Consumers are worried about the economy, supermarket operators are slashing prices, and food stores are closing left and right - in other words, conditions are perfect for industry stocks to perform.
The factors that have long troubled investors about the supermarket sector are no longer as worrisome, as operators have established strategies for capturing sales and translating them into profits. So while market watchers see turmoil in other industries amid rising inflation and gas prices, they have come to view supermarket companies as a safer bet, leading to a relatively strong performance in the stock market in the first half of the year.
"As the year has progressed and consumers have slowed down a bit, I think some of the more defensive names like food and drug retailing are starting to do a bit better," said Mark Husson, managing director and global head of consumer research in the New York office of HSBC, London. "Those stocks tend to be good inflation hedges, and it looks like inflation is bubbling up a bit."
The Supermarket News Index, which tracks 28 publicly traded companies, saw an increase of 1.24% in the first six months of 2006, compared with the S&P 500, which grew by 0.11%. Eighteen supermarket and wholesaler stocks rose in the first half, vs. 10 that declined. Of those 18 gainers, 11 rose in double digits.
Some of the top gainers were small or midsized companies that moved up based on news events, such as the acquisition offer for Marsh Supermarkets that helped propel its stock 37%, but other gainers seemed to rise based on their own organic performance. That includes two of the largest operators, Kroger Co. and Safeway, which saw first-half growth of 15.4% and 9.94%, respectively, and smaller operators like Spartan Stores, Ingles Markets and Ruddick Corp., parent of the Harris Teeter chain.
Supervalu, which with the acquisition of most of Albertsons' assets assumed a place among the "big three" traditional operators, saw a slight decline as investors may be waiting for the company to prove that it can digest such a large chunk of the industry.
Analysts said investors had previously been slow to embrace supermarket stocks because of the competitive environment and because they weren't yet convinced that the companies could successfully generate earnings from their store-level investments in new formats, pricing and promotion. Supermarket companies have begun to make a case for themselves on that front, however, and investors are not as concerned about competitive pressures as they had been.
"Wal-Mart has become less of a factor," said Husson, who has long argued that investors gave the Bentonville, Ark.-based giant too much credit for its ability to steal sales from the major supermarket chains. "Sometimes there are entire conference calls at Kroger or Safeway where nobody even mentions the word 'Wal-Mart.'"
Many of the supermarket stocks also are benefiting from store closures by Winn-Dixie, Ahold, Albertsons and others that have sent customers over to the surviving competitors.
"There's a more benign competitive environment, and you have all this rationalization taking place after all these years of looking for it," said Jason Whitmer, an analyst with Cleveland Research Co. "With all the stores that are hopefully coming out of the market and not just changing hands, I think that is a potential catalyst right now, and I expect a lot of good things will come out of that for everybody."
He also noted that while Wal-Mart remains a competitive threat and continues to add more food retail square footage in the market, the company seems to be focusing a lot of its attention on nonfood categories, like apparel.
"A lot of supermarkets have become more comfortable with Wal-Mart looking over their shoulder, and they are presenting a more relevant set of marketing, merchandising and store-level initiatives than they have over the last five years," Whitmer said. "Some of the larger players have come up with better end-market initiatives that are taking hold with consumers. They are having a lot of success right now, and I don't think that will end tomorrow."
He also pointed out that investors seem to appreciate the role supermarkets play when consumers experience pressure on their disposable income, as high gasoline prices and unease about the economy may be causing more consumers to try to save money by eating at home rather than going to restaurants.
While all of these factors have helped propel sales for the industry, the real incentive for investors has been the fact that supermarket companies have been able to convert those top-line gains into earnings growth.
"Right now you are getting to the point where sales growth is better, but what's happening is earnings growth is also up," said Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va. "The fundamentals are good. If the fundamentals weren't good, people wouldn't just run to these defensive stocks."
Wolf noted that Kroger in particular has been able to translate sales growth to the bottom line.
"What I really like about Kroger is that they have this combination of price and promotion, and they are addressing both ends of the value equation, through commitment and execution," he said. "Three-plus years ago, they really decided to look at price and value, and they made a commitment to it. At the same time, they are getting better at the quality side of the business, with better service and shorter wait times at the checkout."
Perry Caicco, an analyst with CIBC World Markets, Toronto, expressed similar sentiments.
"Kroger had put up eight consecutive quarters of same-store sales growth, but really didn't get credit for it until a few weeks ago," he said. "It finally overcame years and years of abuse from an investor point of view."
While Safeway has also had sales and earnings growth - with much of the former coming from its "lifestyle" remodels - Wolf posited that Kroger's top-line initiatives to drive sales by cutting prices have actually been in place longer.
"I think the market gave Safeway credit last year, but investors are waiting to see what kind of returns these lifestyle stores are really going to yield beyond the first year," he said. "You remodel a store and sales will go up, but what really needs to be known is what the second and third years are going to be like. They are expensive remodels at $4 million to $5 million, and a one-year sales pop doesn't justify the remodel, but a multi-year return probably does."
Kroger, he argued, "should be getting less circumspection" because its return on investment is "less ambiguous."
The element of the unknown also seems to be at work in the stock price of Supervalu, which was off 6.23% to $30.70.
"The one big surprise [in the first half] has been Supervalu," Whitmer said. "Not in their performance - there haven't been too many surprises there - but I have been surprised that there has been so much negative sentiment about the opportunities for that company.
"The assumptions have been primarily focused around all the things that could go wrong rather than all the things that will go right," he said. "The financial and strategic opportunities for that acquisition are very good. They have a pretty good game plan on the table, I think."
Investors "don't see a lot of urgency in being involved with those shares," he added. "Or, they just assume that they are going to mess it up and not be very successful in the integration. In the past the integrations of some of these companies have not been easy, and in fact some have been really bad."
Caicco said investors seem to falling into two distinct camps - either they strongly believe that Supervalu can successfully integrate Albertsons, or they think it will be an unbearable burden for the company.
"Investors are waiting to see," he said. "Opinions are very polarized by that."
Analysts said they expect industry stocks to continue to perform well in the second half of 2006, although several unknowns cloud the forecast.
"The wild card is what happens to the Albertsons stores bought by Cerberus," Husson said. "According to our calculations, Cerberus bought about $10 billion worth of sales. Although it is only closing a small number of stores, that is about $1 billion of sales that has to go somewhere."
He suggested that both Kroger and Safeway could end up acquiring some of those stores, and will at least benefit from picking up their former customers.
Wolf said he views the Albertsons sale as a missed opportunity for Safeway and Kroger, which he said could have "stepped up to the plate" in the acquisition process.
"Kroger in particular would have been a good fit for Jewel-Osco [the Chicago chain acquired by Supervalu]," he said.
The top gainers for the first half were:
Wild Oats, Boulder, Colo., up 61.98% to $19.60. Analysts attribute this stock's run-up not as much to its organic performance as to the possibility that it may be acquired. Los Angeles-based investment firm Yucaipa Cos. last year acquired a 9.2% stake in the organic/natural foods chain, and investors sense that it may eventually seek to engineer a sale to another player.
Wolf of BB&T Capital Markets noted that although Wild Oats in the No. 2 publicly traded player in the organic space - and has done a lot to right its ship and get on a growth track - he said the company may be taking the wrong strategy by building stores that are considerably smaller than the No. 1 player.
He likened Wild Oats' situation to that of home-improvement chain Lowe's about 15 years ago, when it made the decision to mimic market leader Home Depot rather seek to differentiate.
"Lowe's now has a higher valuation than Home Depot, and over time they were actually able to execute better than Home Depot," he said. "That's the strategy Wild Oats should have taken.
"The worst is over, but that doesn't imply that the best is yet to come," he said, "based on the current strategy of running undersized stores. I don't think the stock should be up as much as it is."
Marsh Supermarkets, Indianapolis, up 37.14% to $12, after a loss of 29.51% in 2005. The company put itself up for sale last December, and received an offer of $11.125 per share from Sun Capital Partners, Boca Raton, Fla., in May. But the stock has since risen above that level on the news that another potential bidder - Dallas-based real estate investment firm Cardinal Paragon - has expressed interest in offering $13.625 per share, or about $20 million more than Sun Capital.
ABC Financial, Toronto, which is an investor in Marsh, said that it was encouraged by the second offer proposal.
"All you needed was an enterprising group to take a good look at the company to decide that the sum of the parts was greater than the whole," said Irwin Michael, portfolio manager, ABC, in an interview with SN. "I think there are diamonds in the rough here."
Marsh has taken what one observer described as the "highly unusual" position of rejecting the higher bid - as it was required to in its contract with Sun Capital - and suing to determine if it can open up discussions with the new bidder.
Spartan Stores, Grand Rapids, Mich., up 35.84% to $14.63, after a gain of nearly 57% in 2005.
"I think they are at a point where the headwinds are abating and there's a lot of momentum behind them," said an analyst who asked not to be identified. "They've undertaken a lot of initiatives to try and improve the store base, and I think a lot of those are finally coming to fruition."
In addition, the acquisition of the D&W Food Stores chain last year bodes well - driving sales and earnings gains at Spartan, the analyst pointed out.
Spartan also remains poised to continue to grow its distribution business, which has been gaining market share, and could add some of the Carter's Food Centers locations that industry sources said may be closing.
Smart & Final, Los Angeles, up 29.84% to $16.84, after a decline of 10.5% in 2005.
After French parent company Casino Group said it planned to divest some of its assets, and Smart & Final said it had retained Goldman Sachs, this chain of club-store hybrids saw its stock shoot up on the possibility that it could be sold off.
"There's still no guarantee that they will do anything with it," said the analyst who wished to remain anonymous, adding that the stock is "probably a little pricey" based solely on its operating performance. "It's all based on the potential sale."
Arden Group, Los Angeles, up 26.31% to $113.17. Although this company doesn't have any analyst following, it received a favorable recommendation the Motley Fool website recently as a "hidden gem" for investors, citing its steady cash flow and the clarity of its financial reports.
The company, parent of the 18-unit Gelson's chain, posted first-quarter net income of $5.2 million on sales of $118.1 million.
The top five losers in the first quarter were:
A&P, Montvale, N.J., down 27.64% to $22.72, following a gain of 210% in 2005.
A&P's one-time dividend payment of $7.25 in April accounts for most of the decline in this company's stock in the first half, after the company soared last year based on its sale of a majority stake in its Canadian operations.
"It hasn't performed that well, but it's not that big a loser when you add the dividend back in," said an analyst who asked not to be identified.
Investors remain convinced that the company will eventually be part of a consolidation in the Northeast, possibly in combination with Pathmark Stores, Carteret, N.J.
Whole Foods Market, Austin, Texas, down 16.16% to $64.64.
Whole Foods finally tumbled in the first half, after a huge run-up over the last few years. Husson of HSBC also noted that increasing competition in the organics space may be cutting into the company's extraordinarily high profit margins. This is evidenced by recent pledges by the chain to work on reducing prices.
"We have been negative on the stock, although we like the company," he said. "We have argued, and the market has come around to our way of thinking, that their gross margin is unsustainably high. As the organic market develops, the organic premium starts to reduce over time, just like it has in Europe where the organic market is more developed."
Analysts still see it as the premier growth company in the industry.
"There is no one in a pure-play competitive role that can challenge that growth," said Wolf of BB&T Capital Markets. "There are certain limited instances where they have good competition, like from H-E-B's Central Market, but H-E-B is not growing that concept rapidly. Otherwise, Whole Foods' stock would not be where it is."
Nash Finch, Minneapolis, down 14.81% to $21.29, following a decline of 32.5% in 2005.
The wholesaler continues to stumble, following the recent announcement that it would take a charge of about $6 million-$8.5 million related to a customer's financial difficulties.
"The write-down raises the broader question about how much exposure [Nash Finch] may have to other struggling customers," wrote Steve Chick, analyst, J.P. Morgan Securities, New York, in a research note last week. The stock price "looks cheap" at current ratios, he said, but future write-downs such as this would be a more material concern.
Last year, Nash Finch's stock plunged after the company slashed profit projections based on integration problems with the warehouses in Westville, Ind., and Lima, Ohio, that it acquired from Roundy's Supermarkets, Milwaukee.
Target Corp., Minneapolis, down 10.69% to $48.87, following a gain of about 6% last year.
Consumer pressures from the high cost of gasoline might be hurting the discount sector, analysts pointed out, although this stock has received four analyst upgrades in 2006, vs. two upgrades and one downgrade for Wal-Mart.
Analysts estimate that the average Target shopper earns about $15,000 per year more than the average Wal-Mart shopper, making the former less vulnerable to a squeeze on disposable income, according to reports.
Loblaw Cos. Toronto, down 8.98% to $51.50.
Loblaw has had considerable difficultly implementing a new distribution system and driving sales growth, and now Canada's largest supermarket operator also faces the specter of Wal-Mart's entry into its country with the supercenter format.
"I think supermarket stocks are in for tough year up here," said Caicco of CIBC. "Wal-Mart puts a cloud over the whole thing."
He added that much of Loblaw's recent sales growth has been in general merchandise and health and beauty care.
"They have a long way to go to get costs under control and to get the food side going again," he said.