Difficult 2009 Gives Way to Faint Signs of Recovery

Supermarkets suffered through a bleak period during the second half of 2009, and it may be a while before it's business as usual again.

Looking at financial results for the top 10 supermarket chains with public equity or debt, there was little room for comfort:

• Overall sales fell 1.1% during the second half of the calendar year, compared with a 4.8% increase in the back end of 2009.

• Comparable-store sales for the group fell an average of 1% during the July-September period (compared with 2% growth a year earlier) and fell 2% in the October-December period (compared with a 1.5% gain last year).

• Operating income dropped 14.8% during the half, compared with a 4.3% increase a year earlier.

Scott Mushkin, an analyst with Jefferies & Co., New York, said the industry's biggest challenge in the second half of 2009 was deflation — which was running at about 2% during the fourth quarter — “aggravated by one of the most irrational competitive environments we've seen in awhile, which left a lot of chains chasing their tails as deflation spooked some companies, including Kroger, to a degree that didn't seem possible.”

“That combination of rampaging deflation and a tough competitive landscape took its toll on everyone's numbers.”

Mushkin said the first half of 2010 is looking better than the back half of 2009, with deflation running at about 1%. “The environment for inflation is improving and the competitive environment is getting better, and there are signs consumers are willing to trade up, albeit slowly. So there's likely to be a gradual improvement and, while things will still be tough, it will not be as bad going forward as it was during the fourth quarter.”

Andrew Wolf, managing director of BB&T Capital Markets, Richmond, said the second half of 2009 was “a perfect storm in the most negative way, with trading down to discounters hurting unit sales and deflation hurting average ticket sales, and by the fourth quarter the industry was as close to a national price war as it's probably ever been.”

Looking ahead, Wolf said the first half of 2010 will mirror the second half of 2009 but in reverse, “with a pretty ugly first quarter that will look like last year's fourth, only with positive trends, and an improving second quarter that will look like last year's third quarter. I think when companies report first-quarter results there will be signals that things are getting better, and by the second quarter those improvements will be clear.”

Chuck Cerankosky, an analyst with Northcoast Research, Cleveland, said the second half was “pretty tough, as the unemployment situation continued to worsen, which had a negative impact on consumer spending. And shoppers learned to adjust to a slow bottoming out of the economy and made adjustments by trading down, buying less and trying to scrimp and save to find enough money for necessities or for special treats beyond food.

“Strangely enough, supermarkets found themselves in the position of being disadvantaged by the traditional belief they were defensive parts of the economy as consumers recognized this would be a difficult and very long recession, and they were aggressively trying to save money in what they purchased.

“That was obvious in supermarket sales and earnings, with food chains consistently reporting numbers that were below expectations as many consumers went outside the supermarket channel more than ever.”

Karen Short, an analyst with Toronto-based BMO Capital, New York, said the second half of 2009 was “probably the worst environment most of us have ever seen, with chains trying different strategies to get through it, with varying results.”

Looking ahead, she said she expects results to improve modestly, “but the big question mark is what Wal-Mart does. Whether or not its price rollbacks are real, consumers perceive that they are, which means the chains must decide how to react — either by lowering prices themselves to hold onto traffic or not reacting at all and taking their chances.”

While deflation accounted for some of the negative results, so did a move by consumers to look for alternative places to spend their money. According to several analysts, consumers may stick with those alternative channels for awhile, at the expense of conventional supermarkets — at least until the economy improves.

For Bryan Hunt, managing director, high-yield research, for Wells Fargo Securities, Charlotte, N.C., the volume losses experienced by supermarkets during last year's second half will last for at least the next few years.

“The drop in second-half performance was due not only to deflation but also to consumers fragmenting their shopping trips seeking out value, which resulted in growth among dollar stores and club stores,” he pointed out.

“Even with a recovery in the economy, consumers have become more frugal to a large degree; and with dollar stores in particular offering a similar mix to supermarkets and having the capital to continue to grow aggressively, it's my opinion that market share will continue to move to the dollar and club store segment for the next couple of years, at least.”

According to Gary Giblen, executive vice president of Quint-Miller & Co., New York, “A lot of negatives ganged up on the industry during the second half of last year, and it was tough throughout the second half as consumers stopped spending on anything discretionary, traded down aggressively and sought alternative channels.

“Now that they have the experience of shopping at other channels, they will continue to do so on a semi-permanent basis, though there could be a shift back to supermarkets as more consumers return to full employment.

“It's still a question of time versus money that determines where people shop, and as more people go back to work, it will be easier to shop at a more conveniently-located supermarket than to drive out of their way to save money at a Wal-Mart or dollar store,” Giblen pointed out.

“But even if the economy improves people will dribble back to supermarkets very gradually — though that may be quick enough to satisfy the chains, and they are likely to avoid aggressive competition in the near term while the business is coming back.”

Wolf told SN there are signs trading down is already ending. “Some people will stay with the alternate channels, but most will come back to supermarkets slowly, though it may require a lot of price promotions to stanch the bleeding.”

Mushkin also said a consumer return to supermarkets depends on the economy. “If the economy doesn't recover, then shoppers could stick with the alternative channels. But if the economy picks up and people go back to work and price becomes less of a motivation, consumers will again be looking for service, convenience and quality, and that should lead them back to the supermarkets fairly quickly.”

Cerankosky told SN he believes the first half will continue to reflect a consumer shift away from supermarkets, “though we may see easier year-over-year comparisons during the first half, so while the reported numbers may suggest an increase, spending patterns won't be back to normal as people continue to shop at other channels.

“The easy explanation is that the employment outlook is not any better, and to get consumers to trade up and spend more money, they will have to feel a lot better about the job market, and they simply do not.”

Commenting on each chain individually, analysts offered the following observations:

• KROGER CO., Cincinnati, whose sales rose 3.7% during the second half, while comparable store sales were up 1.3% in the third quarter and 1.2% in the fourth; and whose operating income fell 22.4%.

  By moving to more value offerings before the economy dropped, Kroger has been able to maintain positive same-store sales and avoid some of the significant sales declines experienced by other chains, Cerankosky pointed out. “However, it got more aggressive as the economy worsened and as profit margins took a greater hit than anyone would have expected.”

  According to Mushkin, Kroger got overly aggressive on shelf and promotional pricing during the half, “and in doing so it lost its balance. By getting too aggressive, it lowered some prices to Wal-Mart levels, which resulted in a negative return-on- investment — and it acknowledged during the half it probably did not think things through properly.”

  The drop in operating income was due to the poor economy and deflation, Mushkin said. “Kroger was caught off-guard by the severity of deflation and what it meant to its pricing, which resulted in margins collapsing.”

• SAFEWAY, Pleasanton, Calif., with sales falling 7.6% in the half, comps down 3% in the third quarter and 4.1% in the fourth and operating income dropping 29.4%.

  Traffic picked up but revenues fell as the half progressed, Giblen pointed out, with Safeway seeking to reverse the declining sales trend at mid-year with a new everyday pricing program, which it implemented division by division.

  “But it had to spend a lot of extra money on advertising, which offset profitability, and it still had a high price perception through most of the year, before its new program kicked in in terms of consumer perceptions,” he explained.

  According to Cerankosky, Safeway's results were hurt by its broad exposure in California, where housing issues and high unemployment resulted in high consumer debt, “plus, it's going to take awhile for consumers to get acquainted with its ‘Promise’ pricing program, so the mix between sales and margins as the lower-pricing program was implemented has been negative so far.”

  For Mushkin, Safeway's poor results were expected as it adjusted pricing downward. “Unfortunately, Safeway went into the economic downturn priced too high on an everyday basis, at the same time it was cutting back on store labor. But by the fourth quarter, after pricing had been fixed and store labor was added back, Safeway did a good job improving its in-store execution.

  “In the short term that hurt results, including operating income, but Safeway took its medicine in a bad environment and it will reap benefits if the economy improves.”

  Short said Safeway was able to invest in lower pricing by cutting costs, “but Safeway is also focused on preserving profits by communicating to consumers that its prices are better, more so than on actually lowering prices.”

• SUPERVALU (RETAIL), which saw sales fall 4.8% in the half; comps decline 1.3% in the company's second quarter and 6.5% in its third; with operating income for the half down 8.4%.

Unlike Safeway, Supervalu couldn't afford to lower prices with its peer in the sluggish economy because of its balance sheet, Mushkin pointed out.

“Supervalu had to make some tough decisions, but it was saddled with a balance sheet in bad shape, with certain covenants approaching, so Craig Herkert, the new chief executive officer, decided not to participate in the hot promotional environment — nor did he have the capital to fix everyday pricing. So Supervalu let pricing float up, which led to downward pressure on the earnings line,” he said.

“It was a conscious decision to increase cash flow and not make any major pricing moves yet, though it will have to do so at some point as it waits for the operating environment to improve.”

According to Cerankosky, Supervalu faced all the burdens other companies faced from the recession, plus the challenges remaining from integrating the Albertsons acquisition. “While the acquisition made a great deal of sense strategically, the challenges of trying to integrate it were complicated by the shadow of the economy, and that made Supervalu the company that may have been hit the hardest by the recession as consumers changed the way they shopped.

“Supervlau's original strategy was to upgrade the acquired stores with more discretionary, high-margin merchandise, but it was stymied in that effort by the economy, and it entered the second half talking about reduced capital spending and a slower pace of remodels.

“The 6.5% drop in same-store sales in the company's third quarter reflected a different top-line experience than management had expected, and the arrival of Herkert at mid-year and the subsequent addition of a new senior management team changed the way the company opted to go to market, with a lot of mid-course changes at a company that was already having problems.”

• AHOLD USA, Quincy, Mass., which saw sales rise 5.7% during the half; comps increase an estimated 0.7% in the third quarter and 2.2% in the fourth; and operating income climb 8.7%. (Comps at Stop & Shop rose 0.7% in the third quarter and fell 0.4% in the fourth; comps at Giant/Landover rose 1.5% and 1.6%, respectively; and comps at Giant/Carlisle fell 1.5% and rose 1%, respectively.

  Ahold's U.S. sales benefited from an ongoing effort to lower prices at Stop & Shop, Giblen said. Implementation of a similar program at Giant Foods, Landover, Md., also helped, he added, “as Ahold's experience with the program at Stop & Shop enabled it to install it more quickly and more skillfully in the Baltimore-Washington market area.

  “And the program delivered positive results more quickly for Giant because Baltimore-D.C. is a less competitive market than New England, so Giant's pricing moves were more visible there.”

  James Grzinic, Jefferies' Europe-based analyst, said Giant Foods of Carlisle suffered from a challenging margin environment “due to the impact of an aggressive step-up in competitive conditions in the Philadelphia area.”

• DELHAIZE AMERICA, Salisbury, N.C., which saw sales drop 5%, while comps fell 1.3% and 2.8%, respectively, in the third and fourth quarters, and an operating income decline of 15.9%.

  Delhaize America had such a strong first half, Wolf pointed out, “that it got caught a little flat-footed” when things changed in the second, “resulting in a tough third quarter and a worse fourth quarter.”

  Before the chain revived a focus on low pricing in its Food Lion unit earlier this year, commodity deflation and intense competition, from both Wal-Mart and Kroger, hurt second-half results, he added.

• WHOLE FOODS MARKET, Austin, Texas, whose sales grew 5%, while comps rose 0.9% and 3.5% in the company's fourth and first quarters and operating income rose 91%.

Wolf said Whole Foods spent the last two years re-inventing its value image away from the “Whole Paycheck” tag, “so it was running six to 12 months ahead of conventional operations in offering lower prices, and I expect the rest of the industry to recover in the same way. And after reducing its work force and running stores on tighter payrolls, Whole Foods has already gotten its cost structure in line.”

According to Giblen, Whole Foods got a big lift “once its price message caught on. It was able to get that message across very successfully during the second half — in fact, it conducted classes in store about how to eat healthy on a budget that also enabled it to let people know its prices were comparable to the traditional chains on organic items.”

Mushkin said he credits John Mackey, Whole Foods' chairman and CEO, as a visionary who's been able to anticipate what consumers are looking for. “He was able to anticipate the desire of his company's customers for value before the economic downturn, and by launching a value campaign early on, he made customers feel like Whole Foods was on their side.

“He also instituted a health initiative — to get people to eat better — when everyone questioned his motivation, and that's also helped improve the company's sales by improving consumer loyalty.”

Short also said Whole Foods' performance during the recession confirms the strength of the chain's management team, “which demonstrated a fairly solid ability to improve traffic trends while controlling costs.”

• WINN-DIXIE STORES, Jacksonville, Fla., where sales fell 2.8% during the half, while comps fell 1.5% and 2.9%, respectively, in the chain's first and second quarters and earnings before interest, taxes, depreciation and amortization declined 14.7%.

  “Winn-Dixie suffered from having most of its stores in Florida, which has experienced the worst of the recession,” Giblen said. “It also saw Publix spring to life and get more aggressive, which really hurt Winn-Dixie's recovery.”

  According to Cerankosky, the economic downturn interrupted Winn-Dixie's post-bankruptcy recovery “and upset its original game plan as customers started trading down in the face of the terrible Florida housing market and the stoppage in population growth in the state.

  “So it's been a huge challenges for a very good management team, which had to take a hard look at capital spending and cash flow and had to reduce spending, which meant fewer remodels, which was what the company had been counting on to help turn things around.”

  Cerankosky also said Winn-Dixie was impacted by the larger store base and greater economies of scale at cross-state rival Publix Supermarkets, Lakeland, Fla., “though Publix didn't do anything that threatened Winn-Dixie as it started talking more about prices and promotions.”

  Mushkin said he recently became a fan of Winn-Dixie's “because I believe [chairman and CEO] Peter Lynch and his management team have done a good job with very little market share in areas where Wal-Mart is just tearing them up on price.

  “It hasn't made too much price investment - like Supervalu, it has pretty much held the line. But Winn-Dixie is surviving, though it still faces very difficult problems.”

• A&P, Montvale, N.J., which saw sales drop 4.7% in the half, comps fall 3.8% in the chain's second quarter and 5.8% in its third, and EBITDA fall 31%.

  While problems at A&P's Pathmark division continued to plague the company throughout the half, performance at the legacy A&P divisions was strong in the company's second quarter declined rapidly during the last period of 2009 when Eric Claus was let go as president and CEO, Short said.

  “There was no top leadership, and the company tried to throw anything at the wall to see what would stick,” she explained. “But the things A&P was doing just didn't resonate with consumers — at the same time Pathmark was failing to get any sales lift from lowering prices.”

As a stop-gap measure Yucaipa Cos., the Los Angeles based investment firm that owns a major stake in A&P, deployed some of its retail experts to deal with the situation, prior to A&P's hiring of Ron Marshall to succeed Claus earlier this year — “a smart hire,” Short said, “because he will have the support of the legacy A&P people who hired him, while, as a former Pathmark president, the people there will know they have someone on their side.”

• HARRIS-TEETER, Matthews, N.C., whose sales rose 4.2% during the second half, while comps fell 2.4% in both periods and operating income fell 1.4%.

  Giblen said Harris-Teeter's sales increase resulted almost exclusively from new-store growth. “In this bad economy, Harris-Teeter is considered to be high-priced, and it has no program like Whole Foods to address that issue or counteract the price perception consumers have.”

  According to Cerankosky, the tough operating climate for Harris Teeter in North Carolina was offset somewhat during the half by improvements from the chain's stores in the Washington D.C. metropolitan area.

  “Though comp sales were negative, the prompt maturation of the D.C. stores is contributing enough to the bottom line so the total earnings impact of the weak comps is far less than at some other chains,” he said.

• STATER BROS. MARKETS, whose second-half sales fell 0.5%, while comps rose 0.7% in the chain's fourth quarter and dropped 2.2% in its first and whose operating income declined 5.2%.

  According to Hunt, the major cause of Stater's sales declines was deflation. “Customer counts were up significantly during the second half because of the good values Stater was providing, with lower prices and increased discounting, which it promoted aggressively to maintain its customer counts,” he explained.