BANKING ON SUCCESS

ELLIOT ZWIEBACH

The retail food industry improved its overall performance during the first half of 1998, achieving gains in sales and operating income and a healthy boost in comparable-store sales. According to securities analysts interviewed by SN, investments in acquisitions and store upgrades were the primary drivers of financial performance during the first half -- the same factors likely to propel second-half results, analysts said, although they offered varying opinions on which direction the economy may be headed.

A survey of financial results among the Top 15 publicly traded chains for the first two quarters of 1998 -- or, in some cases, the two quarters most closely paralleling the first six months of the year -- yielded the following results:

* Sales rose an average of 10.1% during the first half of 1998, compared to an average gain of 8.7% in the first half a year ago -- driven in large part by consolidations among some of the industry's major players.

* Operating income jumped an average of 25.7% for the six-month period, compared with an average increase of 24.3% during last year's first half.

* Reinvestments in stores by most operators helped comparable-store sales to hit a median of 1.4% for the six-month period. (Comparable figures for the first half of 1997 were not available because of a change in SN's methodology.) The industry performed well during the half, Mark Husson, an analyst with Merrill Lynch, New York, said, "considering there was no inflation to speak of -- less than half of 1%."

With inflation such a small factor during the first half, the sales gains supermarkets achieved were all real, Jonathan Ziegler, a San Francisco-based analyst with Salomon Smith Barney, pointed out.

Looking at first-half results, Ed Comeau, an analyst with Donaldson Lufkin & Jenrette, New York, said, "While each company has its own story, the companies with good stores, good market positions and generally good managements were able to sustain very good profitability in a tough, sluggish environment, while the companies with competitive or management issues found earnings didn't hold up very well. "For several years now we've seen the stronger, better-managed companies rising to the top in terms of size and performance, while others have run into more difficulties coping with the environment. This is the sixth year of low inflation and slow growth, so it's been a grinding environment for each company."

According to Husson, "Overall sales growth for the industry was strong during the half, with the large food retailers clearly outperforming the industry as a whole, while players like Penn Traffic and Grand Union were saddled with significant debt and unable to reinvest in their store base."

Analysts cited Safeway most often as the industry's prime example of a chain that's doing most things right. "Safeway is aggressively paying down debt from cash flow while still benefiting from very good market shares in stable markets, which is a winning combination," Comeau said. "Other companies -- those without acquisitions or without a plan to reduce costs -- are getting weaker year by year."

According to Ziegler, "There's really nothing original here. But companies like Safeway and Kroger are putting capital back into their stores to make them more consumer-friendly and more exciting. And they both have strong leaderships that recognize it pays to put money into the stores to get customers to spend more."

Looking at competition, Ziegler said that most strong retailers continued learning how to be successful competing with supercenters. "What's happening more and more," he said, "is that supercenters are applying pressure on smaller operators and independents, which frees up some sales in the market, and the strong supermarket players and the supercenters are dividing up the spoils.",

Husson also said the growth of supercenters, as well as the growth of more traditional competitors from within the industry, "added massive amounts of new space" for food retailers to cope with.

Several chains benefited from consolidation during the half, analysts said, including Food Lion, which acquired Kash n' Karry Food Stores at the end of 1996; Safeway, which acquired Vons Cos. early in 1997.; Fred Meyer, which acquired Ralphs Grocery Co., Hughes Family Markets and Quality Food Centers, earlier this year, and Albertson's, which acquired Seessel's, Super One and Smitty's during the half.

Analysts expressed very different scenarios on their expectations for the second half.

For Husson, the second-half outlook is uncertain. "There's still a slight pall of smoke over what consumers will feel like during the holidays," he said.

"It's possible people will be less inclined to spend heavily this year, and we might see them trading down because of the increased possibility that jobs are not as secure as they've been the last two or three years, and the economy is undoubtedly slowing down because of foreign markets, leading to the threat that unemployment will start rising. "What that might mean for the food industry is that some supermarkets might start cutting prices and margins before the end of the holiday period, and that could trigger a competitive reaction."

Ziegler, on the other hand, said he expects the second half to produce "gangbuster results," relative to the U.S. economy. "We're seeing a slowdown in other industries but few pressures on supermarkets, which seem basically to be improving their results," he told SN.

Comeau was in the middle, saying he expects things to remain pretty much the same during the second half, "with good performances by the same companies."

Looking at some of the chains individually, analysts made these observations:

A&P, Montvale, N.J., with sales in the half off 0.6%, comparable-store sales up 0.5% and operating income down 20.5%.

Comeau said A&P's sales were hurt during the half as the company closed more stores than it opened -- although that benefited same-store sales comparisons, he added.

"A&P is still wrestling with tough competition while it tries to restore its markets and deal with competitive conditions in the metropolitan New York area.

And it's bearing the expense of ramping up its capital spending program," Comeau added.

He said he expects some improvements in the second half because of A&P's ongoing increase in total square footage.

AHOLD USA, Atlanta, Ga., whose first-half sales rose 4.6%, comparable-store sales increased 1% and operating income was up 14.9%. Husson said some of Ahold's gains are the result of improvements from its ongoing Operation Compete, which involves sharing of best practices among the companies it owns, "and that should continue into the second half."

Ahold is also benefiting from procurement synergies, Husson said, with up to 70% of products sourced at the group level -- "a big increase over the prior year," he said -- "which has helped gross margins."

He also said private-label sales have been strong.

ALBERTSON's, Boise, Idaho, with sales up 7.6%, comparable-store sales up 0.3% and operating income up 9.5% during the half.

Husson said Albertson's first-half results benefited from the holiday the company took from earnings growth from mid-1996 to mid-1997, "during which it reinvested in front-end services and re-engineered its food offerings.

"Albertson's sort of reinvented its business, and customers are getting turned on and comps have begun to tick up as a result."

Although comparable-store sales were up less than half a percent for the half, they were up 1.5% in August and 2.3% in September, Husson said, "though comparisons will be a little tougher during the second half."

Comeau said he credited Albertson's sales increase during the half to additional square footage and the acquisition of several smaller chains, including Seessel's Supermarkets, Memphis, Tenn.; Smitty's Supermarkets, Springfield, Mo., and Super One stores in Des Moines, Iowa.

Albertson's acquisition of Buttrey Food & Drug Centers, Great Falls, Mont., was not finalized until the third quarter; its proposed buyout of American Stores Co., Salt Lake City, will not be concluded until early next year.

DOMINICK'S SUPERMARKETS, Northlake, Ill., with sales down 10.3%, comparable-store sales off 1.9% and operating income down 2.1% during the half -- results analysts attributed to disruptions caused by the company's conversion of its Omni stores to Dominick's Fresh format during the first half. Dominick's has reached agreement to be sold to Safeway, Pleasanton, Calif.

FOOD LION, whose first-half sales rose 1.2%, comparable-store sales rose 2.2% and operating income increased 15.9%.

Ziegler said Food Lion sales benefited during the half from its program of expanding smaller stores to mid-sized units to accommodate service bakeries and delis and from reformatting those stores, improving lighting and in-store signage and moving frozen foods to the opposite side of the store from produce, which alters shopping patterns.

Comeau said the strong first-half numbers reflect "Food Lion's ability to get its arms around Kash n' Karry," which it acquired at the end of 1996, and getting rid of its Southwest stores.

According to Husson, Food Lion's comparable-store sales were slightly easier during the half because of a strong second half last year following the addition of the Kash n' Karry stores.

GRAND UNION, Wayne, N.J., with sales down 2.1%, comparable-store sales down 1.1% and operating income up 49.6% for the half. Analysts said the company spent much of the first half focusing on its financial reorganization; Grand Union emerged from Chapter 11 bankruptcy protection in August.

HANNAFORD BROS., Scarborough, Maine, with sales up 5.4%, comparable-store sales up 1.7% and operating income up 11.1% during the half. "Hannaford has enjoyed a very stable performance," Comeau said, "and it added a lot of footage during the first half while eliminating several unproductive stores, including seven in the Southeast, which helped profitability."

Husson said Hannaford was not making money during the half in the Southeast or from its Home Runs home delivery program in the Boston area, "but the chain's underlying profits are strong," he said.

KROGER CO., Cincinnati, with first-half sales up 3.7%, comparable-store sales up 3% and operating income up 8.7%. Comeau said he attributed Kroger's strong comparable-store sales to "a pretty aggressive store growth plan for several years, with the result that a lot of those stores are maturing."

According to Ziegler, Kroger delivered "very strong comps and improved execution at store level" during the half, despite the ongoing rollout of Wal-Mart supercenters. He also said Kroger has benefited from the introduction of frequent-shopper cards in some markets.

Husson said Kroger is benefiting from ongoing remodeling. "Remodeled and replacement stores do well for them," he said. Kroger's announcement that it will acquire Fred Meyer, Inc., Portland, Ore., was made last week; the company said the deal will not be consummated until early next year.

FRED MEYER INC., Portland, Ore., with sales up 147.3% following its acquisitions of Ralphs, Hughes and Quality Food Centers during the half, comparable-store sales up 2% and operating cash flow up 185.6%. Husson said sales at Fred Meyer's supercenters in the Pacific Northwest were "very robust" during the half, while comparable store sales were hurt by the Ralphs and Hughes operations in southern California.

"Fred Meyer is increasingly dependent on California," Husson said, "and the Ralphs and Hughes stores were struggling during most of the half. But as the half drew to a close, the company began seeing more positive comps."

Ziegler said Fred Meyer began to see benefits during the half from upgrading some of its Smitty's stores in Phoenix, converting the Hughes stores to the Ralphs merchandising program and adding a new format at some Ralphs stores that features more general merchandise, similar to the Smitty's Marketplace approach.

The company is expected to merge with Kroger Co., Cincinnati, early next year.

PATHMARK STORES, Carteret, N.J., with sales down 0.8% for the half, comparable-store sales up 1.1% and operating income up 9.1%.

Ted Bernstein, a high-yield analyst with Grantchester Securities, New York, said Pathmark's comparable store sales were strong and total sales were off only marginally because of positive changes in store-level operations, including stronger promotions, a better perishables selection, an emphasis on politeness toward customers by store personnel "and a real focus on how to execute at store level that was missing before."

PENN TRAFFIC CO., Syracuse, N.Y., with sales down 5.6%, same-store sales off 3.7% and operating cash flow down 30.5% for the half.

According to Bernstein, the chain's weak first-half performance reflects Penn Traffic's inability to stop its financial descent. "Competition has been very fierce in most of Penn Traffic's marketing areas, and the company remains in bad shape because of overleveraging.

"And although it started some initiatives during the half under Phil Hawkins guidance (before Hawkins' resignation in August), those didn't pan out.

"Hawkins was able to take some costs out of the system but he failed to get more customers in the stores and to increase sales, and there was some disarray as the company struggled to determine what its franchise was and what image it wanted to project."

SAFEWAY, Pleasanton, Calif., with a first-half sales increase of 17.6%, comparable-store sales topping all other chains at 3.2% and operating income up 36.2%.

Comeau said Safeway's sales and operating income in the first half benefited from the acquisition of Vons Cos. during the first half of 1997; from improved sales in Canada following a strike in the second half of 1997, "and solid year-to-year results in its core business."

Comeau said comparable-store sales are strong "because Safeway is doing so many things right."

Husson said last year's Canadian strike enabled Safeway to renegotiate its Canadian contracts "and get a lower labor cost going forward, which should show up in increased profits next year."

Ziegler said Safeway benefited during the half from the ongoing rollout of frequent-shopper cards in all but one division. It also benefited from having most of its operations on the West Coast, where the economy remained strong throughout the half, he added.

Operating income has benefited from "the culture of thrift" that Safeway preaches, helped by the Vons acquisition and an improved product mix, Ziegler added.

"Safeway is probably the best operator today, and it continues to fine-tune its business to improve execution of in-store services, private label, in-stock conditions, fresh departments and attitudes toward customers," Ziegler added.

Safeway's acquisition of Carr Gottstein Foods, Anchorage, Alaska, will not be consummated until sometime next year; its fourth-quarter acquisition of Dominick's Supermarkets, Northlake, Ill., will close this month.

Performance at the Top

Here are financial results for the Top 15 supermarket chains with public equity or public debt. Although reporting periods vary, the chart represents sales, operating income (or operating cash flow) and comparable-store sales for the two quarters most closely paralleling the first six months of calendar 1998. Comparisons are with the year-ago period.

Sales Operating Income

Chain billions Change millions Change Comp Sales Reporting Period

1.Kroger Co. 12.8 3.7% 51 3 8.7% 3.0% 12/28/97-6/13/98

2.Safeway 11.0 17.6% 712.1 36.2% 3.2% 1/4/98-6/20/98

3.American

Stores Co. 9.8 3.3% 387 1.9% 1.4% 2/1/98-8/25/98

4.Ahold

U.S.A. 8.0 4.6% 346.4 14.9% 1.0 2/29/97-7/12/98

5.Albertson's 7.8 7.6% 418. 8 9.5% 0.3% 1/30/98-7/20/98

6.Fred Meyer 7.5 147.3% 606.2(d) 185.6% 2.0%* 2/1/98-8/15/98

7.Winn-Dixie(a)6.4 3.8% 108.5 -12.9% 2.4% 1/8/98-6/24/98

8.A&P 5.4 -0.6% 72.9 -20.5% 0.5% 3/1/98-9/12/98

9.Food Lion 4.7 1.2% 236.6 15.9% 2.2% 1/4/98-6/20/98

10.Giant Food 2.0 4.5% 62.2 (d) 67.3 1.9% 3/1/98 -8/15/98

11.Pathmark 1.8 -0.8% 107.9 9.1% 1.1% 2/1/98-8/1/98

12.Hannaford

Bros. 1.6 5.4% 79.1 11.1% 1.7% 1/4/98-7/4/98

13.Penn Traffic 1.5 -5.6% 58.2(d) -30.5% -3.7% 2/1/98-8/1/98

14.Dominick's (b)1.3 -10.3% 50.4 -2.1% -1.9% 1/25/98-8/8/98

15.Grand Union (c)1.2 -2.1% 52.5 (d) 49.6% -1.1% 1/4/98-7/18/98

FOOTNOTES:

* Comparison excludes Smitty's Supermarkets, Phoenix, and Hughes Family Markets, Irvine, Calif., which were being remodeled and remerchandised. (a) Reflects results for third and fourth quarters of 1998. (b) Reflects results for second and third quarters of 1998. (c) Reflects results for fourth quarter 1997 and first quarter 1998. (d) Earnings before interest, taxes, depreciation and amortization.