Analysts Discuss Consolidation, Turnarounds and Format Differentiation

ELLIOT ZWIEBACH

NEW YORK — Following is Part 3 of the 14th annual SN Financial Analysts’ Roundtable, in which analysts discuss the prospects for several supermarket operators, including A&P, Winn-Dixie Stores, Whole Foods Market, Ahold, Delhaize, Aldi and Fresh & Easy.

A&P

SN: Let’s talk about some specific operators, beginning with A&P and the impact Yucaipa Co.’s latest $115 million investment is likely to have.

MEREDITH ADLER, Barclays Capital: What is [Yucaipa principal] Ron Burkle’s plan for A&P? He’s a mergers-and-acquisitions guy — that’s what he likes to do — so what’s his plan?

KAREN SHORT, BMO Capital Markets: If I had to guess, I would say he wants to roll up the still highly fragmented East Coast, maybe by putting A&P and Pathmark together with Supervalu’s Shaw’s and Acme banners — although something would have to be arranged with Supervalu’s distribution facilities if that were to happen.

SIMEON GUTMAN, Canaccord Adams: I think that idea is one that’s been on the table for a while. But now I think he’s got to take an operational view and fix A&P before he does anything else. I think that’s why he’s got to be more committed operationally than he ever has been before.

ADLER: A&P had been having a liquidity problem, so liquidity was an issue at one point, and Burkle’s money and refinancing made a big difference to A&P’s long-term outlook.

SHORT: Prior to the financing, I think some vendors were starting to get nervous because I had a significant vendor contact me to ask very specific questions about A&P. Again, it’s not so much reality as it is perception, and if the vendors get nervous, that can have a ripple effort on the vendor community, as it did at Winn-Dixie.

The math on A&P from a free-cash-flow perspective would have told you it would have been fine this year and next year. It would have been the 2012 converts that might have been problematic if A&P didn’t materially improve by the time those converts matured.

ADLER: Didn’t you have to make some assumption about EBITDA at Pathmark?

SHORT: Oh, yes. Pathmark’s fully allocated EBITDA for the first quarter was zero , according to my math. That’s the only way you get to $80 million in reported EBITDA for that quarter.

ADLER: That would mess up the free cash flow, though, wouldn’t it?

SHORT: Yes, though no one realized how quickly it would deteriorate.

GUTMAN: On the last conference call, A&P said some of the gross margin investments in focus markets were being offset with tonnage. But based on recent comments, management suggested it is no longer getting the full return, potentially placing EBITDA at risk. This financing gives it the wherewithal to put capital and price investments back into the stores.

SN: Is it the Pathmarks that are dragging A&P down?

SHORT: Yes, Pathmark is the problem. A&P’s EBITDA was up slightly, depending on how you allocate corporate overhead, but Pathmark, the way I was calculating it, had to be at zero this quarter, which is pretty scary.

SN: So was A&P’s acquisition of Pathmark a bad idea, or is it just one that hasn’t paid off yet?

SHORT: The problem is that A&P was very quick to say it achieved its $150 million synergy goal, but unfortunately Pathmark’s EBITDA also deteriorated materially, and in my opinion, they are both in the same bucket, so it seems disingenuous for the company to claim it achieved its synergy target — and then give executives a bonus for achieving that target — when the acquired Pathmark EBITDA declined as much as it did. Offsetting that, one could argue, is that Pathmark’s EBITDA prior to the acquisition was probably somewhat inflated.

SN: So what do you see as the long-term outlook?

ADLER: A&P has great assets and locations that can’t be duplicated, and at some point — maybe when the industry is consolidated enough that someone feels it has to have A&P — it will be acquired. I can’t personally see that day, but that’s the theory.

JOHN HEINBOCKEL, Goldman Sachs: I can’t believe, given the volumes Pathmark is doing, that its EBITDA margin will not get back to 3% or somewhere approaching that at some point, which would not be a good number anyway. But I think there’s a lot of upside in that business if A&P can just capture the benefit of the volume the stores are already doing.

WINN-DIXIE STORES

SN: Winn-Dixie seems to have a handle on getting things turned around, and it’s doing a market-by-market remodeling program. What do you see as the long-term prospects there?

GARY GIBLEN, Quint, Miller & Co.: Despite having a host of challenges, including over-promoting on high-low, which was bad for profitability, Winn-Dixie has been able to dial it back and achieve increases in both sales and margins.

ADLER: And it’s still doing a lot of remodels.

SHORT: Yes, but Winn-Dixie also has the right price perception, while Publix's poor price perception is probably hurting Publix and helping Winn-Dixie, as evidenced by same-store results in the most recent quarter, when Publix reported a minus 2.6% comp including the Easter benefit, while Winn-Dixie reported a positive 1.6% comp including the Easter benefit — one of the widest spreads we've seen in a while.

ADLER: The most fundamental issue for Winn-Dixie, as it is for A&P, is sales per square foot. We haven’t seen a really meaningful improvement in sales productivity at Winn-Dixie yet. I think it’s done a lot of good things, and there is probably more low-hanging fruit. It’s done a better job than anyone expected to be able to hold on to sales without being wildly promotional.

But I think the unanswered question is whether it will be able to drive meaningful improvement in sales productivity, given its formidable competition. So far, I don’t think Publix has reacted much — and with the modest comps Winn-Dixie has had, I’m not sure Publix has seen any reason to smack Winn-Dixie around, and maybe it never will, given Publix’s size and positioning. But there could come a time where that is what Publix does, and the marketwide remodeling activity by Winn-Dixie might be a step toward helping it deal with that response, if and when it comes.

SHORT: I think Winn-Dixie made the decision this fiscal year to be fairly rational in order to manage gross profit dollars, but it also managed to maintain a positive comp throughout the year, even in the most recent quarter. The results would indicate its strategy was probably a very good one, at least this year. And because Winn-Dixie has a better price perception than Publix, sales were stable and EBITDA was well above plan.

I don’t know how long that can last, though. Next year will present a bigger challenge because the comparison will be tough on EBITDA, and at some point the company will need to show a consolidated 3% comp at minimum to justify its capital investments.

ANDREW WOLF, BB&T Capital Markets: Something is up with Publix because Publix has never had negative same-store sales before. Maybe it’s just the economy, but maybe it has actually slipped a bit operationally. Winn-Dixie currently is outperforming Publix — and really, who would have thought that was possible? You have to tip your hat to Peter Lynch [Winn-Dixie chairman, president and chief executive officer]. He’s brought a lot to the table down there. Question is, with two-thirds the sales productivity of Publix or less, where can Winn-Dixie go? That’s a different issue.

GUTMAN: Being less promotional, Winn-Dixie’s top line was OK, driven by remodeling activity. Or maybe it’s simply deflating itself less, in theory, or was it showing a market-share gain? I would assume some of it is market-share gain, and therefore I think the outlook is stable

Gary Giblen, executive vice president, Quint, Miller & Co.

SHORT: Winn-Dixie has a ton of cash and revolver availability, so it could keep going at it for a long time.

ADLER: It has built its cash up over many years, which is to its credit, because the bankruptcy plan assumed it would be a net borrower at this point in time.

GIBLEN: Plus, Florida is among the last to recover as a housing-bust market, but there are some signs that it is recovering, just as California started recovering six or eight months ago. That would help Winn-Dixie a lot because it’s almost entirely Florida-centric since its restructuring.

WHOLE FOODS MARKET

SN: Whole Foods was hurting before the recession. How is it going to come out of this economy?

GIBLEN: Whole Foods is getting religion about cost-cutting and return-on-capital, which is good, but one problem is that structurally it can’t cut costs very much because there’s a certain labor content to the stores that’s integral to the experience.

WILTAMUTH: The bigger question is, has it changed any of its consumer perception issues? The consumer still views a visit to Whole Foods as an indulgent shopping trip, and if consumers are still in an economizing mode, they will pull back.

WOLF: You can be theoretical, but when you open a store in Chicago that’s twice the square footage of anything else there, as Whole Foods has done, and you get more than double the sales —what that tells you is, those consumers are either non-typical or you’ve got something good going at your store, or both. In any case, that new Chicago store is a positive data point that indicates Whole Foods is going to be able to go toe-to-toe with the conventional operators there. And it has had other good new-store openings lately.

It has also reinvested in pricing and promoted more to create some traffic. And I think the other thing going on is that it’s been losing customers for about two years, whereas the conventionals have been losing them for about a year because the restaurant turndown in 2008 helped the conventionals while it never came to the rescue for Whole Foods. Remember, in the last down cycle, a lot of restaurant traffic went to Whole Foods and its comps went up 10%, but in this down cycle that traffic just skipped Whole Foods and went to Safeway. So now Whole Foods is closer to being done with customer attrition, I believe, and it’s showing more value, and sales will turn a bit.

HEINBOCKEL: But will there be a return to growth?

WILTAMUTH: What’s the right long-term earnings growth number, now that you’ve reduced your square footage growth to 7%? What’s the normal comp for Whole Foods now? That’s where investors should be focusing their attention — on the longer-term growth story.

ADLER: And can it generate a return from its capital investments?

GIBLEN: Yes, but not till its gross margin goes down, because it’s going to be selling so much on deal. That’s merchandise gross margin, excluding occupancy costs.

ADLER: It’s more expensive to promote, and it requires more labor expense to provide those promotions. If Whole Foods starts to get its customers addicted to promotions, costs could go up. I think there’s also a risk that it may have changed its image. How much can you focus on price without losing your quality image?

GUTMAN: Whole Foods’ store openings are going to accelerate over the next couple of years, and unless it can somehow push out more leases, incremental pre-opening expenses will create a headwind. Therefore, average weekly sales per store will have to ramp up for earnings growth not to slow.

ADLER: I wish the market would focus on returns a little bit more. The biggest slowdown at Whole Foods was in its new stores — that’s when its slowdowns started.

MARK WILTAMUTH, Morgan Stanley: The biggest destroyer of its returns lately has been the Wild Oats acquisition.

ADLER: I was actually thinking about comps, but yes, that’s my thesis, certainly.

WOLF: You have to give Whole Foods its due, though. It adapted really quickly. It’s had some success stories, particularly in the new stores, but it’s really changed much of its formula a lot faster than you would have thought. On the other hand, I completely agree that it got caught up with the trend of the day — whether that was Internet marketing years ago or how well its larger stores like Columbus Circle [in New York] did — which made it think it could open a similar store in the middle of Ohio and expect it to do the same business.

HEINBOCKEL: I think the most interesting thing, when you look at retail today, is that there’s very little differentiation, very little excitement, in anybody’s store. It’s gotten stale, and I think Whole Foods is one of the very few retailers that is truly differentiated.

So my concern is that you can focus too much on cost. Whole Foods needs to stick to playing its own game, which means maybe you can’t grow at a rate of 7% or 8% a year and maybe you can only comp at 2% or 3%. Maybe this is not a 25% growth company anymore — maybe it’s a 12% or 13% growth company. But you’re far better off growing at that rate than trying to be something you’re not.

Whole Foods will never have a price image. It just needs to make sure it doesn’t put up impediments to some crossover customers coming in.

WOLF: Whole Foods has always had better shelf pricing than most conventionals — it just depends on who you’re pricing with. So it wasn’t like it had to change its price structure significantly.

ADLER: But so much of its business is in perishables.

WOLF: I agree that the perishables offering is the big question. It can’t dumb down the majority of what it sells or it won’t be differentiated.

But in the grocery aisles, all Whole Foods has to do is put up some signs saying it’s lower on packaged organic chicken broth than the guy down the street — a lot of that is just blocking-and-tackling merchandising that it never had to do before — and it can get an improved price image that way.

GIBLEN: It’s done a marvelous job communicating price to the extent it can. I absolutely think it’s done the right things quickly. It’s just that you can’t change the economy and the consumers’ mindset. To its credit, though, Whole Foods has not overstated recently what it can accomplish — though Wall Street expectations are excessive, in my view.

ALDI and SAVE-A-LOT

ADLER: The company we have not spoken about at all here is Aldi. Nobody is opening anywhere near as many stores as Aldi is. I think it’s going to open 500 stores this year. That’s a lot of stores. Now, granted, they’re very small stores, but Aldi has a differentiated format and a track record of operating in a very efficient manner.

HEINBOCKEL: We’ve said for years the hard-discount concept, which includes Save-A-Lot as well as Aldi, is extremely underdeveloped in the U.S. A few years ago, I think hard discounting was 5% of grocery sales in the United Kingdom, and it was considered a failure there. But if you get to 5% in the U.S., the numbers would be huge — $35 billion or $40 billion.

So I think that’s the big growth opportunity in the U.S., and not just in food retailing but in any area of retailing. Where’s the growth opportunity in the U.S.? I think it’s the hard- discount format, whether it’s Aldi or Save-A-Lot or somebody else. I think that’s where the growth is. You can’t get more convenient and you can’t get lower pricing, and it’s perfect for an aging population. I don’t know how big Aldi will get, but it will be substantially bigger than it is today.

ADLER: We didn’t talk about this when we talked about Supervalu [in Part 1 of the roundtable], but if you want to criticize Supervalu’s former management, it seems like it missed an opportunity with Save-A-Lot, which had a bigger store base and better-quality perishables than Aldi, and management could have pushed growth at Save-A-Lot a lot harder than it did. It had its reasons for not doing so, but I think that failure opened up the way for Aldi.

HEINBOCKEL: It’s not too late, though.

ADLER: No, you’re right, it’s not too late. It’s just that, at this point, Supervalu has a lot of other stuff to do — though at least it’s positive to hear that Save-A-Lot is now reporting directly to Craig Herkert [Supervalu chairman and CEO].

HEINBOCKEL: It doesn’t fit anywhere else. It’s so different, and it’s run completely separately. I think it’s perfect to report to Craig, and he has some familiarity with the concept because he competed against some of those stores when he was with Wal-Mart U.S., so I think it makes a lot of sense. I’d like to see him grow Save-A-Lot faster.

FRESH & EASY NEIGHBORHOOD MARKET

SN: Speaking of smaller formats, do you see any possibility for Tesco’s Fresh & Easy to be a success in the U.S.?

ADLER: My comments years ago about Tesco’s plans to enter the U.S. turned out to be absolutely right. I said its only competitive advantage was its willingness to lose a lot of money.

HEINBOCKEL: The Fresh & Easy stores have evolved a bit and become more promotional. I think you see the merchandise offering being tailored a bit more toward the local neighborhoods. Hard to say if it’s going to have to evolve further, but I always thought one of its bigger challenges was the message. It’s trying to be a lot of things to a lot of people, and while it’s great casting the net wide, that makes it hard to get your brand message out. So that’s one thing Tesco needs to think about — trying to be less things to all people and focusing more on a stronger brand message, whether that’s directed to an upscale customer or a low-income customer.

WILTAMUTH: I think it can learn from its initial real estate push, too, because it took a scattershot approach initially, where it was looking at high-end markets, low-end markets, ethnic markets — a little of everything. So it now has some feedback on how those initial stores performed, and maybe it will be more targeted with its real estate direction.

But it’s got such a big commitment to the supply chain infrastructure it’s already built out that it seems like it’s going to be staying. It’s just a matter of how it changes the merchandising.

ADLER: Based on one of the discussions I had with the company early on about Southern California, it sounded like Tesco picked 15,000 square feet as the store size because that’s the only real estate it could get. Even though Tesco management claimed to have done all this consumer research, it isn’t clear to me that the company got a message from consumers saying they were dying for a really tiny store.

So I don’t know if Fresh & Easy has the right locations. Is it stuck with what it has already built? Is it embedding itself in big losses? I’m not sure how long the leases were that it signed.

HEINBOCKEL: I’m not sure store size is the problem. I don’t think its stores need to be bigger. I think it’s more a question of whether what it is putting in those stores is what customers in each specific neighborhood want to buy. And what’s your message, what do you stand for?

WOLF: I think it’s a novel idea, but the consumers voted and so far they don’t really like it. They like Trader Joe’s. I thought Fresh & Easy sounded like a home run, theoretically, with discounted, high-quality goods, because that was a home run for Trader Joe’s, and Fresh & Easy was going to add more perishables.

ADLER: Theoretically, I agree with you. But I’m thinking about the actual execution. Those are the blandest stores you’ve ever seen, and with a high-end product mix.

WOLF: And Tesco wants to use a superior logistics model, but consumers aren’t responding to cheaper chicken and cheaper sushi because of the way the stores have been set up.

HEINBOCKEL: I don’t think people go to Trader Joe’s for price. Maybe they go partly for price, but it’s the product quality, it’s the ambience with the Hawaiian shirts and all.

ADLER: It’s fun.

WOLF: And they go for the three-buck Chuck [wine] as well as other low-priced items. Like you said, Fresh & Easy doesn’t have any identity.

HEINBOCKEL: Fresh & Easy has its own version of "Three Buck Chuck," and it’s very good, but it hasn’t marketed it well.

WILTAMUTH: I think from the outset Tesco was trying to train the consumer in too many things — on private label being half the store, that you shouldn’t look at high-low but rather at everyday low price. When people are looking for value, they’re used to looking high-low. Tesco has even had some pushback on how the stores merchandise fruits and vegetables — it puts out prepackaged bags with three pieces of fruit, so consumers don’t get to choose their own three favorites. I mean, that’s a lot to push on a consumer.

ADLER: And no people in the store, and a huge focus on technology. And if you’ve never been in the store before, what’s your point of connection? It’s the people, and I would say limited assortment was a problem. So I would say the issue is more than having too much private label.

WOLF: If it had studied the market a little better, I think it would have figured out prebagged produce has a negative connotation in Southern California.

ADLER: But it did study the market. Didn’t the company say it did a lot of research?

SN: It made a big deal about living in people’s homes and looking through their pantries.

WILTAMUTH: And maybe that’s part of the problem — it was too much of a consulting project.

GUTMAN: One might have come in expecting to get Trader Joe’s, and that’s not what people got. Maybe they come in expecting more deeply discounted private label, but then you have many nationally branded items. Tesco seemed to do a little bit of everything.

Mark Wiltamuth, executive director, Morgan Stanley

ADLER: I went in the store the first time as if I were a shopper, and it took just two minutes to walk through the whole store. I didn’t look at price points. After that, as a customer, I just wanted to walk right out. The store was not very interesting.

There was one point where I was standing in the produce department, facing the other side of the store, and all I saw was this wall of Coke. It was the most boring thing you could possibly think of. It was like, did anybody bother to just stand right there and look across the store and see this?

SN: So what do we think is going to happen to Fresh & Easy?

WILTAMUTH: It will just keep evolving the merchandising until it gets something that’s working because of the cap-ex the company has laid down for the supply chain infrastructure. That is all there, and it’s not going away, so it’s just going to have to keep tweaking merchandising until they get it right.

ADLER: I’m willing to bet that they leave…

GUTMAN: Pull the plug?

ADLER: Yes, though not right away, but I would lay a pretty healthy bet that they will throw up their hands at some point.

HEINBOCKEL: The backstage operation is very impressive, and the quality of the food is very good. Tesco just has to get more people to try it.

AHOLD

SN: Ahold seems to have resolved most of its problems and gotten its pricing on track. What’s likely to happen next?

HEINBOCKEL: I think it’s more of the same.

ADLER: It has a lot of cash, though, and that becomes a problem eventually, since it can’t sit on cash forever.

SHORT: I thought it was going to be using a lot of that cash for debt reduction.

ADLER: Somebody told me the company has 1.5 billion euros or something like that and doesn’t want to pay down more debt.

GIBLEN: Maybe Ahold should buy one-third of Shaw’s [from Supervalu] — the operations in non-overlapping markets in northern New England. It couldn’t do it in Connecticut and Rhode Island, obviously, for antitrust reasons.

ADLER: Why would Supervalu sell one-third of the company? That doesn’t make sense. But could Ahold buy A&P/Pathmark?

SHORT: I think there would be way too much overlap from an FTC perspective.

DELHAIZE AMERICA

SN: What’s the situation at Delhaize America?

ADLER: I think the only meaningful problem Delhaize has is Florida. I don’t think the company is terribly happy about how things have gone at its Sweetbay stores in Florida. Is that fair to say?

VIRGINIA CHAMBLESS, JP Morgan : Yes, that’s fair to say. From a strategic standpoint, it seems like most of the merger-and-acquisition activity Delhaize has been doing has been in Europe, while in the U.S. it’s been pretty quiet. So Delhaize could buy some chains that don’t overlap its stores, but I don’t know that it’s interested in doing anything significant right now.

SN: It was brought up a year or so ago that Delhaize was potentially linked with Ahold, though it was a more of a down-the-road kind of thing.

Andrew Wolf, managing director, BB&T Capital Markets

ADLER: I think a lot of bankers have tried to make that happen. It does seem very logical, though. I mean, their U.S. operations don’t overlap very much.

SHORT: Well, even if a combination makes strategic sense, I think the Belgian and Dutch cultural clash would pose a much bigger impediment to a deal getting done than many people realize.

REGIONAL CHAINS

SN: Does Winn-Dixie’s [post-bankruptcy] turnaround give hope to other companies involved in bankruptcies?

ADLER: I think every company has its own situation. My industry contacts say that Bi-Lo is a healthier company than Bruno’s. But who knows?

SN: What about Bashas’?

GUTMAN: Those assets need a lot of help, too. That’s not what took that company into bankruptcy, but eventually that’s what’s going to hurt them.

ADLER: Interestingly, Bashas’ is a non-union operator in a primarily union market. And actually, what’s interesting with all three of the chains that have filed for bankruptcy — Bi-Lo, Bruno’s and Bashas’ — is that they’re all mostly non-union.

WOLF: I used to really believe — and I still do, to some extent — that the industry is disadvantaged by having so many really good private competitors. But I think this downturn has put a lot of pressure on some of them. We just discussed Publix — for years I’ve been saying it’s the best chain around, and now it’s comping negatively. It doesn’t mean it’s not a good chain, but Kroger is not comping negatively.

It’s these family businesses that are filing or maybe putting themselves up for sale. Take Bashas’ — it was local, everyone knew it, the family was involved in politics, a local chain with decent market share. So you see some new pressures. It’s not universal. For instance, Winco is still scaring the daylights out of people.

HEINBOCKEL: Maybe the dividing point isn’t public-private but how you go to market. If you’re a private guy that focuses on price and value, you could win against a public chain that doesn’t focus on price and value. I believe there are probably a good number of private companies doing well. It’s a question of how do they go to market.

FUTURE HEADLINES

SN: OK, we’d like you to predict some headlines you expect to see in SN in 2010.

GUTMAN: “Supervalu Back on Track.”

ADLER: I think it’s a little early for them to give up, but I think one you might see towards the end of the year is, “Tesco Exits U.S.”

HEINBOCKEL: “Inflation Resurgent” — maybe not before this time next year, but a little after that.

WILTAMUTH: I think the headline before that is gong to be, “Deflation Cloud Lifts.”

GUTMAN: “Supermarkets Get Their Groove Back.”

WOLF: Mine’s a question headline: “Is the supermarket business recovering or just back to flat or stable?”

ADLER: How about, “Is Wal-Mart going to hang on to the share it’s gained?”

WOLF: And one other headline, which would come before that: “Is the health care debate going to affect the cost structure of non-union competition?”

Matter of fact, I really think there’s a chance it could, and that could really turn the union issue on its head in favor of supermarkets. On the other side of the union issue, there’s the pension liabilities that are underfunded and whether those are going to feed into earnings or not and what that means for next year, and if there’s going to be labor unrest because of it.

HEINBOCKEL: I don’t think you’re going to get any strikes with unemployment so high.

WOLF: No, I don’t think you’re going to get any strikes, but you may have stalemates.

ADLER: One company told me that the last time it had this kind of union issue, where it had a pension plan that was very underfunded, it had to put a plan together to fix it. They’re never allowed to assume the market’s going to recover in a big way.

WOLF: Well, the pensions used to be overfunded, and the unions would allow the markets to use the overfunding to pay for the wage increases.

ADLER: But that was the law, that they had to increase benefits before they could build a surplus. They had to increase benefits, or they’d lose the tax deductibility.