ADVANTAGES AHEAD 2004-09-13 (2)

ELLIOT ZWIEBACH

NEW YORK -- The food industry may have narrowed the labor gap with alternative formats as a result of the Southern California labor dispute, industry analysts told SN, but they disagreed about whether that dispute set any precedents for the negotiations that have followed in other parts of the country.

Discussing the issue at SN's ninth annual Financial Analysts' Roundtable here, some argued that the new second tier of employees created by the Southern California settlement could lower service levels, thereby removing a major point of differentiation that has given supermarkets a presumed edge over alternative formats, while others said that differentiation has already been minimized by greater consumer interest in price over service.

Other issues the seven analysts discussed during the roundtable included:

Industry consolidation, which they generally agreed has run its course for the foreseeable future.

Alternative formats, which they said will continue to take share from conventional chains, with the potential for dollar stores and a resurgence of wholesale clubs to see significant growth.

The low-carb trend, which they said has probably run its course but may lead to more healthy overall eating habits.

Trade practices, which they agreed are here to stay, though they disagreed on whether retailers or manufacturers were more blameful for abuses.

The two European-owned U.S. chains, with analysts saying they believe Delhaize America is making significant gains while Ahold's U.S. holdings are struggling to cope with consolidation.

The analysts offered differing views on the impact of the 141-day Southern California labor dispute that ended in March.

Gary Giblen, senior vice president and director of research for C L King Associates, New York, said he believes the chains lost some ground by making concessions in the final settlement that were not part of their original "last, best and final offer."

"There were points gained by each side, but [the final contract] was not as good as the chains had wanted at the outset," he said. "This breakdown of 'last, best and final' is a very scary precedent."

Giblen said most contracts signed following the Southern California settlement "have pretty clearly gone in favor of the employees. They generally are not giving up anything at all in health care, and they're getting 2% to 3% guaranteed wage increases."

Mark Husson, New York-based managing director and global head of consumer research for HSBS Securities, London, said he believes the chains scored a victory in Southern California because they were able to close the gap in labor costs with supercenters. "The single biggest competitive advantage that Wal-Mart [Stores] has is on labor, [and] the settlement in Southern California was a major step forward in closing that gap to within something at least in the same ballpark but maintaining an employee base capable of giving good service. I don't think you can read that strike as being anything other than a major success for the food retailers."

Bryan Hunt, vice president of the fixed income division of Wachovia Securities, Charlotte, N.C., also scored it as a victory for the chains, pointing out that even one of the smaller retailers who signed the new labor agreement "could reduce its labor costs by roughly $100 million in the third year of the contract [when shared medical costs kick in] so this labor disruption will be a huge benefit in the long run because it has set a precedent for a two-tier wage system and shared health care costs."

Hunt also said he expects some of the labor savings to show up eventually on the chains' bottom lines. "Are the Southern California operators going to take these huge cost savings and reinvest them in pricing to take market share? I believe most of the price investments have transpired and therefore a majority of the cost savings should flow to the bottom line in the coming periods."

Mark Wiltamuth, executive director of Morgan Stanley, New York, said ongoing increases in wages and benefits, coupled with higher operating costs, may create future problems that the industry will have to address. "For a low-margin business, that is still a problem," he declared.

Margaret Cannella, managing director of JP Morgan Securities, New York, expressed concerns about whether the introduction of a second tier of employees would have a negative impact on service levels at the stores. "One of the things I don't hear the supermarkets talking about very much is the fact that with the settlement, the industry is going to lose a more experienced labor force," she said. "Though it may not lose it initially, it may go away over time, and without that more experienced labor force, their point of differentiation with the supercenters or the warehouse clubs will be slightly lost."

Andrew Wolf, managing director for BB&T Capital Markets, Richmond, Va., said he believes the loss of experienced workers may not be a bad thing. "Price is much more important than service [as] the share shift to non-union formats [demonstrates]. That added service element in traditional supermarkets certainly wasn't enough to stanch that."

He also noted that supermarkets offer buyouts to senior people all the time and that the union jobs are not as highly skilled as they might once have been. "In this world where we're seeing increasing competition from non-unionized formats, I honestly don't see any real differentiation in the skill level brought to bear by the unionized labor force. So when you look at trying to get the cost structure down and getting a massive influx of people who may be inexperienced but who bring down your cost structure by 600 basis points, it's a reasonable trade-off," Wolf noted.

Turning to the threats posed by alternative formats, Hunt said Wal-Mart is gaining market share at the expense of supermarkets, with grocery sales climbing 16% to 18% this year at supercenters and 6% to 10% at Sam's Clubs, compared with market-share gains of only 3% among supermarkets.

However, Husson said most of Wal-Mart's share gains are coming from outside the top 100 metro markets and from competitors other than Albertsons, Kroger and Safeway. Dollar stores have also been picking up a lot of business, Husson said, "but I think the dollar stores will fall firmly and hard flat on their face over the next few years. I don't think [they] are very good merchants, and procurement on fresh food is a mess."

Giblen said he believes club stores may be on the verge of "a second round of huge gains. They petered out, especially on the food side, in the mid-1990s, "[but] now Costco has created a very powerful perishables and price advantage and Sam's is trying to catch up from trailer-park perishables to the proper standard, and BJ's is going out there after [the consumer] as well."

John Heinbockel, vice president of Goldman Sachs, New York, suggested supermarkets could win back sales from alternate formats with more general merchandise. "If you're a good food retailer, you've already got the traffic and now you just have to expose your customers to the right general merchandise,."

On the subject of industry consolidation, Heinbockel summed up the analysts' opinion when he said, "I think it's pretty dead, and I think it will stay dead for quite a while," although smaller, fill-in transactions are "likely."

Regarding the low-carb trend, Wolf said that movement seems closely related to a shift in consumer interest toward health and nutrition. "One of the key merchandising trends on which the traditional stores really have to accelerate their focus is natural and organic foods," he said. "They need to experiment and be a little more bold because that's one of the places where you can differentiate yourself on service, quality and merchandising."

Cannella said she believes the low-carb trend has created "a subtle change in the way people look at eating. Some of the trends that we've seen are very much more long term in the way people are eating and are going to eat."

As for industry trade practices, Wiltamuth said trade allowances "are like a drug to the supermarket industry. Retailers keep going back and asking for more."

SN ran the first half of the roundtable in last week's issue. The text of the remainder of that discussion follows:

THE NEW LABOR SCENE

SN: One of the major industry events in the past year was the strike-lockout in Southern California. What are some of your thoughts on the short- and long-term impacts of the strike for employers and for the union?

GARY GIBLEN: I believe the jury is still out as to exactly what will be the benefits to the chains. But when I look at it, I think of it as the industry losing because the precedent had been to stand pat at the "last, best and final offer," which was a successful and brilliant innovation when Steve Burd [Safeway chairman, president and chief executive officer] introduced it to the industry a number of years ago. But that really didn't play out in Southern California because the final settlement favored the initial union position. There were points gained by each side, but the central point is it was not as good as the chains had wanted at the outset. This breakdown of "last, best and final" is to me a very scary precedent.

Right now there are a lot of labor union contracts pending, and it could be really bad or it could be not so bad. But I think it's a negative that the supermarkets didn't get enough in Southern California, and they didn't get very far at all in addressing the labor disparities.

MARK HUSSON: I'm not sure where you're getting your information that the final agreement was actually better for the unions than the last offer the employers made.

GIBLEN: I'm getting it from reading the contract, rather than listening to the rhetoric.

HUSSON: The difference is the unions have had to accept that there is a gap of 600, 700 and 800 basis points between labor costs at Wal-Mart [Stores] and labor costs at supermarkets. That's big. And even if the unions were to argue that food retailers have historically been more productive than Wal-Mart employees, they can still weigh two things. The single biggest competitive advantage that Wal Mart has is not on procurement -- I don't know whether Wal-Mart buys any better or worse than the supermarkets do, but I would guess it's about the same -- but on labor, where they are streets ahead, and unless you have a structural shift in the cost of labor, you are going to continue to see 600 or 700 basis points in the spread. You don't want Wal-Mart-type employees in a full-service supermarket because Wal-Mart is not a full-service operator. The settlement [in Southern California] was a major step forward in closing the gap to within something at least in the same ballpark while maintaining an employee base capable of giving good service. I don't think you can read that strike as being anything other than a major success for the food retailers.

SN: Are the supermarkets going to be cycling employees three years down the road?

BRYAN HUNT: The cycling of employees has already started. Many workers that went on strike didn't come back to work, so a new tier level of employees with lower wage rates has been introduced into the system. We believe one of the smaller retailers that was involved in the contract negotiations could reduce its labor costs by roughly $100 million in the third year of the contract, and the shared medical costs [in the third year] will allow the Southern California operators to close the cost gap with Wal-Mart as it moves into Southern California, so this labor disruption will be a huge benefit in the long run because it has set a precedent for a two-tier wage system and shared health care costs.

From the evidence we've seen, including the retailers' own sales numbers, it appears the "big three" chains lost somewhere between 10% and 15% market share in Southern California. Safeway mentioned on a recent conference call that sales peaked out in June and softened in July, which leads me to believe it's going to be expensive for them to regain all of the sales they lost. We believe the share loss will be permanent based on the significant number of announced store closures.

MARGARET CANNELLA: One of the things I don't hear the supermarkets talking about very much, which I think is important, is the fact that with the settlement -- which I think they absolutely needed to pursue and which I think was a win for the supermarkets -- the industry is going to lose a more experienced labor force. Though it may not lose it initially, it may go away over time, and without that more experienced labor force, their point of differentiation with the supercenters or the warehouse clubs will be slightly lost. I think that's a very important outcome of this whole series of events because that has truly made the conventional supermarket very different from all the forms of new competition, and I think we have to watch carefully as this labor force that they now have, which is a different one from what they had in the past, grows and develops.

But you also asked what the outlook is for unions in the supermarket industry, and we've been looking at numbers with regard to union membership and those numbers suggest, depending on how you count supermarkets, that the overall union membership has been down over a period of time, and maybe more importantly, the premium paid to union workers on an hourly basis is also shrinking, which might suggest what you might see in the airline industry or what you might see in the auto industry -- that the role of the union in the supermarkets in the future may be diminished. It's certainly diminished already, it's just a question of how much.

GIBLEN: In terms of the impact of the Southern California strike, settlements that occurred after that have pretty clearly gone in favor of the employees. They generally are not giving up anything at all, or anything material, in health care, and they're getting 2% or 3% guaranteed wage increases. There's hardly 2% to 3% inflation in the general economy now, but we are still seeing that in the contracts.

HUSSON: But there's a two-tier structure in place now, and for the existing employees there isn't as much change as there is for a new employee that comes in.

GIBLEN: I agree that the one benefit that emerged was the flush-out of the senior-level workforce, but that will be offset as same-store sales continue to be challenged and underperforming stores close, which they are doing in Southern California, or we could drive the reverse effect so senior, tenured workers will bump out the junior folks, averaging up the cost of labor.

HUSSON: Could you explain why this contract bumped senior people out?

GIBLEN: Some senior people didn't come back to work.

HUSSON: Approximately 15% did not, but we don't know how many of those people were senior and how many of those were junior.

GIBLEN: You're right, unfortunately for the industry. Of the people that didn't come back, it's probably more junior people because the senior people have rich packages and more at stake. Only in the immediate period of the strike, when wages were cut to strike pay, did an appreciable number of senior workers exit.

HUSSON: I think that over time, the opposite effect may actually prove to be the case. You'll get much less turnover of senior people in this business because there's no way they will get another contract that will maintain their benefits at 300% over market levels, because who in their right mind would give that job up?

JOHN HEINBOCKEL: There will be less turnover among tier-one employees and more among tier-two people because you're not going to give up that entitlement. My key question is, in three years, what percentage of the workforce will be tier two? My best guess is 35% to 40%. I think it's going to build gradually, unless there's a buyout, which the chains may very well pursue. In fact, they probably will.

HUSSON: I think what's going to happen, if things have stabilized and the chains are not getting all their share back, is a buyout will happen sooner rather than later. But Wall Street is famous for extrapolating the last two weeks' worth of data and suggesting there's a trend. We don't know what will happen at all.

HUNT: Rarely does anything flow to the bottom line after massive restructurings and cost-cutting programs, especially in highly competitive or commodity businesses. Are the Southern California operators going to take these huge cost savings and reinvest them in pricing to take market share? I believe most of the price investments have transpired and therefore a majority of the cost savings should flow to the bottom line in the coming periods.

MARK WILTAMUTH: With the pace of increases growing so rapidly on the wage and benefit sides of the cost equation, we may just see a slowdown in the growth of wages and benefits, and we will still see higher year-to-year selling, general and administrative costs for food companies. For a low-margin business, that is still a problem.

HEINBOCKEL: It depends on where you can get identical sales to. At the end of the day, I think you've probably got to get somewhere between 1% and 2% ID growth to get some leverage, and I think that's going to be very hard. If you're flat, you can get some leverage for a period of time in Southern California, but by and large you've got to get to between 1% and 2%. Can you get there by reinvesting savings back in the business? I think some companies can, if they invest in the right things and are diligent, but most companies cannot. A lot of companies won't, either because they won't invest the right amount of money, which is probably the lion's share of it, or they won't invest in the right things. The right things, to me, would be some mixture of pricing and service. I don't think you can focus on one at the expense of the other. Or if you try, you will end up losing. Maybe you don't lose to Wal-Mart but to Whole Foods or Wegmans instead. I think you've got to be able to do both.

ANDREW WOLF: I want to respectfully disagree with Margaret's supposition that it's a bad thing that the chains may be losing their experienced labor force. I think price is much more important than service, and that's proved out by the pricing spread. When the pricing spread got as great as it is now, that's when the share shift to non-union formats, particularly Wal-Mart supercenters, really began to accelerate. Whatever the service element was, it wasn't enough -- that added service element in traditional supermarkets certainly wasn't enough to stanch that. Secondly and more importantly, why are they doing all these buyouts of senior people if those people are so important? I think it's just not a highly skilled job, to be frank with you, especially at a traditional supermarket, especially at a traditional large public supermarket. Maybe the meat cutter, but even the meat cutting they do now is not as highly skilled like it used to be.

So I think when you look at those two things -- trying to get the cost structure down and getting a massive influx of people who may be inexperienced but who bring down your cost structure by 600 basis points -- it's a reasonable trade-off. If you ask supermarket executives if they would be willing to replace their whole labor force with a group that could bring costs down 800 basis points and take a shot at training them, I would have to think they would all take the 800 basis-point reduction in cost structure and the strain of training the new employees.

I also agree with Mark that it was a win in Southern California. I think the chains got most of what they wanted initially, but in other contracts since then they haven't, and that's really the quagmire. I think the employers could break the union because they have more financial firepower, but I think their shareholders would probably revolt, particularly if they felt it would weaken the chains in such a way that it made no economic sense. But nevertheless, they have to get major concessions from the union, I believe, for the industry to become competitive again. Nothing against the unions, because they've done great things for their membership, but in this world, where we're seeing increasing competition from non-unionized formats, I honestly don't see any real differentiation in the skill level brought to bear by the unionized labor force, and I think it puts those companies in a compromised position competitively.

OUTLOOK FOR INDUSTRY CONSOLIDATION

SN: What do you see when you look at the national picture for consolidation?

HEINBOCKEL: I think it's pretty dead, and I think it will stay dead for quite a while. One of the good questions to ask in any situation, whether a company bought a good asset or not or paid a good price or not, is philosophically, should it be taking capital out of a business or putting capital back in? I have nothing against a healthy level of reinvestment in the existing business, but to significantly expand your footprint in the current environment is much less ideal. If a company is going to spend X billions of dollars on an acquisition, would it not be better off not just financially but also operationally to earmark that money for share repurchases or debt reduction? Perhaps the only exception would be those rare instances where you get a premier asset at a very good price, along with truly intellectual capital in the form of formats or merchandise expertise. But other than that, you have to wonder whether that capital should be taken out of the business and given back to the shareholder in some form. It's not clear how broad-based that thinking is, but if it has enough adherents and if you combine that with the fact there's simply too much work to be done internally, I think it will keep people from doing sizable deals for quite some time. However, smaller, fill-in transactions will still be done and should be done, since they enhance core market positions and carry relatively strong [returns on investment].

HUSSON: What we're talking about here is two types of deals. One type is real-estate deals where underperforming assets show up in need of some kind of help, where each store can be bought at probably less than it costs to build a new one in a market that's adjacent to your current market. The second type involves moving into a new area, like an Albertsons who felt there was something it needed in Shaw's that was worth burrowing in to get. I think you're going to more real-estate deals than a lot of hopping across the country with companies going into brave new markets via acquisition.

WILTAMUTH: Investors have become convinced that the big deals that happened in the late 1990s were all value-destroying. A lot of those deals went for 10 to 12 times EBITDA, and I think there's still a big price disconnect between what the sellers think they're worth and what the buyers will pay. You just don't see large transactions coming to the market, and you still have anti-trust issues overhanging.

HUSSON: Well, [Albertsons' acquisition of] Shaw's helped us get past that a little bit. The Hannaford Bros. and Shaw's acquisitions are geographically next to each other, and one was half the multiple of the other, so deal prices have dropped smartly lower.

WILTAMUTH: The market didn't really stand up and salute the Albertsons' acquisition. The stock did not have a reaction on the announcement at all.

HUNT: There are only a few potential buyers out there, and the only investment-grade company with a balance sheet to make acquisitions right now is Supervalu. The high-yield companies are unlikely to make a substantial acquisition in the near-term, so I agree that acquisitions are probably dead for a while.

GIBLEN: You can again use Pathmark as a mirror of the industry. It's by far the most attractive asset strategically for anybody, but nobody's bought them. It's remarkable that no one has made a move for Pathmark.

HUSSON: My prediction is that Albertsons will own Pathmark within three years.

WOLF: I think Albertsons in a sort of technical sense got a really good deal [with Shaw's]. They didn't pay that much, and it should be fairly accretive. If the market didn't think it would be accretive in year one, the stock would have gone down. Albertsons' acquisition of Shaw's may be helping the stock somewhat, but I would say that the more important issue, as John pointed out, is what they should be doing with their money. Albertsons is the fifth largest drug store chain, and that's a much healthier industry [than supermarkets], and maybe they should be using the assets of the supermarkets as a cash cow and getting into some other lines of trades, especially ones that make sense, which would obviously be drug stores.

WILTAMUTH: You have to be careful not to over-judge the Albertsons deal on the first- or second-year earnings-per-share accretion because the hybrid security they used effectively adds 40 million or 50 million new shares for Albertsons three years down the road, so looking at it over the life cycle, maybe you are neutral or up slightly by the end, but it's not as accretive as it looks up front.

HUSSON: So maybe the whole story rests and falls on reverse synergies ...

GIBLEN: ... which have never been realized in the history of the industry.

HEINBOCKEL: Kroger got a lot of reverse synergies out of Fred Meyer. It probably didn't seem that way initially, but when you look at getting Food 4 Less and Fred Meyer, I think it might go down in history as one of the smarter deals in food retailing.

WAL-MART AND OTHER ALTERNATE FORMATS

SN: Let's hone in on alternate formats and where they are going.

HUNT: The 28 supermarket companies that file publicly are going to spend roughly $8 billion on capital expenditures this year, whereas Wal-Mart is going to spend $12 billion. Wal-Mart is going to add more square footage than every operator in the U.S. combined. Wal-Mart grocery sales are growing at 16% to 18% this year and Sam's Club stores are growing grocery-related sales at 6% to 10%, while the supermarket industry is growing at maybe 3%. Wal-Mart will take all of the growth in the industry in 2004. Wal-Mart is the consensus threat, but I believe some operators have proved they can co-exist and thrive profitably in the face of Wal-Mart expansion.

HUSSON: It's clear Wal-Mart is gaining share on supermarkets, but the one thing we've spent a lot of time looking at is where that share is coming from. It's all very well to say Wal-Mart added $20 billion in sales, but if only $5 billion or $6 billion of it came from the big cities because it put only a third of its stores in the top 100 metro markets -- at the same time the big food retailers' total sales are going up faster than the rate that the market was going up -- then the major food retailers are gaining share too. So what we are talking about is, everybody who's not Wal-Mart and not the big food retailers is clearly losing a lot of share, and in the big cities over the last six years, everybody that's not Wal-Mart and the top three retailers has lost nearly 25% of their share.

Obviously, the first thing to say is that Wal Mart is getting a lot of share, but sometimes it's like dropping bombs in the desert -- there's a lot of ordnance but it doesn't necessarily do a lot of damage because people aren't there.

With regard to dollar stores, I think that I've already talked about what happened in 1994 and 1995 as we came out of the last recession and club store sales were negative. The clubs back then were a lot more like gritty discounters than they are today, when they have become kind of yuppie playgrounds in many senses. Well, who was the gritty discounter that emerged in the recession in the early 2000s that was adding loads and loads of square footage and who everyone decided was the next new thing? It's the dollar stores.

But I think the dollar stores will fall firmly and hard flat on their face over the next few years. They're the next one to take it on the chin. I don't think the dollar stores are very good merchants. I think the in-store environment is weak in almost all cases, and procurement on fresh food is a mess. You've started to see inflation bouncing around again, and the dollar stores are all at sixes and sevens.

GIBLEN: I totally agree with Mark that there's a general law or cycle -- called "the wheel of retailing" -- where you come up with a hard-discount format and other people copy it and then the hard discounter adds bells and whistles to make a profit, and the concept kind of falls apart through co-opting.

As for the next big thing, I think clubs are going to get a second round of huge gains. As Mark correctly said, they were big in the early 1990s, and then they petered out, especially on the food side, in the mid-1990s, and now Costco has created a very powerful perishables and price advantage and Sam's is trying to catch up from trailer-park perishables to the proper standard. And that would mean, as a whole, a large group of Sam's stores with low prices and acceptable perishables.

SN: But Sam's is going out after the business customer.

GIBLEN: Oh yes, but it's not abandoning the consumer. And BJ's is going out there after them as well. BJ's is not as big an operator, but they're giving it a go, and if Costco ever bought BJ's, that would be scary for the supermarket industry because it would put better management in charge of some assets in the Northeast and would accelerate Costco's penetration into certain markets. So I think the next big thing would be round two of warehouse clubs. And a secondary next-big-thing would be more Whole Foods, with Whole Foods building really big stores as they are now but also developing a format to go into smaller markets.

SN: BJ's has come out saying they are taking on supermarkets, and Whole Foods has said they are going to blow supermarkets apart. It almost seems like there is a bit more aggressiveness by the alternate formats to take on supermarkets directly.

GIBLEN: Steve Burd's new strategy is to Whole Foods-ify Safeway. He pretty openly put it that way, so yes, the two formats are converging.

SN: Do you see Wal Mart getting into more formats and diversifying some more?

WOLF: Absolutely. Wal-Mart is an innovative company, and it experiments with formats -- a lot of them -- and it has failures and successes. I mean, it tried to bring a hypermarket to the United States in the 1980s.

GIBLEN: It also tried to do convenience stores even before that, though it didn't pursue that very much.

WOLF: I think the jury is still out on Neighborhood Markets, but I think two years from now we are going to see some movement there.

HUSSON: The jury wasn't out at this table two years ago, when a lot of people here thought the Neighborhood Market was the end of food retailing as we know it. Well, it's not.

WOLF: It's my opinion that Wal-Mart will continue to revise a Neighborhood Market-like store, supermarket or whatever, that can be rolled out in large numbers. What they're finding now is that they can shrink supercenters down a bit and put them closer to each other, and that's still a more powerful format.

WILTAMUTH: Even that new 99,000-square-foot supercenter seems to be something they're paying more attention to.

HUSSON: It's an interesting race to the middle, isn't it? Wal-Mart has got 100,000-square-foot supercenters in two big cities and Kroger isn't building anything that's less than about 70,000 square feet. I think Kroger is uniquely able, amongst the largest supermarkets, to roll out those big units because they attract market share, and they've got the Fred Meyer buying and merchandising skills in general merchandise.

HEINBOCKEL: They're trying to get at supercenter-style economics from a reverse angle. The big boxes have been adding food to drive incremental traffic for their higher-margin general merchandise. However, if you're a good food retailer, you've already got the traffic and now you just have to expose your customer to the right general merchandise at the right price. When we talk about getting a 1% to 2% ID sales growth, nonfoods alone could play a big role in getting there, but you have to have the know-how to buy the right product right, source it effectively, price it right and merchandise it attractively, and not everybody can do that. Whoever can will have a distinct advantage.

HUNT: If the new 99,000-square-foot Wal-Mart supercenter is economical, then the company has figured out a way to enter communities that have blocked the 200,000-square-foot-plus superstores. Whether it's California or Chicago, Wal-Mart may have figured out a way to enter new markets.

HUSSON: Now all it has to do is find the real estate.

One other thing that I think is worth mentioning is that British supermarkets recently have been buying convenience stores, with good results. The Tesco Metro stores, for example, have been fantastic, with very high private brands, a lot of very fresh products and unbelievable densities that are producing $3,000 to $4,000 per square foot. American supermarkets have got a lot on their plates right now, but convenience as a segmentation strategy is something they have to have in big cities. It's only a matter of time before somebody cracks that code, and while I'm not sure who's really working hard on it right now, I believe Delhaize is the one who is working hardest.

THE LOW-CARB TREND

SN: Is the low-carb trend over?

WOLF: I think it's not quite over, but it went from a fad to a medium trend, and I think the latest numbers show about 7% of consumers are on low-carb diets. There's a seasonality to it, and since bikini season is already over, you can move it down a bit on the consumers' priority list, and we may have to wait till next spring to see how much it's gone down.

But I think the low-carb movement is really related to the critical idea that the consumer really cares about health and the healthy quality of food and nutrition, though not to the exclusion of taste. That's one of the reasons low-carb isn't doing well -- because it just doesn't taste that good. But the trend toward eating healthy, as the American Dietetic Association tracks it, is obviously borne out by the way the natural food industry is growing in double digits and Whole Foods is growing about 20%. So one of the key merchandising trends on which the traditional stores really have to accelerate their focus is natural and organic foods. They just have to take some swings at that plate. They are treating it as just another category, but if they really want to succeed with it, they've really got to start making some commitments. They need to experiment and be a little more bold because that's one of the places where you can differentiate yourself on service, quality and merchandising.

Even Wal-Mart is going there. I cover the natural food industry, including the biggest producer, Hain, which has a growing relationship with Wal-Mart, and Wal-Mart is going into natural foods because they are going where the consumer is. This is not rocket science, but the chains need to take some swings and be more aggressive.

HUNT: I don't think the low-carb diet trend is going to die, but rather it will evolve. Low-carb allowed many dieters to reintroduce fat and meat into their diets. It has focused packaged food companies on the perils of processed sugars and simple carbohydrates. The food pyramid is about to change dramatically, and it will be used as a marketing tool in supermarkets and as a tool to change how our children are fed at school.

CANNELLA: The low-carb food pyramid is exactly the opposite of the former government food pyramid. You can turn that original pyramid upside down, and if this becomes the new official food pyramid, rather than just a craze for low-carbs, then what we've seen is a subtle change in the way people look at eating. I don't know that the craze will last or the growth in low-carb will be as dramatic as it has been, but some of the trends that we've seen are very much more long term in the way people are eating and are going to eat. People will be healthier.

TRADE PRACTICES

SN: One thing that hasn't changed a lot is supermarket trade practices. Are we likely to see changes in that area?

WILTAMUTH: Trade allowances are like a drug to the supermarket industry. Retailers keep going back and asking for more and more from the packaged goods industry, and that industry is increasingly feeling like they are not getting anything for their trade allowance dollars. You're seeing some push-back from that, and it's causing further stress on both sides of the industry.

WOLF: I have a completely different view. I think the food manufacturers started it because they like it. It's a way for them to sell their product. They were the originators of this idea. Some of them don't like it now, but plain and simple, they originated it. I'm not saying retailers haven't abused it -- it's been well known for a long time that some wholesalers made their whole margin on this kind of stuff.

WILTAMUTH: It does raise the question of what is your true cost if you're a food retailer. Wal-Mart asks for the dead-net low cost -- they don't want the trade allowances. A lot of food retailers may not know what their true food costs are.

HUSSON: There's good money to be had out there. The manufacturers aren't very efficient either. They say, "Here's your dead net price," and shake hands around the table, and as you're getting up from the table they say, "By the way, we're a bit overstocked for the November quarter, so how about taking 50,000 cases, and I can give you some money for doing so." So there's money above dead-net, and we all know that. Wal Mart is deeply suspicious that it doesn't get the same dead-net cost as other retailers after rebates and slotting fees and so on.

WOLF: I agree that it is completely inefficient, and we can explore all the best theories in the world on how to get rid of it, but these are multibillion-dollar trade practices.

GIBLEN: I think the biggest change is just that the CPG companies are being more discriminating as to where the dollars are going, and I think the trade dollars will always be there and it will always be inefficient. But it is less inefficient in the sense that a company like Winn-Dixie is not getting the same proportional share as Supervalu because their sales per square foot and their sell-through is less, so there is some discipline out there. Also, vendor allowance accounting has been cleaned up to the point that you can't arrive at the same financial-statement benefit from getting some of these allowances, and as a result some chains have begun to struggle and post bad numbers.

HUSSON: There is one case study, I guess, where we've seen a retailer -- Delhaize America -- move from high-low to close to dead-net, and their gross margin went up three quarters in a row after the change.

DELHAIZE/AHOLD

SN: Finally, let's talk about the two European-owned companies in the industry, Delhaize and Ahold. Let's begin with the outlook for Delhaize America, which has been highly leveraged.

HUNT: Since the fourth quarter of 2002, Delhaize America has generated real growth and a massive amount of free cash flow -- about $1 billion over the last three years. Its cash balance is roughly $500 million, and the company has been reducing bond debt through sinking fund payments. Although the acquisition of Hannaford was a leveraging event, it has been very fruitful for Delhaize America. The company has extracted a bevy of best practices from Hannaford, which have allowed Delhaize to maintain its industry-leading operating margin.

If you look at Delhaize America as an individual filer, it's got the best EBITDA margins and the best credit metrics in the industry, with the exception of Supervalu. I believe Delhaize has been one of the best performers over the last 12 months. With regard to its credit rating, I wouldn't be surprised to see the company upgraded in the next 12 to 15 months.

CANNELLA: Delhaize has two new prototypes that it's testing -- Blooms and Sweet Bay -- and it's going to be putting a good deal of money into both those prototypes. And provided those prototypes do well and generate the appropriate return, I think there's a high probability Delhaize will get its investment-grade credit ratings back, which is what the European parent firm wants, though that is probably more important to them in Europe than it is here.

HUNT: The new formats aren't going to make a big difference in the next 12 to 18 months with regard to an upgrade in the credit ratings. I think what's going to make a bigger difference for the company is the fact Food Lion is taking whole markets -- Charlotte or Raleigh, for example -- and remodeling all the stores in those markets at one time, which basically locks their competitors out from doing the same thing. They are using a large amount of contractor capacity in Charlotte to remodel their 85 stores there. They did the same thing in Raleigh, and comparable-store sales there have improved from the worst in the chain to the best.

HUSSON: Just as an aside, I think Pierre Beckers [Delhaize America chairman] is perhaps the most flamboyant and glamorous leader in food retailing, and a lot of people feel compelled to listen to him and kind of get entranced by his vision, and I think we need more people like that.

HUNT: What's been very interesting about Delhaize is, when it got downgraded and the bonds were trading in the 80s in September of 2002, the market was skeptical that the company's price-format store, Food Lion, could compete with a rapidly growing, price-driven Wal-Mart supercenter. I believe the convenience and price differential of Food Lion relative to Wal-Mart allows the company to be successful. There are more than 500 Food Lion stores in North Carolina and Virginia, so we doubt a consumer would drive five miles past a Food Lion to shop at a Wal-Mart supercenter to capture savings of 5% to 7%. Food Lion has proved to be successful, in my opinion, despite its significant 30% overlap with Wal-Mart supercenters.

WOLF: I think the greatest attribute of Food Lion is convenience. It's more convenient than a supercenter or most larger supermarkets. It's convenient however you approach it. You see Food Lions out in semi-rural areas where you won't see another supermarket. You'll see maybe two Food Lions for every Kroger. So if a consumer is going to shop a supercenter on the weekend and get a large order and shop a supermarket once or twice in the middle of the week, the primary attribute there, depending on the service level they want, may just be convenience, especially for a fill-in visit.

CANNELLA: Food Lion is the kind of store that an elderly person can actually get around in, and there's a place in the world for it. Food Lion may not have the cleanest stores, they are certainly not the most attractive stores, but they are easy to get around.

GIBLEN: The other big thing Food Lion has accomplished is to bring perishables from unacceptable to very respectable levels. They took away perishables as a reason not to step foot in a Food Lion.

HUNT: Perishables at Food Lion have changed dramatically in the last four years. When I moved to Charlotte four years ago, my wife was reluctant to buy perishables from Food Lion, but now the quality of the company's perishables is superior. At Food Lion, they stock [perishables] three or four times a day, depending on the traffic of the store, instead of once a day -- an operating technique the company adopted from Hannaford.

SN: What about Ahold, which has had distinct problems internally. How have those problems affected its U.S. operations?

WOLF: I'll talk about one market that I'm more familiar with than the others, Washington D.C. where Giant Food is one of Ahold's top assets. Giant clamped down and opted to cut back their cap-ex programs there because of liquidity issues, and other competitors saw it as a great opportunity to step up capital spending in a really growing market with a lot of disposable income. In addition, you're going to see increasing new entries by Harris Teeter in that market, Safeway is investing more in that market and Wegmans already has two stores there with more to come, I think. Washington is considered an attractive market, which I think it is, and when everybody else ratcheted up their capital expenditures, that wasn't a good thing for the Ahold assets. Giant is still a great asset, but you usually want to be the guy expanding in the good markets, not letting your competitors get ahead of you.

GIBLEN: I think what Andy is saying is very much true in all of Ahold's U.S. markets. Albertsons will tell you that one reason they like Shaw's so much is because [Ahold's] Stop & Shop is contracting by reducing labor and cutting corners overall, and while it is still an excellent chain, it's a lot less excellent than it's been. Living in Connecticut, I see Shaw's and Stop & Shop all the time, and you can see the change. To Ahold's credit, it's not as though Stop & Shop has become a dump -- it's just less excellent. It's lost an edge.

WOLF: There have been morale issues among management and store-level employees at Giant Food since they merged into Stop & Shop. That kind of thing is almost always going to cause some potential for morale issues.

CANNELLA: The big drag on Ahold in the U.S., I think, has been Bi-Lo and Bruno's. Ahold has put both companies up for sale, but I would think the likelihood those companies could be sold in one piece is pretty limited, so their underperformance in the U.S., at least for the next couple of years, is probably pretty much assured.

GIBLEN: It's pretty hard to outperform when you've publicly said the whole division is up for sale. That accelerates the deterioration, so they'd better sell it fast or it's going to balloon into a wasting asset.

HUNT: Can Ahold de-lever itself with the sale of Bi-Lo or Bruno's? Considering that Shaw's, a healthy operator, sold for 6.4-times cash flow, we believe it will be difficult for Ahold to reduce its leverage multiple significantly through the sale of Bi-Lo or Bruno's. Additionally, the supply pressure from more than 125 Winn-Dixie stores that are for sale in some of the same Southern markets could further pressure the proceeds from that sale.

SN: What's the likely disposition of Winn-Dixie?

CANNELLA: There will be a lot of cherry-picking of individual stores, but no one wants to go in and buy the whole company. Many of those stores have been in various life forms as part of other companies that also came to unattractive final ends.