Changing Price Image Takes Time: Analysts

ELLIOT ZWIEBACH

NEW YORK — Supermarket retailers who try to change their image — in or out of a recession — face a difficult challenge, according to analysts at the 14th annual Financial Analysts' Roundtable sponsored by SN here.

“For the guys playing catch-up — like Supervalu and Safeway — you're seeing big price cuts and little consumer response,” Mark Wiltamuth, executive director of Morgan Stanley, New York, said. “It's just demand decline and erosion for them. If you're playing catch-up at this point, you're going to be at a disadvantage.”

An analyst could have made similar comments about Stop & Shop in 2006, when it began changing its pricing image, or Kroger in 2003, Andrew Wolf, managing director for BB&T Capital Markets, Richmond, Va., pointed out. “You've just got to buckle your seat belt and hope the laws of economics continue to work, [though] I wouldn't argue that this is the worst time to do it.”

John Heinbockel, vice president of Goldman Sachs here, said he agreed. “It's the worst time economically and competitively to do it. When Kroger lowered prices, everybody else was playing their ‘C’ game. Now, if you're trying to turn your business around, more people are playing their ‘A’ game, and I think it's much tougher.”

For Meredith Adler, managing director here for London-based Barclays Capital, trying to change a chain's price image is always difficult.

“When costs were going up, it was a very tough time for supermarkets to improve their price image because they couldn't actually tell consumers they were lowering prices because inflation wouldn't let them lower prices,” she explained.

“But the reverse is also true — that it's tough to try to improve your pricing image when consumers are anticipating lower prices because they know costs are coming down. There are clearly companies who have said they don't have the right balance between shelf and promotional pricing, but I think it's going to be very hard to convince consumers their balance is better in this current environment.”

As for ongoing industry consolidation, the analysts said they don't believe the large chains are going to take a chance on acquiring companies they consider to be broken.

“It will be hard to do any deal that's broken,” Heinbockel said, “not just because there's no value for the seller but because nobody's going to take that risk on the buying side. So I think you are in stalemate territory.

“The only deals that will get done are transactions of 10 of 20 stores that are in-market. No one is going to take a risk until you fix what you have first.”

But if a company wants to pursue a deal, the credit market is open to the idea, Virginia Chambless, executive director of JP Morgan, New York, said.

“The credit markets have definitely unfrozen, and I think the bid for paper is definitely there in the investment-grade market. The idea that bond investors are willing to buy for strategic [merger-and-acquisition] transactions is real because levered plays are still going to be off the table, so the financing markets are much more open today than they have been in the last year.”

Karen Short, New York-based director for BMO Capital Markets, Toronto, said a company like Kroger would have to ask itself whether it wants to risk a better credit rating for a large-scale acquisition, to which Chambless replied, “I think Kroger could definitely do an acquisition of several hundred million dollars at its current ratings level, but what is out there that would be that big?”

With acquisitions generally on the back burner, most companies are concentrating on store remodelings, though capital-spending budgets have been shrinking, the analysts pointed out.

For Chambless, that might be the wrong approach. “You almost wonder if now wouldn't be a good time to be investing,” she said. “I think the pullback [in spending] is very reactionary. To say that companies are using all their free cash flow to pay down debt is what everyone wants to hear, [whereas] I would view the pullback in cap-ex as a negative if the industry is not keeping up the stores.”

Simeon Gutman, vice president here of Canaccord Adams, Vancouver, British Columbia, said he agreed that companies ought to consider more offensive spending, but he does not believe the industry is falling behind on store investments.

“Ahead of the current economy, new-store growth had slowed to a crawl. But [it is] not falling way behind now because as long as capital is deployed toward fixing the current fleet of stores, that's OK.”

Part 2 of the roundtable discussion follows. Part 1 was published in the Sept. 14 issue.

PRICING

SN: Could you talk about the challenges that supermarket companies are facing in achieving a balance between everyday low pricing and promotional pricing?

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

MEREDITH ADLER: It's interesting that when costs were going up, it was a very tough time for supermarkets to improve their price image because they couldn't actually tell consumers they were lowering prices because inflation wouldn't let them lower prices.

But the reverse is also true — that it's tough to try to improve your pricing image when consumers are anticipating lower prices because they know that costs are coming down. So I think there are clearly companies who have said out loud they don't have the right balance between shelf and promotional pricing, but I think it's going to be very hard to convince consumers that their balance is better in this current environment.

ANDREW WOLF: But I think the industry has a pretty good scorecard for those who are committed to it. Kroger's been at it a long time, and it's doing great. Ahold, on the other hand, showed up pretty late, and while in theory it seems it would be very hard to make a price statement during a period of inflation, Ahold has gotten a fair amount of momentum after not treating its banners well on price.

ADLER: But it started before the recession.

MARK WILTAMUTH: Ahold hit it just right. It lowered prices in 2006 and 2007 when there was not a lot going on in the price environment.

WOLF: Looking at Giant [Foods of Landover, Md.], Ahold's consolidation back at Quincy [Mass.] caused major problems. To have repaired that now and show comps up over 3% shows it can work.

ADLER: I'd be really curious to see what the long-term trend was of average weekly sales for Ahold's Giant Foods. The fact they're up 3% is OK, but it came off a pretty low base, while Stop & Shop's average weekly sales probably didn't come off such a low base.

WILTAMUTH: There's an interesting lesson to be learned in the magnitude of the duration of price investment that you need to make to really turn the tide. I mean, Stop & Shop started in 2006, and it took nine months of price investment before consumers noticed and same-store sales went back up.

ADLER: Inflation also helped it.

WILTAMUTH: In any event, the time in which Ahold was doing it is a lot different than what everyone is looking at now, because right now nearly every food retailer is cutting price, though everyone may not be advertising as heavily as Stop & Shop was back then. But I think it's going to take longer for grocers to turn the dial. And I think that's the struggle the industry is having right now.

For the guys playing catch-up — like Supervalu and Safeway — you're seeing big price cuts and little consumer response. It's just demand decline and erosion for them. If you're playing catch-up at this point, you're going to be at a disadvantage.

WOLF: You probably would've said that about Stop & Shop for nine months in 2006, so no one really knows. I don't know, and Safeway's executives don't know. And Kroger didn't know six years ago. You've just got to buckle your seat belt and hope the laws of economics continue to work. I wouldn't argue that this is the worst time to do it, but low base or not, Giant just posted 3.5% same-store sales.

JOHN HEINBOCKEL: It's the worst time economically and competitively to do it. When Kroger lowered prices, everybody else was playing their “C” game. Now, if you're Supervalu trying to turn your business around, more people are playing their “A” game, and I think it's much tougher.

INDUSTRY CONSOLIDATION

SN: How does the economic situation affect prospects for industry consolidation, and how does the credit market figure into those prospects?

WILTAMUTH: I don't think we're going to see too many big industry deals. First of all, there are antitrust issues, and second, investors would revolt. We've seen too many value-destroying acquisitions in the past decade, and I don't think it would be well-received at all at this time.

GARY GIBLEN (EVP of Quint, Miller & Co.): I agree. But there are some companies that really need to trim down. Supervalu started with the sale of the Utah stores, and it's conceivable it could sell off Shaw's or the Southern California Albertsons, if it can find buyers, because it needs to focus on more financial flexibility.

ADLER: Supervalu doesn't need more financial flexibility. To sell assets for financial reasons would be unnecessary and stupid. But could they do it because management is stretched? Yes, that's possible, but liquidity is not an issue for them.

SIMEON GUTMAN: The most interesting player is Kroger and whether it gets back into this arena and starts sniffing around for deals.

HEINBOCKEL: If you look at what Kroger has done historically, big deals have to be transformational. Fred Meyer was very transformational.

ADLER: Kroger doesn't like turnarounds.

HEINBOCKEL: So what out there is transformational that gives it something it doesn't have today? Not much.

WOLF: Kroger is obviously the most likely to do a deal — it is doing well, and it brings something to the party beyond economies of scale. But for Kroger, there are different criteria beyond just transaction price and synergies.

GUTMAN: You are not going to get Kroger to bite on a possible Shaw's-Pathmark-A&P roll-up if it's broken.

HEINBOCKEL: It will be hard to do any deal that's broken, not just because there's no value for the seller but because nobody's going to take that risk on the buying side. So I think you are in stalemate territory here. The only deals that will get done are transactions of 10 to 20 stores that are in-market. No one is going to take a risk until you fix what you have first.

GUTMAN: With everyone beneath them — the private regional companies, for example — does Kroger's strength create a compression, a cascading move that pushes out the true soft underbelly that expedites the demise of those companies?

HEINBOCKEL: It would be great to expedite that demise, but the problem is you're not going to have any Circuit Citys here because that just doesn't happen in food retail. It would be great to take that capacity and get it out in one shot. Even for some regional operators, it's a slow process — 10 stores here, 10 stores there — and that's always been the problem.

WOLF: The Albertsons stores in Utah are a great example, with 36 being sold to Associated Food Stores, so only about 10% of the sold stores are coming out of that market.

Mark Wiltamuth, executive director, Morgan Stanley

From a different perspective, the Supervalu deal in Utah kind of sheds light on where the interest is coming from because it involved a strategic bidder, Associated Food Stores. But it could have fit Cerberus' side of Albertsons as well, given that Bob Miller said he wants to add onto what he has, and that Utah deal would have fit Albertsons LLC really nicely since Miller knows those operations.

ADLER: We don't know how long those stores are going to stay open, though. Right now it's a co-op buying all those stores, but Associated said it's going to sell the stores to independents. The history of these kinds of deals is, the independents operate them for a couple of years and the stores that are really weak don't survive. As John just said, it's a very slow process and it takes a long time.

WILTAMUTH: We haven't even talked about the whole financing side of this — who's going to pony up for a big deal in this market?

VIRGINIA CHAMBLESS: The credit markets have definitely unfrozen, and I think the bid for paper is definitely there in the investment-grade market, and we have seen a number of deals happen in the high-yield market as well. The idea that bond investors are willing to buy for strategic M&A [merger-and-acquisition] transactions is real because levered plays are still going to be off the table, so the financing markets are much more open today than they have been in the last year.

KAREN SHORT: I guess the question for Kroger as a buyer is, does it want to have a better credit rating, or is it willing to risk that credit rating for a large-scale acquisition?

CHAMBLESS: I think it depends on the scale, because I think Kroger could definitely do an acquisition of several hundred million dollars at its current ratings level, but what is out there that would be that big?

SHORT: And weighing an acquisition with a better credit rating, Kroger wants access to A2P2 commercial paper.

CHAMBLESS: It does — and it wants its S&P rating to go to BBB-flat, and it is almost there.

Andrew Wolf, managing director, BB&T Capital Markets

ADLER: It's been close to that for a long time.

CHAMBLESS: I think there's a subtle shift in its tone on wanting to get there.

ADLER: I got the feeling it was a function of the bank markets and Kroger feeling vulnerable that it was not diversified in terms of its financing options. But it has been very open about the need to get a better rating and be able to access the commercial paper market.

The way I look at the credit metrics, I don't see Kroger having more leverage than Safeway, when you include leases. Maybe Kroger's interest coverage isn't as good because its debt is not as cheap as Safeway's. I don't understand the ratings agencies' view, given how stable Kroger's cash flow has been.

CHAMBLESS: I think the agencies maybe liked seeing Safeway spending money on cap-ex as opposed to share repurchases, whereas Kroger was doing a little more share repurchase than debt pay-down and Safeway wasn't buying back as much stock.

ADLER: Safeway did borrow money to buy back stock at some point several years ago — it borrowed quite a bit of money, like $750 million, to buy back stock. But Kroger hasn't done that.

CAPITAL SPENDING

SN: Can you talk about the impact cutbacks in capital spending will have across the industry?

ADLER: You'd like to believe that every cutback in capital spending was based on a company doing a return analysis that said a particular investment would no longer generate a good return, but none of us gets inside the companies' return calculations and you just don't really know if they are always making the right decisions. For Winn-Dixie, for example, a big piece of the story is remodeling, and it hasn't cut back on cap-ex because it couldn't cut spending and still have a good investment story.

CHAMBLESS: You almost wonder if now wouldn't be a good time to be investing. Construction costs are down, so from an opportunistic standpoint, it would be a better time to invest now than a year and a half ago.

GUTMAN: I agree there could be some more offensive spending. Curiously, though, Harris Teeter — a retailer in a territory where it could march forward and take some market share — is pulling back on spending. First it cut its 2010 cap-ex, and then it cut the 2011 cap-ex. Arguably, Harris Teeter is a differentiated retailer that had some price-investment adjustments that needed to be done, but it did those adjustments ahead of the game, and now it is pulling back on spending far in advance.

SHORT: Yes, but if it is cutting back in 2011, it is potentially because it plans to build a $100 million distribution center, and once you factor in the DC, the cap-ex goes back up to 5.5%.

ADLER: Early in the year, companies said all kinds of things. For example, in December, Safeway said it would use all its free cash flow to pay down debt, and I thought that was a bad idea because the company is relatively un-leveraged now.

WOLF: What's going on is, everybody is cutting cap-ex.

HEINBOCKEL: Kroger's not.

WOLF: Kroger's not, but it's not building any new square footage either.

HEINBOCKEL: I think if Kroger had a choice of spending less or spending more, then directionally it would spend more because the returns are there. I don't know if that will continue, but you have a certain amount of leeway, when you are doing as well as Kroger does, to take opportunities that others have abdicated.

WOLF: And that includes Wal-Mart, so we are talking about everybody but Kroger.

ADLER: Some real estate guys told me some big retailers were going to their landlords and buying their leases out entirely because a lot of landlords need cash right now, which is taking advantage of an opportunity. So you don't need to build anything new, but it makes sense to buy property now at a reasonable price and then have the control, rather than having to fight with a landlord later if you want to make changes to the store.

HEINBOCKEL: It's not like buying subprime mortgages, but you may end up buying the real estate at a good enough price where that investment ends up making money directly.

ADLER: That could mess up the capital expenditure numbers. We do know that when Kroger opens new stores, it is making the decision to own rather than lease a lot more of the properties than it used to, which makes it look like its cap-ex is still very high. But it is basically adding tangible assets that it didn't own before.

WOLF: Kroger is not adding stores — in fact, it is slightly contracting, unless it does a small acquisition — but it is adding square footage because it is doing remodels, and those are basically expansions and relocations. And it's a great strategy because it is boosting return on assets.

But basically demand is down for the industry, and nobody is adding stores, which is a very rational response.

CHAMBLESS: But when you talk about the industry spending cap-ex on new stores and remodels, I think the pullback is very reactionary, and to say, as Meredith said, that companies are using all their free cash flow to pay down debt is what everyone wants to hear, but it is very reactionary and very defensive. I would view the pullback in cap-ex as a negative if the industry is not keeping up the stores or if there is any compromise there.

GUTMAN: Ahead of the current economy, new-store growth had slowed to a crawl — the industry was not building, it was over-stored to begin with, and I think the companies are recognizing that. But they are not falling way behind now, because as long as capital is deployed toward fixing the current fleet of stores, that's OK. The only thing you can't defend against is someone becoming more convenient than you are right now, and absent small-box formats, no one's really going to get that close. Essentially, they have stopped growing.