COMPETITION FOSTERS WEAK SECOND-HALF RESULTS IN TOP 10

Elliot Zwiebach

The industry hasn't turned the corner yet.

Supermarket operators' challenges are too great to engender widespread optimism from analysts, although some see indications of a possible turnaround ahead after a weak performance in the second half of 2004.

SN's own comparisons for the top 10 chains with public equity or debt showed an uptick in sales of 6.2% in the last two quarters over the same period in 2003 -- driven largely by weak comparisons for Kroger, Albertsons and Safeway that stemmed chiefly from the strike-lockout in Southern California during the last two months of 2004 -- while operating income fell 7.8%.

Comparable-store sales in the July-to-September quarter rose to an average of 2.6%, compared with an average lift of 0.7% a year earlier, but comps for the October-to-December quarter fell to an average of negative 1%, compared with a positive 5.5% in the prior year -- a disparity resulting in large part from the impact of the labor dispute, which skewed comps for the "big three" chains while boosting comps disproportionately for Stater Bros. Markets.

Stater's comps fell more than 22% in the 2004 quarter after rising nearly 50% in the 2003 quarter. Excluding Stater from the 2004 comparison, fourth-quarter comps for the other nine of the top 10 public chains jumped an average of 3.6%, compared with 0.7% a year earlier.

The industry's overall performance in last year's second half "was the same as it's been for the last three years, with average or below-average sales and declining margins, though we began to see some companies breaking out of that pattern late in the year," said Jason Whitmer, an analyst with Midwest Research, Cleveland.

"Kroger was the first to break out, with better top-line sales but crummy margins, which prevented it from having much earnings momentum," he said. "But perhaps the industry is closer [to turning results around] than some people think, given that the last six months of 2004 were better than the first six months, so maybe the next six will be even better. We've already seen some improvements in sales, and with margins getting less worse than they've been, maybe we'll see easing of cost pressures and some improvements in the earnings component."

IMPROVEMENT SEEN

Jonathan Ziegler, an analyst with J.M. Dutton Associates, El Dorado Hills, Calif., said second-half results for most of the leading public companies "were not particularly exciting, though they were generally positive. But I think the gradual improvements we've been seeing should continue and things should look better during the first half of this year.

"For example, I think we're seeing more traction in commodity price increases due to inflation -- with more of them being passed on -- and that will show up in stronger same-store sales numbers. Furthermore, the industry isn't going to swallow increases in energy prices, so it will pass those along as well and make them stick, which is a favorable trend that will result in higher sales and better profitability.

"But competitive pressures won't let up, and some of the sales gains will be offset by increasing numbers of supercenters and dollar stores, although the fact that supercenters are operating off a larger base means their same-store sales might slow a bit, which should help the chains."

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., said the competitive environment in the second half was probably tougher than it had been previously, although the industry was able to begin passing along higher commodity prices late in the year.

The strike-lockout, which didn't end till late February 2004, will continue to impact results through the early part of the first half of this year, Wolf said, but sales overall should benefit as companies continue to pass through inflation increases, "though I don't expect real sales to accelerate," he added. "And once inflation subsides, then gross margins will be less crimped, even if the competitive environment stays robust, and that should help earnings."

THE STRUGGLE CONTINUES

Gary Giblen, senior vice president and director of research for C L King & Associates, New York, offered a less optimistic assessment, noting that financial results in the second half were worse than those in the first half of 2003, "with most investors thinking Kroger was starting to get the right combination of sales and margins, which turned out not to be the case -- and if Kroger, considered the best of the big three chains, is struggling, then the other two are struggling more."

With no let-up expected in competitive pressures and labor costs, Giblen said he sees no improvements likely in the first half of this year. "People have been looking for the industry to bottom out for the last three years, but it still hasn't hit that point yet," he said.

Mark Wiltamuth, an analyst with Morgan Stanley, New York, offered a similarly bleak outlook. At a time when the industry is growing at a rate of about 1% to 3%, he said, "Wal-Mart is consuming all of the growth in the food retail industry, with grocery sales growing at an estimated 16% to 17%. And club stores are growing at a rate of 8% to 9%, while the major grocers are pursuing 2% to 5% sales growth. Against this backdrop, competitive intensity is likely to rise in the years ahead."

Wiltamuth also expressed concerns about the margin outlook. "Earnings estimates for Kroger, Safeway and Albertsons have been falling short of investor expectations for four years now, and while the economy has improved and improvements to labor contracts have been achieved in the wake of the Southern California stike-lockout, promotional discounting and battles for market share continue to erode margins for the major grocers," he said.

Bryan Hunt, an analyst with Wachovia Securities, Charlotte, N.C., said the industry's performance in the second half of 2004 was "a little better" than in the previous six months, as inflation waned and the promotional environment eased in certain markets, "which enabled a lot of companies to reduce debt and solidify their balance sheets going into 2005. However, the industry was still unable to cut costs fast enough to make up for increases in pension and health care costs and the price pressures from discount stores and warehouse clubs."

Hunt said he expects industry profits will continue to weaken during the first half "as health care and pension costs continue to outpace sales growth."

SN looked at second-half financial results on a company-by-company basis. Those results, and analyst comments, follow:

KROGER CO. Cincinnati, whose sales for the half rose 5.5% to $26.6 billion; comparable-store sales (excluding fuel) grew 1.8% in the third quarter and 0.8% in the fourth; and operating income increased 3.7% to an estimated $1 billion.

Wolf said Kroger performed better in areas outside Southern California. "The sales recovery was due to investments in price, exemplified by a margin contraction of 91 basis points excluding fuel in non-struck markets, which had a negative impact on earnings," he pointed out.

Ziegler also said Kroger's overall sales gains came at the expense of profits as it gave away too much gross margin by overpromoting. "The good top-line numbers indicate an impressive recovery, but they came at a price, and the gains in operating income were due to weak comparisons against a strike-impacted second half in 2003," he pointed out.

Giblen said increases in fuel prices also contributed to Kroger's overall sales gains, while earnings suffered "because of Kroger's inability to find the equilibrium between adequate margins and sales growth."

ALBERTSONS, Boise, Idaho, whose sales for the half rose 21.9% to $21.1 billion; comps rose 0.5% in the third quarter and 5.3% in the fourth; and operating income rose 24% to $703 million.

Analysts acknowledged that Albertsons' strong sales growth reflected its acquisition of Shaw's Supermarkets in New England last April and of Bristol Farms, an upscale chain of 11 Southern California stores, in September; however, comp results exclude sales from both acquisitions. They also told SN the acquisitions made it difficult to determine how well Albertsons was actually doing during the half as it recovered from the Southern California labor dispute.

Wolf said Wall Street was disappointed by Albertsons' earnings in the half, despite the jump on operating income. "It's easy to improve on strike-impacted results, but the company's guidance had led investors to expect more than Albertsons delivered," he explained.

Ziegler said Albertsons' second-half performance was unspectacular. "Comps of 0.5% in the third quarter did not even duplicate the rate of inflation, and while the company claimed a huge fourth-quarter recovery in Southern California from the strike-lockout a year earlier, the comp increase of 5.3% indicates comps in most other areas must have been lackluster."

Wiltamuth said Albertsons was forced to invest more in margins during the half than it had anticipated after the launch of its "Check the Price" campaign in the third quarter "revealed more markets and product categories where further gross margin investment was required."

"Investors were generally disappointed with Albertsons' top-line results and by the quality of earnings," Whitmer said. Margins were stronger than at Kroger and Safeway, he pointed out, "but the underlying strength of the top-line was not as good. And Albertsons wasn't operating its stores as well, and it probably needs to get rid of a lot of locations."

SAFEWAY, Pleasanton, Calif., whose sales for the half increased 1.9% to $19.7 billion; comps (excluding fuel) were negative 0.5% in the third quarter and negative 0.3% in the fourth; and operating income fell 14.7% to $737 million.

Although comps continued to be negative, they picked up slightly during the fourth quarter in comparison with the strike-impacted quarter a year earlier, Wolf pointed out. He said the negative trend was partly due to "internal problems created by the acquired businesses -- Dominick's, Randalls and Genuardi's -- which continue to have an adverse impact on Safeway's results."

Giblen also said those acquired chains complicated Safeway's ability to grow sales. "As the primary target of the Southern California strike, Safeway had the biggest recovery to make and should have had the best comps of the top three, yet it had the least gains because of broad-based problems beyond the strike, including its ongoing struggles with the integration of the three acquired chains," he said.

Whitmer said the drop in income was mostly due to higher operating and administrative expenses as Safeway tried to recover from the strike. He said he attributed the sales increase to Safeway's ability "to find the right formula for its stores. Over the last six months, it's been moving forward with its 'lifestyle' store remodels and cleaning up its centralization operation to be in a position to improve sales going forward, and those efforts are starting to show."

Ziegler said second-half results "were nothing for Safeway to crow about. Sales growth was uninspiring, but the good news is the chain's reaction to that, which is to roll out its lifestyle stores, which may improve results going forward."

AHOLD USA RETAIL, Quincy, Mass., whose sales for the half rose 0.4% to $12.9 billion; comps fell 1% in the third quarter and 0.7% in the fourth quarter; and operating income fell 6% to $245.1 million.

Jerome Samuel, an analyst for Ixis Securities, Paris, said operating profits for Ahold's U.S. retail operations "fell well short of expectations," with the bulk of the shortfall stemming from restatements, onetime items and other special provisions as the company seeks to overcome past financial issues.

Comparable-store sales at Ahold's Stop & Shop division were negative during the half "because it had to increase its promotional activities due to pressure from Wal-Mart, which depressed operating margins, but that didn't generate enough sales," Samuel said.

Patrick Roquas, an analyst with Amsterdam-based Rabo Securities, said results were negatively affected by increased competitive pressures, as well as by the company's ongoing integration of its Stop & Shop and Giant Foods operations. "Giant of Landover in particular saw the impact from competitive square footage growth and promotional activities, while Giant of Carlisle and Tops showed resilience, and Bi-Lo and Bruno's performed ahead of expectations [prior to their divestiture earlier this year]," he noted.

DELHAIZE AMERICA, Salisbury, N.C., whose sales for the half fell 0.5% to $8 billion; comps rose 1.7% in the third quarter and 1.5% in the fourth; and operating income rose 7% to $414.6 million.

Sales at Delhaize America were impacted by an extra week in the prior year, analysts said; adjusted for that week, sales for the half were up 6.5%,

Hunt said he attributed the overall increases to marketwide remodelings of Food Lion stores in Raleigh and Charlotte, N.C.; the acquisition of the midsized Harvey's chain in North Carolina in 2003; and ongoing sales strength at Hannaford stores in New England.

"Operating profits were fantastic in the half," Hunt added, with operating cash flow margins expanding from 7.6% to 8.4% as a result of the chain's ability to cut costs, stress higher-margin perimeter departments and reap the benefits of fewer competitive pressures in the Southeast with a weakened Winn-Dixie.

Ziegler said he attributed the sales and income gains to efforts to reformat the Kash n' Karry stores under the Sweetbay banner and to strengthen the smaller Food Lion stores by emphasizing new perishables programs, while Samuel said Delhaize America continued to benefit "from four or five years of clearing its portfolio to end up with a better base of stores."

Giblen said Food Lion benefited during the half from declining fortunes at Winn-Dixie and the transition of Bruno's and Bi-Lo to new ownership, "and it also benefited from the effort to move the stores beyond just price to a better perishables offering," while Kash n' Karry benefited from a stronger fresh orientation as it transitioned to the Sweetbay banner.

WINN-DIXIE STORES, Jacksonville, Fla., whose sales for the second half of the calendar year fell 4.2% to $5.4 billion; comps fell 3.7% in the first quarter and 4.8% in the second; with an operating loss of $251.1 million. The company filed for Chapter 11 bankruptcy protection in February.

Giblen said Winn-Dixie's second-half results were impacted by the vicious cycle in which it found itself. "As bankruptcy became more imminent, vendors tightened their trade credit, which made it difficult for Winn-Dixie to keep its stores well-stocked, which made it difficult to grow sales," he explained.

Hunt said the ongoing decline in Winn-Dixie sales "is a function of not having a brand identity. It has so many stores in so many different conditions in so many different demographic areas that it's hard to communicate with consumers what Winn-Dixie means. And the fact the company has been through several different strategies and top managements over the years creates confusion among the chain's managers as well."

Ziegler said Winn-Dixie also suffers from being caught between the upscale merchandising of Publix Super Markets and the price-oriented programs at Wal-Mart supercenters, "which take market share from it at both ends. Winn-Dixie has failed to get its arms around what it wants to be in terms of presenting itself to the market, and the addition of Peter Lynch as CEO came too late in the half to have much impact."

A&P, Montvale, N.J., whose second-half sales rose 1.3% to $5 billion; comps rose 0.1% in the second quarter and fell 0.1% in the third; and earnings before interest, taxes, depreciation and amortization (EBITDA) rose 14.7% to $28.8 million.

A&P's ability to cut costs helped boost profits during the half, Hunt said, "with sales stabilizing as some of that cost cutting fell to the bottom line." The company also benefited from an easing of competitive pressures in the Northeast and New Orleans and from remodeling efforts in its Farmer Jack division in Michigan and Ohio, he pointed out. "Plus, it saw margins increase 20 basis points in the half, which is a big number in a company that generates EBITDA margins of 1.8%."

Giblen said most of A&P's gains occurred in its Canadian operation. "While sales in the U.S. continue to be flat to minimally positive, A&P is continuing to lose money and leak cash every quarter, all of which is masked by the strong results in Canada," he said.

WHOLE FOODS MARKET, Austin, Texas, whose second-half sales rose 22.8% to $2.3 billion; comps rose 14% for the fourth quarter and 11.4% for the first quarter, and operating income rose 25.5% to $132.6 million.

"Whole Foods is the 800-pound gorilla in its sector, and there's really no one nipping at its heels," Wolf said, "and its level of execution is better than anyone else, anywhere."

To Giblen, Whole Foods is "the success story of the industry." He credited some of the chain's second-half gains to its ability "to retain virtually 100% of the business it picked up during the Southern California labor dispute."

Ziegler said Whole Foods' comps "came down a bit late in the half because the company picked up so much business in Southern California during the strike. While 11.4% was a very reachable number, I would have expected more softness because Southern California is such a major market for it, but Whole Foods continued to show great merchandising execution."

PATHMARK STORES, Carteret, N.J., whose second-half sales rose 0.2% to an estimated $2 billion; comps rose 0.5% in the third quarter and fell an estimated 0.9% in the fourth; and EBITDA fell 24% to an estimated $72.4 million. (Pathmark was scheduled to report fourth-quarter results late last week.)

Hunt said Pathmark's sales flattened out during the half as it continued to cope with competitive pressures from Wakefern's ShopRite operation -- pressures that prompted the chain to make some promotional changes that didn't work as planned, he pointed out. "Pathmark tried to be perceived as the low-price provider in its marketplace, but it stubbed its toe, which it acknowledged, by promoting second-tier brands in its circulars."

That misstep, combined with a move to everyday low pricing on health and beauty care items, weakened profits, he added.

Ziegler also cited Pathmark's promotional missteps during the half, "including spending money on less important products that consumers didn't care about, which didn't move the needle." He said the EDLP program for health and beauty care items, "is a good idea but one that will take longer to reach a break-even point in an economy where sales in general are soft."

STATER BROS., Colton, Calif., whose second-half sales fell 3.1% to $1.7 billion; comps rose 13.4% in the fourth quarter and fell 22.2% in the first; and operating income fell 47.2% to $46.2 million.

The drop in sales for the half and, especially, for the first quarter are attributable to the strong increases Stater enjoyed at the end of calendar 2003 and the early part of 2004, observers pointed out.

Sales were also negatively impacted late in the half by heavy promotional activity at the three major chains, Hunt noted, "which resulted in quite negative comps and hurt profitability." However, he said Stater's comps have risen approximately 7% a year over the last two years on a compounded annualized rate, "so sales are strong, despite the second-half comparisons."