A Tale of Two Halves: Stocks Retreat After Gains

Investors who bought supermarket stocks in January and sold them by July did a lot better in 2007 than those who held on to the bitter end.

Not all food retailers followed the pattern, but many issues that showed remarkable gains through the first half of 2007 fell almost as sharply in the second half as investors grew increasingly concerned about the economy and consumer spending, and about retailers' ability to maintain margins amid cost pressures.

“It was a battle in investors' minds between sales momentum and margin expansion, with the ideal being a fair amount of each contributing to the numbers,” said Chuck Cerankosky, an analyst with FTN Midwest Research, Cleveland.

Among the 23 food retailing and wholesaling stocks tracked by SN, 15 were up at year-end. The SN Composite Index eked out a 1.6% increase for the year, less than both the S&P 500 Index, which rose 3.53% for the year, and the Dow Jones Index, up 6.43%.

“Small- and mid-cap value was incredibly in favor in the first half of the year, so the performance of the stocks in the first half was just phenomenal,” said Karen Short, an analyst with Friedman Billings Ramsey, New York. “Then, as people got jittery about the economy, they sort of came back down. Supermarkets are normally a good defense when times are jittery, but unfortunately it didn't play out that well.”

Many investors dumped their holdings to take advantage of the first-half run-up, she explained.

For the larger supermarket companies, the big question investors had was whether their customers were going to be willing to pay higher prices as supermarkets attempted to pass on their cost increases. Retailers for the most part found they could raise shelf prices to maintain their margins, although some struggled at times with the equation.

“My theory was that product inflation, particularly in the commodity areas, was too quick to be passed through, and if it was fully passed through it would hurt volumes,” said Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va. “There wasn't as much of a gross-margin squeeze right away as I anticipated, but there was, unambiguously, a drop-off in real sales growth,” defined as reported growth minus the inflation index.

While costs on some dairy product rose as much as 20%, however, “it was a conundrum,” he said, “because if you pass it through, your volume goes down, but if you don't pass it through, your profits go down. The group still ended up for the year, but the reason they came off was the market recognized correctly that real sales growth was slowing, and took down their estimates.”

KROGER UP 16%

Among the “big three” traditional supermarket operators, Kroger fared the best, despite an unsteady performance that alternated between positive and negative quarterly surprises. Despite reaching a high of $31.94 on June 1, Kroger saw its share price slip at the end of the year when it used a one-time tax benefit to prop up earnings, closing up nearly 16% for the year, to $26.71.

“I think the business is strong at Kroger, but they made a decision in the third quarter that I think upset many investors,” said Short. “Throughout all the fiscal year they have been knocking the cover off the ball. They had been investing in price, but it had been generating pretty decent sales, and you could look at the increase in sales and the increase in gross margin dollars and know that it was a smart investment they were making.”

Then in the third quarter, “the company did not get a lift from investing in price, and that caused the sell-off,” she said.

“Kroger unfortunately has been a little bit of a quarter-to-quarter story,” Short said, adding that she expected the company to report a strong fourth quarter. “They should be able to fairly easily meet or beat consensus [estimates], and that should help the stock a little bit, but not enough to get people excited.”

Safeway was basically flat for the year, and analysts were mixed on just how strong that company's underlying business is overall.

The company finished down about 1%, closing at $34.21, despite a strong run-up early in the year.

“The trouble is that everybody struggles to figure out what Blackhawk is worth,” said Perry Caicco, an analyst with CIBC Capital Markets, Toronto, referring to the supermarket company's gift-card business. “They've done a reasonable job trying to explain Blackhawk to people, but when supermarket analysts, who are mere mortals, try to look at a card network system with unbelievable growth, you just don't know how to value it — I've seen it anywhere from $3 to $10 per share.”

Caicco suggested that until Safeway either spins off part of Blackhawk in a partial public offering or sells a portion to a partner, “it's going to be very difficult” for investors to determine how much value to place on the business.

Other analysts were skeptical about the performance of Safeway's underlying retail performance.

“If you look at Safeway without Blackhawk, the stock should remain more or less flat, if not have some pressure on it, because I think the results are not that robust,” said Short. “But having said that, they do have Blackhawk, and I think you're going to see some good things from that business, but the stock isn't really reflecting Blackhawk today, nor should it.”

She said Safeway could face a dilemma once it decides what to do with Blackhawk — it would risk alienating growth-oriented investors by spinning it off, and at the same time it could be ready to spin off Blackhawk, it will also be winding down its lifestyle store-remodeling program.

Short said she believes much of the same-store sales gains Safeway enjoyed last year were the result of Albertsons store closures in its markets, not necessarily because of the lifestyle remodels.

“I don't think [same-store sales] are poor, but they are masked by some decent sales lift from the Albertsons store closures,” Short told SN.

Supervalu was another company whose stock rose early in the year and then came crashing back down. After rising to nearly $50 per share through mid-July, the stock slid down the other side of the mountain and settled for a mere 5% gain for the year, to close at $37.52.

“In the first part of the calendar year, they got a lot of credit for margin expansion and integrating the Albertsons properties,” said Cerankosky.

Analysts said investors may have expected too much ongoing benefit from the Albertsons acquisition, however, and when Supervalu reported that same-store sales were flattening out, the stock quickly gave back much of its gains.

“To the extent that the economy impacts supermarkets, it's going to impact the weaker supermarkets,” said Caicco of CIBC. “And of course Albertsons is largely unrenovated, so if anyone was going to be impacted, it would be them.”

Caicco said he thought Supervalu came through with “a very solid earnings number” when it reported second-quarter results in July. “I think the same-store sales were a little soft, and I think maybe people were expecting a little too much from the Albertsons stores,” he said.

GAINS AT A&P, SPARTAN

On the other hand, investors rewarded A&P, Montvale, N.J., for its acquisition of Pathmark Stores, which didn't close until November but helped propel A&P's stock price to a gain of nearly 22% for 2007, to close at $31.33.

Analysts said it would take a couple of quarters to assess how well A&P is handling the incorporation of the Pathmark stores. In the next few quarters, A&P can be expected to record some one-time charges for the integration, but synergies should begin to show up later in the year, the analysts said.

“It's kind of an execution-driven story,” said Short. “We're not going to see anything from them for the next two quarters — when they report around September, that's when we should start to see some real numbers come out about them.”

Another company that had a roller-coaster year was Spartan Stores, Grand Rapids, Mich. Despite nearly doubling to a 52-week high of $34.74 in July, Spartan's shares settled down to finish the year up just over 9%, to close at $22.85.

“Their wholesale and retail operations have continued to generate profits ahead of our expectations,” said Cerankosky. “The company added some new business over the course of the year — it's one of the few companies with a major wholesaling operation that actually saw that part of the business expand.”

Short said the stock slid off its midyear highs for several reasons that all seemed to come together in a perfect storm — earnings growth did not match the surge the company experienced in the prior year from the acquisition of D&W Food Stores; the company was no longer in the Investors Business Daily Top 100 list, where the company's brief stay had lured some funds to invest in the stock; and the stock also lost some of its attractiveness to so-called “quant funds” — those that invest based strictly on computer-generated quantitative analysis.

“The second half of the year was like a bloodbath,” she said, noting that more than 30% of the investor base had been quant-based funds.

Looking ahead to this year, analysts are fairly optimistic for strong performance among food retailers.

“Investors are generally going to be looking for signs that a specific chain's customers are buying a rich product mix,” said Cerankosky. “They are going to be looking for companies that can sustain their profitability while growing market share.”

He said the weakening economy does not seem to be having much impact on supermarket performance.

“Customers may be economizing in other areas, like waiting another year to buy a new car or a new television,” he said. “They may have the opportunity to do some trading up in the retail space — it will be another year of sales momentum and margin maintenance and, hopefully, expansion, being balanced in investors' eyes.”

Caicco said the investment Kroger made in pricing in the past year should have prepared them well for whatever the economy throws at them this year.

“If there's a weak consumer, Kroger is really well positioned for that, because of the investments they have made,” he said. “I think one of the big question marks will be around Supervalu, and whether they can start to turn comp-store sales at Albertsons into positive territory on a consistent basis.”

TOP GAINERS AND LOSERS

The top five percentage gainers for 2007 were:

• North West Cos., Winnipeg, Manitoba, up 34.77%, to $20.93, following a gain of nearly 30% in 2006. This company, which operates 220 stores under several banners across northern Canada and Alaska, saw strong sales and earnings growth in 2007 and capped the year with the acquisition of Cost-U-Less, a warehouse-store operator with locations in the Caribbean and South Pacific.

  Through three quarters, Northwest posted profit gains of 6.9%, to about $75 million, on a sales increase of 9.4%, to $746.5 million, compared with year-ago results. Same-store sales were up 5.2% in that period, and food sales increased 9.3%.

• Costco Wholesale, Issaquah, Wash., up 31.95%, to $69.76, after a gain of about 7% in 2006.

  “I think investors were pleased to see some margin expansion there, including some very good expense management around their electronics return policy,” said Cerankosky. “There were some abusers of the electronics return policy, and those were not necessarily the customers Costco wanted to have.”

  He said the company also seemed to execute sales growth exceptionally well, both through existing stores and with its domestic and international store-development plan.

  “They remain the best wholesale-club business model,” he said.

• Nash Finch Co., Minneapolis, up 29.23%, to $35.28, following a gain of about 7% in 2006. Another stock that peaked in July, investors saw improved cash-flow margins throughout the year in the company's military, retail and supermarket wholesale divisions, despite the loss of Martin's Super Markets as a wholesale customer.

  “They are only now getting to the point where they can start investing in the future,” said Karen Howland, an analyst with Lehman Bros., New York, told SN after the company's third-quarter earnings call.

• Winn-Dixie Stores, Jacksonville, Fla., up 24.96%, to $16.87, in its first full year as a public company again after emerging from bankruptcy in 2006. The stock more than doubled to about $32 a share by June after a first-quarter earnings surprise, but wasn't able to maintain the momentum through the second half of the year.

  “This was their first full year since emerging from bankruptcy, and they were able to get out in front of investors and tell their story,” said Cerankosky, although he said strong results from remodeled stores early in the year “generated a lot of enthusiasm and may have led investors to expect a little more than the company would, in fact, deliver.”

• Arden Group, Los Angeles, up 24.94%, to $154.69, following a gain of about 36% in 2006, tied with Ruddick Corp., Matthews, N.C., for the No. 5 spot among gainers, also up 24.94%, to close at $34.67, after a gain of 30.4% in 2006.

Arden Group saw sales and earnings growth throughout the year from its upscale Gelson's format, and operating income rose sharply through the first three quarters as a percentage of sales.

Ruddick Corp., parent of the Harris Teeter chain, continued its strong growth story in 2007 with promising results from its new stores in the Washington, D.C., market, analysts said.

“Harris Teeter has decent sales momentum, and they were one of the few chains at the end of the year that had increasing same-store sales,” said Wolf of BB&T Capital Markets. They are a pretty high-end franchise, and that helps with their pricing power, and their ability to pass through inflation.”

He also said the company's stores in the D.C. market are “no longer as dilutive as they once were.”

Cerankosky said he thinks Harris Teeter has also benefited from the reduction in competition in areas where Bi-Lo and Winn-Dixie have shuttered locations over the past few years.

“It's another story of a well-differentiated chain, and despite a pretty high level of store-expansion cost, they've been able to grow earnings in some quarters better than expected.”

The five biggest decliners for 2007 were:

• Target Corp., Minneapolis, down 12.36%, to $50, following a gain of less than 4% in 2006. The company outperformed No. 1 rival Wal-Mart Stores for most of the year, but investors became concerned as the holidays approached and sales projections weakened.

• Whole Foods Market, Austin, Texas, down 13.06%, to $40.80, after a loss of about 40% in 2006.

  Wolf said the stock could have fallen even further if not for a strong sales performance late in the calendar year.

  “There's a lot on their table,” he said. “They have a London store that has to be managed to lose less money, and they've got the Wild Oats stores to convert.”

  He said he believes sales are improving markedly at the acquired Wild Oats locations, but the company is still “ramping up new-store growth to the detriment of earnings.”

  Cerankosky pointed out that Whole Foods is also seeing more competition from other food retailers in the natural and organic space.

• Ingles Markets, Asheville, N.C., down 14.77%, to $25.39, after a 90% run-up in 2006. This company may have traded up strongly in 2006 because of speculation that it could be acquired, analysts said. The retailer reported a 37.7% gain in net income for the fiscal year that ended Sept. 29, buoyed by comp-store sales gains of 9.2% in the fourth quarter and an overall sales gain of 92% on one less week than the preceding year.

• Loblaw Cos., Tor-onto, down 30.38%, to $33.97, behind a slide of more than 14% in 2006.

  The largest Canadian chain underwent a management change and embarked upon an ill-advised price-reduction spree, according to Caicco of CIBC World Markets.

  “They made a decision that their prices were too high, regardless of where Wal-Mart was, which meant everybody had to lower their prices, which made margins melt away,” said Caicco. “It was one of many rather questionable decisions they made during the year.”

• Metro Inc., Montreal, which led all decliners with a loss of 30.55%, to close the year at $26.35, from a gain of nearly 25% in 2006. Metro was also impacted by Loblaw's aggressive pricing stance, Caicco said, although investors were also concerned about Wal-Mart's supercenter expansion in Canada.

“The Canadian economy was strong all year,” he said, noting that some retailers might have had cost deflation from produce purchased in the U.S. because of the decline in the value of the U.S. dollar, but “nothing that impacted margins.”

Supermarket News 2007 Annual Stock Price Comparison

2007 Gainers & Losers
[Ranked by percentage change]