ECONOMIC PRESSURES SQUEEZE RETAILER PERFORMANCE

ELLIOTT ZWIEBACH / Additional reporting: Christina Veiders

The slumping economy took its toll on financial results among supermarket companies during the first half of the year, and the outlook for the second half is more of the same, according to SN research and securities analysts.

As pocketbook issues became more important to consumers, retailers responded by investing gross margins to become more price aggressive in an effort to hold onto sales, analysts told SN. Moving into the final quarter of the year, they were guarded in their expectations for second-half results.

As a group, the 10 largest public supermarket companies saw sales rise 6.3% from an 11.8% rise a year ago, according to SN research. Average same-store sales declined 0.1%, compared to an increase of 1.7% in the prior year. Meanwhile, operating income increased 10.7% for the group.

The decision by retailers to sacrifice gross margins to boost sales represented a reversal of operating philosophies for the major players, Chuck Cerankosky, managing director for McDonald Investments, Cleveland, pointed out.

"During the long economic upswing that preceded this period, retailers successfully traded customers up with more discretionary merchandising and higher price-point items," he said.

"But as consumers began cutting back during the first half of the year, retailers began offering more promotions and better pricing, which helped them maintain sales to some degree while having a negative impact on earnings."

According to Gary Giblen, senior vice president and director of research for C L King Associates, New York, "First-half financial results were dismal, reflecting the full bloom of the challenges that started in the latter part of 2001. Even the so-called best and brightest had disappointing results."

Jonathan Ziegler, San Francisco-based managing director for Deutsche Banc Alex. Brown, New York, said soft sales and margin pressures, "combined with the deflationary impact of Wal-Mart's expansion," had a negative impact on first-half results. To remain competitive, the major chains continued to seek cost reduction and used that money to plow back into more aggressive pricing, he added.

But Ziegler said he does not believe giving away margin is the way the industry ought to be going "because dropping prices doesn't give you enough sales lift to make up for the profits you lose. And in any price contest with Wal-Mart, Wal-Mart will win every time."

Mark Husson, analyst, Merrill Lynch, New York, noted the zero growth in overall food retailing volume in the first half, and said that "sometimes there is no amount of promotion that can get people to buy more stuff."

Ziegler said he doesn't anticipate much positive uplift for financial returns in the second half. "Sales didn't make a great rally in the third quarter, and some of the majors are already predicting that sales for the year will be flat," he told SN.

Meredith Adler, analyst, Lehman Bros., New York, said the biggest challenge for food retailers in the second half of the year will be to "keep your traditional loyal customers shopping at your stores in the face of a difficult economic environment and the increasing noise -- promotional and pricing -- from a wide variety of competitors including the drug stores."

Cerankosky said he is guardedly optimistic about second-half prospects. While noting that he's not ready to forecast any turnarounds -- and while saying he anticipates similar levels of competitive activity to continue through the second half -- "I think consumers will begin to spend again on discretionary items as they begin to feel better about the economic outlook, their own job security and their income levels."

Looking ahead, Giblen said he does not expect much change from the first half. "I have been optimistic in the past, but at this point, I see nothing good to look forward to. My sense is that things won't stabilize until the first half of next year, and even then the stabilization will be at only modest levels."

Discussing individual chain performance, analysts made the following comments:

KROGER CO., Cincinnati (first-half sales up 3.8% to $27.6 billion, operating income up 4.4% to nearly $2 billion and same-store sales up 0.6% and 0.8% for the first and second quarters, respectively).

"Kroger had a successful first half given the retail environment. They managed to make huge cuts in the head office costs, some regional costs and they passed some of those efficiencies onto the consumer," said Husson.

"Kroger was one of the first operators to recognize the difficulties that were coming, and it has done about the best job coping with the environment because it knows how to do things right," Giblen told SN. "But it's still seeking a happy medium between investing too little in gross margin, as it did during the first half, which resulted in disappointing comp sales, and investing too much, as it did in the third quarter in an attempt to pick up comps."

Ziegler said Kroger's sales lift came from its efforts to lower prices, "and although it got good execution at store level, it wasn't enough to make up for the margin it lost. But the company said it found $500 million in cost savings that it was able to plow back into more aggressive pricing, along with lowering its gross margins. So Kroger made the trade-off of sales and margins for profits."

According to Cerankosky, Kroger got more aggressive on pricing ahead of most competitors. "Kroger is historically predisposed to going after market share first because of its history of dealing with price operators in its core markets, and although it had gotten away from that pursuit for awhile, it said in the middle of last year that it would go after sales and market share more aggressively, and that started showing up in the results for the first half."

AHOLD USA, Chantilly, Va. (first-half sales up 27.7% to $23.5 billion, operating income up 33.8% to $1.2 billion and same-store sales up 1.3% and 1.4% in the first and second quarters, respectively).

David Shriver, London-based managing director for Credit Suisse, First Boston, said Ahold's U.S. food retail business "did pretty well and bucked the trend of U.S. food retailing overall." He cited Ahold's Northeastern businesses -- Stop & Shop, Giant Food of Landover, Md., and Giant of Carlisle, Pa. -- as more than making up for the poor performance turned in by Bi-Lo, Greenville, S.C. Despite the tough economy, Shriver said he expects Ahold will continue to outperform the industry overall.

Cerankosky also noted that sales and income benefited from the acquisitions in September 2001 of Bruno's Supermarkets, Birmingham, Ala., and Alliant Foodservice, Deerfield, Ill.

According to Husson, Ahold's comparable-store sales are "the best in [U.S.] food retailing," even though they have problems in the South where comp-store sales are lacking. "As a stand-alone company in the U.S., Ahold has done a pretty good job during the first half."

ALBERTSONS, Boise, Idaho (first-half sales down 2% to $17.9 billion, operating income up 241% to $984 million and same-store sales up 0.8% in the first quarter and down 0.6% in the second).

Analysts said the drop in sales is a direct result of the closing of 157 underperforming stores and the chain's exit from 95 stores in four markets (Memphis and Nashville, Tenn., and Houston and San Antonio). According to Ziegler, Albertsons' same-store sales performance would have been significantly worse if the company broke out pharmacy sales from the total.

But the outlook for the chain's financial performance is good, Ziegler said, with its efforts at store remodelings, including the expansion of dual-branded stores, and the rollout of frequent shopper cards. "And it's just scratching the surface -- Albertsons still has a long way to go," he said, "and it can expect sales lifts going forward."

Adler said, "This is a company that's been downsizing and trying to focus on markets where it's stronger and doing a lot of other things to improve its business."

Giblen offered a more critical viewpoint. "On the surface the first-half results look good, but there are indications Albertsons is making its earnings projections by raising prices and making cost reductions that are only short-term solutions," he said. "Nothing went wrong in the first half, but there were a lot of disturbing things beneath the surface. For example, we should not see gross margin going up, which is a bad idea in this environment and an indication the company is raising prices.

"The numbers look good, but subsequent quarters will show if Albertsons is achieving those results through expedient, short-term means."

SAFEWAY, Pleasanton, Calif. (first-half sales up 2.3% to $16 billion, operating income down 2.2% to $1.2 billion and same-store sales flat in the first quarter and down 1.1% in the second).

"They have been struggling," said Adler, especially in its acquired businesses. She noted that Wal-Mart continues to move into Safeway markets and Safeway's execution of strategies to improve its business has often been lacking.

According to Ziegler, Safeway prefers to attribute its lower financial results to the economy and the fact that consumers are trading down, "but I have to believe that Wal-Mart is hurting the chain, with 15% of its stores overlapping Wal-Mart supercenters. And although Safeway is getting better all the time at competing with Wal-Mart, as well as Costco, those companies continue to have a significant competitive impact on Safeway."

Safeway was a little slower than Kroger to invest gross margin in lower pricing, Ziegler pointed out, "and the first half of the year was the first time in several years that gross margin took a hit. And while Safeway did make the investment, comparable sales remained soft."

Ziegler said he expects Safeway to lower its earnings guidance in the next few weeks.

Cerankosky said Safeway's results have been negatively impacted by the company's exposure to the technology corridor that runs from San Jose, Calif., and San Francisco north to Seattle -- areas that have seen a lot of unemployment.

"In years past Safeway did an outstanding job getting customers in those areas to trade up, but with less disposable incomes, those consumers have started to cut back or to move to other formats, and those actions have resulted in lower sales and earnings for Safeway," he explained.

DELHAIZE AMERICA, Salisbury, N.C. (first-half sales up 2.3% to $7.4 billion, operating income up 2.3% to $624.5 million and same-store sales up 1.5% for the first quarter and off 1.2% for the second).

"Delhaize America in many respects reflects the problems the industry is having overall," said Shriver. He pointed to Food Lion's efforts to unsuccessfully drive top line through low pricing. "If Ahold is bucking trends in the U.S. food retailing sector, then Food Lion is a great illustration of all the problems the industry is facing."

"There's deep disarray at Delhaize," Giblen said, because of some management changes, challenges in Europe and ongoing challenges integrating Hannaford and Food Lion, and it appears almost like there's been cross fertilization of the worst practices rather than the best practices because it's not getting positive synergies."

Husson notes that Delhaize's Hannaford business held up well while Food Lion has been hard hit by the blue-collar recession.

WINN-DIXIE, Jacksonville, Fla. (first-half sales up 0.7% to $5.9 billion, operating income up 136% to $184 million and same-store sales up 0.1% for the thirdquarter and 1.2% for the fourth).

Analysts agreed that same-store sales in the half were going up against very weak numbers in the prior period, when comps were down more than 5%. But there has been sales improvement at Winn-Dixie," one analysts told SN, "despite facing one of the most competitive landscapes in the industry, which makes it very tough for the company to differentiate itself from the competition."

According to Giblen, "Winn-Dixie has really hit upon some good, basic programs that have helped increase comps and margins. Sales are benefiting from its early steps to convert more stores to a warehouse format, and the introduction of a requent shopper card is also helping. It sold its Texas operations, which was its worst division, and with those losses off its books, the company has been able to focus more on its stronger operations.

A&P, Montvale, N.J. (first-half sales down 3% to $5.8 billion, operating income up 110% to $115.4 million and same-store sales up 0.2% and 0.5%).

One analyst, who declined to be named, said sales were affected by the sale or closing of 55 stores during the last half of 2001 and the first half of 2002.

"But A&P is spending a boatload of money to make up for ground it's lost over the decades without getting any bang for the buck, but nothing seems to be working, and everyone is still waiting for Great Renewal returns to stick."

Giblen was even more blunt. "The company has begun its descent into meltdown," he told SN. "Things looked promising and heading for a sustainable turnaround, but once again, it didn't stick because A&P doesn't have the team to execute its initiatives properly. The company did the right thing getting out of Atlanta, focusing on its core areas and putting capital into its stores, but it doesn't have the people at store level to execute its programs properly."

PATHMARK, Carteret, N.J. (sales down 0.5% to $2 billion, operating income down 4.5% to $86.4 million and same-store sales down 1.2% for the first quarter and down 1.5% for the second).

Giblen said, "Pathmark is suffering more from the downturn in the economy, which affected the Greater New York area more post-9/11 than it has in other parts of the country, and the competitive intensity has increased greatly. Pathmark was pressured by ShopRite and by the competitive response of A&P to ShopRite's moves, and as a result it engaged in a series of successive promotions without letup, and competition only got more intense as the year progressed. In addition, Pathmark has gotten a little less sharp in its execution of store conditions and in its advertising."

Another analyst said Pathmark's sales were negatively impacted by factors affecting the entire industry, including food deflation; sales leakage to alternative formats; and the buildup of specialty departments over the last decade that are being hurt in a weakening economy.

PENN TRAFFIC CO., Syracuse, N.Y. (sales down 1.3% to $1.2 billion, operating income down 4.3% to $48.7 million and same-store sales up 0.6% and 1%).

"Penn Traffic got a boost in the first half from the introduction of frequent shopper cards, and comp sales have held their own," Giblen said. "The company continues to improve its basic blocking and tackling to achieve better results, but it's likely to fall victim to increased competitive pressures, and it may have already reached the inflection point."

HARRIS TEETER, Mathews, N.C. (sales down 4.5% to $1.2 billion, operating income up 13.1% to $44.2 million and same-store sales down 1.7% in first quarter and 1.2% in second).

"The same kind of competitive environment that has hit Food Lion has hit Harris Teeter in their market," said Husson. "The good thing is the productivity gains at Harris Teeter are better than anybody would have thought," he added.

"What helped Harris Teeter was the closing of some underperforming stores in its non-core areas," Giblen said. "But the results demonstrate just how bad things are, because even taking out its worst stores, comps were still weak, which is a rarity for Harris Teeter, and that reflects the economy and the competitive pressures in the Southeast, which have been brutal because of pressure from Wal-Mart."