RISING COSTS, FAILED PROMOTIONS DIM PATHMARK OUTLOOK

JON SPRINGER

CARTERET, N.J. -- Pathmark Stores here last week termed its first-quarter sales a "major disappointment," and reduced its earnings and sales estimates for the year.

The chain cited steep inflation among key categories, and a resulting failed promotion strategy, as well as higher-than-expected health care costs, for the quarter ended May 1 that saw total sales down by 1.5%, same-stores fall by 1.4%, and market share lost to competitors. The company expects to post a net loss per share of between 6 cents and 10 cents when it fully reports its first-quarter results on June 3.

"Clearly, I'm not happy with this performance," Eileen Scott, chief executive officer, said in a conference call, during which Pathmark reduced its sales and earnings estimates for the year from those it had made in early April. The company now expects same-store sales for the year to be flat to 1%, vs. 0.5% to 1.5% as stated in previous forecasts. Earnings per share are now expected to be 28 cents to 47 cents, vs. previous projections of 53 to 60 cents; earnings before interest, taxes, depreciation and amortization are now expected to range from $170 million to $180 million, vs. previous expectations of $183 million to $187 million.

The announcement came as a shock to some observers, including analysts who recently were praising Pathmark's performance under Scott, who became CEO 18 months ago. "It was a miserable surprise," said analyst Jonathan Ziegler, who in April rated Pathmark a "buy" rating in a report for J.M. Dutton & Associates, El Dorado Hills, Calif.

Pathmark stock, trading at $8.54 on the Nasdaq market when markets closed Wednesday, had tumbled more than 20% by early Thursday. "I think this is an early warning signal that there's near-term turbulence ahead for supermarkets," Ziegler told SN.

Soaring prices for items such as meats, butter and cheese hurt sales due to sticker-shock, and cut into profits when Pathmark couldn't pass along the entire cost increase, Scott said. A resulting attempt to recoup margins by promoting secondary items cost the chain market share.

"We reallocated promotional funds away from some key destination categories like carbonated beverages to secondary categories like New Age beverages," Scott explained. "When promoting other destination categories, we shifted ad dollars to secondary items within the category: Purex detergent instead of Tide.

"The belief was these switches would increase the movement of secondary items while enabling us to achieve our gross margin target. But the promotions were not effective. They did not give us a good sales return," she added. "We also did not react to certain promotions from some of our supermarket competitors, which also affected sales and market share."

Shrink remained at "unacceptable levels," and medical costs during the month of April were also higher than Pathmark had anticipated, Scott lamented.

Pathmark will try and regain its footing by aggressively promoting destination categories, though Scott said she expects margin pressure will continue, and additional investment will be needed to regain traffic and top-line sales.

"The problems with our promotional plans during the first quarter will not be repeated," she said. "We learned some valuable lessons during the quarter, and we're aggressively addressing all of the factors behind our poor performance."

With commodity items like beef, chicken and butter experiencing double-digit price increases over the prior quarter, Pathmark struggled to put together promotions that didn't sticker-shock their shoppers, Scott said. "We had trouble hitting price points that would excite the customers," she said. "So in some cases, we shied away from inflated commodity items because of fear of what price points the competition would come out with. In those cases, we mis-stepped."

Pathmark's struggles illustrate the dangers inflation may cause in today's competitive marketplace, according to Gary Giblen, director of research at CL King & Associates, New York.

"It looks like their competition was better able to hold the line on prices, and they gained market share," Giblen told SN. "It shows that the lesser of two evils can be to go for sales and take a hit on margins. Inflation can be hazardous to your health."

Scott acknowledged that while moderate inflation could help the supermarket industry, the "dramatic level" of price increases during its first quarter proved challenging. Commodity items have been rising due to heavy demand for grains, environmental factors, and rising fuel costs, observers said.

"The large spikes we had in the first quarter in categories like pork, eggs and milk were tough ones to pass along to the consumer, and a lot of that is driven by competitive reasons," Scott said.

Ziegler likened supermarkets struggling with rising commodity costs to service stations, which tend to see margins squeezed when gas prices initially rise. "Inflation is tough on the way up," Ziegler said. "I think eventually supermarkets will get these increases through, but there's going to be turbulence in the near term."