STRONG AND GETTING STRONGER

ELLIOT ZWIEBACH

Supermarkets delivered soft sales and strong earnings during the first half of 1999, with the prospect for similar sales but higher earnings during the second half and into the new millennium as the benefits of consolidation begin to kick in, securities analysts told SN.

A survey of financial results for the Top 10 supermarket companies with public equity or public debt for the period approximating the first six months of the year yielded the following results, including adjustments in post-merger results: sales for the half rose 7%, operating income increased 10.6% and comparable-store sales hit a median of 1.4%.

Debra Levin, an analyst with Morgan Stanley Dean Witter, New York, said sales softened during the half, particularly during the second quarter, "as inflation came down and some deflation appeared, along with a pickup in competitive pressures."

She said earnings generally showed good growth, although the positive effects of consolidation were not apparent during the period because of delays early in the year in government approval of the Kroger-Fred Meyer and Albertson's-American Stores Co. mergers.

"But even at the beginning stages of those consolidations, we can see some benefits from synergies," Levin said, "and, going forward, companies should be able to achieve significant synergies that are ahead of expectations -- although not until next year, and more likely not until the second half of next year."

Ed Comeau, an analyst with Donaldson Lufkin & Jenrette, New York, said first-half results were strong, "though there's a continuing concern that sales are tough to come by. But on balance, there were no dramatic changes in sales, with most companies maintaining stable, positive comps."

There were also no earnings disappointments during the half, Comeau said, except perhaps for the subdued performance of Food Lion and Hannaford Bros., which announced plans in August to merge.

"From an earnings standpoint, it was pretty much steady as she goes," he said. With the two big mergers both closing during the half, "neither Kroger nor Albertson's had the opportunity to realize significant synergies," Comeau said. But looking forward to next year and beyond, "those companies should show very strong results as integration moves forward," he noted.

Gary Giblen, New York-based managing director of Banc of America Montgomery Securities, San Francisco, said most companies were able to expand gross margins and operating margins during the half, while sales were "pretty respectable" for most chains, with Albertson's, Safeway, Food Lion and the Fred Meyer division of Kroger Co. enjoying the results of accelerating their internal store-development programs.

According to Meredith Adler, a securities analyst with Lehman Bros., New York, companies whose sales were sluggish coming into the year -- including Kroger, Albertson's and Safeway -- remained sluggish through the first half, with little change anticipated through the second half, although a new initiative by Safeway scheduled for the fourth quarter could improve the sales picture there.

Part of the sales problem, Adler said, is due to "portfolio inflation," in which chains with operations in several markets see good results in some offset by poor results in others, ending up with an average sales performance overall.

First-half earnings, on the other hand, were good, Adler said, with most chains seeing strong growth in high-margin categories like nonfood and perishables and lesser growth in lower-margin grocery categories.

Looking ahead to the second half, Ted Bernstein, a high-yield securities analyst with Grantchester Securities, New York, said the Y2K issue and expectations for a millennial New Year's celebration make the second half intriguing.

"I think it will be interesting to see how the Y2K issue plays out in December, when we might see a pickup in buying comparable to a big snowstorm all over the country, with people stocking up because they're afraid they won't be able to shop for food in early January. When you combine that with the added New Year's excitement over the new millennium, both factors could drive comps up for the fourth quarter and down in the first quarter of 2000."

Levin told SN she anticipates a subdued increase in same-store sales, "but we will see more benefits coming from the industry consolidations, which should provide a big boost to earnings."

According to Comeau, the second half looks like more of the same as the first half, "though on balance, it may be a little better, with sales trends likely to perk up with Y2K stockpiling and millennium partying," he said.

Giblen said he does not anticipate any radical changes during the second half, although he expects results to improve as Safeway reaps the benefits of ongoing acquisition integration and as Kroger and Albertson's "get more juice out of their acquisitions -- though that's likely to be a bigger story next year than in the second half," he noted.

Adler said she doesn't expect much change in sales performance during the second half, although earnings will probably begin to benefit from integration -- a process that could slow earnings growth for the half as preparations for systems changes get complicated by Y2K issues but that should show better results beginning early next year.

Looking at each of the Top 10 chains individually, analysts made these comments:

KROGER CO., Cincinnati, with sales up 16.7%, comparable-store sales up 3.2% and 3.6% in the first and second quarters, respectively, and operating income up 24.3%.

Giblen said a faster pace of growth at the acquired Fred Meyer stores enabled Kroger to improve its first-half numbers, particularly with the better grosses from nonfood categories at Fred Meyer department stores. As for sales, "Fred Meyer has historically run the best comps in the industry, and that continued, particularly at Ralphs, where capital invested a couple of years ago, along with better execution under Fred Meyer's direction, helped the results there," Giblen said.

Comeau also said sales at Fred Meyer's Ralphs division had "a nice snapback" because of easier comps.

According to Levin, Kroger's results for the half continued to benefit from substantial investments over the last several years in new stores, distribution centers and technology.

ALBERTSON'S, Boise, Idaho, with sales up 5.3%, comps up 0.8% and 1.5% in the first and second quarters, respectively, and operating income up 8.5%.

One analyst, who asked not to be quoted by name, said Albertson's sales have been disappointing because of a lack of merchandising flair.

"Albertson's strength has never been merchandising -- it's been execution, which has historically made it one of the industry's most profitable companies," the observer told SN.

"But as the industry has become more competitive, Albertson's lack of merchandising flair has hurt the company. And although it has experimented with different strategies, those have not yet been spread sufficiently throughout its store base to have much impact."

Adler offered a similar assessment. "Albertson's has always produced very high returns, but it's also traditionally short-changed customers because it hasn't spent more on labor to merchandise the stores.

"However, it's finally becoming more sophisticated in terms of marketing and begun doing the right things, but it may be too late to become the dominant force in many of the markets in which it operates, and it may have to decide to divest stores in some markets where it has no chance to be the No. 1, 2 or 3 market-share performer."

The tradeoff is, whatever money Albertson's opts to spend to improve its sales position is likely to hurt earnings, Adler pointed out.

According to Giblen, Albertson's comparable-store sales were only modest, with most of the increases coming from growth at former American Stores operations, particularly the drug stores.

Levin also said the freestanding pharmacies Albertson's acquired from American Stores strengthened its results, while a slowdown in store-remodeling projects last year may have contributed to the overall sales slowdown.

"In addition, Albertson's remains an everyday-low-price company while most other major operators are typically more promotions-oriented, and those players seem to be more successful in boosting sales," Levin said.

Comeau said what he termed the company's disappointing same-store sales results were probably one factor that led to Dick King's resignation as president earlier this year. "So the company is still wrestling with some sales issues, and due to the large number of cookie-cutter stores it has, it will take time to build the stores into something with a little more pizzazz," Comeau said.

SAFEWAY, Pleasanton, Calif., with sales up 13.5%, comp sales up 2.8% and 1.5%, respectively, and operating income up 25.7%.

According to Levin, Safeway's sales softened a little during the second quarter because of tough comparisons with prior periods -- a situation prompting the company to implement a series of new selling strategies in the fourth quarter.

"The company hasn't defined those strategies publicly, but they will apparently involve promotions, merchandising adjacencies, product mix and pricing as Safeway rethinks how to operate its business to drive sales," Levin explained.

She said Safeway's acquisitions of Dominick's, Northlake, Ill., and Carr Gottstein Foods, Anchorage, Alaska, are moving along well "and helping Safeway reduce costs, and the Randall's acquisition [concluded at the end of the second quarter] should be a terrific addition going forward."

Comeau said Safeway's "lackluster performance" in the first half was in part the result of strong results a year ago, when second-quarter comps of 7.4% reflected a weak 1997 -- a period during which Safeway experienced an extended strike in Canada -- making comparisons difficult this year.

But sales also slowed because of tougher competition in some markets, particularly Arizona, he added.

He said Safeway's earnings for the half were in line with expectations, with a little dilution from the Dominick's acquisition.

After six or seven years of high-powered activity, Safeway's momentum has slowed a bit, Comeau added, "although it's still performing at a high level of profit margins and is integrating its acquisitions quickly."

To revive its sales momentum, Comeau said, Safeway plans to introduce strategic initiatives at all stores that have reportedly been tested at 20 to 25 locations.

"As the bar has been raised, the focus of [chairman and chief executive officer] Steve Burd and his team is on building sales momentum, putting the new strategies and their implementation front and center," Comeau said. "Over the past six to 12 months, Safeway's focus has been on making its next acquisition, but that focus will shift for a while to developing better sales momentum."

Giblen said Safeway's decision to become more aggressive represents a more offense-oriented approach. "During each year of Steve Burd's regime, Safeway has had easy improvements because it started from so far back," he said.

Adler said Safeway's sales have run ahead of the industry's trend for years, "but after lowering prices and improving service, that growth has slowed down, and it's now looking for new ways to drive sales -- with the expectation that the new strategies it will introduce will be unique programs that will give it a competitive advantage."

AHOLD USA, Atlanta, with sales up 35.8%, same-store sales up 3.5% and 2.9%, respectively, and operating income up 46%.

Ahold's strong first half reflected the benefits of best practices, Levin told SN. "Management has gotten very in-depth on sharing operating practices among divisions, including merchandising and pricing strategies, and that has proven very successful," she said.

The acquisition of Giant Food, Landover, Md., has gone "extremely well," Levin noted, "with management ahead of expectations at drawing operating profits from that division."

Adler said Ahold's U.S. operation is experiencing "a lot of success," with the integration of Giant Food moving very well, along with the sales performance at Stop & Shop, Quincy, Mass., as a result of "great execution."

Ahold has also been making particular progress at its Tops Friendly Markets division in upstate New York and Cleveland, "after years of whittling away at longterm problems and finally seeing an improvement in profitability, although not as much in sales," Adler said.

WINN-DIXIE STORES, Jacksonville, Fla., with sales up 4.2%, same-store sales down 1.7% and 3.9%, respectively, and operating income up 28.4%.

According to Adler, Winn-Dixie has been struggling "for a number of years to really change the nature of its business -- from operating small stores geared to price to middle-sized, middle-class stores full of service departments -- but the corporate culture has not made the adjustment. It doesn't understand the new format, nor does the customer.

"So Winn-Dixie continues to be a work-in-progress that changed the stores before it changed the culture, and it's now scrambling to change that culture to manage the fixed costs of operating bigger stores."

With James Kufeldt retiring as president in late August and the company searching for a successor from outside the company, Winn-Dixie has a chance to take a new approach, Adler said. "The new executive will probably help to change the culture, but how much he can do depends on the Davis family, which owns 70% of the stock," she explained.

Giblen expressed similar thoughts. "Winn-Dixie continues to cast around for a strategy that will work, now that Food Lion has beat the pants off its claim to low-price leadership," he said. "And while the new president may have all the right answers to Winn-Dixie's problems, he's going to have to fight a strong corporate culture, along with facing extensive competition."

According to another observer, who asked not to be quoted by name, "Winn-Dixie has had leadership issues for years that extend beyond the top level of management. There's been a lack of focus there, and the company has finally decided to seek outside blood to try to turn things around.

"Over the last eight years or so the company has spent a lot of money on new stores, but it's never gotten a solid return, nor has it executed well. There are problems with employee training and store locations, and the stores have not gotten the kind of foot traffic they need to sustain solid returns."

What's hurting Winn-Dixie sales, Comeau told SN, is that "it's fighting a lot of competitors in its core markets, particularly Wal-Mart supercenters. But whereas Kroger's overlap with supercenters in the Southeast affects only 10% to 15% of Kroger's store base, it's affecting 100% of Winn-Dixie's stores."

A&P, Montvale, N.J., with sales off 0.2%, comps up 5.3% and 4.3%, respectively, and operating income up 41.5%.

Analysts all attributed A&P's strong same-store sales performance to Project Great Renewal, the initiative A&P unveiled at the end of 1998 that has seen the company close or sell 155 of 170 target stores.

"That's resulted in a drop in overall sales," Levin said, "but comps are up because the company has eliminated the weakest performers -- plus, new stores opened over the past four years are maturing nicely and are starting to have an impact."

Comeau said A&P has removed the bad apples from its store base and moved forward with aggressive new programs. "The efforts of Christian Haub [A&P's chairman] are admirable and are definitely moves in the right direction, and the company is making strides in rebuilding itself from the bottom up."

Adler said she agreed that, although total sales dropped during the half, the quality of the remaining sales is a lot higher. "And in contrast to Winn-Dixie, A&P is making a major cultural change and shaking things up in terms of store performance, and it will soon attack the supply-chain system and bring some of those practices to store level," she said.

According to Giblen, A&P is "at the top of the first inning in what's likely to be an overtime game, although it's definitely improving its batting average. But it's going to take a while to get all the improvements done."

FOOD LION, Salisbury, N.C., with sales up 5.5%, comps up 2% and 2.4%, respectively, and operating income up 7.6% in the half.

Giblen said Food Lion's excellent results in the half were somewhat overshadowed by its pending merger with Hannaford. "But its core operations produced strong comps, along with good margin expansion and improved results coming out of its Kash n' Karry operation," he told SN.

According to Comeau, the chain's solid performance is due in part to an easing of competitive conditions in Virginia and North Carolina in the last two years -- with the influx of competition from Hannaford, Harris Teeter and Winn-Dixie and the upgrading of Farm Fresh slowing down.

He also said Food Lion has benefited from expanded strategies for its frequent-shopper card.

PATHMARK STORES, Carteret, N.J., with sales down 1.2%, comps down 0.8% and 0.3%, respectively, and operating cash flow (earnings before interest, taxes, depreciation and amortization) off 4.3%.

Bernstein said overall sales dropped slightly because Pathmark is operating a handful fewer stores, "but essentially the chain's results are flat, which indicates the company is doing a great job holding its own in a very tough environment."

Comeau said Pathmark management has done a good job, "despite being in a tough market competing with ShopRite."

Pathmark is expected to be acquired by Ahold USA by year's end.

HANNAFORD BROS., Scarborough, Maine, with sales up 4.6%, comps up 2.7% and 1.1%, respectively, and operating income up 8.1%.

Hannaford has had a hard time maintaining earnings growth, Giblen said, for two reasons: its Internet-based Home Runs program, which is costing the company 16 cents a year in earnings per share, and what he termed "the quagmire" in the Southeast, "and the horizon for profitability is unclear, even after the merger with Food Lion." The chain also faces soft sales in upstate New York, where it has failed to catch on with consumers, Giblen said.

According to Adler, Hannaford's core business in the Northeast continues to do well, "but its Southeast stores are not yet profitable, and the company is continuing to spend a lot of money on its Home Runs delivery program."

With Hannaford planning to merge with Food Lion, "it will be interesting to see how different the company will be in the next year as Hannaford seeks a partner for its Home Runs business and as its Southeastern stores are combined in some way with Food Lion's business," Adler said.

PENN TRAFFIC CO., Syracuse, N.Y., with sales down 13.8%, comps down 4.5% in the first quarter and up 1.1% in the second, and EBITDA down 30.6%.

According to Bernstein, comparisons with the prior year are not relevant because the chain was operating until June under bankruptcy protection, during which it closed or sold 56 stores.

Looking ahead, he said, he expects Penn Traffic to do marginally better during the second half, "but it has a tough row to hoe because it's facing tough competition from established operators in all its markets."