BUILDING THE BOTTOM LINE

MARK HAMSTRA

Safeway and Kroger Co. improved their overall profitability in 2005 after successful measures to drive sales, but small, regional supermarket chains also achieved high returns, according to data compiled by SN.

In the second SN Profit Leaders Index, Kroger and Safeway debuted at Nos. 4 and 7, respectively, after special charges taken in 2004 kept them off the list and strong sales rebounds and cost controls led to better margins.

The index measures five indicators of profitability - return on assets, return on equity, net margin, gross margin and operating profit margin - and calculates the average of all five to assign a ranking.

Arden Group, the Compton, Calif.-based operator of the upscale, 18-unit Gelson's chain, achieved the topmost slot in the index for the second year in a row as the company clearly reaps the benefits of its premium pricing. It has the best profit ratios of any of the chains, beginning with its enormous 45.56% gross margins, nearly double those of most traditional supermarket chains.

Arden joins other regional operators that yielded high profit ratios in the most recent fiscal year, including Sunbury, Pa.-based Weis Markets; Charlotte, N.C.-based Ruddick Corp., parent of the Harris Teeter chain; and Village Super Markets, Springfield, N.J., a ShopRite operator.

Other companies in the Top 10 include Wal-Mart Stores, Bentonville, Ark.; Whole Foods Market, Austin, Texas; Delhaize Group, Brussels; and United Natural Foods, Dayville, Conn.

Arden's high profitability is a result of its longstanding premium positioning and high product quality, said Jonathan Ziegler, an analyst with Dutton Associates, El Dorado Hills, Calif.

"They are similar to Whole Foods in a way," he said. "Gelson's is truly an upscale chain. In a sense, they were very far ahead of the curve in doing perishable programs and in operating the upscale quality, full-service supermarket. Plus, there aren't very many of them, so they are not mass market like Vons or Ralphs."

In fact the only other chain with gross margins (calculated as sales minus cost of goods sold) approaching those of Arden is Whole Foods Market, the natural/organics chain known for its high pricing. Whole Foods tallied gross margins of 35.08% in 2005. Its gross margin grew slightly in 2005 from 34.76% in 2004.

Whole Foods' gross margin exceeds that of Wal-Mart by about 12%, and is 6 percentage points better than that of its natural-food rival, Wild Oats Markets, which had a gross margin of 29.14% in 2005.

Like Arden, Whole Foods is able to translate its high gross margins to the bottom line: The natural retailer's net margins of 2.9% in 2005 were third among companies in the SN Profit Leaders Index behind Arden's industry-leading net margins of 4.22% and the 3.59% net posted by Wal-Mart, which generates stronger margins on its nonfood sales to compensate for the narrow profit percentage it tallies from the sale of perishable items.

At the other extreme are the club stores, which operate with relatively little overhead compared to their sales volumes. Costco and BJ's Wholesale generated 2005 gross margins of only 12.44% and 10.39%, respectively, but produced net margins of 2.01% and 1.62%, within the range of traditional supermarket operators.

Kroger's efforts to reduce gross margins through sharper pricing have helped drive both the top and bottom lines at the nation's largest traditional supermarket operator. The Cincinnati company's gross margin of 24.75% in 2005 continued a steady progression of declines in that ratio since 2001, when it reaped gross margins of 27.35% on sales of $49 billion.

Safeway, by contrast, has maintained much higher gross margins - ranging from about 29% to about 31.5% for the past six years, as the Pleasanton, Calif., company has faced fewer price-oriented competitors in its core West Coast markets and has not adopted the more aggressive price positioning that Kroger has.

Keeping Costs Down

Kroger has been able to boost net income - even as gross margins have declined - through sheer sales volume and by keeping costs down, a trend that has continued through the first half of this year amid higher costs for diesel fuel and utilities.

"You can have a handle on the expense side as long as the sales are good enough, and Kroger's sales have really been outstanding," said Mark Husson, managing director and global head of consumer research in the New York office of HSBC, London.

Safeway has had a more challenging time managing expenses, as it operates a large number of stores in California, where utility costs have been extraordinarily high, he pointed out.

"California is uniquely bad when it come to electricity and power in general, because they basically have to burn gas to get electricity," he said. "So, year after year, Safeway has to sort of manage its way through something like $100 million of cost increases just on energy."

He noted that Safeway utilizes an energy management department, which helps the company "do a better job than most" at managing utility costs. He added that Kroger, with a greater concentration of stores in the Midwest, faces utility costs that are "not quite as horrendous."

Jason Whitmer, an analyst with Cleveland Research, agreed that same-store sales growth at the major chains has been a boon to the bottom lines.

"Better sales equals better leverage," he said. "Being able to leverage costs is a major plus for high-fixed-cost business, especially when you can put more pallets onto a truck, or have fuller trucks altogether or have more efficient routes altogether."

Whitmer noted that supermarket companies have focused on incorporating efficiencies into their distribution operations to keep costs at manageable levels despite pressures from rising diesel-fuel prices.

"There has been a big effort to have more efficient routing," he said. "At Safeway, having a more fixed-cost business has been a major area of focus for them. They are working all the way back with their suppliers and the vendors to the point where they are on the same page, so they don't get a lot of activity that would be cost-prohibitive. That's been a major initiative, directly influenced by the cost of gas."

Whitmer said one of the main areas of cost reduction for supermarket operators lately, however, has been shrink reduction.

"The biggest bucket that has moved the needle for everybody is shrink," he said. "Historically, that has not been an area that has been well-managed for retailers, but it's been getting a lot more specific attention, especially at Safeway, Kroger and Albertsons. They have all paid attention to it and have all had success to varying degrees, with price optimization software and things like that."

The reduction in shrink can also be traced back to the sales gains at these companies, he pointed out. Better sell-through on perishables has helped reduce waste, he said.

New labor contracts also have contributed to improved profitability, he pointed out.

"The contracts gave companies some needed labor savings, but the companies also have been working on improving labor productivity in the store, as far as relegating labor to peak times and things like that."

Whitmer also cited Albertsons' efforts to trim labor by having store managers run two stores in some regions.

"I think generally, there are fewer hours in the channel," he said. "That is another reason these companies are doing so well - the sales growth is exceeding the margin investments. That is the reason we liked Kroger a year ago, except now they are able to fund everything they are spending, whereas before everything was coming out of their own pocket."

In a recent conference call with analysts, Rodney McMullen, Kroger's vice chairman, said the combination of strong sales gains and cost controls helped boost margins in the first quarter of this year.

"Leverage from strong identical sales, plus good cost control in such areas as energy usage and labor productivity helped us overcome some of the significant increases in fuel and energy-related costs that many companies are facing," he said.

Kroger said its operating, general and administrative expenses declined 19 basis points in the first quarter, to 18.17% of sales. The company estimated that higher energy prices negatively impacted margins by 0.07%, vs. a negative impact of 0.13% in the fourth quarter of 2005.

The company also cited credit card fees as a major component of costs in the first quarter.

"Even with the increase in sales we had, credit card fees are still a major issue for us because those go up as more credit card usage occurs," said McMullen. "They don't decline as a result of higher sales; they just keep going higher. It's a big issue."

Another factor affecting margins is gasoline sales at supermarket-operated fuel centers, which have suffered reduced profitability as costs for raw materials have gone up.

In Safeway's first-quarter conference call, Steve Burd, chairman and chief executive officer, said the impact for supermarkets is even bigger than for traditional gasoline outlets.

"When costs go up you get a margin squeeze, and that margin squeeze for us might be just a bit exaggerated because our volumes are so much greater than people in the traditional or pure fuel business, because we have a higher volume per station," he said. "And so we experienced the cost increase long before them. As soon as costs stabilize or when they stabilize, margins immediately return to normal - it's just that we haven't really seen quite a stabilization yet."

Maintaining Margins

Although Whole Foods, No. 3 on this year's SN Profit Leaders Index, is working on improving its price image, analysts expect the chain's margins to remain within their normal range.

"Any time you add value, you should be getting a higher gross margin," said Scott VanWinkle, managing director, Canaccord Adams, Boston. "Whole Foods has stated pretty clearly that they just reinvest all their incremental margin into pricing. I think you're going to see incremental opportunities to expand gross margin through leverage and better buying be passed on in better prices.

"Whole Foods' model is not to let their gross margin go up. They are trying to use their size and strength to improve their value proposition."

Whole Foods itself conducted a study last year, finding that the primary deterrent to consumer purchases of organic product is high prices, he pointed out. The chain recently launched ads in New York that tout the chain's prices for the first time in that market.

"These specialty retailers should have higher gross margins," VanWinkle said. "They invest a little more in service, so their labor costs are going to be higher, on a per-store basis. If you are going to have higher labor costs, you had better be selling products at a better margin."

The company's high mix of prepared-food offerings relative to traditional supermarket chains also adds to the high gross margin, although VanWinkle also pointed out that such offerings also come with higher rates of shrink.

Wild Oats also operates with relatively high gross margins - 29.14% in 2005 - which puts it in league with regional operators Weis Markets and Ruddick Corp.

"Wild Oats doesn't have the sales productivity per square foot that Whole Foods has, and I think in general they've been a little more competitive on pricing with operators in their trade radius," Van Winkle said. "But in general I'd say they are similar to Whole Foods [in terms of generating high gross margins to fund higher labor costs]."

SN Profit Leaders Index

RANK: COMPANY; RETURN ON ASSETS; RETURN ON EQUITY; NET MARGIN; GROSS MARGIN; OPERATING PROFIT MARGIN; METRICS AVERAGE

1) Arden Group: 13.50; 24.11; 4.22; 45.56; 6.78; 0.188

2) Wal-Mart Stores: 8.13; 21.12; 3.59; 23.06; 4.90; 0.122

3) Whole Foods Market: 7.22; 9.98; 2.90; 35.08; 4.89; 0.120

4) Kroger Co.: 4.68; 21.82; 1.58; 24.75; 3.36; 0.112

5) Ruddick Corp.: 5.70; 11.27; 2.31; 29.21; 3.89; 0.105

6) Weis Markets: 8.04; 10.502.85; 26.39; 3.58; 0.103

7) Safeway: 3.56; 11.41; 1.46; 28.93; 3.16; 0.097

8) Village: 6.11; 11.66; 1.58; 26.08; 2.77; 0.096

9) Delhaize ; 3.56; 10.18; 1.96; 25.26; 4.83; 0.092

10) United Natural; 6.38; 14.07; 2.02; 19.18; 3.52; 0.090

11) Ingles: 2.49; 9.60; 1.17; 25.59; 4.03; 0.086

12) Spartan: 4.80; 12.50; 0.89; 18.74; 1.82; 0.078

13) Costco: 6.44; 11.97; 2.01; 12.44; 2.79; 0.071

14) Wild Oats Markets: 0.76; 2.91; 0.28; 29.14; 0.94; 0.068

15) BJ's Wholesale: 6.46; 12.65; 1.62; 10.39; 2.56; 0.067

16) Foodarama: 0.30; 2.28; 0.08; 26.04; 3.50; 0.064

17) Smart & Final: 3.35; 7.80; 1.07; 16.68; 2.13; 0.062

18) Nash Finch Co.: 3.83; 12.79; 0.91; 9.46; 2.86; 0.060

19) Supervalu: 3.41; 7.87; 1.04; 14.53; 2.19; 0.058

20) Ahold: 0.79; 3.42; 0.36; 20.69; 0.56; 0.052

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