ON THE MARK

JON SPRINGER

The drumbeat off in the distance may indeed be the consolidation march, but as long as Pathmark walks alone, John Standley intends to walk tall.

As the chain marks its first year since Yucaipa Cos. became its lead investor, and Standley its chief executive officer, industry speculation over Pathmark's next conquest has occasionally overshadowed its current challenges. Standley won't comment on rumors but is candid about the tricky turnaround effort that's just beginning under his leadership.

"If we do the right things at Pathmark, it's all going to work for us in the end," Standley told SN in a recent interview at Pathmark Stores' Carteret, N.J., headquarters. "No matter what happens."

Since its founding 40 years ago, Pathmark has frequently encountered speculation about its future. Its founders survived a takeover attempt from the Dart Group with a leveraged buyout in the 1980s that eventually led to a prepackaged bankruptcy.

In the 1990s, Pathmark was nearly absorbed by competitor Ahold until antitrust concerns scuttled the deal. Most recently, in 2004, a struggling Pathmark put itself up for sale, resulting in the 49% takeover and $150 million cash infusion by Los Angeles-based Yucaipa. That summarily sparked discussion of Pathmark leading a roll-up of East Coast retailers similar to that engineered by Yucaipa on the West Coast in the 1980s.

Investor interest in Pathmark is understandable: With 141 locations in densely populated East Coast markets, Pathmark stores have historically been among the most productive in the industry, generating in excess of $700 per square foot and $28 million in annual sales per store.

But for a sales power plant, Pathmark has struggled to light up the scoreboard in recent years. Annual company sales have flat-lined at just under $4 billion for five years running. Comparable-store sales have fallen for two years in a row. And fierce competition, high costs and a lack of investment have hurt the bottom line, with Pathmark recording losses of nearly $350 million over its last two fiscal years.

Standley, the former chief financial officer at the troubled drug chain Rite Aid, joined Pathmark last August determined to begin another turnaround. But this one, he said, differs in meaningful ways.

"Rite Aid was in a situation where the average store volume was lower than the rest of the industry, and the challenge there was to try to reconfigure the stores and the real estate to try to migrate to a higher-volume box to get the right leverage in the business," he said.

"This is the reverse of that. The great news here is we have pretty spectacular volume per store, as compared to the competitors and the industry. The trick is, what can be done to leverage the existing customer base. We don't have to find a whole bunch of people we don't know to come and shop here."

Simply stated, Standley's plan for Pathmark involves parlaying its considerable foot traffic into higher sales on the store perimeters, helping to create a more profitable sales mix. The effort involves better merchandising and marketing; new investment in the store base, including a new store prototype; and a better understanding of the Pathmark shopper.

"Consumers who choose us, choose us because they're comfortable in their Center Store experience. The challenge is to get more of the edges of the store into the basket when they shop us for the center-of-the-store needs," Standley explained. "It's different from what some other guys face because they're building new concept stores perhaps because they don't have the volume they need to get their model to work. We have customers coming into the door, but we're not getting as much into the basket.

"It isn't that we don't do any business on the perimeter of the store - we do," he added. "It's just, if you talk a percentage or two increase of penetration in the perishable departments, that's worth a fair amount of margin at the end of the day."

Pathmark's new emphasis on perishables is reflected in its ad slogan, which recently transitioned from a message of empathy for busy consumers - "It's About Time" - to an appeal to their tastes -"All About Fresh."

The Yucaipa Connection

Standley, 43, grew up in Orange County, Calif. As a young accountant at Arthur Anderson, his clients included retailer Food 4 Less, through which he first encountered the chain's owner, Ron Burkle, and his nascent investment fund, Yucaipa.

"I had a unique blend of financial skills and retail skills which was well-suited to Ron - it was his skill as well," Standley said. "So when we ran into each other it was a pretty good fit."

Standley would eventually join Burkle and Yucaipa as they swept through West Coast assembling regional retailers. Starting with Food 4 Less, Standley took positions with each of the chains Yucaipa added to its growing empire: Smitty's, then Smith's Food & Drug, then Ralphs Grocery Co. and finally, Fred Meyer. After that conglomerate merged with Kroger, and Yucaipa slowed its investment pace in the supermarket industry, Standley served briefly with Fleming Cos., then joined ailing Rite Aid in 1999.

As Yucaipa returned to the supermarket business with Pathmark last year, and forged a five-year management contract, Standley hopped aboard, succeeding Eileen Scott as CEO.

Upon joining Pathmark, Standley described a company focused inwardly, with stores badly in need of new investment and better merchandising.

"In the past Pathmark was a lot about internal processes - the way the ad got prepared, or how the store got set up," Standley said. "Now we're trying to wake everybody up and say, 'This is about the customer.' Big picture, we're trying to build a company that's more consumer-focused and consumer-driven."

Standley is among a host of new leaders at Pathmark. Ken Martindale, a 20-year veteran of Smith's who also joined Yucaipa in the West Coast roll-up, was named chief merchandising and marketing officer earlier this year. He shares the co-president role with Frank Vitrano, a Pathmark veteran and the chain's chief financial officer.

Project 2005

Yucaipa wasted little time exerting its influence as the lead investor in Pathmark. By the time Standley arrived last August, plans were already under way for what was known as Project 2005 - an initiative to clear clutter throughout the stores and introduce new items, particularly in the store perimeters and in nonfood departments. Those changes - which officials emphasized were only the first step in a new approach to merchandising at Pathmark - took place last November at all of the company's stores.

"I think what Yucaipa identified early on was the merchandising processes in the company had come to a halt over a period of time - whether that was from capital constraints or to make earnings, I don't know and I don't want to guess," Standley said. "But the merchandising had not evolved much over a long period of time."

Swiftly implemented at a relatively small expense of $12 million, Project 2005 met with mixed success, Standley admitted. The addition of numerous new perishable items provided officials with clues about what Pathmark's shoppers responded to, but their rapid rollout caught associates playing catch-up on package sizes and ordering processes, leading to high levels of shrink over the winter months.

"I think we presented [the merchandising changes] to the customer in the right way and we executed. It was the behind-the-scenes processes that killed us," he said. "We didn't do a great job of thinking through all the implications of what we were asking the stores to do. There wasn't a lot of history to go with, so there was some estimation involved."

Overall, Standley counts Project 2005 as a positive, saying it "knocked down the walls between merchandising and operations," freeing the company's merchants to make more changes. It also got Pathmark into categories it needed to develop further, such as organics and dollar items, without sacrificing its core Center Store strength.

Certain Project 2005 category additions, such as toys, succeeded from the start; others, like kitchen items, showed promise over the longer run, Standley said. Organic offerings yielded both hits and misses, with the successful items and displays remaining in stores today while others were put aside until a time when Pathmark's shoppers are ready for them.

"We opened up the processes and let the merchandisers do their thing, experiment a little, take some risks," he said. "That was all very positive for us. We're going to have to take some lumps along the way, but we'll also find some things that work."

Fears among some store operators that reducing floor displays of sale items would hurt Pathmark's grocery sales turned out to be unfounded, Standley added.

"There were shockers and side stacks everywhere - it was hard to get around the store," Standley said. "Our entranceways were stacked with chips and crackers and soda pop. The grocery people were concerned and said we better pick up a lot of perishable sales because grocery's going to go kaput. But it didn't happen. Grocery performed well even without all that stuff everywhere."

Today, Standley added, "We have more discipline in the stores in terms of what merchandise is getting out on the sales floor and how to best merchandise it. We still have some flexibility in the system for operators to chase sales, when that's the appropriate thing to do, but there's a lot more discipline there today."

Hailed by Standley as a master of "the science and the art" of merchandising, Martindale said Pathmark's tight geographic focus - all of its stores are located within 100 miles of its headquarters - benefits its understanding of its customers and neighborhoods and will allow the retailer to deliver to them better than competitors.

"We're going to try to run each store in this business as if it were a one-store business," Martindale said.

Operating in competitive and price-sensitive markets, Pathmark needs to proceed delicately, according to Burt P. Flickinger III, managing director of Strategic Resource Group, New York, and a stockholder and bondholder in Pathmark. Flickinger said moves to protect margins at Pathmark in his opinion have eroded its price image over the last year.

"To Yucaipa's credit the stores are very clean, very neat and well-signed. The new remodels look absolutely perfect," Flickinger told SN. "But they're getting beaten by competitors like ShopRite on key items. This is a market where people pay high rents and high prices for property, and there are high costs of day-to-day living. This is a market that's always slugged it out on price - and many lower-middle-income consumers can't afford to pay premium prices.

"The history books are full of people who've come from premium-price markets like California and think they can do the same thing on the East Coast, but it hasn't worked out," Flickinger added, citing chains such as Grand Union and Penn Traffic.

New Store Design

Lessons from the Project 2005 experience, along with additional merchandising changes, will eventually make their way to a Pathmark new store prototype currently in the planning stages. Standley said the prototype will likely debut next year as part of an extensive store renovation, but that certain aspects of the new store design - perhaps a particular department in an ongoing renovation - could arrive even sooner.

While the new store will look distinctive from those already in the chain, it will reflect the desires of Pathmark's shoppers, Standley said. That may distinguish Pathmark from competitors, such as A&P, that are busy rolling out their own new prototypes.

"I can [open] a store tomorrow and make it someplace where I want to shop," Standley said, "but it might not be what our customers want. This is going to be a process built around consumer feedback and where we think the customer is going."

One avenue to greater consumer insight is the Pathmark Advantage loyalty card, which according to Standley is used by 80% of Pathmark shoppers accounting for 90% of its sales. While used mainly for continuity programs and targeted marketing programs in the six years it has existed, Standley plans to extract "more robust data" from card purchases and use it to drive customer behavior.

"We've been working on putting new tools behind the data we have, [asking] what insights can we learn from the data we have, and what can learn about the customer," he said. "For example, we can ask - what's in this data that we might stir around and help us make decisions about a new store prototype?"

Pathmark is also making changes in how it presents its card to consumers, he added.

Elsewhere, Standley sees opportunities and cost savings in labor and distribution. Shortly after his arrival he instituted labor buyout and corporate downsizing programs. Savings in distribution involve a new round of discussions with C&S Wholesale Grocers, Pathmark's primary supplier.

"I think in the past there wasn't a lot of discussion going on with C&S. It had kind of fallen apart and things were at loggerheads," Standley said. "One thing that's changed over the last nine months is that communications between us and Rick [Cohen, C&S CEO] and his team have opened up quite a bit. We're talking about the opportunities and issues, and they're helping us sort through them."

The Elephant in the Room

No discussion of Pathmark gets very far without speculation of a merger. Even an improved Pathmark would lack the clout that market leadership might provide, analysts and investors said. And in saturated, dense markets faced with increasing challenges from alternative formats, building one's way to market dominance is daunting at best.

Then there are the public pronouncements. Yucaipa has long since made clear its intention to use Pathmark as a vehicle for a potential East Coast roll-up, and since first investing in Pathmark, has taken a 15% stake in Wild Oats Markets, made a preliminary offer for local ShopRite operator Foodarama, and, sources said, was the unnamed private investor behind the failed "pipe deal" for Albertsons.

Pathmark competitor A&P in the meantime is also looking to partner up, according to comments from its executive director, Christian Haub, and echoed more recently in published remarks from a representative of the Tengelmann Group, A&P's largest shareholder. Analysts say a potential combination of A&P and Pathmark have kept the stocks and bonds of both groups afloat, with potential synergies through distribution, advertising and shared services key to either company's ultimate financial success.

Standley declined to address speculation over specific combinations but said he believes in the potential value that consolidation holds.

"If you're asking me personally if there's value in combinations and mergers, I absolutely do believe value can be derived from those combinations. If you have the right combinations and circumstances, it can create value for all of the company's stakeholders," he said.

Whether Pathmark can turn itself around - additionally, whether Yucaipa can meet its investment criteria - without the benefit of a merger remains to be seen. Observers and analysts harbor little doubt something will happen eventually, and they expect Pathmark will be a part of it.

An A&P-Pathmark combination "makes all sorts of sense on paper, but it doesn't mean a deal will necessarily get done," Neil Stern, senior partner with McMillan Doolittle, Chicago, told SN. "That said, everyone who looks at this [Northeast] market could tell you it would look healthier if there's fewer players in a consolidated market rather than several guys with 10% market share."

In the meantime, Pathmark has the luxury of investment capital - and the protection from an impatient market - its lead shareholder brought it a year ago.

"[The Yucaipa investment] gave the company liquidity, and a minority shareholder with a strong interest in the company. That helps you because it gives you flexibility to do the things you need to do to get it right," Standley said. "Turnarounds always have twists and turns and some things you don't expect. So having strong support from your shareholders is an important part of this."

The investment has also brought a new energy and a change of direction at Pathmark's headquarters, according to Vitrano.

"As a guy who's been here in the past, I think the groups are clearly working together better as a team. There are more people involved," he said. "Prior to the equity infusion, the board said, 'We've really got to figure out what we want to do when we grow up.' It was a long, exhaustive process looking for equity, and ultimately the board decided and the shareholders agreed, that hooking up with Yucaipa and getting the infusion was the thing that made the most sense for us."

High Productivity

With large stores in densely populated markets, Pathmark has consistently shown store productivity in excess of industry averages*, but its earnings have been erratic and sales have stalled.

FY Ending: Sales; Comp-Store Gain (loss); Net Earnings (loss); Number of Stores; Sales per Square foot; Sales per Store

Jan. 2006: $3.977 billion; (0.8%); ($40.1 million); 141; $725; $28.1 million;

Jan. 2005: $3.979 billion; (0.8%); ($308.6 million); 143; $724; $28.1 million

Jan. 2004: $3.991 billion; 1.2%; $16.5 million; 143; $734; $28.4 million

Jan. 2003: $3.938 billion; (1.7%); $1.3 million; 141; $724; $28.2 million

Jan. 2002: $3.963 billion; 2.5%; ($242.0 million); 138; $738; $28.8 million

*U.S. supermarkets averaged $18.1 million in sales per store and $483 per square foot in 2005, according to Food Marketing Institute.

Source: Company reports