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Stocks Surge in First Half, but Future Looks Cloudy
Supermarket investors watched industry stocks continue to race ahead in the first half of 2007, but there may be a few speed bumps ahead. After a six-month span in which 18 of the 26 food retailing and wholesaling stocks tracked by SN recorded double-digit gains in share price, analysts remain bullish on the industry but are also sounding a few notes of caution. We're at that classic time period right
Donna Boss
July 9, 2007
20 Min Read
MARK HAMSTRA
Supermarket investors watched industry stocks continue to race ahead in the first half of 2007, but there may be a few speed bumps ahead.
After a six-month span in which 18 of the 26 food retailing and wholesaling stocks tracked by SN recorded double-digit gains in share price, analysts remain bullish on the industry but are also sounding a few notes of caution.
“We're at that classic time period right now where the stocks have gone up and all of a sudden everybody goes, ‘Uh-oh, there's lots of stuff that can go wrong,’” said one analyst, who asked not to be identified. “They will probably go through that over the summer.”
The SN Composite Index of supermarket retail and wholesale stocks in the first half was up 6.63%, which beat the 5.57% gain posted by the S&P 500 Index in that time frame, but still lagged the 7.33% gains for the Dow Jones Index during a bullish first half.
Kroger Co.'s first-quarter earnings report last month didn't instill much confidence in investors, who saw the Cincinnati-based company's compressed margins as a warning that chains might not be able to raise prices at the shelf as easily as they had hoped to compensate for rising product costs.
“One of the big fears is food inflation, especially after Kroger's report, where they got a little squeezed between cost of goods and retail prices,” the analyst said. “Plus, you've got Tesco's opening in the second half, so people are going to think long and hard about the sector.”
Andrew Wolf, an analyst with BB&T Capital Markets, said he thinks the run that the industry has enjoyed over the past two years could be slowing — perhaps to a trot.
“You will probably see the stocks performing not nearly so well in the second half, but performing in line with earnings growth, given a neutral stock market environment,” he said. “If the market goes up a lot or down a lot, things could be different.
“The momentum has at best peaked, and at worst it is slowing slightly. You see a little more economic slowing, a little inflation crimping margins more than expected, and you see that labor is still a big part of this business,” he said, referring to the strike threats that emerged this year in markets like Southern California and Texas.
However, he noted that investors have come to see supermarkets in a much more positive light than they used, to, which minimizes the downside risk for food retailers.
“The stock market has really changed its view on the outlook for supermarkets,” Wolf said. “The fact is that the supermarket business is doing well, and there's a pretty decent likelihood that it's going to continue to do well.”
The analyst who had asked not to be named also said he thinks industry stocks will continue to perform well in the longer term, given some of the positives, such as Wal-Mart's slowdown in supercenter development and the fact that the industry appears to be in a good position to weather inflation.
“I actually believe the industry will be fine through most of this,” he said. “It's a lot easier to manage these inflationary pressures when your stores are in good shape, and all of your being is not devoted to having to lower your prices to get traffic.
“It's a little bit better than it was a few years ago. I think most everyone will feather it through quite nicely.”
He also said he believes that the impact of Tesco, the British retailer that is slated to begin opening stores in the Southwest, might not have a big impact on conventional supermarket operators, and might “take a long time to develop.”
“Investors have realized that the stores are better than before,” he said. “A lot of it comes down to operations. Companies have spent the last three or four years improving the offering at all of these stores.”
Sales Growth
Chuck Cerankosky, an analyst at FTN Midwest Research, Cleveland, said top-line growth among supermarket operators is attracting investor interest.
“One of the surprising things to people who are recent to these investing stories has been the strong sales trends,” he said. “It clearly shows that traditional supermarkets are not going to be killed off by Whole Foods and its ilk at the high end and supercenters at the lower end.
“They showed that they could adapt to some of the changes in the marketplace, and they addressed some of their cost issues, and within some of that, they were able to segment their store offerings to specific customer demographics.
“Those investors saw the improved cost structure at some of the leading chains. They also saw that this is an industry that has really consolidated — a lot of capacity has closed, been consolidated, gone to other uses, or has just slowly been going dark. Consolidation may not happen overnight, but as a certain amount of capacity goes off the air, it is releasing market share to the stronger chains.”
One of the companies largely responsible for the reduction in capacity was one of the first half's largest gainers. Jacksonville, Fla.-based Winn-Dixie led all supermarket stocks through June with a gain of 117% after the company surprised investors with a strong third-quarter earnings report. After a year in bankruptcy, Winn-Dixie has emerged as a leaner, more competitive supermarket chain that investors seem to think has the potential to regain some of its former power in the Southeast.
“It's a story that has legs,” said Karen Short, an analyst at Friedman Billings Ramsey, New York. “There are lots of people who think Winn-Dixie doesn't have a reason to exist, but I disagree. You can't have the entire Southeast only shopping at Wal-Mart and Publix — there's room for a No. 2.”
It wasn't until Winn-Dixie reported its fiscal third-quarter results in May that investors were able to see how well the company was really performing, she explained.
“They reported their second quarter shortly after emerging, and it was very noisy,” she said, noting that it contained data from both pre- and post-emergence from bankruptcy. “The general consensus was, ‘How could the company have emerged in such a mess?’ But it was so noisy, that wasn't the right conclusion, necessarily.”
She said when the company reported surprisingly strong EBITDA in its third quarter, it attracted some new investors, which has helped strengthen the stock. Short-sellers — those who had gambled that the stock would lose value — also helped drive up the share price, she said, as they were forced to purchase shares to fulfill prior obligations.
Another knock on Winn-Dixie, she said, was the company's slow approach to developing a prototype remodel, although she said she thinks the company now has a design that will work and will soon begin a more aggressive rollout.
Kroger, Supervalu Up
Among the other strong gainers in the first half were two of the top three traditional supermarket operators: Kroger, whose shares rose 21.93%, and Supervalu, operator of most of the legacy Albertsons stores, whose shares rose 29.57% in the first half of the calendar year.
Kroger's gains, which followed a 22% gain in 2006, were in part propelled by a strong fourth-quarter report in which the company posted 5.3% same-store sales gains (excluding fuel) and a 36% gain in net income, to $384.8 million, compared with the first quarter of a year ago.
Although enthusiasm for the stock was tempered last month when Kroger said it suffered margin pressure as a result of cost inflation in the first quarter, analysts said they believe the impact on the company's share price may be short-lived as the chain adjusts its retail pricing to compensate for cost increases.
While Kroger's share-price gains were driven by strong sales results, investors rewarded Supervalu for its effective integration of last year's acquisition of Albertsons, analysts said.
“I think, justifiably, investors have shown great confidence in the Supervalu management,” said Cerankosky. “They made, as [Chief Executive Officer] Jeff Noddle calls it, a transformational acquisition for the company because it puts much more of the fortunes of their company into food retailing instead of wholesaling.”
The new company, which includes the best-performing assets of the old Albertsons chain, more than doubled its net income in the fiscal year that ended in February, to $452 million, as the higher margins from its retail operations drove more revenues to the bottom line.
The company is investing heavily in remodeling its acquired stores, rolling out a “premium fresh and healthy” redesign that can be highly customized by market.
“I think what they are doing is running the stores better,” said Wolf. “Those stores have always done good volume, plus the economy has been good, and people have been spending with a little less discretion. They are in a better industry environment, and things picked up.”
Although the same-store sales growth at Supervalu has not been as strong as it has at Kroger and Safeway, the trends have been positive, analysts pointed out.
“Kroger has been working on bringing better value to their customers the longest, Safeway the second longest, and Supervalu the least, so it's only natural that they would be lagging on same-store sales growth,” Wolf said.
Safeway Down
Although both Kroger and Supervalu performed well in the first half, Safeway was one of the four industry stocks to actually post a decline in value through the first six months of the year. Analysts noted that Safeway's share-price decline of about 1.5% in the first half of 2007 followed gains of 46% in 2006, when it was one of the industry leaders. The company throughout last year reported success from the rollout of its lifestyle store remodels, which helped drive the stock price, and late in the year disclosed that its Blackhawk gift-card division was projected to be a much larger generator of cash flow than analysts had expected.
“Safeway had a huge year last year, and their valuation was already higher than Kroger's,” noted Wolf. “Kroger has basically caught up with Safeway.”
Spartan Stores, which led all gainers for 2006 by doubling its share price, remained among the top performers in the first half of 2007 with an increase of 57.24%, to close at $32.91. The company in March said it would acquire the retail stores of Felpausch Food Centers in Michigan, and it also boosted its wholesale operations with the addition of Martin's Super Markets in Indiana as a customer.
Short of Friedman Billings Ramsey said she thinks Spartan can continue to build its wholesale business by taking customers away from rivals, such as Nash Finch Co., the Minneapolis-based wholesaler who had supplied Martin's.
In addition, she said, Spartan stands to gain from the closure of some Farmer Jack stores in the Detroit area and the acquisition of several of those stores by Spartan's wholesale customers.
Nash Finch was perhaps one of the biggest surprises of the first half, analysts said, as the company saw its stock rise more than 81%, to $49.50, despite losing the Martin's account and scaling back its retail operations.
Merger Activity
Much of the stock activity in the first half was driven by a combination of merger activity and improved operations.
In addition to the pending acquisitions of Wild Oats Markets and Pathmark Stores by Whole Foods Market and A&P, respectively, the first half also saw Canadian operator Sobeys get subsumed by its largest investor, Empire Cos., also based in Stellarton, Nova Scotia (See Page 25 for Sobeys' fourth-quarter earnings report.) The high premium Empire offered for that company drove its share price up about 41.5%, to $57.95.
Also, Smart & Final, the Los Angeles-based warehouse operator that had been publicly traded but was controlled by French retailer Casino Group, was acquired in the first half by New York-based private equity firm Apollo Management for $22 a share, a 16% premium over its closing price at the end of 2006.
Investors seemed to strongly support the Whole Foods-Wild Oats deal, at least until the Federal Trade Commission sued to block the acquisition for what it considers antitrust violations. Whole Foods offered $18.50 per share for its smaller rival, for a total of nearly $700 million, including debt. The agreement, reached in February, caused both companies to enjoy a spike in share price, although the possibility of the deal falling through and slowing sales growth has since dragged down the shares of Whole Foods. The stock lost about 18% of its value in the first half of 2007, following a loss of nearly 40% in 2006.
“I think the issue with Whole Foods is that the stock price got a little ahead of itself,” said Cerankosky. “Management had consistently told investors that the company could not maintain — nor could any company maintain — double-digit same-store sales for long. As that truth began to show up in earnings, the stock was hit pretty hard by investors.”
He said he thinks the stock, still priced at a higher earnings multiple than traditional supermarket companies, will languish for a while, while the market sorts out what the future holds.
“It is going to take a breather for the next six months,” he said. “Whether or not they make this acquisition, it means two very different things for the company. They are working hard to hit that $12 billion sales target, and the absence of that acquisition might mean more aggressive new store development. The consummation of that acquisition might mean a whole different company than it was beforehand, both in the structure of the balance sheet and the mix of stores they are operating.”
Wolf said he thinks the current share price at Whole Foods “reflects a lot of risk that the deal might not happen.”
He also noted, however, that the price reflects the slowdown in same-store sales at the company and the high cost of rapid expansion.
“They have had some major growing pains from ramping up store growth,” he said, noting that changes in accounting for leases on stores not yet opened also has hurt the company's earnings.
Although Wild Oats has not seen any widespread improvements in its financial performance, its stock has remained relatively high on the prospects that it could end up being acquired by another operator or by private equity if the Whole Foods deal gets blocked, analysts said.
The other big dealmaker in the first half, Montvale, N.J.-based A&P, by contrast saw its shares rewarded for its agreement to acquire Pathmark, as well as for ongoing improvements in store operations and a renewed focus on its core Northeastern markets. The stock was up 30.3% for the first half of the year, to close at $33.54 at the end of June.
Short said she thinks many of the investors who had bought into the stock in anticipation of the long-anticipated Pathmark deal have now been replaced by those who see A&P as a long-term investment.
“I think you have had some pretty substantial turnover in the investor base, because you had some catalyst-driven investors waiting for a Pathmark announcement,” she explained. “Then you have those investors cycling out of the name, now I think what you have is a pretty stable investor base with a long-term horizon.”
The fact that Fidelity Investments is now a holder in the stock, for example, gives other investors “a vote of confidence,” she said.
Like Wild Oats, Pathmark Stores, Carteret, N.J., saw its shares remain relatively high — up 16.23% for the first six months, to $12.96 — on the likelihood that it, too, would be acquired, rather than on its performance. Short pointed out that Pathmark has shown some better trends in its EBITDA recently, however.
Top Gainers
The following five stocks had the largest increase in share price during the first six months of 2007:
Winn-Dixie Stores, up 117.04%, to $29.30, after closing last year at $13.50. The company surprised investors with a strong third quarter, reporting EBITDA of $46 million for the period that ended April 4, its first full quarter out of bankruptcy protection. Same-store sales were up 1.6% in the period. “It's very much a sales-driven story,” said Short of Friedman Billings Ramsey. “It's all about getting leverage on the operating expenses.” She said investors were particularly surprised at the high gross margins, which benefited from the disposal of some assets through the bankruptcy process. She also said investors had not taken into account how much better the company could operate once its was out from under the weight of bankruptcy. “Vendor support was reduced [during bankruptcy], and the company was pretty highly promotional to keep from bleeding market share,” Short said. “They have become much more rational with their promotional behavior.”
Nash Finch Co., up 81.32%, to $49.50, after a 7.14% gain in 2006. Nash Finch regained some of its former value after a troubled couple of years. “I think a year ago, the stock price was an aberration,” Alec Covington, who came aboard as CEO in March of last year, said in a recent interview with the Minneapolis-St. Paul Pioneer Press. “It clearly should not have been trading that low, even given the state of affairs within the company.” The company reported flat sales for the first quarter of this year, with a 10% decline in retail sales offset by gains in the company's military-distribution business.
Spartan Stores, up 57.24%, to $32.91, after a gain of 100.86% in 2006, to $20.93. The company scored a big win a year ago with its acquisition of D&W Food Centers, the upscale chain that had been a customer of Supervalu, and this year has continued to rack up new wholesale customers and grow its corporate store base through acquisition. Analysts see even more opportunities for acquisitions in the company's core markets of Michigan, Ohio and Indiana. “I think Spartan can continue to do well on the sales and earnings side,” said Cerankosky of FTN Midwest Research, noting that the company now has the “talent on the retail side to make these acquisitions work.” Short of Friedman Billings Ramsey also pointed out that the company was recently named to the Top 100 list at Investors Business Daily, an influential trade publication. “There are a lot of investors who only play off that list, so suddenly it started hitting a lot of screens,” she said.
Sobeys, up 41.48%, to $57.95, after a gain of 8.65% in 2006, to $40.96. The company was acquired by what had been its largest shareholder, Empire Cos., in what many saw as a very rich offer of $58 per share, following a weak earnings report in March. “I think Empire decided ‘Sobeys is our biggest asset, we've invested a lot of money and time in fixing the problems it had, and we can see out 18 to 24 months, when the food industry doesn't have such a beleaguered outlook, our earnings power is going to be pretty good,’” said one analyst at the time, who asked not to be identified.
A&P, up 30.30%, to $33.54, after a loss of 19.01% in 2006, to $25.74. Analysts applauded the company's efforts to revitalize the store base with “Fresh” remodels and to focus on core markets in the Northeast. It has become much more investor-friendly, she said, by breaking out profitability at its peripheral divisions and by disposing of underperforming assets, such as Farmer Jack in Michigan.
Top Losers
The following four stocks had declines in share price during the first six months of 2007.
United Natural Foods, down 26%, to $26.58, after a gain of 36.06%, to $35.92, in 2006. The natural-products distributor has seen its fortunes tied to those of its largest customers, Whole Foods and Wild Oats, and investors seem concerned that the wholesaler will lose some profitability as a result of the proposed merger of the two chains. “At the end of the day, a single customer now accounts for 40% of [United's] sales,” said one analyst after the merger was announced.
Whole Foods Market, down 18.39%, to $38.30, after a decline of 36.39%, to $46.93, in 2006. The company is battling investor concerns over the declining same-store sales — after years of double-digit growth — while also wondering if the Wild Oats deal will go through. Competitors are also gaining share on Whole Foods' natural/organic turf. “Nearly all the tangential competitors are impinging more on the natural food space,” said Wolf. “It takes slices of sales, here and there, and that's part of the reason sales are slowing.”
Metro Inc., down 1.63%, to $37.32, after a gain of 24.39%, to $37.94, in 2006. Analysts said the company, which acquired A&P's Canadian operations in 2005, might be feeling pricing pressures from a renewed effort by Loblaw to retain market share in Ontario as that company revamps its operations.
Safeway, down 1.53%, to $34.03, after a gain of 46.07%, to $34.56, in 2006. Safeway's big gains at the end of last year left the company vulnerable to some softness this year, analysts said. “Toward the end of last year, there was the enthusiasm for Blackhawk built in, but then when the first quarter came out and the company hadn't spun Blackhawk off or shown any results, the market got a little less enthusiastic about it,” said Cerankosky, who said he expects a better stock performance in the second half.
Half-Year Gainers and Losers
(Ranked by percentage changes)
CLOSE 6/29/2007 CLOSE 12/29/2006 AMT.CHANGE PCT.CHANGE
Winn-Dixie 29.30 13.50 15.80 117.04
Nash Finch 49.50 27.30 22.20 81.32
Spartan Stores 32.91 20.93 11.98 57.24
Sobeys 57.95 40.96 16.99 41.48
A&P 33.54 25.74 7.80 30.30
Supervalu 46.32 35.75 10.57 29.57
Kroger 28.13 23.07 5.06 21.93
North West Co. 18.90 15.53 3.37 21.70
Ahold (ADR) 12.52 10.58 1.94 18.34
Delhaize (ADR) 97.92 83.28 14.64 17.58
Wild Oats 16.76 14.38 2.38 16.55
Pathmark 12.96 11.15 1.81 16.23
BJ's Wholesale Club 36.03 31.11 4.92 15.81
Ingles 34.45 29.79 4.66 15.64
Village 47.81 42.75 5.07 11.85
Target 63.60 57.05 6.55 11.48
Costco Cos. 58.52 52.87 5.65 10.69
Arden Group 136.40 123.81 12.59 10.17
Ruddick 30.12 27.75 2.37 8.54
Loblaw Cos. 51.95 48.79 3.16 6.48
Wal-Mart 48.11 46.18 1.93 4.18
Weis Markets 40.51 40.11 0.40 1.00
Safeway 34.03 34.56 -0.53 -1.53
Metro-Richelieu 37.32 37.94 -0.62 -1.63
Whole Foods 38.30 46.93 -8.63 -18.39
United Natural Foods 26.58 35.92 -9.34 -26.00
SN Half-Year Stock Price Comparison
CLOSE 6/29/2007 CLOSE 12/29/2006 AMT.CHANGE PCT.CHANGE
A&P 33.54 25.74 7.80 30.30
Ahold (ADR) 12.52 10.58 1.94 18.34
Arden Group 136.40 123.81 12.59 10.17
BJ's Wholesale Club 36.03 31.11 4.92 15.81
Costco Cos. 58.52 52.87 5.65 10.69
Delhaize (ADR) 97.92 83.28 14.64 17.58
Ingles 34.45 29.79 4.66 15.64
Kroger 28.13 23.07 5.06 21.93
Loblaw Cos. 51.95 48.79 3.16 6.48
Metro-Richelieu 37.32 37.94 -0.62 -1.63
Nash Finch 49.50 27.30 22.20 81.32
North West Co. 18.90 15.53 3.37 21.70
Pathmark 12.96 11.15 1.81 16.23
Ruddick 30.12 27.75 2.37 8.54
Safeway 34.03 34.56 -0.53 -1.53
Sobeys 57.95 40.96 16.99 41.48
Spartan Stores 32.91 20.93 11.98 57.24
Supervalu 46.32 35.75 10.57 29.57
Target 63.60 57.05 6.55 11.48
United Natural Foods 26.58 35.92 -9.34 -26.00
Village 47.81 42.75 5.07 11.85
Wal-Mart 48.11 46.18 1.93 4.18
Weis Markets 40.51 40.11 0.40 1.00
Whole Foods 38.30 46.93 -8.63 -18.39
Wild Oats 16.76 14.38 2.38 16.55
Winn-Dixie 29.30 13.50 15.80 117.04
INDICES
Dow 13,427.73 12,510.57 917.16 7.33
S&P 1,506.34 1,426.84 79.50 5.57
SN Composite 2,059.43 1,931.40 128.02 6.63
Retailers 1,865.29 1,749.28 116.01 6.63
Wholesalers 704.39 664.25 40.14 6.04
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