Shopper Squeeze 2008-03-17

MARK HAMSTRA

Supermarkets will face more food-cost inflation in 2008 than they did in 2007, and the increases will be difficult for many operators to pass on to their customers, according to a survey conducted last month by SN.

For the most part, food retailers in their recent earnings calls have indicated that they have been able to pass their cost increases along to their customers in the form of higher retail prices, but nearly 80% of respondents to SN's online survey said they expect rising food costs to impact their margins to some degree in 2008.

The weak economy and rising food costs are dealing a one-two punch to consumers, but so far food retailers have been able to withstand the whirlwind as consumers have been willing to dig deeper into their wallets and more of them seem to be curtailing restaurant spending in favor of at-home dining. But with some analysts projecting continued sharp food-cost increases, and with gas prices expected to spike to new highs this summer, consumers could be under more pressure than they have been in decades to tighten their grocery budgets.

“It is an interesting time in the food industry — consumers are challenged by a slow economy and higher energy prices,” said Ephraim Leibtag, an economist with the U.S. Department of Agriculture Economic Research Service, Washington, who studies retail food prices and the dynamics of food markets. “We have experienced this in the past, but it has been a while. The big question is whether there is a way out in the short term, or will it be longer term.

“It remains to be seen how long the economic slowdown will last, and whether or not the slowing economy will prevent retailers from passing on high costs,” he said. “Where does the buck stop? Who is paying and who is not?”

After food inflation of 4% in 2007, analysts are predicting a similar increase in 2008. Some reports have suggested that food inflation could be even higher this year and could be long-lasting, while others have said they expect food costs to moderate by the end of the year.

Chuck Cerankosky, an analyst with FTN Midwest Securities, Cleveland, said he believes consumers may be cutting back in other areas, which may have the impact of freeing up their grocery budgets.

“Inflation is hitting all aspects of consumers' lives, not only food and fuel, but utility bills, the cost of automobiles, and other things, so people are going to make an incredible variety of spending decisions based on what they view as their economic position,” he said. “That might mean spending even more at a supermarket because they are deciding they are not eating out nearly as much as they have been, or they may cancel a vacation, or they may opt out of buying a new car. The trading down and other decisions that are made in a wobbly economy are not just going to be made within the confines of the grocery store.”

Whether supermarkets pass through their cost increases could vary by market, he pointed out, with some retailers in highly competitive areas keeping prices low to retain market share.

“But at the end of the day, higher operating costs that all retailers share need to get passed along, or the business just cannot operate profitably,” he noted.

Ayuna Kidder, an economist at TNS Retail Forward, Columbus, Ohio, said in general she expects retailers to be more promotional on price during economic downturns.

According to that company's February ShopperScape survey on household spending, rising food prices have begun to change consumer behavior. More than half (51%) of all shoppers are not buying food items that seem “just too expensive,” the survey found, and 43% of all shoppers said they are dining out less to save money. More than one-third (39%) of all shoppers are cutting food budgets by making more frequent use of coupons, and 37% are “simply spending less overall.”

In SN's survey, 52.3% of respondents said they planned to conduct “a little more” price-focused advertising this year than last year, while another 38.6% said they would not increase such promotional activity.

Some retailers have noted in recent earnings calls that they have begun to see consumers trading down to lower-priced products, such as substituting chicken for beef and choosing private-label products rather than name brands. In SN's survey, 86.4% of respondents said they believe consumers have been doing some substitution, although most of those — 50% of the total — said trading down has been limited to “a few products here and there.”

Some retailers in recent presentations to analysts and investors said they have not witnessed this phenomenon at all. In the survey, 11.4% of respondents said they had seen no trading down by consumers.

According to a report on CPG prices from Information Resources Inc., Chicago, consumers began to shift their purchases toward more private-label product last year and could continue to do so this year, depending on whether inflation moderates.

In the 10 categories tracked by IRI that had the largest price increases in 2007, consumers either bought less or shifted more of their spending to Wal-Mart or private label. IRI noted that frozen poultry was an exception, where demand increased despite price hikes.

The 10 categories with the highest price increases, according to IRI data, were fresh eggs, up 30.3%; frozen poultry, 20.2%; refrigerated juices, 14.5%; milk, 12%; bakery snacks, 11%; baby formula, 10%; coffee, 7.9%; skin care, 7.6%; and cat food, 6.5%.

A Cautious Customer

In a fourth-quarter earnings conference call with investors, Steve Burd, chairman, president and chief executive officer, Safeway, Pleasanton, Calif., said consumers have become “more cautious.”

“I think some of that caution stems from the fact that they are a little bit concerned about the economy,” he said. “Everybody is forecasting some kind of recession, and then we have an unusual situation where you add to that the uncertainty of more inflation than consumers have seen in some time. We see some evidence of consumers trading down.”

He said the trading down has been visible in the weakened demand for high-end merchandise, such as premium wine, and also in the increased demand for private label across many different food retailers.

Safeway generally passed on product-cost inflation quickly to consumers, Burd said, although occasionally there is “a little bit of lag.” Sometimes Safeway is able to protect its gross margins, he said, while other times it is only able to “protect pennies of profit.”

Still, he advised analysts that they should view inflation as a “neutral event” for supermarkets because of the offsetting gains from consumers who have cut back on restaurant spending and the increased sales of private-label products.

He likened the current inflationary environment to what food retailers have always dealt with in their produce departments, where rapid swings in price are commonplace.

“It is challenging,” he said. “But we don't see it as a problem that can't be managed.”

Many supermarket companies have indicated that they are benefiting from what Deborah Weinswig, an analyst at Citi Investment Research, New York, called “trading in,” the phenomenon retailers have described as occurring when consumers cut down on dining out in favor of eating more meals at home.

In the SN survey, more than 90% of the respondents said they felt their customers were eating more meals at home to save money, with 52.3% saying they felt consumers were adding “a few meals here and there” at home instead of going to restaurants, and 38.6% saying they believe that their customers “have cut back significantly on dining out.”

Weinswig, in a conference call with investors last week discussing the topic of trading down as it relates to retailers, restaurants and CPG companies, cited recent research from the USDA that indicated an increase in at-home dining at the expense of restaurants.

In 2007, she said, food-at-home expenditures increased as a percentage of overall food spending for the first time since 2001, reaching 53.2%.

“More significantly,” she added, “food-at-home share increased 210 basis points over the 51.1% in '06. That's the highest year-over-year increase since the 1940s.”

January data indicate the proportion of food spending for at-home dining increased even more in January, to 54.6%, she noted.

“Some of the ‘trading in’ phenomenon has to do with supermarkets improving their ready-to-eat meals, combined with higher prices at the restaurant and higher gas prices, since consumers would rather just stay at home and eat, as opposed to making another trip,” she said.

Delhaize Group, the Brussels-based parent of Hannaford Bros., Food Lion and Sweetbay in the U.S., said in reporting its results for the fourth quarter earlier this month that it has been seeing some evidence that consumers are spending more on prepared foods and frozen dinners, indicating a shift away from restaurant spending.

Jeff Noddle, chairman and CEO, Supervalu, Minneapolis, said he also believes the current economic environment may create an “opportunity” for supermarket operators.

“I think the restaurant business is going to be more stressed because of this,” he said.

He said it is still too early to accurately predict how consumers will behave as the year progresses, however.

“It doesn't feel to me like [the country is in a recession] yet, but now that we are past the holidays, I think the next few months will be very telling in terms of how the consumer feels about their outlook and their position,” Noddle said.

Glen Petraglia, a Citi Investment Research analyst who follows the restaurant industry, said he believes restaurants began to see the first signs of trading in toward more at-home dining last year when gas prices began to spike. With some observers projecting that gas will hit $4 per gallon this summer, analysts expect consumers to continue to cut back on their driving.

In the SN survey, more than 90% of respondents said they believe consumers have cut down on their shopping trips to outlying destinations because of high gasoline costs, with 15.9% saying consumers have cut back “significantly” on these trips.

Retailers still expect their top lines to be buoyant in 2008. According to the SN survey, only 11.4% of retailers said they expect their average basket sizes to be smaller in 2008 than in 2007, and 45.5% said they expect bigger baskets.

Only 6.8% of respondents said they expect all of their sales growth to come from inflation — 54.5% said less than half of their sales growth will be inflation-generated, while 31.8% said more than half of their growth will result from inflation.

In January, overall food inflation was 4.9% higher than the prior-year period, and food-at-home prices rose 5.8%, according to data from the U.S. Department of Labor.

New Consumer Paradigm

Retailers for the most part seem to be convinced that for every dollar that consumers save by substituting a cheaper product, a new dollar lands in the till from increased spending on higher-cost product and from customers cutting back on dining out.

Mona Doyle, president, The Consumer Network, Philadelphia, said she doesn't see consumers cutting back on their market baskets or food-at-home purchases. Instead, consumers have cut back in other areas, especially eating out at fine dining restaurants.

“In years past, if people were going to trade down, it meant they were trading down from steak to something that took a lot longer to cook,” she said. “That is not happening. What is happening is those people eating at home are those who are budget-strained — from our numbers, it looks like about 30% to 40% [of consumers]. We are still seeing the majority of people who are ‘la-di-da’ — they aren't changing anything. If they aren't hurting, they aren't changing. It is business as usual.”

Doyle said she sees most food shoppers in an adjustment mode when it comes to food inflation. “They may stop adjusting,” she said. “It will be very interesting to see how this generation [those under age 45] trade down in supermarkets, because they haven't done that in the last 10 years. This generation feels entitled to a whole range of flavors and good food. They have expectations of what good food is all about. Are they going to cut back on organic or stop buying sauces? I doubt it.”

According to Doyle, supermarket spending in recent years has become a matter of balancing convenience, health and taste, with less emphasis on budgetary concerns.

“Consumers see food spending as an incidental,” she said. “But if things get worse, then they'll go back to seeing it as an area they really have to cut back. Then it is anybody's guess.”

Non-Necessities Go First

Leibtag of the USDA also said he thinks consumers will be reluctant to cut back on their grocery spending.

“The general economic view tells us that food overall is a relative necessity, and grocery store shopping, vs. eating out, is more of a necessity, or one area that consumers can fall back on,” he said. “So, with the weakening economy and higher prices for food, it is the non-necessities that go first. If consumers are cutting back, it is probably not on basic food staples.”

Consumers tend not to be too sensitive to price increases in the 4% to 6% range, he said, but do begin to change their behavior once those increases rise to the level of 10% to 15%.

He pointed out that food retailers have been able to maintain their margins so far in the inflationary environment.

“Look at 2007 government data on retail margins — they were pretty steady for retailers, if you look at retail price and wholesale cost as measured on the governments' index of producer prices. There were some subcategories that took a hit, and they weren't able to recover margins at retail, but overall, retail margins were steady at 4% to 5%, which implies retailers were able to pass those costs along to consumers in the form of higher retail prices.”

For higher-end consumers whose food budgets are a small percentage of their overall spending, food-price inflation is relatively benign, he said. However, for those lower-income consumers who spend a significant portion of their income on food, inflation is apt to force changes in their shopping patterns, such as switching to more discount retailers.

“If you were already shopping at Wal-Mart, then you may buy less,” he said. “You may eat out less and trade down in the restaurants you go to or trading down from branded to private label.”

He pointed out that elderly consumers on fixed incomes are likely to be among those consumers looking for ways to save money on their grocery bill.

In her presentation on trading down, Weinswig said Wal-Mart stands to perform well in the current environment, noting that the company generated higher comparable-store sales than its higher-priced rival, Target, during the last recession in 2001-2002, but the situation reversed in the years since then as the economy improved.

“Now, for the past three quarters we've seen Wal-Mart out-comp Target, and we think that's the beginning of a longer-term trend,” she said.

Based on a gloomy economic outlook for the year ahead that includes ongoing increases in energy costs, a weak housing market and continuing increases in unemployment rates, “We expect more trading-down behavior in terms of where consumers shop, the products they buy and the choice to buy private-label vs. branded product,” Weinswig concluded.

Miguel Gomez, assistant professor of agricultural and consumer economics at the University of Illinois at Urbana-Champaign, who concentrates in food retailing, said the USDA projects a continued rise in these commodity prices until 2010, when farm production and yields are expected to catch up to global demand, and prices are expected to stabilize.

He noted that food consumption and demand are on the upswing not only in the U.S., but also in China and India, where there has been a gradual shift to meat consumption, which is impacting commodity costs.

The demand for biofuels as an alternative to oil is also a factor in rising food costs. However, in the long run, Gomez sees a minimal impact on food prices.

“Governments in the U.S., Europe and South America have developed policies to mandate the increased use of biofuels in energy consumption,” he said. “The private sector is responding and investing in production capacity. Those are huge investments and they aren't going to go away, but the impact on food prices, we believe, is not going to be that dramatic.”

Several analysts said they see traditional supermarkets as being well positioned to weather the current economic and inflationary environment.

“I think some consumer shopping venues are going to be much better positioned in this environment than others, and I would put the traditional food retailer in that camp,” said Cerankosky of FTN Midwest Securities.
Additional reporting by Christina Veiders