BIG RETURNS

Greg Gattuso

The nation's largest supermarket chains continued to reap the rewards of their investments in technology, acquisitions, capital expenditures and internal changes in the second half of calendar year 1997.

Although sales showed modest gains compared with the corresponding period in the prior year, increased efficiencies resulted in significantly higher operating results.

The 15 largest chains had sales of $82.0 billion in the second half of the year, an increase of 5.9% over the 15 largest chains last year.

Operating results for the group, however, increased 13.3%, reflecting the returns on various investments in the chains' supply chain, acquisitions and new store construction or remodels.

Financial analysts contacted by SN said the overall positive financial position of the 15 largest chains is not a new phenomenon, but rather a continuation of several industry initiatives to squeeze costs out of the system.

"Technology is paying off, no question about it," said Jonathan Ziegler, San Francisco-based securities analyst with Salomon Smith Barney, New York. "Sales numbers are starting to look better, but it is applied technology that is really driving this industry, driving margins and driving productivity.

''Investors get excited about technology, and [supermarkets] is the group to get excited about because they're the ones who are applying the technology and reducing costs from it."

Ziegler said even slight improvements in margins -- multiplied by the huge sales volume achieved by a supermarket chain -- have "a magnified effect on the bottom line."

Ziegler said the second half also saw more rational prices and promotions.

"In the old days, we saw a 'turkey giveaway phenomenon,' " Ziegler said. "That is different now, in that the industry is tying promotions to frequent-shopper cards."

While the overall results are positive, "this is evolutionary, not revolutionary," he added. Debra Levin, a securities analyst with Morgan Stanley Dean Witter, New York, said the benefits of consolidation also contributed to improved performance in the latter half of last year.

"The larger companies have done an excellent job in terms of realizing synergies from internal consolidation and external consolidation, and their new store programs seem to be working well," said Levin.

"Companies are doing better in terms of procurement, improved productivity at store level and better labor scheduling," she noted. "The companies are making progress in terms of inventory management."

Levin noted that the economy was strong in the second half, although that was not reflected overall in sales figures.

"Overall sales for supermarkets were rather sluggish, and significantly different than the economy," she said. "But I think that has more to do with overcapacity than with anything else."

Levin said new square footage from supermarket operators as well as non-traditional operators, such as supercenters, drug stores and discount stores, all chipped away at supermarket same-store sales.

By geographic region, the Pacific Northwest "seems to be doing particularly well," Levin said. The business climate remains tough in the Southeast, and is "fairly stable" in the Midwest, she said.

Mark Husson, retail analyst at J.P. Morgan, New York, said more than technology, it was capital expenditures that made the most significant contributions.

"The after-tax return on a five-year rolling cap-ex number has been improving every single year for the last five years for the major food retailers," Husson said.

''One of the exciting things about this trend is that the large food retailers, over the last five years, have stepped up cap ex to 3.5% or more of sales, and have expanded square footage quite dramatically, 3% or 4% per year."

Husson said the increases in capital expenditures and square footage coincide with increases in profitability because larger stores can offer more items, and more higher-margin items, like expanded produce, flowers, household products, kitchen appliances and videos. In addition, private-label sales get a boost from remodeled stores, he said.

"The retailer's brand is inextricably linked with the state of the store base in the consumer's mind," Husson said. "You can have best-quality private-brand products in the world, and the most swanky advertising. But if your store base is only 30,000 square feet and looks outdated, you're not going to have any success in wooing the consumer with your advertising message.

"If, however, you've got bright, shiny, hygienic, clean stores with lots of interesting fresh foods and gourmet foods on display in nice new stores, then your brand starts to matter. Consumers start to think of retailers as a national brand in their own right, rather than just labels on a shelf."

Husson said large food retailers' private-label programs account for about 20% of sales, compared with an industry average of about 15%. For the two largest players, Safeway and Kroger Co., private-label sales are up to about 25%, Husson said.

"The other players are looking to catch up to where the best guys are already," Husson said. "And guys out in front are looking to extend that lead."

Ted Bernstein, high-yield analyst at Grantchester Securities, a division of Wasserstein Perella Securities, New York, said internal changes have also contributed to stronger operating results by slimming down operations and taking costs out of the system. "We've seen even troubled operators like Penn Traffic do things to reduce expenses," Bernstein said. "They streamlined their management structure and consolidated five or so operating divisions that they were running and saved a lot of money as a result. At Pathmark, they outsourced warehousing and distribution on the grocery side to C&S Wholesale Grocers.

"[Cutting costs] has allowed operators to at least hold their own, if not improve results," he added.

Below, SN asked the financial analysts to comment briefly on some of the industry's largest chains. Here is what they said:

KROGER CO., Cincinnati, is starting to get a lot more aggressive on its "big buy-big sell" program, Husson said. Under that program, Kroger leverages its large scale to centrally coordinate procurement for all its divisions. The result is more efficient than having each Kroger Marketing Area handle its own procurement.

SAFEWAY, Pleasanton, Calif., showed results that were greatly enhanced by its acquisition of Vons Cos., Arcadia, Calif. However, Ziegler said both chains would have done well independently.

"Safeway is on the right course, and Vons is making progress," he said. "When you put them together, you take out overhead and you find them sharing best practices."

Levin said Safeway continues to be "a superb operator."

"They continue to be doing an impressive job of improving operating profitability, and the Vons acquisition has been accreditive from the beginning and continues to grow in its contribution," she said.

AMERICAN STORES CO., Salt Lake City, had a disappointing second half, Levin said, in which it produced two consecutive quarters of negative year-over-year earnings comparisons.

"Both the supermarket and drug store divisions are struggling," Levin said. "Expenses are high and they are working to get that under control."

ALBERTSON'S, Boise, Idaho, had easy comparisons against soft third and fourth quarters a year ago. The chain has stepped up its acquisition program, "but even aside from the acquisitions, they've done a tremendous job in the second half, really showing better-than-expected earnings and improving their weakest units," Levin said. "They are also doing more with merchandising that will benefit them going forward."

WINN-DIXIE STORES, Jacksonville, Fla., is embroiled in a "very competitive, very promotional" Southeast market, Levin said, and continues to struggle with soft same-store sales. However, it is making progress in terms of earnings, she noted.

FOOD LION, Salisbury, N.C., is reaping the benefits of its Kash n' Karry acquisition and its frequent-shopper programs, analysts said. In addition, the divestiture of its Southwest operations means those stores will no longer be a drag on earnings, the analysts said. Analysts said the company will have fewer new store openings and take a more rational approach to pricing in its Southeast base.

A&P, Montvale, N.J., had a weak second half, which Levin attributed to intense competition in the Northeast, particularly the Philadelphia market. And the chain continues to suffer from a store base that has a good number of "older, weaker, obsolete units," she said. Many A&P units are also located in noncore markets that are spread out and not achieving critical mass.

FRED MEYER INC.'s numbers were distorted by the merger with Smith's Food & Drug Centers, Ziegler said. However, under the Portland, Ore.-based chain's management, Smith's has turned negative same-store sales figures into positive territory. Husson said Smith's has also taken advantage of Fred Meyer's best practices, making merchandising and operations changes, but Fred Meyer "is not going in like a bull in a china shop." Husson said Fred Meyer's own stores also had a very strong half both in food and nonfood, including jewelry.

GIANT FOOD, Landover, Md., showed strong recovery, but the company acknowledged an easy comparison with last year, which was affected by a five-week truck-driver strike. However, Levin said Giant's management has embraced "a much more strategic vision than they have in the past and they are tackling some very serious issues."

PATHMARK STORES, Woodbridge, N.J., produced "a real solid fourth quarter -- more solid than a lot of people expected," said Bernstein. "They stood their ground and made a statement about where they stood on the value pricing spectrum and produced a positive same-store sales result for the year, notwithstanding deflation."

HANNAFORD BROS., Scarborough, Maine, "has stuck to its very difficult job of building volume and awareness in the Southeast," according to Husson. Meanwhile, the company is facing imminent pressure from Wal-Mart Supercenter expansion in Hannaford's New England base.

PENN TRAFFIC CO., Syracuse, N.Y., took costs out of its management structure and attempted to reinvest those savings back into lower prices, Bernstein said. "To date, we haven't seen any significant benefits," Bernstein noted. "By lowering prices they have reduced gross margins, but they haven't driven the sales volume that they need."

Gaining The nation's largest supermarket chains continued to experience strong operating gains, despite a difficult sales environment that included low food inflation and competition from supercenters, drug stores and discount stores, as well as other supermarkets.

2nd Half 1997 2nd Half 1996

Sales Gains

Over Prior Year 5.9% 7.5%

Operating Income Gains

Over Prior Year 13.3% 11.9%

Numbering the Giants

Below are financial results for the 15 largest supermarket chains with public debt or equity. Although reporting periods vary, this chart represents sales and operating income for the two quarters most closely parallelling the last six months of calendar year 1997. Same-store and comparable-store sales, where reported, reflect only the latter of the two quarters.

Sales (in billions)

1.Kroger Co. $14.2

2.Safeway $13.2

3.American Stores Co. $9.6

4.Albertson's $7.4

5.Winn-Dixie Stores $7.3

6.Ahold USA $6.6

7.Food Lion $5.6

8.A&P $4.8

9.Fred Meyer Inc.2 $3.4

10.Giant Food $2.4

11.Pathmark $1.8

12.Hannaford Bros. $1.7

13.Penn Traffic Co. $1.5

14.Bruno's $1.3

15.Dominick's

Finer Foods $1.2

Footnotes: 1 Includes Vons operating results. 2 Includes Smith's operating results from 9/9/97, the date of its acquisition. 3 Excludes Smith's stores. 4 Excludes impairment loss of $39.95 million. 5 Excludes former Omni stores. All reporting periods represent third and fourth fiscal quarters, except Winn-Dixie (first and second quarters), Bruno's (second and third quarters) and Dominick's (fourth and first quarters).