'RETURN TO RELEVANCE'

ELLIOT ZWIEBACH

NEW YORK - Excess capacity - too many stores to serve too few consumers - remains one of the industry's biggest challenges, but some easing may be on the horizon, according to participants in SN's 11th annual Financial Analysts' Roundtable here.

The sale of stores by Albertsons LLC will certainly help reduce capacity, John Heinbockel, vice president of Goldman Sachs here, said. "It would seem unlikely that Cerberus and Bob Miller [chief executive officer of Albertsons LLC] are in there for the long haul, considering the low-volume, low-margin nature of these stores. It will be very difficult to turn them around. A large number of stores will go dark or be sold to nonfood operators, reducing capacity. Still others may go to less-direct competitors, such as Whole Foods or Wild Oats. Finally, traditional operators will be able to complete some in-market acquisitions - exactly the type of value-enhancing transaction the industry needs more of."

With capacity already coming out of the system, "the whole Albertsons dynamic will be good for Safeway and Kroger over the next 18 months," Heinbockel added.

Mark Wiltamuth, executive director of Morgan Stanley here, reflected some of the same thinking. "The Cerberus aspect of this deal is the thing that's most interesting because how often do you have someone willing to take the bad parts off your hands and in the process close down some industry capacity and help out with the remaining players?" he said.

Meredith Adler, managing director of Lehman Bros. here, acknowledged that some reduction in capacity has occurred, particularly in the Southeast, where Winn-Dixie has been closing stores, "but we haven't seen quite enough nationally," she said. "To get to a really healthy environment, you have to see the weaker players in every geography give up, and while we're seeing some of that, it would be nice to see more."

Andrew Wolf, managing director of BB&T Capital Markets, Richmond, Va., echoed her remarks. "If there was going to be similar capacity reduction throughout the country, you could get pretty bullish on the industry, though that's a big 'if,'" he said.

According to Carla Casella, vice president, high-yield research, for JP Morgan here, "We want to see more asset sales, upgrades or market exits by companies where they can't be dominant, and more deployment of capital where they can be dominant. It's important just to see more capacity coming out because as you exit a market, some of the stores go dark and some could go to other players."

Analysts were generally upbeat in their expectations about the economy and its positive impact on the supermarket industry.

Wiltamuth said he's more bullish on the industry than he has been in years. "I think we're coming out of an era where all the companies have been cutting prices and into a period where there's a healthier approach to return on invested capital, where the companies are deploying more money for remodels and less for expansion of capacity. Comps are in the positive range among the industry majors, and they are getting margin flow-through, which we haven't seen in years."

"Supermarkets, particularly the larger ones, enjoyed the beginning of a return to relevance this year as pricing became more competitive in many markets and as customer service and perishables merchandising also improved," Heinbockel said. "The proof is in the comps, [with] some of the larger companies producing their strongest sales gains in five years."

Wolf was also upbeat in his assessment, pointing to gross margin expansion as "another aspect of a very favorable backdrop" and adding he expects that same trend to continue for another quarter or two. "But beyond that, it's just a question of how hard the economic landing is going to be because in the last few recessions same-store sales came to a grinding halt."

Supermarkets have been winning back some of the customers they lost to Bentonville, Ark.-based Wal-Mart Stores in the last recession, Wolf pointed out, "as some of the pricing has gotten relatively better and as some companies like Safeway have begun to differentiate themselves more."

Casella said high-yield operators are just beginning to realize the value of lower debt levels. "Safeway is investing in renovations and its new lifestyle store formats, [but] the high-yield players don't have the capital to do that. Yucaipa had to come in and help Pathmark, and A&P had to sell Canada, so some companies are starting to understand it, but we still see a lot of debt on the supermarket scene, and they'd be much more nimble if they could get that down."

Other topics during the two-hour roundtable discussion:

The analysts said it's probably too soon to pinpoint how successful Supervalu will be in operating its newly acquired Albertsons assets. "It's definitely going to be a wait-and-see situation for at least a year," Casella said, because of the challenges of integrating two companies and the fact that a smaller player bought a larger one.

Adler said she's also not looking for a quick resolution. "You're not going to get a speedy integration out of Supervalu - that's not who they are," she pointed out. "They're very methodical, and sometimes even slow." But she expressed optimism about the project's ultimate success because in many of the Albertsons markets Supervalu is moving into, "it has very established brands already," Adler said.

According to Wolf, Supervalu's biggest challenge is to fix the core operations of the old Albertsons. "In terms of pricing, merchandising and the asset quality of Albertsons, it all lags the competitors, and that's the risk," he said. "[But] I think those things can be fixed because [Supervalu] bought good assets."

Looking at the possibilities for consolidation in the Northeast, Adler said a combination of Pathmark and A&P "makes sense, and both companies could benefit," while Heinbockel said a combination of Pathmark and Ahold-owned Stop & Shop "would be the most ideal" because of the similar customer demographics, brand positioning and subpar levels of profitability.

The analysts said they doubt there's much interest among private equity firms in investing in supermarkets. "Leveraged buyout firms are looking for companies where they can come in and fix something," Wiltamuth said, "and I don't think they have the leadership and management teams to make things better."

Heinbockel said it's more likely LBO companies could buy divisions of larger companies, "[though] many are operating at peak market shares or [operating] margins and can't be improved," he noted. Adler said she believes private investors would be better off putting their money into dollar stores.

Adler and Casella expressed some skepticism about the payoff for the investments Safeway is making in its lifestyle format, though Heinbockel said he believes the investments "are creating value and should be made [because] the alternative - doing nothing - is not a good one."

Wolf said he prefers Kroger's strategy over Safeway's "because it's better priced, and it's going to continue to be priced better. And I think that's the right attitude: Even as you're bringing your merchandising upscale, keep bringing your pricing down and deliver more value to customers."

Heinbockel said any sales increases at Kroger should drop to the bottom line rather than be reinvested. "With such a rational approach, comps will be solid, share should be gained, profit growth would be healthy and the stock could at least hold its current valuation."

Part One of SN's roundtable coverage follows:

Industry Outlook

SN: How is the economy doing, and how is that impacting the supermarket business?

JOHN HEINBOCKEL: The macro-economic outlook is challenging, and food-at-home consumption is more cyclical than people think. Historically, food consumption has correlated surprisingly well with overall consumer spending. When consumer spending weakens, food consumption also comes under pressure, simply because food is such a big part of most household budgets that when belt-tightening is needed, it is one of the best targets for savings. If consumer spending is going to slow, as we think it will, food consumption will be challenged. However, any drop-off should be buffered by temporary share gains from restaurants, which will continue as long as gas prices remain high.

That said, the micro-economic outlook is better than it's been in many years. Although I don't want to get overly giddy, supermarkets, particularly the larger ones, enjoyed the beginning of a return to relevance this year as pricing became more competitive in many markets and as customer service and perishables merchandising also improved. The proof is in the comps. Some of the larger companies are producing their strongest sales gains in five years. Another positive - we are starting to see capacity leave the system. The whole Albertsons' dynamic will be good for Kroger and Safeway over the next 18 months.

So macro is getting tougher, but the micro is improving. Therefore, my outlook is one of guarded optimism. Supermarket stocks, as so-called defensive names, will essentially perform the opposite of the broad retail sector. To the degree the consumer softens and retail continues to under-perform, these stocks will move higher. However, at some point, investors will be convinced the consumer is bottoming and will begin to use the food retailers as a source of funds in favor of more cyclical names, though this would still appear to be a few months away.

MEREDITH ADLER: There seems to have been a shift in some of the views about Wal-Mart and the pressures Wal-Mart puts on the market. We did our own study comparing Wal-Mart prices over a two-year time frame, and we found Wal-Mart has actually been raising prices in food and narrowing the gap a bit with its conventional competitors. And while I think it's important to keep in mind that pricing is a piece of it, so is capacity, and I don't think Wal-Mart has slowed its expansion into new markets, so it's still very keen on becoming a national chain and having a presence everywhere, and sometimes there's a need to remind people that Wal-Mart is still out there and still putting pressure on the market in some regions.

On the other hand, Wal-Mart is fairly up-front about the fact it's adding less incremental capacity in a market where it is already in a strong position, and that helps anybody, like Kroger, who has faced Wal-Mart for a while, so you're seeing some of that. And while there has been some reduction in capacity, which is good, it's not enough, and I keep waiting for more in some geographies. For instance, when Winn-Dixie closed a lot of stores in the Southeast, it really did help, and other operators have really benefited from that, but we haven't seen quite enough of that reduction in capacity nationally. To get a really healthy environment, I think you have to see the weaker players in every geo-graphy give up. And while we're seeing some of that, it would be nice to see more.

In general, I have been feeling marginally more positive about the industry and about some of the companies, but excess capacity is still a concern.

MARK WILTAMUTH: If you look back over the last three SN roundtables, I've probably had one of the more bearish views among any of the analysts, but even my views have moderated in the last year or so. Compared to where we've been in the last three years, the group does have an improved outlook. The group overall still has structural pressure from Wal-Mart in terms of store expansion, but we do have some industry consolidation that has played out. Now I think we're coming out of an era of self-help, where all the companies have been cutting prices for almost three years in a row, and into a period where there's a healthier approach to return on invested capital - where the companies are deploying more money for remodels and less for expansion of capacity - and I think that's been one of the factors that's been helping these stores along. But you have to give credit where it's due here and mention that the comps are in the positive range among the industry majors, and they are getting margin flow-through, which we haven't seen in years, and I think those are both signs that we've come out the other side of the crisis.

In terms of the big picture, we are seeing some cracks in consumer demand trends on the restaurant side. Casual dining restaurants, including some of the majors in the industry, are down 5%-7% on traffic in the last few months, and I think we're also seeing people eating more at home. And that's also a positive for the whole retail food industry.

CARLA CASELLA: Looking at the industry from the debt side, we always wonder how long it takes for high-yield supermarkets to realize the value of having lower debt levels. I think we're seeing some of that now as high-yield companies look at how much investment-grade players like Safeway are investing in the business and realize they have to spend more to compete. The high-yield players don't all have the capital to do that. Yucaipa had to come in and help Pathmark, and A&P had to sell Canada, so some companies are starting to understand it, but we still see a lot of debt on the supermarkets we cover and think they'd be much more nimble if they could get that down.

One contingency we watch from the debt side is the ratings agencies, which seem to be so questioning about whether supermarkets in general should be high investment-grade credits. Given this concern, supermarket operators must be asking themselves what do they get for getting debt levels down, and that's one thing we're grappling with in high yield. I agree with what we're hearing about consolidation - we think consolidation is nearing the end game.

We want to see more asset sales, upgrades or market exits by companies where they can't be dominant, with more redeployment of capital where they can be dominant. But that raises the same point Meredith was making - it's a way of addressing the overcapacity because as we see a company closing stores in a market, some stores would go dark and some would go to other players. But we still think we're seeing overcapacity.

ANDREW WOLF: Looking at second-quarter results, I would say the industry is in kind of a Goldilocks macro-environment right now, by which I mean industry demand growth is accelerating even while the overall economy has slackened moderately. Also, the product-cost environment has turned favorable for gross margin expansion, reversing the three-year downtrend from 2002 through 2005.

In regard to restaurant competition, people are still going on weekends for entertainment purposes, but in terms of an early-week shop, that's where they are losing traction. So the "what's for dinner tonight" business is down at restaurants. With consumers having less disposable income after filling the gas tank, restaurants are one of the places middle-class folks are saving money. And you can track it in terms of real sales growth and see that supermarkets experienced an acceleration in the second quarter from the first quarter, while restaurants decelerated. The first quarter of the year was the opposite because gas prices were relatively low and the restaurants did well, but this got reversed in the second quarter with the latest spike in gas prices. To me, it appears that spike was enough of a hindrance to get people to go to grocery stores more often but apparently not enough to get existing customers to trade down, which is part of the Goldilocks aspect.

Another "good news" trend is product pricing in food, which has been very favorable recently after a few years where it was really very unfavorable, particularly in commodities. In 2003 and 2004, meat was inflating very quickly and retailers couldn't pass all of that through. But they tried to pass as much as they could, and as they did that, volume went down because of the price elasticity of demand. That was a tough environment, and it happened in dairy too, and those are two huge departments of the store, something like 35%-40% of sales. But that's all reversing now, and we've actually seen deflation in both groups over much of the last 12 months and you're seeing gross margins expanding, so that's another aspect of a very favorable industry backdrop.

And you could probably project that same trend out another quarter or two, but beyond that, it's just a question of how hard the economic landing is going to be. That's where I think the rubber will really hit the road for the industry because in the last few recessions, same-store sales came to a grinding halt, and as John was saying, there's a lot of cyclicality of demand in these stores, and that goes to this point of differentiation: As people have to tighten their budgets, will they trade down out of the supermarket format or not? That's what I think they did in the past where there was this huge influx of Wal-Mart capacity with lower pricing, and people who were feeling relatively worse off went to those stores and actually abandoned supermarkets. Supermarkets are starting to get some of those shoppers back now as some of the pricing has gotten relatively better, as Meredith pointed out, and as some companies like Safeway have begun to differentiate themselves more. We'll see in the next recession if demand is going to hold up much better than it has in the past two recessions.

ADLER: If there is a recession.

WOLF: Well, eventually there will be one, though I'm not predicting one in the near term.

Supervalu

SN: What prospects do you see for Supervalu now that it's becoming a major retail player? Can it go toe-to-toe with Kroger and Safeway? Will it be able to keep its localized management style, and will it be able to establish its own brand image as the other major chains have done?

ADLER: I would say you're asking hard-to-answer questions. Supervalu closed the deal in early June, and it has a tremendous amount of work to do. I think it has an advantage because in a number of the acquired markets it has very established brands already, and I might argue that Kroger has not created a single brand image anywhere. What Kroger has tried to do is to get as local as it can without losing the economies of being a big company, and I think you're going to see Supervalu attempt to do the same thing. But Supervalu is not going to change Jewel or Shaw's or Acme, each of which has a strong brand identity. What may be more challenging is whether Supervalu is going to be keeping the old Albertsons brand name in Southern California, Salt Lake City and the Pacific Northwest, because the question is, what do those stores stand for? I worry about the Pacific Northwest in particular because Supervalu has a pretty distant No. 3 share there, and it has strong competition in Fred Meyer and Safeway.

The bigger challenge may be, simply, can it make the integration work? I happen to believe it can, but I'm sitting here with an opinion, not with a whole lot of facts to support that because not much has happened yet.

WILTAMUTH: The debate for investors is, can Supervalu do the integration without any bumps in the road, and will it hit all the numbers it's laid out for the Street to analyze? I think there are a lot of people saying this is such a big deal that there may be some bumps in the road, so I think that's where the push-pull is on the debate.

CASELLA: It's definitely going to be a wait-and-see situation for at least a year. Looking back, some acquisitions have gone very well and some have not gone well, and the key to success seems to be how early the two parties started talking about which systems they were going to use, which processes, which managements and how quickly they jumped on each of those.

I think the other critical success factor we're seeing is whether it's a small player gobbling up a larger player or vice versa. In this instance, I'd say they're wavering in the middle to the weaker side of the equation, with a small player acquiring a big player.

ADLER: I'm going to disagree about the speed of integration because I've looked at mergers for a long time, and you could argue that Safeway's biggest mistake was moving way too quickly to try to turn the chains it acquired into Safeways, whereas Kroger's success with the Fred Meyer acquisition was that it wasn't in a hurry. The one good thing here is that Cerberus is paying Supervalu a hell of a lot of money to support its operations, which I see as sort of a cushion to allow Supervalu to take the time to downsize the corporate structure. Corporate is really the toughest part of it, right? I mean, it doesn't have to merge cultures at store level because it only has one group of stores in Chicago or Southern California that just have to be what they've always been, while the issues at corporate are going to be harder. You're not going to get a speedy integration out of Supervalu. That's not who they are. They're very methodical, and sometimes even slow.

CASELLA: I just have to step in on my own defense and say that I don't think that speed of closing the transaction was what I was trying to get at, but speed at how quickly they started to talk and work together to put a plan in place.

WILTAMUTH: I think the Cerberus aspect of this deal is the thing that's most interesting because how often do you have a transaction where someone is willing to take the bad parts off your hands?

ADLER: And pay you to support them.

WILTAMUTH: That's right, and in the process close down some industry capacity and help out the remaining players. So I think in some ways the real estate aspect of this - the Cerberus component of the transaction - is probably the grease that made the transaction occur, and it really left Supervalu in a position to cherry-pick the best assets, and it's not too often a retailer gets that opportunity.

ADLER: Actually, the whole thing was pretty ironic since nobody thought Supervalu's [Cub Foods] Chicago assets were all that great. And without having to shop for a buyer, it got to sell those stores to Cerberus because Cerberus wanted to get the deal done. Supervalu wanted to get the deal done, too, and it didn't want to spend a lot of time negotiating - it just did the deal to sell those Chicago stores.

HEINBOCKEL: To me, the biggest positive is that Supervalu set the synergy target low. If you look back at other transactions, synergies can easily approach 1% of sales. In Supervalu's case, that would imply savings of $350 million, but the official target is only $150 million to $175 million, so this looks fairly conservative.

Although this is encouraging, Supervalu still has to jump-start the top line. If it can't establish consistent comp growth of 1%-2%, it will be difficult to leverage expenses and drive EBITDA margin expansion over the longer term. The company might also be forced to eventually step up promotional activity. Finally, it won't get credit for synergy-driven profit growth if comps are subpar.

Given potentially significant synergies and the importance of the top line, we believe management should reinvest in the business in order to establish as strong a comp trend as possible heading into fiscal 2007. This is especially true with the 2006 consensus sitting at the low end of the guidance and the current stock price already discounting some speed bumps. Why not just deliver the consensus and end the year with a much healthier sales trend? If the company opts to show better-than-expected earnings this year at the expense of sales, the ultimate turnaround will be that much harder to pull off.

WOLF: I think in terms of pricing, merchandising and the asset quality of Albertsons, it all lags the competitors, and I think that's the risk, so Supervalu probably should do what John is suggesting. The risk is that the synergies get reinvested into fixing the business relative to competition, which has moved ahead of where the Albertsons stores are currently. Even at Jewel, I think pricing was goosed in the last six months or so [before the sale], which is what happens when you have an asset sitting there waiting to be bought and you want to protect EBITDA so the deal can get done. And some of the novel programs Albertsons tried didn't work, like having one store manager over two or three stores, which also caused degradation of the quality of the stores and service levels and so on. So Supervalu has a lot to fix just with the core operations. Yet, I think those can be fixed because it bought good assets, but the price of the fix may not be fully appreciated.

I still think Kroger would have been a more natural strategic buyer for Albertsons, though maybe the overlap in California is what kept Kroger out. Nevertheless, in terms of Jewel, Shaw's and Acme and fixing those core assets, I think Kroger has shown over the last few years that it can remodel stores, get the pricing right, get sales going - all the things John mentioned. Safeway more recently has managed to do that using a completely different strategy than Kroger - in fact, a strategy that's more capital-intensive. Further, while Supervalu has these competitive issues, the backstage integration of the two companies is very complex.

WILTAMUTH: I think it'll be interesting to see what Supervalu will be able to do with this broader national footprint. Given all the years Supervalu has spent in the wholesaling business, there are probably some synergies yet to be seen on transportation over the next several years.

ADLER: In terms of logistics, Supervalu says there's excess capacity. It's my opinion that Supervalu didn't have a lot of choices - that this was a deal it basically needed to do because its wholesale business is tough and its retail businesses are not very well positioned. This deal gives it a lot more flexibility, I think, to take a hard look at the core assets and close those that are underperforming.

I happen to be a fan of the deal, and part of it is respect for the CEO [Jeff Noddle], who I think is very realistic, and I think it's going to be a breath of fresh air for the Albertsons organization to have a guy who can look at what they're doing and figure out exactly what to do with any underperforming assets. This group of managers has had their hands tied behind their backs because former Albertsons management had to make decisions for the entire organization, and that tended to under-optimize the best parts of the business. Now Supervalu will have the freedom to make investments in Jewel, for example, which Albertsons couldn't have done when it was bleeding in Texas and Florida.

But I wish somebody would tell me what Cerberus plans to do. Closing 100 stores is great, but what do you do with the other 550-600?

WOLF: I heard another 100 would be up for sale shortly.

HEINBOCKEL: That would not shock me. I have not heard anything specific, but it would seem unlikely that Cerberus and Bob Miller are in there for the long haul. That is particularly true considering the low-volume, low-margin nature of these stores. It will be very difficult to turn them around.

However, this is a positive for the industry as a whole. A large number of stores will go dark or be sold to nonfood operators, reducing capacity. Still others may go to less direct competitors such as Whole Foods or Wild Oats. Finally, traditional operators will be able to complete some high return-on-investment, in-market acquisitions - exactly the type of value-enhancing transaction the industry needs more of.

Northeast Consolidation

SN: Looking at the potential consolidation of the Northeast, what potential scenarios do you see for how you think that region might consolidate?

CASELLA: [Los Angles-based investment firm] Yucaipa drives a series of combinations.

HEINBOCKEL: I think you absolutely have to start with metro New York because that is the largest and most fragmented market, it is centrally located and the margin expansion opportunities are substantial. Although several scenarios are possible, I continue to believe a Pathmark-Stop & Shop combination would be the most ideal. Both have excellent asset bases and large, highly productive stores, and very subpar levels of profitability. In addition, both have somewhat similar customer demographics and brand positionings, so any banner consolidation would be easier and less risky. It's uncertain if such a combination will ever come to fruition, but it's probably the best one.

ADLER: Do you think the Federal Trade Commission would have any objections to that combination?

HEINBOCKEL: I know the same combination was blocked by the FTC in the late 1990s [when Ahold sought to acquire Pathmark], but the market really is very fragmented compared with the rest of the U.S., and the FTC has changed its methodology to include Wal-Mart, so I don't think it would be as problematic as last time.

ADLER: You have to look at the economics, and although I don't think A&P and Pathmark have identical problems, Pathmark does not have a sales-per-square-foot problem but it has an absolute cost structure problem and its overhead is too high for the size of the company, whereas A&P probably has both problems. But you can make the argument that a combination of those two companies makes sense, and both companies could benefit. Plus there is substantial duplicate overhead, so there's logic behind that transaction.

There are a lot of people at A&P, with new management there, who believe they can deal with the sales-per-square-foot problem as the initial focus and then not have to worry about the other issues, whereas it seems to me Pathmark has fewer options to fix its business and it would be more desperate. But from everything we've heard, there's been lots of discussion between those two companies, and price appears to be an issue, along with the role of the respective management teams. I think most people agree that [A&P CEO] Eric Claus is much more of an operator than Pathmark's John Standley, who has a financial background. And in the end, A&P is still a family-owned business, and it gets to do whatever it wants.

WOLF: One of the problems in the New York market is that it's so fragmented. It's the last really fragmented major market. You've got three guys with 10% share, with one price operator [ShopRite] who's private and who goes on a warpath every other year, and then you've got a strike every third year, plus a bunch of crazy union rules. Even Whole Foods has said it couldn't believe the situation in New York City, one of the capitals of the gastronomic world, where there are no really good supermarket operations, which is no wonder with fragmentation and the kind of cost structure they have. So I would say it looks like consolidation is going to be a tough job for whoever takes it on.

SN: Do you see Keene, N.H.-based C&S Wholesale Grocers playing any role in consolidation of the Northeast?

HEINBOCKEL: Because C&S supplies Pathmark, A&P and Stop & Shop, Northeast consolidation would probably benefit the company in the short term. By improving routing, procurement and promotional coordination, costs would be reduced, which could be reinvested to drive market-share gains both at the retail and wholesale levels.

Longer term, consolidation increases the risk that some of these customers could embrace self-distribution again. We recognize that, at present, there are supply contracts in place lasting anywhere from six to 15 years. However, once they expire, sufficient scale would exist to take this important function in-house. Whether or not the retailers do will depend on how well C&S helps them lower their costs between now and then and how much capital they will have to invest in distribution. At this point, self-distribution seems highly unlikely in the foreseeable future.

Role of Private Equity

SN: With private equity firms amassing huge buyout funds, what are the chances we'll see a big supermarket chain acquired by one of them?

WILTAMUTH: I think the private investors all had the opportunity to look at Albertsons and you saw them pass, so I don't think it's going to happen.

CASELLA: There are a lot of other places they can look for a retail fit, outside of supermarkets.

ADLER: These properties are not cheap anymore.

WILTAMUTH: Leveraged buyout firms are looking for companies where they can come in and fix something, and I don't think the private equity firms have the leadership and management teams to come in and make things better, which makes it hard for them to make the numbers work.

ADLER: There's also a fair amount of leverage in the industry, which makes it much harder. I think the dollar stores are the place there should be some LBO involvement.

WOLF: Look at Marsh. Marsh had a semi-auction - and that's a fixer-upper. And for whatever reason, everybody took a pass on Albertsons a few months ago, whereas I might have expected there would have been an active auction there. But if something like that became available today, I think the auction would be more interesting, though it might end with the same result because Albertsons-Supervalu was a very complicated deal, which I think also limited the options for an auction. But I think there's a little more interest overall from private equity for supermarket assets.

HEINBOCKEL: The LBO models we have run tell us the IRRs [internal rates of return] are not that good, certainly under 20%, even if reasonably aggressive assumptions are made with respect to sales growth, margin expansion and exit multiples. Maybe you could have divisions of larger companies getting LBO'd, but in many cases these divisions are operating at peak market shares or EBITDA margins and can't be improved.

As for the real estate value of these properties, the only thing that keeps fueling the discussion is the sheer amount of money available for private equity to invest. Thus, the thought process may be that a lower IRR, perhaps as low as the low teens, is better than no IRR or not putting the capital to work. That is certainly possible.

ADLER: But Cerberus is an LBO, so you did have one private equity buyer out there that was interested in doing a deal.

Real Estate Values

SN: What role does real estate value play in supermarket acquisitions?

WOLF: One of the reasons supermarkets, even old grungy ones, don't get turned into other types of stores is that, very often, that's not the best use because it's expensive to refurbish them and get rid of all the extensive plumbing and piping. The cleanup cost can make the conversion to a nonfood format prohibitive.

CASELLA: We did some real estate panels, and our big call was that we felt there is real estate value in retail, but with supermarkets you've got to discount that value because it's hard to convert those boxes to something else, and real estate experts tended to agree.

ADLER: I understand it takes $1.5 million to strip a box that's been a supermarket, back down to just its four walls, and that's a lot of money to spend.

WILTAMUTH: Real estate developers also look at grocery property as unattractive because it's usually the primary draw on a retail pad and it doesn't have good adjacencies. Very often the adjacency is a dry cleaner. To convince another retailer to go into that space, the adjacency has to be a draw, and most retailers want to be next to another big box where there's already a lot of car traffic. So, for many real estate developers, grocery real estate has not been attractive.

In valuing real estate, you have to look at the difference between the real estate value and the cash flow value that you want to put on a grocery operator. An existing grocery operator is looking at cash flow multiples, while the real estate guys are looking at a completely different set of numbers.

HEINBOCKEL: So you would think that a very large portion of the value in the Albertsons stores Cerberus bought would come from Northern California. Even though the stores there are not big and have relatively low volumes, it is so hard to get real estate there that I would think Cerberus would extract a lot more value from that market than any other, including Florida.

ADLER: It can't be a surprise that California was the first place Cerberus is looking to sell since those stores were not doing well as Al-bertsons supermarkets.

WOLF: The low price Cerberus paid proves the point that it's the clearing price that's important, and if it is able to sell just half the stores to other supermarket operators, it will have done well, even if it just closes the rest.

SN: So the higher cost of converting a supermarket would argue against a quicker reduction of capacity in the industry?

ADLER: Yes. If you think about it, Cerberus has to proceed in a step-by-step manner. It has to operate the stores because the best buyer it wants to get out of this is another supermarket, and you're not going to buy a store once it's dark. Cerberus will have to operate the stores and maintain them the best it can. Of course, there are some locations, particularly in Northern California, where there probably isn't anybody who is likely to buy them as a supermarket and it could close those locations.

The other problem with supermarket locations is their neighborhood quality. There are a lot of retailers that might want that size box, but they don't fit into the local residential neighborhood.

Kroger and Safeway

SN: Let's talk about Kroger and Safeway. Can each maintain its recent strong financial performance going forward?

HEINBOCKEL: I think we need to see how they fare against increasingly tough comparisons in the second half of the year in order to put their performance in perspective. If they can settle into a consistent 2%-3% comp range, that would be impressive, especially given the still over-stored nature of the industry. Considering the progress that's been made on the labor cost front, this would be sufficient to achieve expense leverage and generate low double-digit profit growth.

That said, the competitive environment remains very dynamic. Traditional supermarkets have undoubtedly gotten the attention of their non-traditional competitors, who are likely to respond with their own investments in pricing and/or customer service. Questions abound. How will Wal-Mart's remodels impact the food side of the store? How much capacity will Tesco add on the West Coast, and will its format be effective? How will Supervalu respond to its tepid sales? It seems highly likely that comp trends have to moderate from here, but can they remain above the 2% level required for expense leverage? We think they can, as long as any downturn in consumer spending is modest.

CASELLA: I think the jury is still out on Safeway in particular. It's getting nice comps and talking about very good responses from consumers on the lifestyle format, but it's got to be wondering if it's all worth the amount of capital it's taken to get there, and my question is, how costly is it going to be to maintain the new store format?

ADLER: I had a private meeting with a top Safeway executive and a client, who asked whether the company had any idea if it was going to get a return on its remodels and whether it would require a three-year lift in comps to get that return - and because Safeway didn't have any data to show it was going to get that lift over three years, wasn't the company just making a big bet - and the executive told us, "Yes, we're making a bet," which didn't give me tons of confidence.

HEINBOCKEL: I believe Safeway will get an attractive return on the lifestyle investments, though it can't get to a return on investment that equals or exceeds the company's pretax hurdle rate of 22.5%, largely because the average investment is so high at $3 million. Nonetheless, our estimated return, in the high teens, is nearly double the cost of capital. So one could argue that these investments are creating value and should be made. The alternative - doing nothing - is not a good one.

WOLF: Safeway had to do it because it had deferred investment with low cap-ex and it had trashed some of its acquisitions and had to fix them anyway. And at this point, I have to admit it's doing better than I expected. I think it's very hard to change a big company, but to Safeway's credit, at least vs. my expectations, it's ahead of what I thought it could do. I think it's achieved a lot for a company that size with such an ambitious undertaking.

In terms of stock-price performance, it's hard to know what the margins are at Dominick's and Randalls - probably closer to 0% than to 5%, I'm sure. And that's where the upside could come, and that's sort of the bet from here. I think you could get a pretty decent marginal return on the stock as well in the next two or three years as Safeway continues the lifestyle remodels. But I think investors are valuing Safeway stock over Kroger because they see a bigger margin recovery gap and they hear management talking about it, whereas Kroger's not talking about it at all - and Kroger doesn't really have any broken assets to fix like Safeway does. So, that's sort of the stock play.

But I prefer Kroger's strategy because I think it has a lot more sober outlook for the long term. And I'm very concerned, when a recession hits, about what we're going to see from the supermarket industry based on historical performance, and I think Kroger is positioned well because it's priced better, and it's going to continue to be priced better. Dave Dillon has said that the way the company used to make its numbers was by "pushing the pencil" and raising prices, but it's never going to do that again as long as he's running the place. And I think that's the right attitude: Even as you're bringing your merchandising upscale, keep bringing your pricing down and deliver more value to consumers.

HEINBOCKEL: Kroger always talks about EBIT margin remaining flat over the long term, and with a base-case comp of 2%, where the expense ratio is static, that assumption is probably correct. However, if the comp is higher, incremental leverage will be achieved and EBIT margin should be able to expand moderately. In my view, this increment belongs to the shareholder and should drop to the bottom line. It should not necessarily be reinvested because it's very unclear just how good or bad the ROI will be. With such a rational approach, everyone is happy - comps will be solid, share should be gained, profit growth would be healthy and the stock could at least hold its current valuation.

ADLER: I think Kroger management would agree with you, but it's afraid to say anything and it's afraid to commit because it wants to under-promise and over-deliver. But if you look at the numbers it reported in the first quarter and you take out the impact of gas on the gross margin, the operating margin actually improved.

Going back to Safeway, I personally am kind of skeptical about recovery at Dominick's and Randalls because reducing capacity in a marketplace always puts you at a disadvantage to where you were before, and Safeway closed a lot of capacity, especially in Chicago. In addition, I learned very recently that Safeway has an extremely unattractive Teamster contract in Chicago. I thought its whole problem there was with United Food and Commercial Workers Union, but apparently its Teamster contract is so ugly and there is nothing to get the Teamsters to change that contract, so Safeway is working at an economic disadvantage, and it's already closed 15% of its stores in that market. So if the market's really betting on recovery there, it's going to be tough. When it comes to Randalls, I'm not so sure about recovery because Texas is such an ugly market, though it's one of the markets Cerberus is downsizing, and maybe that will help.

I also think the market continues to forget that Wal-Mart isn't done expanding geographically, and the places it's going - primarily the Western U.S. - are all Safeway markets.

WILTAMUTH: That's a very interesting point. When we're all out marketing and talking to investors, Wal-Mart just doesn't come up as a top topic anymore. Everyone just assumes we've all digested it and it's not a force. But if you look at it, Wal-Mart is adding 12% more supercenters every year, and every supercenter is new grocery capacity, and with its position and its lead in the industry and the grocery industry only growing 0%-3% a year, it is still a structural force to contend with.

WOLF: What's interesting about pricing is, if you look at the last quarter for Safeway and Kroger, they both took down their retail prices even though gross margin was up as a result of better shrink control, so managements are at least acting the way they should be, looking at the future and the relative pricing and where they need to be long term, and I applaud that. It's more of a philosophy than something mechanistic. It's part of a productivity loop, and they're trying to get closer to that - they're trying to get more transactions to get to where they need to be on sales than from pricing - and that's how you run a retail operation for the long run if you want to survive.

Delhaize

SN: Delhaize seems to have made quite a bit of progress in the last year, but can it maintain that momentum?

CASELLA: We like Delhaize, and it's a big part of our high-yield supermarket index. I think it's shown more impressive business trends than some of the larger players in the market. Delhaize recognizes where a new concept is needed or might work, and it tries it and tests it without going crazy with rollouts. I'm thinking of its Bloom in North Carolina, as well as Bottom Dollar, the deep-discount chain it's trying, also in North Carolina, plus switching all the Kash n' Karrys in Florida over to Sweetbay. Coupled with the fact that it does a good job with inventory management and it's got the Hannaford chain that's somewhat of an example for them as it makes changes down South, I think it's doing the right blocking and tackling, and I think that's why it's showing good results.

ADLER: Of course Delhaize benefited deeply from Winn-Dixie closing all of its stores in many of Food Lion's markets.

WOLF: I think Delhaize likes the Hannaford people - [Food Lion CEO] Rick Anicetti and Hugh Farrington, who is still on the board - because Delhaize has allowed them to take over most of the U.S. operations, which was smart. Now it almost looks like, even though Delhaize overpaid for Hannaford at the time, when you factor in the human capital, maybe it was worth it. When Hannaford was a public company, I thought it was one of the most innovative - it was hiring women executives because, after all, most shoppers are women, and it was hiring Cornell graduates with food management training. So Hannaford has always been a very progressive company, and the parent company in Belgium made a good decision on whom to let run the U.S. operations.

ADLER: The question really becomes whether or not Delhaize has a big enough footprint to succeed long term or does it need to expand and become more of a powerhouse and if so, where does it want to put its capital? I'm not sure it still has much opportunity to make Food Lion a better operation, but at some point it has to wonder, with all these skills and technology and great business processes, doesn't it want to do something more with the business?

CASELLA: To its credit, Delhaize has stuck with its successes at this point and not over-reached. I think it's still committed to going only into adjacent markets, but at some point, whether it wants to expand more aggressively will become a decision it's going to have to make.

Ahold

SN: There's been talk Ahold is a private equity target because of issues at some of its U.S. banners. What are the chances of its rebounding or moving into someone else's hands?

ADLER: I want to know who was surprised Ahold decided to sell the Tops stores in Cleveland. How long have those been troubled assets - 10 years, at least. And it appears the company made a serious miscalculation when it put Stop & Shop and Giant-Landover together. It thought the outcome would be to make Giant-Landover stronger, but the end result was it diluted Stop & Shop because it took management attention away from the core business, and Ahold appears to have ended up with less than it had before.

HEINBOCKEL: In any multi-division company, strong businesses often have to subsidize weaker ones, and Ahold is certainly no exception. One could argue that, since problems with U.S. Foodservice began in 2003, Stop & Shop and Giant-Landover have not sufficiently reinvested in their businesses, and as a result, unlike Kroger and Safeway, their comps are not at five-year highs.

Stop & Shop management has recently talked about reinvesting in price, and that is absolutely the right thing to do. The store base is in terrific shape and perishables quality is still superb, but price perception has slipped. The business needs to be reinvigorated with a strong, sustainable price reduction program. Of course, this costs money, as would a much-needed accelerated remodel effort at Giant-Landover.

ADLER: What's interesting is that Supervalu said Shaw's was going to be less price competitive going forward, whereas Ahold said, I believe, it is going to get more competitive at Stop & Shop in New England, which seems somewhat contradictory.

CASELLA: I think there's a lesson to be learned here about the benefit of keeping focus. There's been so much going on at Ahold since 2003 in terms of selling assets worldwide, dealing with U.S. Foodservice and dealing with the U.S. retail operations, which wasn't the worst of the operations until the company took its eye off the ball. It should have sold Tops sooner, and we think it could have consolidated some of the regions better. Probably at this point, it's not so broken that private equity won't look at it, but we think a sale of the whole company is less likely than selling pieces of it, such as U.S. Foodservice.

WOLF: In combining Stop & Shop and Giant, Ahold really bungled the Giant Foods side of it. Giant has lost a lot of market share. In fact, since the middle of the year, it's down about 3%. It's really ugly, and it was really done poorly. It was like a textbook case of how not to handle such a complicated internal integration.

Echoing Carla, I wouldn't be surprised if the private equity guys were kicking the tires because the retail brands are still strong, though the profitability certainly has been diminished. Also, U.S. Foodservice needs to be rationalized, but for whatever reason, these guys don't have the moxie to do it, though that's something that could also be done on a private basis. It could all be done publicly too - it's not like it makes a lot of money - but nevertheless, I think the whole U.S. operation is probably an interesting asset for the private equity folks.

ADLER: It doesn't seem like Ahold's management has a clear strategy, either. It's amazing how you can spend a couple of years doing the obvious by fixing things that are broken, but there's a certain point where everybody wants you to have a long-term strategy and everybody wants you to say what you're trying to accomplish. The old Ahold management, regardless of what you think about its ability to execute or whether it had a good strategy, had a very strong, clear message about where the company was going and what it wanted to accomplish. That makes it even more obvious how little strategy the company has at this point, which is why you get rumors about private-equity interest. I'm not a high-yield analyst anymore, but I don't think you could take the entire company private because it's too leveraged today.

Winn-Dixie

SN: What are your thoughts about Winn Dixie and the impact of its store closings?

WOLF: Well, Ingles just threw out some huge same-store sales numbers, and so did Publix - comps in the range of 7%, adjusted for Easter. And there are a lot fewer Winn-Dixie stores in their markets now than before, and people have to shop somewhere. And Harris Teeter bought some Winn-Dixie stores that it's remodeling and putting in the comp base, so along with reduced capacity comes a more limited opportunity to boost the local-market asset base. I think you could say that if there was going to be similar capacity reduction throughout the country, you could get pretty bullish on the industry - though that's a big "if."

ADLER: That's what I'm waiting for elsewhere in the country - something more like Winn-Dixie in other places.

WOLF: But while some investment analysts have been saying for years that consolidation is just around the corner and been wrong, you could say they've been like a broken clock - though at least the clock is ticking the time right now. The point I was trying to make in the Winn-Dixie case is you can see just how much leverage there is in getting rid of so much capacity, especially in a decent economic environment.