SOBEYS GOES NATIONAL

ELLIOT ZWIEBACH

STELLARTON, Nova Scotia -- Sobeys, a Canadian institution for almost 95 years, is just beginning to emerge from infancy as a national player.

"We look at Sobeys as a three-year-old company," Bill McEwan, president and chief executive officer, told SN. "Prior to 1998 we were a grocery chain operating only in Atlantic Canada, but once we acquired Oshawa Group, we became a national company."

The transition required some corporate adjustments, McEwan said, "but as we've integrated and optimized the acquisition, we've become very comfortable with who we are today."

Who Sobeys is today is Canada's largest retail operator, with more stores than any other company and the second-largest market share in Canada.

Its financial position was strengthened last month when Sobeys disclosed plans to sell its food-service business to Houston-based Sysco Corp. According to McEwan, proceeds from that sale will enable Sobeys to pay down debt from the Oshawa transaction, which will improve its ability to borrow money to fund expansion, including potential acquisition opportunities.

In addition, the company formed a strategic alliance with Sysco, which will enable Sobeys to explore new procurement opportunities across North America, McEwan said.

"We're the largest retailer in Canada and Sysco is the largest food-service distributor in North America, so we anticipate opportunities to work together to optimize sourcing and procurement of produce and private-label products, to increase the efficiency of each of our logistics and distribution systems, and to develop new concepts to satisfy the changing requirements of our respective customers.

"For example, the produce Sysco buys in California is the same produce we were using in our food-service operation, and by combining handling, we think we can be more efficient -- using one truck to make two drop-offs, for example, instead of two half-full trucks going to two locations. We also believe we can consolidate sources of supply and buy from a single grower with a larger volume -- something that would make the alliance worthwhile just from that aspect alone."

Sobeys also sees opportunities for sourcing private label from some of Sysco's sources, McEwan said, "and we see opportunities for using information about changing consumer preferences in food service to improve our own home-meal replacement offerings." Lowering its cost of borrowing by selling the food-service operation will enable Sobeys "to fuel an aggressive expansion program, which will put us in position to consider strategic opportunities beyond organic growth," he noted.

He said Sobeys isn't targeting any particular acquisitions at this time, "but we want to be ready to capitalize on whatever opportunities may unfold. We always have our ear to the ground everywhere, but we believe our focus should be on establishing a better market presence where we currently do business.

"So our priority will be to capitalize on opportunities in Canada. But we will pay attention to everything going on in the North American marketplace."

As Sobeys seeks to strengthen its operations, its goals include the following, McEwan told SN:

To allocate up to $330 million (U.S.) a year to retail development.

To gear its stores to meet very localized marketing needs.

To continue to develop its national procurement and merchandising strategies.

To streamline 12 corporate banners down to five or six.

Sobeys is a public company whose stock is controlled by Empire Co. here, which owns 62% of the outstanding shares. Empire was a major investor in Hannaford Bros. Markets, Scarborough, Maine, until it sold that stock and used the proceeds to finance the Oshawa acquisition.

Sobeys operates 1,331 stores in Canada's 10 provinces and one of its two territories, including 466 corporate stores and 865 franchised stores. Of the corporate stores, 281 are supermarkets (Sobeys, Garden Market IGA, IGA extra and Lofoods), 65 are drug stores (Lawtons Drugs) and 120 are convenience stores (Needs and Green Gables).

For the fiscal year ending in May, Sobeys said it expects sales to reach $7.6 billion (U.S.), a 5.6% increase over the $7.2 billion reported a year earlier. Excluding the food-service segment, which accounted for about one-third of the total, McEwan said retail sales this year will jump nearly 7% to $6.2 billion, and the company anticipates a similar increase next year.

He also said the company expects earnings per share to grow about 30% this year and same-store sales to climb 4%, "although we're ahead of that right now," McEwan pointed out, with comparable-store sales through the second quarter up 4.4%.

McEwan joined Sobeys in late 2000, after stints at Supervalu, Coca-Cola and A&P, where he was president and chief merchandising officer of the Canadian division before becoming president and CEO of A&P's Atlantic region.

Three days after his arrival at Sobeys, the company's computer program, which had been installed at 15% of the stores, crashed -- leading to a halt of the program's implementation and a financial write-down that resulted in skepticism on the part of Canadian securities analysts when McEwan forecast a strong financial year ahead.

"He went out on a limb," one analyst, who declined to be quoted by name, told SN, predicting earnings for the fiscal year ending in May 2002 would rise 16 cents per share; distribution costs would drop 10 cents per pallet load; and savings on selling, general and administrative expenses would total $10 million.

By the end of the second quarter on Nov. 3, Sobeys was running ahead of schedule on all three financial goals, analysts said, with earnings up 10 cents per share -- due in part to Sobeys' new national merchandising initiative, they noted; distribution costs down 7 cents -- due primarily to more efficient use of warehouse facilities, they said; and SG&A savings of $6.5 million.

"Sobeys is achieving its goals by focusing on taking costs out of the business," Bill Chisholm, an analyst with Dundee Securities, Toronto, said. "It's made its distribution system more efficient, pushed private label more effectively and, for the third year, invested heavily in capital expenditures, and it's starting to see the benefits at its store network."

However, Sobeys is still lagging behind on operating cash flow (EBITDA, or earnings before interest, taxes, depreciation and amortization), analysts said, with margins running at 3.5% at the end of the second quarter, up 32 basis points, compared with 5.3% for Metro and 5.9% for Loblaw Cos.

Sobeys' goal, one analyst said, is to achieve an EBITDA margin of 4.6% -- the Canadian industry average -- but that will take several years.

EBITDA margins are down as a result of the Oshawa acquisition, the analyst pointed out. "The stores Sobeys acquired were underperforming and were suffering from a lack of capital investment for years, so they were lacking both from a physical as well as a merchandising standpoint."

Sobeys is dealing with the physical store conditions through its aggressive capital investment program. It is dealing with the merchandising challenges through a new, national program featuring regional execution.

That program, called C.O.R.E. -- Consumer Opportunity Realization Engagement -- involves an effort to secure longer contracts with a smaller number of key vendors, "designed to leverage selling opportunities, not just procurement opportunities," McEwan said.

Instead of several one-year purchasing agreements with single vendors, each with their own sales targets, the C.O.R.E. program involves a single contract with each vendor and a single sales target for all of that vendor's products, McEwan said.

"With fewer long-term agreements, we can set realistic targets and then develop creative selling programs around those targets on a regional basis," he explained. "And we can spend more time focusing on the marketing and selling of products and less on negotiating agreements with vendors."

Sobeys plans to invest $300 million to $330 million this year and in each of the next two years in capital projects, with 48 new stores and 19 expansions scheduled this year, and 60 new stores planned for next year, McEwan said.

The company had already opened 23 of the 48 new stores and completed 16 of the 19 expansions through the end of the second quarter.

Sobeys is also in the process of streamlining the number of corporate and franchised banners from 12 down to five or six, McEwan said. "We clearly have an opportunity to rationalize our banners across the country," he explained.

During the second half of 2001, it converted 37 store banners -- 14 Sobeys stores in Quebec to IGA extra, a more dominant banner there; a combination of 17 franchised stores in Ontario to the IGA and Price Chopper banners; and six stores in Atlantic Canada to the Lofoods banner -- with plans to complete 18 more conversions during the balance of the year.

"Going forward we intend to convert a lot of smaller corporate and franchised stores in all regions to a single banner," McEwan said, though Sobeys isn't sure yet what name will ultimately be selected. "But it will likely come from one of the company's existing banners and will be put in place over the next two to three years," he explained.

Acquisitions are a possibility, McEwan noted, though he said Sobeys prefers to focus on organic growth "because we see great opportunities to increase sales per square foot through an aggressive capital plan. But to the extent that acquisition opportunities unfold, we're interested in doing what makes strategic sense, and we intend to be in a position to capitalize on those opportunities when they arise."

Industry observers in Canada said the primary potential acquisition candidates there could include A&P Canada, Safeway Canada and Overwaitea. Of the three, only Overwaitea -- which operates in western Canada -- is for sale, "but the asking price is too high right now," one analyst said.

Chisholm said Sobeys would probably be interested in acquiring A&P's Canada stores to improve its position in Ontario, where all the A&P stores are located. However, another analyst said she doubted A&P, Montvale, N.J., wants to sell its Canadian holdings "because it's one of A&P's few jewels."

A history of labor problems at Safeway Canada could prompt the Pleasanton, Calif.-based company to consider a sale someday, the analyst added. Chisholm said he agreed, noting Safeway has not put much investment into its Canadian operation "so it's conceivable it could become an acquisition candidate."

McEwan declined to discuss potential acquisitions. Asked if Sobeys might become an acquisition candidate itself, McEwan said he doubted it, pointing out that Empire "has indicated a strong commitment to continue to develop Sobeys and its core business."

While Sobeys operates the most stores in Canada, it is a distant second in market share to Loblaw, which has a national share of 30.1%, with Sobeys at 12.4%, Safeway at 7.4% and Metro at 6.5%.

Sobeys is not intimidated by Loblaw's strength, McEwan told SN. "We certainly intend to be competitively aware of what's going on, but we're not going to react to what the competition is doing. We'll go forward with our own strategies," he said.

"We'll build our business by focusing on one market, one store and one category at a time to serve one set of consumers and move ahead from there."

In contrast to competitors that operate larger stores with more general merchandise, Sobeys offers a more conventional assortment in its stores, McEwan noted.

While corporate stores run in the range of 40,000 to 55,000 square feet, Sobeys stores as a group average only 12,000 square feet, Chisholm pointed out, "so they've got to keep investing and making the stores larger," he said.

To determine what customers want, Sobeys conducted a market overview a year ago that identified 1,784 distinct food marketing areas in Canada. Of that total, the study indicated Sobeys was in 902, and it was No. 1 in 610, McEwan said.

"We went to each community, looked at our competitive position there, the maturity of the market and opportunities for greenfield development. We had no specific strategic plan at that point except to get the best return on our investment over a period of time by being very precise in how we allocate capital.

"There are always markets where you look at upgrading opportunities vs. the condition of your business to determine whether it's worth the cost of investment. So we looked at what we were doing coast to coast, and one of our conclusions was that we should be focusing on our core retail opportunities and divest the food-service business."

As it focuses on retail, Sobeys' overriding goal is to operate stores that consistently provide the most worthwhile shopping experience, McEwan said.

"Over the last year to 14 months, we've developed that new priority -- to be the most worthwhile shopping experience for everyone who touches our business, including customers, employees, franchisees and suppliers, which will make us the most worthwhile experience for shareholders as well ... Everyone talks about the business but they don't talk from the perspective of those who make the shopping decisions," McEwan said.