A NEW PROFIT PICTURE

Elliot Zwiebach

Some of food retailing's most profitable public companies are not the ones with massive scale, but instead those with a strong core of stores in a limited geographic area.

According to an exclusive analysis of publicly owned companies in the grocery industry, many of the nation's smaller, regional supermarket operators are outperforming their larger counterparts. Profit metrics are also better for nontraditional players like Whole Foods Market, Austin, Texas, and Wal-Mart Stores, Bentonville, Ark., whose returns and margins are surprisingly similar despite operating at opposite ends of the price and service spectrum.

The analysis, using data from the companies' most recently filed annual reports, showed Arden Group, the Los Angeles-based parent company of Gelson's Markets, with the best average metrics in the industry, followed by Whole Foods and Wal-Mart. Albertsons had the eighth best average, while Kroger and Safeway did not crack the top 15 as a result of significant write-downs in 2004.

Included among the best performers were such regional operators as Ruddick Corp., parent of the Harris Teeter chain, which operates 138 supermarkets in six states in the Mid-Atlantic; Weis Markets, which operates 157 supermarkets in the Northeast; Village Super Market, which operates 23 ShopRite stores in New Jersey and Pennsylvania; and Ingles, which operates 200 stores in the Southeast.

The listing, compiled for SN by Fairchild News Service, a division of SN parent company Fairchild Publications, New York, is designed to offer a broad snapshot of the industry's profitability and as a way to rank which companies achieved the best overall profitability in the most recent fiscal year. It measures the average of return on assets, return on equity, net margin, gross margin and operating margin.

On that basis, Arden Group had the industry's highest returns -- in large part because the company doesn't build many new stores, Gary Giblen, an analyst with GMG Capital, Darien, Conn., explained. "With few new stores, Arden has already depreciated its assets, so whatever it earns goes right to the bottom line.

"If you build a large number of new stores, as Whole Foods is doing, then it takes awhile for those units to become productive, which lowers your return on assets in the short term. But Whole Foods does well because of its high comparable-store sales and its growing market share."

For operators like Arden Group and Whole Foods, both of which go after upscale customers, offering more value-added products also enables them to maintain better operating margins, Giblen said. "They're able to keep up expense ratios because sales are good so they can absorb operating expenses. The trick is to have high gross margins and still have good sales.

"But if you alienate customers with high prices that are not justified by superior products or services, sales will suffer and your operating structure will be high," he noted. "A&P has some of the industry's highest gross margins, yet it has negative operating margins because of poor sales and poor operations."

STRIKE'S IMPACT

Among Kroger, Albertsons and Safeway, declining metrics are a result of the rise of Wal-Mart and the residual impact of the Southern California strike-lockout, analysts told SN.

"Kroger set the record straight when it told investors not to look for a V-shaped margin recovery," Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., said. "Some investors had assumed after the strike-lockout ended [after 141 days at the end of February 2004] that consumers would come back and so would profitability. But it's clear the fundamental structure of the industry has changed -- initially because of the chains' perceived need to invest margin to defend against Wal-Mart's market-share gains, followed by the ongoing inability of the chains to recover all the share they lost during the Southern California labor dispute."

Although Kroger and Safeway both had strong gross margins in 2004 -- 25.33% and 29.58%, respectively, they both had negative returns on assets and equity that weighed down their profit metrics for this analysis.

Other companies that had negative earnings in 2004 and failed to make the top 15 included Pathmark, Ahold, Smart & Final, Wild Oats Markets, Fresh Brands, Spartan Stores and A&P.

While the major chains have seen their returns and margins slipping, regional players are seeing their metrics gaining strength, Wolf pointed out. "Over the last couple of years, regional chains like [Ruddick-owned] Harris Teeter and [privately held] Publix -- the ones serving a more upscale market -- have seen improving returns because they are good at merchandising to their local consumers and they execute well," he said. "Not surprisingly, execution doesn't improve with scale."

POLAR OPPOSITES

One of the more interesting anomalies in the rankings are the very similar metrics shared by Whole Foods and Wal-Mart.

"It's basically a coincidence," Chuck Cerankosky, an analyst with KeyBanc Capital Markets, Cleveland, pointed out, "because the two companies are so different. And although they operate on very different scales, both share good managements that execute very well within their target niches.

"At Wal-Mart, it's the supercenter and discount stores division that drives returns on assets and equity because the volumes of customers in those stores generate huge sales that contribute to healthy profit margins," Cerankosky explained. "Furthermore, Wal-Mart operates a lot of real estate at relatively low cost so it ends up with attractive returns, and its profit margins reflect its efficient operations.

"Whole Foods, on the other hand, emphasizes a more narrow product mix and a focus on a higher-income, more highly educated demographic -- and yet it has similar metrics to Wal-Mart because both focus on niche markets with high per-store volumes."

PRICE VS. SERVICE

Giblen said most retailers are striving to move their operations closer to Wal-Mart on the price side or Whole Foods on the service and quality side, "but you need to have cost efficiencies to minimize operating expenses while driving strong sales."

The nearly identical operating margins at Whole Foods and Wal-Mart "show you can be successful in different ways," he pointed out. "Whole Foods has a high gross margin with high operating expenses, whereas Wal-Mart has a low gross with low operating expenses."

Safeway, on the other hand, has a high gross margin but a low operating margin, Giblen said. "Safeway is losing sales while sustaining high expenses, and it isn't able to absorb those expenses because of inefficiencies at Dominick's and Randalls. But if it can accomplish its goals of converting most of its stores to the lifestyle format, then it can become more like Whole Foods and conceivably double its operating margins. The same is true for A&P with its fresh stores. Everyone wants to go where Whole Foods is."

Wolf said Delhaize had better operating margins than Albertsons or Kroger "because despite the fact the bulk of its stores are in the Southeast, where they're closer to Wal-Mart, those stores are smaller and much cheaper to operate, with a lower break-even point and less sensitivity to changes in sales trends."

SN Profit Leaders Index

Rank. Company: Return On Assets; Return On Equity; Gross Margin; Operating Profit Margin; Metrics Average

1. Arden Group: 18.56%; 34.05%; 4.51%; 44.82%; 6.88%; 0.22

2. Whole Foods Market: 9.01; 14.44; 3.55; 34.76; 5.93; 0.14

3. Wal-Mart Stores: 8.54; 20.79; 3.60; 22.94; 5.99; 0.12

4. Ruddick: 5.81; 11.76; 2.25; 29.06; 3.92; 0.11

5. Weis Markets: 7.64; 10.00; 2.73; 26.20; 3.44; 0.10

6. Village Super Market: 5.73; 11.04; 1.38; 25.51; 2.60; 0.09

7. Ingles Markets: 2.70; 11.01; 1.35; 25.95; 4.03; 0.09

8. Loblaw: 7.42; 17.88; 3.69; 8.11; 6.30; 0.09

9. Albertsons: 2.42; 8.19; 1.11; 28.04; 3.08; 0.09

10. Supervalu: 6.15; 15.37; 1.97; 14.64; 3.66; 0.08

11. Delhaize Group: 1.80; 5.14; 0.91; 27.57; 4.30; 0.08

12. Costco Wholesale: 5.85; 11.57; 1.87; 12.76; 2.94; 0.07

13. Marsh: 0.56; 2.37; 0.18; 30.15; 1.43; 0.07

14. Foodarama Supermarkets: 0.52; 4.37; 0.15; 26.37; 1.63; 0.07

15. BJ's Wholesale Club: 6.05; 12.18; 1.58; 10.50; 2.48; 0.07

Source: Financial data compiled by Fairchild News Service (FNS) from the most recent annual reports filed with the Securities and Exchange Commission. Calculations by FNS. The SN Profit Leaders Index is an average of each of the profitability metrics, and is strictly used to rank the performance of each of the companies.