Stocks Languish Amid Investor Concerns

MARK HAMSTRA

When it came to trading down, investors followed consumers in the first half of 2008.

In a dismal six-month span that saw both the Dow Jones Industrial Average and the S&P 500 Index decline at a double-digit pace, only a handful of food retailing stocks tracked by SN managed to eke out gains.

At one end, low-price leader Wal-Mart Stores, Bentonville, Ark., led all gainers, reflecting both its positioning as a benefactor of a weak economy and strategic initiatives that analysts say are rewarding shareholders.

At the other end was Whole Foods Market, the Austin, Texas-based purveyor of natural, organic and specialty foods that has had the worst showing so far this year among stocks tracked in SN's index. Analysts attributed the decline, which followed a poor showing in 2007, to a combination of factors, including a shift away from some premium products by consumers, an expensive store-development initiative and the challenges of the Wild Oats acquisition.

Only six of the 24 stocks tracked by SN showed gains in the first half: Wal-Mart, BJ's Wholesale, Kroger Co., Empire Co. (Sobeys), Spartan Stores and Costco.

“Overall, in the first half, grocers were kind of par for the course,” said Jason Whitmer, an analyst with Cleveland Research.

Early in the year, investors seemed to shy away from the stocks, he noted, but interest in the food retailing companies returned as the industry appeared to be handling inflationary pressures and some operators began proving themselves as defensive investments amid cutbacks in consumer spending.

“I think there was a lot of concern in the investment community about food inflation — whether consumers would be trading down, and how much, and whether they would be trading out of the industry,” said Chuck Cerankosky, an analyst with FTN Midwest, Cleveland. “There are a lot of crosscurrents, and I think investors have not seen the industry through an inflationary period for quite a long time. It's compounded by the fact that the last time around, when the economy slowed down, conventional food chains were impacted.”

Although Kroger's stock price ended the first half of the calendar year on an upswing, it had to bounce back from a trough it descended into late last year when investors became concerned that it would struggle with passing along fast-rising food cost inflation.

Safeway and Albertsons, the other two largest traditional supermarket operators, both had company-specific issues impacting their performance on both the positive and negative side, and both ended the first half with double-digit percentage declines in their share prices.

“It's a market that is so easily spooked that investors need to see evidence before jumping in,” said Karen Short of Friedman, Billings, Ramsey, New York.

“In a weak environment, consumer staples should perform,” she added. “The discounter, dollar and club stores have all materially outperformed food retailers; Kroger is the only standout.”

Andrew Wolf, a Richmond, Va.-based analyst with BB&T Capital Markets, noted that in addition to concerns about retailers' ability to raise shelf prices and pass on inflation, most also showed very little real sales growth when inflation was factored out.

“Volumes went down for the industry, and stock valuation is closely tied to volume for these companies,” he said. “The reason earnings kept going up and stock prices didn't was this lack of real sales growth.”

SN's Composite Index of food retailing stocks was up slightly for the first half, by 3.88%, reflecting Wal-Mart's gains in the period. That compares with a 14.44% decline in the Dow Jones Index and a decline of 12.83% in the S&P 500.

Analysts said they are hopeful that industry stocks might perform better in the second half.

“I think we are going to see that inflation is not such a bad thing,” said Short. “There is so much skepticism about whether food retailers can pass on inflation, or whether they are all going to lose share to Wal-Mart and Costco, and I think the truth probably lies somewhere in the middle. The impact on the stocks' performance is going to be company-specific — some will execute better than others.”

Wolf of BB&T said he thinks the industry could get a margin boost from a short-term respite in protein costs as ranchers cull their herds and dump supply on the market, but that situation could reverse and put pressure on margins later in the year.

“I think the industry is set up for a better quarter in gross margins,” he said. “But then there will be a U-turn, and protein prices are going to soar, so you could end up back in a period where gross margins are getting squeezed again.”

WAL-MART VS. WHOLE FOODS

>Although the disparity between the performance of Whole Foods and Wal-Mart in the first six months paralleled the trading-down that consumers did, the issues impacting their respective performances were much more complex, analysts said.

The impetus for Wal-Mart's stock revival — it was trading near a five-year high last week — originated last October when the giant discounter unveiled a plan to cut back on expansion in the U.S., according to Cerankosky.

“I think Wal-Mart did an internal reflection last year about ‘were they still a growth company or not?’ — and they decided that the growth was not going to be as rapid,” he said, noting that the company's pullback on capital expenditures, its share repurchase program and its dividend increase all helped tilt investor sentiment. “Had they been continuing at the same rate of expansion with not nearly as much cash going back to stockholders, I think the stock price performance would have been much different and not quite as enjoyable to investors.”

Cerankosky also said the company positioned itself well for consumers who were trading down.

“They set themselves up for an economy that was going to be a little tougher on their price-sensitive customer,” he said. “I think there has been a certain amount of economic pressure on some of their customers, offset to a degree by customers trading into their box.

“In general, sales have been adequate and margins have been up in the core Wal-Mart Stores division,” he said.

Whitmer noted that Wal-Mart seemed to have rejuvenated itself after it restructured its management team a year ago.

“They have cleaned up the stores, and I think they are making an impact on the channel at large — not just because people have to watch their wallets a little bit more, but because the entire experience has gotten better,” he said. “They seem to be turning the corner on a lot of strategic initiatives; a lot of their efforts the last two or three years are starting to pay off in terms of marketing, merchandising and operations.

“They are in the right place at the right time with the right strategy,” he said.

While investors have latched onto Wal-Mart as a company that has made all the right moves for the current environment, they see Whole Founds as its opposite.

“People have started to question the luster of Whole Foods,” said Scott Van Winkle, an analyst with Canaccord Adams, Boston.

Although Whole Foods has long been priced as a growth stock, investors have begun to reassess the lofty values that had been placed on the company's shares now that its same-store sales growth has slowed to levels comparable to those of traditional supermarket operators.

“That seems to be the biggest investor issue: ‘Why do I pay a premium for Whole Foods when Safeway's putting up the same type of growth?’” Van Winkle said.

In addition, he cited the company's “cost issues” related to its aggressive new-store growth strategy, as well as the complications of the Wild Oats acquisition, which was completed late last year but has not yet been accretive to earnings.

Although consumers don't seem to have shied away from purchasing organic and natural products during the economic slowdown, some consumers seem to be trading down from the premium-priced products Whole Foods offers, analysts said.

“Whole Foods has always been a retailer that has two core constituents,” said Van Winkle. “One is the health-driven, value-driven organic consumer, and the other is the premium ‘foodie’ consumer, and that premium foodie consumer seems to be where the problem is.”

Cerankosky noted that Whole Foods' stock price has also been impacted by the Wild Oats acquisition.

“A lot of people thought the Wild Oats acquisition would be additive to the company's earnings right away,” he said. “That was not the case, and the stock came from the very high [price-earnings] ratios from the rapid earnings growth, to a much more reasonable valuation as the earnings decrement for fiscal 2008 has become apparent.”

Van Winkle said he sees the potential for Whole Foods' stock to fare better in the second half.

“The good news for Whole Foods is we are getting into much easier comparisons on the earnings side,” he said. “No. 1, the Wild Oats acquisition is probably a couple of quarters away from all that cost being pulled out of that business, and that deal likely being accretive to earnings. Also, the pressure from the accelerated square-footage growth of the last couple of years has probably peaked.”

TRADITIONAL OPERATORS

Kroger rallied toward the end of the half as investors came to realize that the company was not suffering any negative impacts from inflation and was in fact driving increased business with its value offering in the slowing economy.

When the company last month reported same-store sales gains of 5.8%, excluding fuel, and raised its earnings outlook for the year by a few pennies per share, the stock surged even more.

“I don't think investors were expecting sales to be that strong or margins to be that firm,” said Whitmer of Cleveland Research. “The pulse of the Kroger business was remarkably strong, and I think the visibility of that was better than most, and that's why there's been a lot of comfort on the part of investors in that name in particular.”

Safeway, down 16.54% in the first half, has not yet recovered from a cautious fourth-quarter report.

“There was the fear that the company would have to lower its sales guidance, and along with that, potentially, their earnings guidance,” said Short.

Safeway did reduce its outlook for same-store sales growth when it reported first-quarter results in April, but kept its earnings guidance in place.

Short also pointed out that Safeway has been seeing some softness in sales from its aggressive private-label merchandising, and added that it could be seeing some impact from the slowdown in the housing market, particularly in California, where it operates many of its stores.

“To me, the concerns [about Safeway] seem somewhat ill-founded,” said Short. “I think Safeway has a decent mousetrap. Maybe they still need to lower their price points in some departments, but if they had such a weak business model, you wouldn't have seen positive sales in all 10 operating areas in the last quarter.”

The stock also lost some of the punch it had received from speculation about a possible spinoff of Blackhawk, its third-party gift card merchandising division, Cerankosky noted.

“Then, with the investment market so lousy, speculation about the value of Blackhawk and when the spinout of that might take place has certainly been pushed back, and has certainly taken some valuation out of the stock,” he said.

At Supervalu, which saw its stock fall 17.67% in the first half, the company has done a good job of cutting costs, but still has to prove it can move the sales needle on par with its peers, analysts said.

“The sales momentum has not been nearly as strong as Safeway or Kroger,” said Cerankosky, who noted that Supervalu's stock-price performance has largely been tied to its integration of the Albertsons acquisition.

He noted that Supervalu's wholesale business “has been very strong,” however. “That's the company's heritage, and the leadership is represented by some very astute logisticians. They have pioneered a lot of velocity-based distribution network strategies. Those are things they did in the mid-'90s that some of their key competitors have not yet duplicated.”

The top five gainers in the first half of 2008, through June 30, in terms of percentage increase, were:

The top five decliners in the first half were: