Reversal of Fortune

MARK HAMSTRA

Food retailing stocks continued to reward investors in 2006 as operators saw the benefits of the strategic initiatives they rolled out during the past several years.

Successful efforts to differentiate, combined with other factors that helped them drive more sales growth and transition that sales growth to the bottom line, propelled more than half of the supermarket stocks tracked by SN to doubled-digit gains in 2006.

Some companies were rewarded not just on their performance, but on speculation that they would be acquired, while a few were punished as investors backed off previously high valuations.

Whole Foods Market, Austin, Texas, not only was the biggest percentage decliner among stocks tracked by SN, but it also led the losers among all stocks in the Standard & Poor's 500, shedding nearly 40% of its value to end the year at about $47 per share. The natural food retailer had been one of the industry's strongest gainers during the past several years, but a slowdown in new-store development and declining sales took some of the air out of what many said had become an over-inflated stock.

“Whole Foods is an example of a company that didn't do anything wrong at all, but Wall Street's expectations were in ‘La-La Land,’” said Gary Giblen, analyst, Brean Murray, Carret & Co., New York.

Likewise, Wal-Mart Stores, Bentonville, Ark., continued its five-year slide after its sales continued to lag and investors failed to see the same clear picture for growth that the company presented a decade ago.

The stock market overall had a strong surge in momentum in 2006, fueled by improving corporate profitability, but the supermarket industry fared well in comparison, extending improvements that began manifesting themselves last year. Of the 27 supermarket and wholesaler stocks tracked by SN, 14 exceeded the Dow Jones Industrial Average's gain of 16.29%. The SN Composite Index, which is weighted to account for the size of the retail and wholesale companies tracked by SN, was up only slightly, however, at 0.66%, as many of the biggest gainers were smaller, regional players.

The two biggest gainers were Spartan Stores, Grand Rapids, Mich., a regional retailer and wholesaler whose stock price more than doubled, to close the year at nearly $21 per share, and Ingles Markets, Asheville, N.C., a regional player in the Southeast that was up more than 90%, closing Dec. 29 at just under $30 per share.

But the largest operators also reaped gains in 2006, as Safeway, Pleasanton, Calif.; Kroger Co., Cincinnati; and Supervalu, the Minneapolis-based acquirer of most of the Albertsons chain, all saw their stock prices rise in double digits.

“2006 was a reconfirmation of the cyclical upturn that really began in '04 and '05,” said Andrew Wolf, a Richmond, Va.-based analyst with BB&T Capital Markets. “So 2005 could have been interpreted as a one-year rebound, but in 2006, real sales were maintaining and same-store sales were improving, so the second year into it, it's not a one-year bounce. It's a full-scale recovery.”

Analysts said one of the key factors in the upturn of supermarket stocks was the sense among investors that supermarkets were no longer viewed as the outdated victims of nontraditional expansion.

“When you look back to 2001-2002, you had the perfect storm hitting supermarkets, with the economy and the growth of Wal-Mart and Whole Foods,” said Karen Short, an analyst with Friedman Billings Ramsey, New York. “A lot of supermarket chains had just rested on the laurels of convenience, but they finally realized that convenience was not enough, and they had to make changes.

“For a lot of these companies, it's a slow ship to turn, but I think you are finally seeing the results from several years of initiatives,” she said. “Safeway, Kroger, A&P and some others have finally figured out how to compete more effectively, and they finally have some better year-over-year comparisons on the labor front and the health care front.

“A little bit of the headwinds have turned into tailwinds, so I think you are going to start to see some decent results out of these companies.”

Merchandising Initiatives

Analysts cited multiple factors in the industry's appeal to investors in 2006, in addition to the sustained sales growth.

“I think there was a combination of things that were interesting to investors this year,” said Jonathan Ziegler, an analyst with Dutton Associates, El Dorado Hills, Calif. “The stock market told us that the industry is still alive and kicking, and has some growth potential, and that management, as opposed to being victims of Wal-Mart, has taken a much more proactive role in winning back share from Wal-Mart, and they did it by improving their offering and improving their merchandising, tuning down the impact of price — recognizing that Wal-Mart is going to win on price.”

Merchandising initiatives have played a key role in the revival of industry sales, he said, citing in particular the addition of a gasoline offering. Placing gas pumps on the parking lots of stores throughout the country, retailers like Kroger and Safeway may be augmenting their convenience and value propositions, as well as driving store traffic through cross-promotions and habituating customers to stopping at the store more often.

“I think it has made a lot more sense for the industry than adding bank branches,” he said. “I'm not sure why bank branches were not very powerful, but certainly they have not been as effective as gas.”

Another factor that may have inspired investor interest in supermarket stocks in 2006 was the fact that Safeway and Kroger both began paying dividends again after a lapse — Safeway in 2005 and Kroger in 2006. Shareholders had long sought such payouts from the large, slow-growth supermarket companies as a better use of their cash and a guaranteed source of income for investors.

Some companies saw their share prices jump not based on any performance metrics, but on the possibility that they would be acquired. In fact, some of the recent merger and acquisition activity in the industry — notably the sale of Albertsons to Supervalu and a group of private-equity firms — may have also caught the eye of investors.

“When you have all of that pizzazz going on, it draws attention to the industry,” Ziegler said. “There is so much money sloshing around out there in buyout firms and hedge funds, and they are all looking for a way to put their money to work.”

Among the companies whose share prices rose on deal speculation were Smart & Final, which said in April that it had retained Goldman Sachs to help it consider “strategic alternatives,” and saw its share price rise nearly 50% despite a lack of improvements in fundamentals, analysts said.

Giblen of Brean Murray, Carret pointed out that Smart & Final did implement some operational improvements in 2005, but the company's share-price gains in 2006 were still largely the result of takeover speculation.

He pointed out that several other companies that saw strong gains in 2006, including Ingles Markets and Village Supermarkets, also saw their stock prices rise as investors considered them possible takeover candidates.

The Wal-Mart Factor

By and large, however, analysts said investors became convinced in 2006 that the initiatives supermarkets have implemented have taken hold and are functioning to thwart competitive pressures from the likes of Wal-Mart.

“For five years now, the more optimistic people in the industry have said supermarkets would crack the code and figure out how to deal with new forms of competition, and changes in consumers and changes in the economy, but for five years the industry did not crack the code, and it went from bad to worse,” Giblen said. “But by the middle of '06, various different companies did crack the code on how to be relevant to consumers, which is a very positive thing.”

One of the keys to the improvement in traditional supermarket performance, analysts pointed out, was that Wal-Mart is not perceived to be the threat it once was.

“Wal-Mart really has reached a plateau in what they can do in the food business,” Giblen said. “They have bigger fish to fry — it's a lot more important for them to get apparel right so they can compete with Target, rather than squeeze out 0.2% increases on food, so they just let that go on automatic pilot.”

Overall, analysts pointed out, supermarkets figured out their own formulas for success in 2006, and the market recognized that those formulas were working.

“I think there were some pretty remarkable performances behind those stock gains, and they were all real,” Ziegler said.

Kroger Co., Cincinnati, the largest traditional supermarket operator, saw its stock rise more than 22%, to close the year at $23.07, after posting strong comparable-store sales throughout the year. In the company's fiscal third quarter, which ended in November, comps rose 5.3%, and the company projected comps of better than 5% for the fourth quarter.

“Kroger found a perfect delicate balance between price and service and so forth, and so for the last couple of quarters, they have been able to drive strong comps without giving up margin,” Giblen said. “That's just a watershed event for them, and for the industry.”

He said he felt Kroger actually deserved a bigger boost than Safeway in 2006, although he did give Safeway credit for the success of its lifestyle stores. Some of Safeway's gains came at the very end of the year, when the company revealed at its analyst meeting last month growth projections for Blackhawk Network, a division the company developed in 2001 to develop alternate sources of revenues, such as merchandising the gift cards of other retailers through both its own stores and those of other retailers.

Steve Burd, Safeway's chairman and chief executive officer, projected that Blackhawk will grow at an 80% rate in the coming years, and will contribute $100 million to the company's pretax income this year.

The chain's lifestyle remodeling program has now touched nearly half of the company's stores, helping drive comps in the mid-single digits.

Supervalu, Minneapolis, saw its share price pressured early in the year as investors wondered about the company's ability to ingest the acquisition of some 1,200 Albertsons locations, which transformed it into one of the nation's largest retailers. Later in the year, the market seemed to accept that the company was on the right track with the integration.

“It's a little too early to tell, but there's every reason to believe it should work out well,” Giblen said. “They should be able to improve the competitive position of the Albertsons stores they bought.”

Supervalu's shares rose about 10% for the year, closing at $35.75, after a rally of about 23% in the last four months of the year. Much of the sell-off in midyear may be attributable to former Albertsons shareholders divesting shares they received in the acquisition, Giblen explained.

Other stocks that saw double-digit gains in 2006 included Ahold, which was up 40.5%, to close at $10.58. The parent of the Stop & Shop, Giant-Landover, Giant-Carlisle and Tops chains had relatively weak sales within the bulk of its U.S. operations, but its shares rose after the company unveiled a restructuring plan that includes the sale of Tops and of its food-service distribution arm, U.S. Foodservice.

The Amsterdam-based company also was the subject of merger speculation in 2006, as reports indicated the company had been in discussions with Delhaize Group, Brussels, about a combination of the two trans-Atlantic operators.

Delhaize also had a good year, as the parent of Food Lion, Hannaford Bros. and Kash n' Karry saw its stock rise 27.2%, to close at $83.28. As was the case with Ahold, most of Delhaize's stock price increase came in the last half of the year after the merger speculation was reported, although analysts said they were impressed with Delhaize's sales and earnings results during the year.

Pathmark Stores, Carteret, N.J., enjoyed a gain of 11.61% in share price in 2006, to close at $11.15, as the company eked out some performance gains but also was the subject of merger speculation with A&P.

“You had both A&P and Pathmark dropping in the July time frame, but they recovered just on the heightened speculation of a deal happening,” said Short, who said Pathmark's enterprise valuation is “completely out of whack” relative to its cash flow.

Looking Ahead

Analysts are optimistic about the continued success of industry stocks in 2007, although some cautioned that comparable-store sales will face difficult comparisons after the strong year that just ended.

“Sales are looking good,” said Wolf of BB&T Capital Markets. “They could moderate a little, because comparisons are getting tougher, but they have a good pricing environment.”

He pointed out that with the U.S. Department of Agriculture projecting consumer product price inflation of 2% to 3% in 2007, supermarket operators may continue to enjoy strong margins, as he does not see their costs rising as quickly.

He cited union negotiations as “the biggest risk factor for the first six months” of 2007, with a March 4 expiration date for the Southern California pact covering 70,000 workers at Albertsons, Kroger-owned Ralphs and Safeway-owned Vons that was the culmination of a 20-week strike-lockout three years ago.

“Right now the unions are looking at this recovery as well,” he said. “They have a history of wanting to share the good times with the workers. It should be very interesting to see how things go in March in Southern California — it could set the pace for labor negotiations for the year.”

Although some analysts have projected another economic recession in 2007, Wolf noted that it's unclear whether that would have much of an impact on supermarket operators.

“I think the industry is better positioned than they have been in past recessions,” he said. “In the past, management allowed prices to creep up too much without giving anything in return. Now you've got a situation where the merchandising is relatively better and the pricing is relatively better, so it would be interesting, to see what happens in this industry in the next slowdown to see how firm the defensive positioning really is.”

A report in Barron's last week issued a caution about Safeway — noting that much of the company's gains from lifestyle remodels have come in the chain's more affluent markets, speculating that the company may not enjoy the same levels of return from such investments in lower-income areas.

And Giblen pointed out that some industry stocks that have traded up on the prospects of a buyout, such as Smart & Final and Ingles Markets, could see their shares take a hit in 2007 if no deal occurs.

Top Gainers

The five top gainers among supermarket stocks in 2006 follow.

Top Losers

Five food retailing stocks tracked by SN lost value in 2006.

Whole Foods Stumbles in 2006

AUSTIN, Texas — Whole Foods Market here continued to set the standard for food retailing in 2006, but you wouldn't know it by looking at the company's stock performance.

One of the biggest losers of the year in the stock market overall, and the single largest loser among food retailing stocks tracked by SN, the fast-growing company saw its shares slide nearly 40% during the year, to close at $46.93. The company had been trading — and still does trade — at multiples suited to those of a growth stock, but the valuations came down after the outlook for growth became somewhat muddled.

In August, during a report on its third-quarter earnings, the company projected revenue growth in the range of 15% to 20% — impressive on its own, but the company also had been projecting square footage growth in a similar range, leaving analysts wondering what would happen to the double-digit comparable-store sales they had been seeing.

In November, the company posted quarterly comps in the single digits for the first time in three years and projected similar results for 2007.

Analysts said they still believe the company has some of the best performance metrics in the industry, however, and said the stock could start to rebound as store openings accelerate late this year.

“I think it will probably be late 2007 when investor excitement will start to pick up around Whole Foods' acceleration of square footage growth,” predicted Scott Van Winkle of Canaccord Adams, New York. “I think that will be a catalyst. Additionally, the sentiment on Whole Foods is very negative currently, and I think what we're going to find out is it's not that bad — decelerating from their low teens to 6% to 8%. Every other supermarket would love to have those comparable-store sales.”

Andrew Wolf, a Richmond, Va.-based analyst with BB&T Capital Markets, said Whole Foods' financial performance “went from excellent to very good” in 2006. “I don't think there is anything structurally amiss at Whole Foods.”

Although Whole Foods has begun to get more aggressive on pricing to counteract the widely held perception that it is an expensive place to shop, Wolf said he believes the chain's core customers are not averse to paying more for the high quality they feel Whole Foods delivers.

“Their core customer understands that pricing premium,” he said. “They are going to have to be a little more promotional on some things and make some price statements on some high-visibility items, but that's just Retailing 101.”

He said he expects the company to reach “an inflection point sometime in the intermediate term” when performance will begin to improve and investors will take notice.

“They've got the same management team they have had,” he said. “Are they really going to stop executing on a high level? I don't think so.”

The decline in Whole Foods' stock value in 2006 didn't seem to impact fellow natural food players United Natural Foods, Dayville, Conn., and Wild Oats Markets, Boulder, Colo. United was one of the biggest gainers among retailers and wholesalers tracked by SN, with growth of about 36% for the year, to $35.92, and Wild Oats was up about 19%, to $14.38.

Van Winkle said United's stock growth reflected two things: the overall expansion of the natural and organics channel, and the company's new seven-year distribution pact with Whole Foods.

At Wild Oats, he said, the company “had a very good run through the first half of the year” and noted that the share price also reflects that the company is frequently the subject of takeover speculation.
— M.H.