Fla., with sales down 3.6% in the half, comps down 2% in the third quarter and 4.5% in the fourth, and operating income down 27.7%.
Winn-Dixie indicated the shift of Easter affected its sales by 1%; adjusting for that shift, third-quarter comps would have been down 1% while fourth-quarter comps would have declined 5.5% -- "a disastrous showing," according to an analyst who declined to be named.
While most of its competitors in the Southeast were very aggressive on promotions during the first half of the calendar year, Winn-Dixie was not, with gross margins remaining flat, "which is simply not acceptable," the analyst said. He noted, however, that the company has indicated it plans to redress that situation with a bigger investment in gross margin going forward.
Giblen said the fourth quarter was a big disappointment for Winn-Dixie, "with sales lower than expected after an 18-month period that had produced positive results due to the introduction of frequent shopper cards and the conversion of about 25% of the stores to warehouse operations."
"But the basic weakness in the chain's store base, including store operations, plus a lack of a firm identity, caught up with it, as Winn-Dixie found itself caught between price-oriented companies like Wal-Mart and Food Lion and more upscale operators like Harris Teeter and Publix," Giblen said.
PATHMARK STORES, Carteret, N.J., with sales up 1.8% for the half, comps up 1.9% in the first quarter and 0.6% in the second, and operating income up 6.9%.
Pathmark made solid strides in improving its operations during the half, Ziegler said, as demonstrated by the rise in comp sales, "although it does not compete with supercenters and it was coming off easy comparisons. However, the company has put a great deal of effort into its stores, and it's earned the improvement in comp sales."
Sales also benefited from less promotional pressure in its market area, Ziegler said, while operating income was aided by a real-estate gain during the second quarter.
According to Giblen, Pathmark saw positive results from "a favorable combination of circumstances" during the half, including a new top management team, a cessation of price wars in its marketing area and the decision to break its weekly ads on Fridays instead of Sundays.
WHOLE FOODS MARKET, Austin, Texas, with sales up 15.9%, comps up 7% in the second quarter and 7.6% in the third, and operating income up 20.4%.
Whole Foods is in "a whole other world" in terms of its results and what it is doing to achieve them, Wolf said. "Natural foods are growing 7% to 8% a year, so Whole Foods has the wind at its back. And it's not being affected by the economy because people committed to buying natural foods aren't going to change their dietary habits."
Natural foods are the biggest growth area in food retailing today, Giblen said, "and Whole Foods really dominates that sector, especially with Wild Oats in transition right now." He also said Whole Foods benefited from the ramping up of new store openings, "which didn't always get sales and profitability going as quickly as they do now."
Cerankosky said Whole Foods has "an outstanding ability to differentiate its food offerings from the rest of the industry. While everyone else is seeing customers trading down, Whole Foods has seen customers continue to spend money throughout the entire store, and its sales mix is strong enough that profitability has remained high."
"Whole Foods has the key to the formula for winning market share, and that key is specialization," Ziegler said. "Whole Foods is not a general supermarket merchant. It's figured out who its customers are and what the market wants, and it merchandises its stores accordingly. And it's always coming up with something new."
STATER BROS. HOLDINGS, Colton, Calif., with sales up 3%, comps up 3% for the second quarter and 1.8% for the third, and operating income down 9.7%.
"Stater Bros. watches its prices like a hawk and keeps them very competitive at all times," Giblen said, "and the result is always-strong same-store sales. And its sales growth leads to increasing productivity, which is a healthy kind of growth. In addition, Stater consistently sends a clear message to customers that they can go there for everyday-low prices, high-service levels and good meats, and it also lets them know it's a hometown market, not part of a multiregional chain."
HARRIS TEETER, Matthews, N.C., with sales up 3.8%, comps up 1.1% in the second quarter and 1.7% in the third, and operating income up 4.3% for the half.
Harris Teeter's successful performance "stems from its focus on very select markets, after it pulled out of several troubled areas a year ago," Cerankosky said. "And it has really established itself in an upscale niche very successfully, although it's not upscale to the point of being exclusive -- it simply has a strong quality appeal that has served it well. However, it's had to use some promotions to create more profitability, and the fact that its earnings growth is running ahead of sales growth is very good in this economic environment."
He also said that, as a non-union chain, Harris Teeter has the flexibility to manage costs better, "which is a huge advantage."
Giblen also cited the company's decision to exit several non-core market areas, "so the operation consists of the best of Harris Teeter, and its results show the strength of a well-run upscale operator, proving that, even in an economy that's not friendly to upscale stores, if you do it well, as Harris Teeter and Whole Foods do, then you can be successful."
