Inflation, Margin Pressures Subdue Stocks

Investors looking for more lucrative returns as the economy slowly lurches toward recovery may have dumped their defensive holdings in supermarket shares in the first half of 2009, analysts said.

Although a handful of food retailers — six of the 24 stocks tracked by SN — showed gains since the beginning of the year, the stocks overall suffered a sharp sell-off and lost more value than the market overall.

The outlook for the second half doesn't look much better as retailers will go up against inflation-boosted comps throughout the rest of the year, which is likely to make top-line sales appear weak.

The market, after its steep plunge in the second half of 2008, appeared to be acting irrationally in the first six months of 2009 as far as supermarket stocks were concerned. Cincinnati-based Kroger Co., arguably the best performer among traditional supermarket operators, had a stock performance that was among the worst.

Meanwhile, Whole Foods Market, Austin, Texas, continued to see sales erode, but enjoyed a doubling of its stock price in the first half of 2009.

Simeon Gutman, an analyst with Canaccord Adams, New York, outlined three major reasons for investor disinterest in food retailers in recent months: Investors sold “safe” holdings to invest in more discretionary stocks which could explain Whole Foods' rise, in part; expectations that were too high to begin with; and weak sales growth.

“The overall market was shrinking, with more intense promotional activity, which means there were less dollars being fought over,” he said. “It's really hard to capture top-line momentum in that environment.”

In the weak spending environment, supermarkets have managed to hang onto shoppers but consumer caution has led these customers to curtail the discretionary spending that buoys their same-store sales.

Scott Mushkin, an analyst with Jefferies & Co., New York, said he looks for improvements in employment data to trigger interest in these stocks again.

“As we go into 2010, and the employment claims start going down, we would expect these stocks to be really big outperformers,” he said. “When people get their jobs back, they get a hamburger instead of peanut butter, they get a steak instead of hamburger, and the $10 bottle of wine turns into a $25 bottle of wine.

“If the cycle becomes more normal in 2010, things should start to get better. But right now they are left for dead. I wouldn't expect the stocks to get down much more — they are just not going to go up for most of the rest of this year.”

While the stock market overall has rebounded substantially from its plunge last fall, the Dow Jones Industrial Average was still off 3.75% through June 30. SN's composite index, however — a weighted average of all 24 stocks tracked by SN — was off even more, at about 6.9%.

Of the 18 food retailing and wholesaling stocks that lost value in the first half, 13 were down in double digits, including the three largest traditional operators. Even Wal-Mart Stores, which was widely viewed as a greater beneficiary of the weak economy than traditional supermarkets, was among the double-digit decliners with a loss of about 13.6% through June 30.

For some supermarkets, there were specific financial problems that led to their sell-offs. Safeway reported earnings that were well below analysts' expectations in the first quarter, for example, citing aggressive promotions and a weak consumer, and Supervalu lowered expectations by trimming its outlook for the year.

KROGER A ‘MYSTERY’

Kroger's steep decline, however, is not as easily explained by its numbers.

He said investors might view Kroger in the same light as Wal-Mart — stocks that were a safe bet in the early part of the downturn, but became less appealing as some indicators hinted at the beginnings of an economic recovery.

“It was a safety stock, and it has been used as a source of cash for people looking at Best Buy and Home Depot and running those stocks up,” he suggested.

Both Best Buy and Home Depot enjoyed some strong interest in the first half, although they, too, have recently slid back.

Some analysts suggested that Kroger, enjoying a long string of successful quarters, might no longer be considered a value relative to others in the industry.

“They definitely had a premium valuation, but I would say it deserved it,” said Karen Short, an analyst with Friedman, Billings, Ramsey & Co., New York.

She agreed that some investors might have bought into Kroger last year “from a safety perspective.”

This year, then, “there might have been some selling pressure, given it was the richer of the group.

“An issue that broader investors would have is that if you think the environment is going to improve, you want to find a defensive name, and if you don't think the environment is going to improve, then you still want a defensive name, but you want a defensive name that is cheap, and Kroger's not that cheap.”

DEFLATION FEARS

In addition, investors may fear that lower levels of inflation — and deflation in some categories — might make sales comparisons difficult for all supermarket companies in the second half.

“The market likes to make sweeping generalizations, and the generalization is that deflation is a bad thing for these companies,” Short said.

Investors might calculate that Kroger's stock will no longer deserve a premium price if the lack of inflation weakens comps, Short explained.

“Not that I agree,” she added.

One aspect of Kroger's performance that also might have triggered some investor concern was the fact that comps didn't rise as much as inflation in the fourth quarter, Short pointed out, although Kroger has since said volumes were trending up in the first quarter.

Kroger also stands to see fewer revenues from its far-flung gasoline operations in the second half, compared with year-ago levels, analysts said, as the price spikes of last summer have abated this year.

Rivals Safeway and Supervalu, meanwhile, both had smaller declines this year, although both those stocks took their lumps in 2008 — down 30.5% and 61%, respectively.

In Safeway's first quarter, which ended in March, the company posted a sharp drop in net income — down 25.4%, on a sales decline of 7.6%. Comparable-store sales, excluding fuel, dropped 0.7%. The company also lowered its guidance for the year for both sales and earnings.

“They are in a tough environment, and California is not in a great situation right now,” Short noted.

Gutman of Canaccord Adams, who recently upped his rating on Safeway, said he believes Safeway will be in a good position to regain momentum as California emerges from the recession.

“When people return to more normalized shopping patterns, will they increase their organic purchases, but not go back to Whole Foods?” he said. “Safeway might rebound more than people think.”

WHOLE FOODS' OUTLOOK

Like Safeway, Whole Foods is strongly tied to the California economy, Gutman pointed out, with about a quarter of its locations there.

He noted that Whole Foods seems to have committed to stemming customer erosion, trimming costs to enable it to become more aggressive on price.

The company in May reported its second consecutive quarter of same-store sales declines, and said second-quarter net income fell nearly 12%, compared with year-ago levels.

But Whole Foods impressed investors with its 10% increase in income from operations for the quarter, indicating that its cost-cutting initiatives were having some positive impact.

“For the first time, they seemed to have some control over their expenses,” said Gary Giblen, an analyst with Axiom Capital Management, New York.

He said given the stock's 77% decline in 2008, investors searching for riskier investments with growth potential might have targeted the natural and organic specialist early this year.

“Whole Foods had already collapsed in '08,” he said. “Since Whole Foods has two times the earnings multiple of traditional supermarket stocks, that may be more of the discretionary play that investors were looking for in the first half. There was a stampede into riskier stocks, with the feeling that the worst was over, and at least things would not be getting any worse.”

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., agreed that the improved margin performance at Whole Foods might have helped drive interest in the stock again.

“Same-store sales were certainly not robust — not even close — but where they did improve the business unambiguously was in the expense control,” he noted. “Their whole margin structure was better than expected.

“Now, I think the next thing is that sales will have to pick up again,” he added. “Now the stock is revalued fully, and will need good, across-the-board fundamentals to improve further.”

Short of FBR pointed out that Whole Foods seems to deserve a higher multiple than its traditional supermarket rivals.

“The reality is that the stock should never have gotten as low as it did,” she said.

She noted that since Los Angeles-based private investors Leonard Green and Partners acquired a 17% stake in the company last November, Whole Foods has reversed many of the trends that had concerned investors.

“Before the Leonard Green announcement, the stock had liquidity risk, decelerating sales trends, and negative cash flow,” Short pointed out. “Then, after Leonard Green, all of those were reversed, with the exception of the sales declines. They've cut cap-ex, and are exiting some locations they shouldn't have been building anyway.”

She said she believes that even though shoppers have cut back on how much they are spending at Whole Foods, the banner still has a highly loyal customer base.

“I think you can always argue that Whole Foods deserves to trade at a premium to the rest of the supermarket industry because they have a better growth profile,” she explained.

The other natural and organic stock tracked by SN, Dayville, Conn.-based United Natural Foods Inc., saw a 47% gain in the first half of 2009, as that company's profit-margin picture also improved and the company completed the integration of the Millbrook specialty-distribution business.

The two other food wholesalers tracked by SN — Minneapolis-based Nash Finch and Grand Rapids, Mich.-based Spartan Stores, found themselves at the other end of the stock-performance spectrum, however. They were down nearly 40% and 47%, respectively, after both had enjoyed gains a year ago.

“Investors might not believe that wholesalers will do well in a period of disinflation,” said Giblen of Axiom Capital, noting that United Natural's stock could also come under pressure on disinflation fears.

In addition to Kroger, Safeway and Supervalu, other traditional supermarkets that saw their shares decline in the first half of 2009 included Ahold, Ingles Markets, Harris Teeter parent Ruddick Corp., Winn-Dixie Stores and A&P.

Although A&P had specific challenges, especially at its Pathmark division, the other stocks seemed mostly to decline on general sentiment toward the industry.

Brussels-based Delhaize Group, parent of the Food Lion, Hannaford Bros. and Sweetbay banners in the U.S., was among the few traditional operators that saw share gains in the first half.

TOP GAINERS

The following five food retailing and wholesaling stocks saw the biggest gains in share price in 2009 through June 30:

• Whole Foods Market, Austin, Texas, up 101.06%, to $18.98, following a loss of about 77% in 2008.

  “Whole Foods' earnings continue to be lackluster,” said Gutman of Canaccord Adams, who noted that this stock is the one most closely tied to employment trends.

  “That stock is going to have a hard time without wealth creation coming back,” he said.

• United Natural Foods, Dayville, Conn., up 47.31%, to $26.25, following a loss of about 44% in 2008.

  Wolf of BB&T Capital Markets noted that the company's new chief executive officer, Steven Spinner, seems to have put some systems in place that are benefiting the company.

  “He's been there long enough now to implement some good business practices,” he said.

  In addition, he said the stock has rebounded from the extended period of earnings dilution from the acquisition of Millbrook.

• Target Corp., Minneapolis, up 14.31%, to $39.47, following a decline of about 31% in 2008.

  The discounter might have benefited from the transition to more discretionary stocks as the economy showed signs of improving, analysts pointed out. In addition, it survived a shareholder challenge at its recent annual meeting.

  Although net income fell 13.3% and comparable-store sales were down 3.7% in the first quarter, CEO Gregg Steinhafel said he projected that consumers would increase discretionary spending in the second half.

• Delhaize Group, Brussels, up 11.89%, to $70.48, following a decline of more than 27% in 2008.

  “Their performance really was good,” said Giblen of Axiom Capital. “They had been stressed, but then they came on really strong.”

  Although the company issued cautions guidance for the second half, first-quarter results, reported in early May, showed a 2% gain in comparable-store sales in the U.S., while operating profit rose 10.4%.

• Village Super Market, Springfield, N.J., up 3.68%, to $29.75, following a gain of nearly 13% in 2008.

  “I think there's a view that if Pathmark is struggling, that's to the benefit of Village,” said Giblen.

  Village also reported results for its fiscal third quarter, which ended in April, that were among the best in the industry: Net income rose 27%, and same-store sales improved by 7.3%, compared with year-ago numbers.

TOP DECLINERS

The following five food retailing and wholesaling stocks saw the biggest declines in share price in 2009 through June 30:

• Kroger Co., Cincinnati, down 16.51%, to $22.05, following a dip of about 1% in 2008.

  Analysts generally saw little logical reason for the sharp decline in this company's stock in the first half, although several noted that it might have been seen as a “safety” stock in 2008 that was sold off this year in favor of more risky investments to capitalize on a potential economic recovery.

  In addition, investors might fear that the company could be vulnerable to disinflation because of its widespread fuel operations.

• Winn-Dixie Stores, Jacksonville, Fla., down 22.11%, to $12.54, following a decline of about 4.5% last year.

  This stock may have been impacted by a negative outlook initiated by another analyst, noted Short of FBR, who noted that company had “solid EBITDA” in its most recent quarter.

  One of the problems with the stock, she said, could be its disparate investor base. “No investors are in it for the same reasons,” she said.

  In May the company reported a 10% gain in third-quarter net income, and issued higher guidance for full-year EBITDA. Same-store sales were up slightly, at 0.2%.

• A&P, Montvale, N.J., down 32.22%, to $4.25, following an 80% drop in 2008.

  “Fourth-quarter results, at Pathmark specifically, were dismal,” said Short. “Pathmark's EBITDA came down significantly, and they have had some challenges with the integration.”

• Nash Finch Co., Minneapolis, down 39.72%, to $27.06, following a 27% gain in 2008.

  “Their outlook is a little worse, but it's not devastating,” said Gutman of Canaccord Adams. “Theirs is a story people were buying into last year, but people were getting out of it this year, not thinking they could keep it up, and that's all.”

  Nash also reported a decline in profitability for the fourth quarter: Net income was down 27% from year-ago levels. Net income for the year was off 6.7%.

• Spartan Stores, Grand Rapids, Mich., down 46.62%, to $12.41, following a gain of about 2% last year.

“They definitely made some cautionary comments as it related to earnings and to Wal-Mart,” noted Short. “It seemed like supercenter square footage is growing again, and that's not a good sign.”

She noted that because of some special items, earnings could be under pressure, although she said her projections for EBITDA are largely unaffected.