Stocks Off to Rocky Start After 2010 Growth

MARK HAMSTRA

The crystal ball is decidedly cloudy for supermarket stocks in the coming year, with the prospect of creeping inflation weighing against the possibility of improvement in employment and the economy.

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“Against a backdrop of heavy competition, and with a consumer that is still focused on low prices/discounts, we believe food inflation could hurt grocer results either through margin shortfalls or demand declines,” Mark Wiltamuth, an analyst with Morgan Stanley, New York, wrote in a report last week downgrading shares of Safeway and Supervalu.

Karen Short, a New York-based analyst with BMO Capital Markets, also issued a report the same day downgrading certain industry stocks after many share prices had risen in double digits in 2010.

In a conference call discussing the changes, Short said the new ratings were sparked in part by the valuations of several companies BMO labeled as “outperformers” meeting or exceeding target prices.

“As we hit the tail end of last year, fundamental valuations had started to creep up to or go above our price targets,” she explained. “As a result, there were [companies] about which we wanted to remain positive but we would have needed to raise price targets, and in order to raise price targets we would have to raise estimates. And we couldn't justify much higher [estimates].”

Short reduced Supervalu's earnings-per-share estimates for the third and fourth quarters of fiscal 2011 as well as fiscal 2012, reflecting a challenging environment and the company's struggle to improve sales. Short also downgraded Supervalu's price target from $13 to $11.

Short also reduced earnings estimates for Kroger, Supervalu and Safeway, while lowering BMO's rating on its 13-company food-retailing group from “outperform” to “market perform.” Ratings for Safeway and Whole Foods Market were reduced from “outperform” to “market perform.”

The ratings changes followed a year in which almost all 25 food-retailing stocks tracked by SN showed gains, although as a group the shares underperformed the stock market overall.

Fifteen of the 20 stocks that showed gains during the year were up in double digits, led for the second year in a row by Austin, Texas-based Whole Foods, up 84.3% during 2010.

The SN Composite Index, a weighted average of all 25 stocks tracked by SN, was up only 2.48% for the year, however, compared with an 11.02% increase in the Dow Jones Index and an increase of 12.88% in the Standard & Poor's 500 Index.

Among the supermarket decliners were Montvale, N.J.-based A&P, which filed for Chapter 11 bankruptcy protection on Dec. 6 and fell about 71% for the year before its shares stopped trading.

Minneapolis-based Supervalu, still struggling with the 2006 integration of Albertsons and seeking to find a balance between preserving profit margins and driving sales volume with sharp pricing, fell 24.23% for the year to close at $9.63. And Winn-Dixie Stores, Jacksonville, Fla., fell 28.49%, closing the year at $7.18.

Traditional supermarket operators Kroger Co. and Safeway were up 8.91% and 5.64% for the year, respectively, and both also were pressured by the balancing act of price vs. margin during the year.

“The competitive environment remained tough throughout the year, and then inflation started coming in the back half of the year, so for the average company, sales weren't that good,” Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., told SN. “And when the sales aren't that good, the stocks tend not to do particularly well.”

He said his expectation for 2011 is that the industry overall will perform modestly better than in 2010, provided inflation is relatively low and retailers are able to pass increased product costs on to consumers.

Andrew Wolf

“Most economists are predicting a little better job outlook,” he noted. “It depends how severe inflation is — if it's 2% to 3%, it's a good thing. In a slightly improving economy, a little inflation is a good thing. A lot of inflation is not a good thing.

“In a slowly improving economy, the outlook isn't that bad,” he said. “If we were still in an economy where the industry was still struggling to get traffic, in an environment where food costs are going up, that would be pretty scary. But that's not the economy we are in.”

He cited the positive trends in real sales growth during the year as an indicator of the industry's health, as well as strong November sales at supermarkets and strong holiday sales at retailers overall. The price investments supermarkets made during the year have had the desired effect of driving traffic for many operators, “so there is no longer a reflexive need to invest in price all over again,” he said.

Chuck Cerankosky, an analyst at NorthCoast Research, Cleveland, noted that a positive outlook for the industry in 2011 is contingent upon improving economic conditions.

“I think the pace of the economic recovery, especially job creation, is going to drive consumer sentiment,” he told SN. “If consumers remain cautious, it's going to mean that price and promotion will continue to hold their stature among the various strategies that the retailers want to pursue.”

He also said looming industry consolidation could benefit the strongest operators, as the weaker players — such as A&P — shutter stores.

“There are other weak operators in other parts of the country,” he said. “As other capacity goes dark, that is going to benefit the remaining operators, and I think that is a very big issue.”

HIGH-END PERFORMANCE

Whole Foods' strong stock performance in 2010 reflected the resurgence of confidence among upper-income consumers, as well as the company's structural changes made before the economic downturn, analysts said.

“Their customer probably responded well to the recovery of the stock market, so there was a ‘net-worth effect,’” Cerankosky noted, adding that wholesale clubs Costco and BJ's also seemed to benefit from the return of the big spenders.

Whole Foods' “core customer probably felt better earlier,” noted Wolf of BB&T. “It's not an affordable luxury for these people — it is an affordable necessity.”

In addition, “Whole Foods as a company proactively positioned itself well,” he noted. “They did a lot of things internally — they got their cost structure down.”

Also, the company had worked to improve its value image before the downturn.

“If they hadn't done that, they still would have benefited from a cyclical recovery in natural [products], but their recovery wouldn't have been nearly as robust, or it wouldn't have maintained traction. Whole Foods is probably likely to continue to gain customers, even against tough [comparable-store sales] comparisons.”

Having a better value image positions the company to more easily attract and retain new customers to fuel ongoing sales growth, he said.

Short of BMO, even though she lowered her rating on the stock last week, agreed that the company's fundamentals have been sound.

“The expectation of a strong quarter and this fiscal year seem to already be reflected in valuation,” she noted, adding that “longer term, there's a lot more upside” for the stock.

For the fiscal year that ended Sept. 26, Whole Foods saw net income increase 67.5% to $245.8 million, while sales increased 12.1% to $9 billion and identical-store sales were up 7.1%. The company projected earnings-per-share increases of 16% to 20% for the current fiscal year, on sales gains of 10% to 12% and identical-store sales growth of 5% to 7%.

The stock of United Natural Foods Inc., Whole Foods' primary wholesaler, also had a strong year, with a 37.17% increase, to $36.68.

The company added Pittsburgh-based Giant Eagle as a customer during the year, and also enjoyed the resurgence of the higher-end consumer, analysts said.

Wolf noted that UNFI's success reflects the strength of independent natural food stores, which remain the company's largest customer group.

“The independents do not have that same improved price image [of Whole Foods], but the fact that they came back shows how strong the industry is,” he said.

Matthews, N.C.-based Ruddick Corp., parent of the Harris Teeter chain, was also among the top stock-price gainers during 2010, with an increase of 43.18%, to $36.84, which analysts attributed in part to the turnaround in fortunes of the company's American & Efird industrial thread division.

“That business generated more in earnings than most observers thought at the start of the fiscal year, and the result was much better earnings performance for the entire company,” said Cerankosky.

“Harris Teeter did very well, but they are facing a customer that is very cautious, especially in their home state of North Carolina,” he added. “And while they are making progress, it isn't a situation where purchase mixes are returning to normal yet — people are sensitive to price and promotional activity, and that has put pressure on Harris Teeter's margins.”

He added that the chain's management has responded to the environment “appropriately.”

“The company remains very dedicated to its quality aspects, but they are very aware of the need to have a strong private label and competitive prices, because in many of its areas, Harris Teeter is competing against price operators, including Wal-Mart.”

Short of BMO Capital Markets said Harris Teeter's relative success in a challenging year is a testament to the company's strong management team, as well as the flexibility in its labor costs from a nonunion workforce.

“Harris Teeter definitely held in there,” she said. “All in all, to have a 6% increase in EBITDA in a challenging year is not immaterial.”

For the full fiscal year, which ended Oct. 3, Harris Teeter's operating profit was up 3.4%, to $181.6 million, while sales increased 7.1%, to $4.1 billion (including about 2% from an extra week).

Comparable-store sales for the year were down 1.1% for the full fiscal year, although the trend improved during the course of the year.

SALES STRUGGLES

The troubles at Winn-Dixie can be attributed in part to the intense competition and especially weak economy in the Florida market, where traditional operator Publix Super Markets became more aggressive in its position in 2010, and Wal-Mart has a strong presence to attract the most price-conscious consumers.

“I think the industry overall is rounding the corner on hypercompetitive activity, but Winn-Dixie got caught up in that in Florida — it was a one-two punch with Publix and Wal-Mart,” said Wolf of BB&T.

Cerankosky of NorthCoast Research agreed that the Florida market was difficult for Winn-Dixie to navigate in 2010, although he said management appeared to be making the right moves.

“Winn-Dixie has a formidable turnaround to execute with some major competitive and economic headwinds,” he said. “There's a lot of attention to remerchandising, and to refurbishing the store base — a lot of the things that should have been done over the last 30 years. [Chief Executive Officer] Peter Lynch and his team are pursuing those at this time, but the damage of past management failures is part of the challenge there.”

Short of BMO Capital Markets noted that Winn-Dixie — like Supervalu — took a cautious stance on pricing and promotions for much of the year in order to preserve gross profits, which came at the expense of traffic.

“That's a good short-term strategy, but in the long run, the success of the turnaround will be based on the top line,” she said. “Even with the store remodels rolling into the comp base, it is not enough.

“Winn-Dixie definitely skews to the lower-income demographic, and the lower-income demographic is not feeling any better,” she noted, saying the outlook for the company in 2011 is “not particularly inspiring.”

Supervalu likewise “needs sales growth, and that has not been happening,” said Cerankosky.

“It has been a long period of difficult sales comparisons, and that has impacted the company's ability not only to integrate the Albertsons stores it acquired some four years ago, but also to leverage its operating costs.”

He said investors will be watching the company carefully for sales improvements, quarter by quarter.

“The string of comparable-store sales declines has got to be arrested,” he said.

Mark Wiltamuth

In lowering his rating on Supervalu, Wiltamuth of Morgan Stanley said Supervalu's efforts to get its pricing back in line will be a struggle for the company.

“We believe the company's shift in strategy to reduce prices and correct overpricing vs. peers will collide with an inflationary food cost backdrop and continued competitive pressures in key Supervalu markets,” he said in a research note. “While we agree that management needed to take action to address comps running at -7%, we are concerned that the margin sacrifice required and the time it will take to turn the ship will be worse than anticipated.”
Additional reporting by Jon Springer