DEFLATED HOPES

ELLIOT ZWIEBACH

The "D" word had a major effect on supermarket results during the first half of the year, as deflation put pressure on same-store sales gains through most of the first six months of 1997. "It was like removing a tailwind," Jonathan Ziegler, a securities analyst with the San Francisco office of Salomon Bros., New York, told SN. "With tonnage and pricing unchanged, most companies were relying on inflation to boost sales. But with that element removed, growth had to come through greater tonnage, and that didn't happen."

One of the main causes of deflation was the price of commodity-based foods, Ed Comeau, vice president, Donaldson Lufkin & Jenrette, New York, pointed out. "During 1996, there were sharp increases in the price of food commodities that account for 15% to 20% of supermarket sales, led by the depletion in grain inventories and increases in dairy, bakery and poultry prices," he explained.

"But during the first half of 1997, we saw sizable price declines in those categories -- at a time when pricing in packaged goods, nonfood and health and beauty care were relatively stable -- so it was a difficult period for supermarkets."

A survey of financial results among the Top 20 public chains for the two most recent quarters -- generally paralleling the first half of the calendar year -- showed the following:

Average sales rose 8.7%, compared with an increase of 3.6% in last year's first half -- although this year's first-half percentage got a significant boost from a number of major industry consolidations, which raised some chains' sales growth disproportionately.

Reflecting the impact of deflation, same-store sales rose an average of 1.3% for the most recent quarter, compared with an average gain of 2.1% in the same period a year ago.

Operating income jumped 24.3% in the six-month period, compared with a gain of 21.2% a year ago.

Gary Giblen, managing director at Smith Barney, New York, said the first-half results were relatively positive. "With the lack of inflation and some deflation, the first half was just a little bit of a breather for the industry -- a respite from an unbelievably good halcyon year of 1996," he said.

Giblen said he believes deflation will dissipate and inflation will return by the end of the fourth quarter, "given the normal cycles of supply and demand."

Ziegler told SN he is also optimistic that deflation will end soon. "It has certainly stopped escalating -- if it was 1% during the first half, maybe it's at 0.5% now -- and it's likely to become less of a factor through the balance of the year, unless some unanticipated event like El Nino comes along to destroy some crops," he said.

Debra Levin, principal, Morgan Stanley Dean Witter, New York, said first-half pressures came from an increase in total square footage "plus an environment of next-to-no inflation and some deflation. I think comparisons will be easier during the second half as deflation becomes less of a factor, and while we may see the return of some inflation, it will still be a tough competitive environment going forward."

According to Chuck Cerankosky, senior vice president of research for Tucker Anthony, Cleveland, "Overall, it was a good first half -- despite a growing concern as the industry approached midyear that slow food inflation could prove challenging for the balance of the year.

"There's also some concern that the strength of the economy is encouraging more people to eat out, so food away from home was a bigger competitive factor this year than last."

Cerankosky said the second half could be more challenging than the first if food inflation does not return. "If some chains decide to increase sales by lowering prices in an environment where deflation is declining, then the stability in shelf prices the industry has been enjoying will disappear, which would create margin pressures that could impact profits -- though the industry has been so rational for so many years that it's unlikely that will happen."

Looking at results for the first half, it was very apparent that consolidation among several major chains boosted their sales levels disproportionately, observers said.

The leaders in sales increases during the half included Quality Food Centers, Bellevue, Wash., up 167.8% following its acquisitions of Hughes Family Markets, Irwindale, Calif., and Keith Uddenberg Inc., Gig Harbor, Wash.; Ahold U.S.A., Atlanta, up 54.7% following its 1996 acquisition of Stop & Shop Cos., Quincy, Mass.; and Safeway, Pleasanton, Calif., up 34.5% following its April acquisition of Vons Cos., Arcadia, Calif.

Also showing strong sales increases were Smith's Food & Drug Centers, Salt Lake City, up 15.9% following its 1996 acquisition of Smitty's, Phoenix; and Food Lion, Salisbury, N.C., up 11.9% following its late-1996 acquisition of Kash n' Karry Food Stores, Tampa, Fla. Fred Meyer Inc., Portland, Ore., also exhibited strong gains during the first half, with sales up 13.6% -- which securities analysts attributed to its acquisition of 71 jewelry stores in 1996, plus its ability to reverse a period of declines in general merchandise sales that affected the entire nonfood industry. Early in September, Fred Meyer completed its merger with Smith's.

The worst sales during the half were experienced by Bruno's, Birmingham, Ala., down 8.4%; Penn Traffic Co., Syracuse, N.Y., down 8.2%; and Grand Union Co., Wayne, N.J., down 1.9% -- all high-yield chains.

According to Comeau, "Some of the high-yield companies had the toughest times showing good results on the top and bottom lines, which reflects the low inflation and slow-growth environment. The overall environment has gotten increasingly worse with deflation, and when you add that to specific competitive or management problems that each chain is encountering, there's very little room for error. "The gap between the haves and have-nots has widened dramatically, and that's clear when you realize that drops in same-store sales comparisons of 7%, 8% or 9% are hard to achieve. But it demonstrates how severe the fallout can be if you're not right on top of everything."

Observers said the sales drop at Bruno's resulted from the shutdown of 47 smaller-format stores, mostly in Georgia and South Carolina; nearly 50 competitive openings; operating problems at the distribution level, which created out-of-stock conditions at the stores; and an inability by chain management to settle on a satisfactory pricing strategy, which created consumer confusion. Bruno's named James A. Demme as its new chief executive officer in late September.

At Penn Traffic, sales were impacted by competitive pressures in all operating areas, "plus the perception that the stores have high prices and the company's inability to be effective in its promotional strategies," one high-yield analyst told SN -- a situation Penn Traffic is attempting to correct with a major promotional campaign featuring lower prices launched late last month.

Grand Union's declines are a result of "operating undersized stores in an environment of strong competitive promotional activity, particularly early in the year," the analyst said. He also cited "the distraction" of management changes, which saw several executives at the top level leave.

Looking at same-store sales for the most recent quarter, the worst performers were Penn Traffic, down 8.7%; Bruno's, down 7.7%, and A&P, Montvale, N.J., down 2.3%. "Same-store sales at Penn Traffic have been bleeding for two years because of competitive pressures, with the numbers falling significantly on a monthly basis," the high-yield analyst said.

As with the sharp drops in Bruno's total sales, its same-store sales declines are the result of heavy competition, out-of-stock conditions and uncertain pricing, observers said.

For A&P, the problem is primarily in the New York metropolitan market, "where the chain has been hurt by a flare up in competitive activity, particularly from Pathmark [Stores, Woodbridge, N.J.,] and Grand Union," Levin said. "And with so many of its stores in urban markets, A&P had a tough time during the summer maintaining its sales when people went away on vacation."

The industry leaders in same-store sales for the most recent quarter were Fred Meyer, up 6.1%; Kroger Co., Cincinnati, up 3.2%; and Giant Food, Landover, Md., up 2.4%.

"At Fred Meyer, the key was just good blocking and tackling," Ziegler told SN. "The company was also able to pick up business as the stronger economy helped boost general merchandise sales."

For Kroger, the key to strong same-store sales has been the aggressive expansion program that was launched last year, "which began paying dividends this year," Cerankosky said.

Giant Food's same-store sales boost came from an aggressive promotional program in the second quarter "that was designed to kick-start the business after a period impacted by a major Teamster strike that ended in the first quarter," Comeau said.

That effort succeeded in driving comparable-store sales up, he noted, "but at quite an expense as Giant turned the promotional dial a little too far -- far enough to spur sales, but not enough to spur profitability." As a result, operating income at Giant fell 50.2% during the half.

At Grand Union and Bruno's, profits (characterized as earnings before interest, taxes, depreciation and amortization) fell 52.4% and 43.5%, respectively.

On the plus side, the biggest gains in operating income were experienced by Ahold, up 138.5% because of the strong earnings power of its existing U.S. holdings and the addition of Stop & Shop; QFC, up 107.8% because of its core profitability and the strength of its acquired holdings; and Safeway, up 48.7% because of the addition of Vons and the strength of its core business, analysts said.

"Without the addition of Vons, Safeway's operating profit growth would have been up 15% to 20%, even with the negative impact of the strike in Alberta, Canada," Comeau noted.