Analysts Discuss Consolidation, Whole Foods

The industry could be in for a new round of consolidation activity next year in which some major national chains go after some of the larger regional operators, according to participants in SN's 16th annual Analysts Roundtable.

“Like sharks that die if they stop moving forward, these chains are going to grab growth one way or another,” Gary Giblen, managing director of Aegis Capital, New York, said. “[Kroger and Safeway] will justify acquired growth with the rationale of transforming the industry and their company and righting the downward direction.”

The catalyst for consolidation, Giblen said, could be a renewal of price war activity resulting from the difficult consumer environment and the industry's need to resolve volume problems.

That catalyst could actually occur, Andrew Wolf, managing director for BB&T Capital Markets, Richmond, Va., noted. “I think the industry will continue to muddle along with results that are kind of flattish, and inflation will matter a lot. In that scenario, rapid hyper-inflation could put consumers back in play,” he said.

Meredith Adler, managing director for Barclays Capital, New York, offered a similar outlook. “There's a real risk of increased competitive activity that won't be good for profitability,” she said.

John Heinbockel, managing director for Guggenheim Partners, New York, also said he's worried about the operating environment in the first half of 2012, which he said could be weaker than it is today.

It's that possibility that raises the specter of a new round of merger activity, Giblen said. “There is an argument to be made that you are going to see more merger-and-acquisition activity from Safeway and Kroger just to get growth to overcome the macro challenges. Major price wars [could] create a tinderbox, where all it takes is a little bit of flame to light the conflagration, and that will lead to significant M&A activity.”

Wolf said he believes Kroger “is much more receptive on that front.”

Mark Wiltamuth, executive director for Morgan Stanley, New York, said the last round of major industry mergers left investors will little patience for acquisitions in the grocery space. “If you look back to the 1990's, it's just littered with value-destroying deals, accretion that was promised but never delivered and big acquisition premiums paid,” he noted.

Chuck Cerankosky, managing director for Northcoast Research, Cleveland, said he sees a different series of developments — some de-consolidation among the larger companies, “which will result in the formation of some new super regionals.”

Scott Mushkin, managing director for Jefferies & Co., New York, said the outlook for food stocks is not good. “At this juncture I would say bet on the winners — bet on Kroger, bet on Whole Foods, bet on special situations like Winn-Dixie, but stay the heck away from everything else.”

Touching on other topic during their discussions, the analysts made these comments:

• On Whole Foods Market, Austin, Texas: “Whole Foods can sustain its momentum because it had a very differentiated store base going into the [economic] downturn,” Cerankosky said. “Now it's getting a higher return on investment, being more cost-conscious and opening somewhat smaller boxes, so it still has a lot of sales momentum ahead of it.”

• On Winn-Dixie, Jacksonville, Fla.: “It has to take a very tarnished brand name and polish it, and it's going to be a long, slow slog,” Adler pointed out. “But management is very excited about some of the transformational remodels the company is doing. Now that it has remodeled half its store base, the question is, how easy is it to take an already remodeled store and give it the panache you've got in the transformational stores?”

• On Fresh & Easy Neighborhood Market: “Tesco was overly ambitious — it tried to do too many things at once,” Wiltamuth said. “The general idea was to offer something that was fresh and easy, and it didn't really live up to its name.”

The first part of the roundtable ran in the Sept. 12 issue of SN. Part two of the discussion follows, beginning with the analysts' predictions for the year ahead:

MARK WILTAMUTH: I would say food inflation will get worse in the second half and volumes will decline for the Big Three. Kroger might escape it, but at Safeway and Supervalu, I think you are definitely going to see some ongoing volume problems.

JOHN HEINBOCKEL: My prediction is, competition will stay rational until early 2012 and then the consumer will weaken — and I think the operating environment will be tougher in the first half of 2012. I'm more worried about 2012 than this year.

MEREDITH ADLER: Either the market stays rational or it doesn't. Maybe nothing changes until 2012. But I think there's a real risk of increased competitive activity that won't be good for profitability.

ANDREW WOLF: Like the economy, I think supermarkets are in a period of stagflation, so if inflation gets to a cumulative 10%, that would change behavior negatively; and if inflation doesn't somehow settle down, then consumers could be in play. At this point I don't see the kind of massive channel shift you often see in a deep recession. When we were in the recent recession, it caused everybody — even the Whole Foods shopper — to go on strike.

So my prediction is that we are not going to enter into a deep recession in the back half of this year and probably not even in 2012, although we have an increased risk of it, and I think the industry will continue to muddle along with results that are kind of flattish, and inflation will matter a lot. In that scenario, moderate inflation would be okay, but rapid hyper-inflation would be tough, and that could put consumers back in play.

SCOTT MUSHKIN: I think the problem right now is employment, employment, employment and what's going on with the macro economy. The fact is, this industry is under an enormous amount of stress, and it appears to be getting worse, and that's the problem.

But the retailers are running their businesses better, and that combination makes the crystal ball extraordinarily cloudy.

WILTAMUTH: That doesn't sound good for stocks.

MUSHKIN: I agree, it doesn't sound good for stocks. So at this juncture I would say, bet on the winners — bet on Kroger, bet on Whole Foods, bet on special situations like Winn-Dixie, but stay the heck away from everything else.

ADLER: Or just avoid supermarkets altogether.

MUSHKIN: Right. Stay with the winners and say prayers for the losers, even though they are trying to run their businesses better.

CHUCK CERANKOSKY: My prediction is, industry consolidation over the next couple of years is going to include some de-consolidation among some of the bigger players, which will result in the formation of some new super-regionals.

GARY GIBLEN: Actually I think there is an argument to be made that you are going to see more merger-and-acquisition activity from Safeway and Kroger just to get growth to overcome the macro challenges.

The way I see it, major price wars will manifest themselves by the first half of 2012 — because of all these factors that create a tinderbox, where all it takes is a little bit of flame to light the conflagration, and that will lead to significant M&A activity by Kroger and Safeway. It may not be logical or add value in a business school net-present-value sense, but it is going to happen anyway. Like sharks that die if they stop moving forward, these chains are going to grab growth one way or another. They will justify acquired growth with the rationale of transforming the industry and their company and righting the downward direction. A multiple of problematic risk/reward actions get taken in corporate America in the name of “transformational transactions.” I'm not saying it's the rational thing for Safeway to do, but I think the realpolitik is, Safeway has to do it.

WOLF: Don't you think those ideas are a little at odds with each other — the industry blowing up in a price war at the same time companies want to do deals? Not a great idea.

GIBLEN: I think the valuations of the target companies would be lower too, so the actions would be justified.

WOLF: And what would happen after the dust settles?

GIBLEN: If price wars begin and pressures increase, the theory is that the industry should consolidate further, and while we don't have the best currency now, we do have debt capacity, low interest rates and two-way synergies and learnings, so now is the time to proactively change the course of the industry. There are only a few great private supermarket companies out there, so there will be a “gold rush” for the Publix, H-E-Bs and Wegmans of the world.

WOLF: After spending time with Kroger recently, I got the feeling it is much more receptive on that front.

HEINBOCKEL: Safeway's track record on acquisitions isn't great. At this point it wants to hoard cash or at least generate cash. I think it's a fair point that when you see which companies out there you might want to own, there are fewer of them than you would have seen five or 10 years ago.

GIBLEN: I don't think Safeway would be interested in buying a turnaround company, because it has failed to turn around those kinds of companies.

ADLER: It has destroyed some good companies.

GIBLEN: But if it could manage it financially if it could accept dilution for a couple of years and look at it as a transformative acquisition — saying, we're not in the Southeast — boom, we're going with Publix, and we're going to have two-way learnings.