FOOD RETAILING'S FUTURE 1999-09-06 (2)

NEW YORK -- The next round of industry consolidation is likely to involve mid-sized regionals and some of the nation's privately held companies while most of the industry's prime movers in consolidation take a breather.

reluctant to seek partners two years ago may be changing their minds. "I'm kind of waiting to see when big private companies like Publix and H.E. Butt, or smaller ones -- the Wegmans or the Giant Eagles of the world -- say they can no longer go it alone, though it isn't clear to me that they're feeling desperate yet."

Their decisions on whether to seek strategic partners could be prompted by each company's long-range planning, according to Ed Comeau, first vice president at Donaldson Lufkin & Jenrette here. "It's no longer the family company that you can just nurture along and enjoy running -- the business is being taken to another level, and some of these companies will have to decide whether they are ready to jump on that or whether to take advantage now of arguably the highest valuations this industry has seen," he said.

To be truly marketable, retailers must have "a defensible niche or a strong regional stranglehold," Mark Husson, first vice president of Merrill Lynch here, said. "If you haven't got either of those, all you have is real estate, and that's worth only real-estate value."

According to Ted Bernstein, a high-yield analyst with Grantchester Securities here -- a wholly owned subsidiary of Wasserstein Perella Securities -- "The next few months will see a period of digestion of the big acquisitions that have occurred -- and maybe a little indigestion as well -- and then subsequently we'll see the pace [of consolidation] pick up again."

On the subject of financial performance, the analysts said they see an ongoing lack of investor interest in putting money into supermarket stocks.

Gary Giblen, New York-based managing director of Banc of America Montgomery Securities, San Francisco, said the euphoria that followed last year's big mergers by Kroger and Albertson's has waned, "[and] the next six months could be a little slow-going because you're not going to have a lot to hang your hat on."

Drug stores seem to have captured more investors' imaginations, Debra Levin, principal with Morgan Stanley Dean Witter here, said. "Investors like to see momentum at the top line, and it's obvious at the drug stores and less obvious at the supermarkets, and it's doubtful you're ever going to see it."

Jonathan Ziegler, San Francisco-based director for Salomon Smith Barney here, expressed a similar opinion. "We have a group here that's pretty much going to deliver a high-teens earnings growth among the big players, and the drug stores are in that same growth mode, and yet the drug stores sell at a 10-multiple-point premium because they have investors convinced there's a whole macro story there of rapid growth demographics."

Other analyst observations during the roundtable included the following:

Wal-Mart will continue its measured rollout of Neighborhood Markets, though it remains unclear if it will use the small-store format to fill in markets between supercenters or try to penetrate new urban locations.

A variety of alternative formats -- including supercenters, warehouse clubs, drug stores and convenience stores -- are likely to continue to offer stiff competition to supermarkets, with the Internet evolving as possibly the stiffest threat of all.

While retailers in general have Y2K issues under control, outside forces -- power companies, phone companies, vendors and others -- could have an unforeseen effect.

The future of wholesaling is shaky, with the need for wholesalers to completely redefine themselves if they hope to survive.

The complete text of the roundtable follows:

Supermarket News: We've seen an acceleration of industry consolidation, and the big question now is, what's going to happen next? Perhaps we could start out with some comments about the general pace of consolidation we're going to see in the near term.

Debra Levin: My sense is that consolidation is going to continue -- that you'll see a steady pace of smaller companies being acquired, certainly as there are continued operating pressures abounding in the environment as both the large, traditional operators and the Wal-Marts of the world continue to add units, which just exerts more and more pressure. You're going to see companies being acquired that have 20 stores, 50 stores, 100 or 200 stores -- those are the ones that are prime candidates for consolidation.

If there is one major consolidation left, it could be be Ahold joining forces with one of the big three (Kroger, Albertson's and Safeway), but I'm very, very skeptical that will happen because I think there's an issue of real ego by the heads of those chains.

Meredith Adler: In past conversations with some of the private companies, the ones that are strong regionals, they seemed very reluctant to sell, at least two years ago. They were all saying at that time that their businesses were doing well, that they were looking to do acquisitions themselves and were not particularly looking to sell. Now Safeway is talking about getting more phone calls from companies that are feeling more pressure. So I'm kind of waiting to see when big private companies like Publix and H.E. Butt or smaller ones -- the Wegmans or the Giant Eagles of the world -- say they can no longer go it alone, though it isn't clear to me that they're feeling desperate yet.

Ted Bernstein: I think the consolidation that's taken place over the last two or three years has been remarkable, and I think it's brought to the forefront the need a lot of the smaller chains have about being acquired or finding strategic partners. If you look at southern California, for instance, you see that as recently as two or three years ago you had five or six competitors, whereas these days there are essentially three. So chains that operate in those sorts of environments are really becoming very much cognizant of the pressures they face.

The field of [high-yield] companies I follow, which has a good mixture of public and private companies, has been pretty well picked over at this point, and the ones that are left either don't want to sell or can't sell. I think perhaps some of those that originally didn't want to sell might be persuaded to do so ultimately -- companies like Marsh or Stater Bros.

But I think in the next few months we'll see a period of digestion of the big acquisitions that have occurred -- and maybe a little indigestion as well -- and then, subsequently, we'll see the pace pick up again, though maybe not to the same extent that we've seen in the last couple of years.

Mark Husson: Safeway says there are about 55 chains doing between $200 million and up that are potentially acquirable, and you would need to have $1 billion in a standard line market for Safeway to be interested. But if you look at those 55 chains, there are a number that are the size Safeway says it actually doesn't want. So if you narrow it down to really buyable chains, there may be only 25 or 30.

I think in food retailing you need to have either a defensible niche or a strong regional stranglehold, and ideally you want to have both. If you haven't got either of those, all you have is real estate, and I think it's only worth real-estate value. So I think there is still some pipeline there for consolidation with or without making further acquisitions.

SN: Of the major consolidators right now, who do you think is most eager to do another deal in the near term?

Gary Giblen: I'd say Safeway has to be the most acquisitive because Steve Burd [Safeway chairman and chief executive officer] made it very clear that the Randall's deal does not preclude Safeway from pursuing lots of other acquisitions. Given Safeway's record, it really deserves a gold star in the industry for best acquisition integration. Every acquisition it's made, it's done it better and faster than the one before, and Randall's is an easy, automatic-pilot kind of acquisition for Safeway.

SN: So you think the next consolidation will be a Randall's-sized merger?

Giblen: Randall's or larger. There are larger companies, like Winn-Dixie, that would make sense. There'd be no reason why Safeway couldn't do Winn-Dixie tomorrow morning. Bernstein: I also think Safeway is the most eager to do another deal. Safeway will certainly use the island it's established in the middle of the country (Dominick's) as the base to do that. Certainly, I would think it's probably going to grow out of the Chicago area first.

Jonathan Ziegler: I would say Ahold in Western Europe. Ahold is too weighted to the U.S. right now, and I think it will try to balance that out and be a player on the continent.

SN: Didn't Ahold also say it wants to do more in the United States?

Ziegler: Oh, it does, but I don't think that will be the next one. I think Western Europe.

Husson: I would also say Ahold, and maybe not necessarily in the United States. Everyone wants good market shares and slightly white-collar retailers that see the world the way they see it, but Ahold seems relatively unconstrained by the kind of retail formats it picks up. Whereas Safeway buys a certain kind of company where there's a good cultural fit and very strong market shares, Ahold just needs to have a management team that is capable of behaving as part of a larger team. I think that acquisition strategy, which doesn't roll roughshod over the acquired company and doesn't fire everybody, actually meshes quite well with some of the names that are still out there who want to make sure that what they've created over the lifetime of the families involved is preserved in some measure. I think Ahold guarantees them some of that kind of historical significance.

SN: Do you think Ahold will be clinging to the East Coast?

Husson: Well, there's not much left on the East Coast. The Federal Trade Commission is being a pain in the process, and I think for that reason, Ahold can't cling to the East Coast in the way it has in the past. Although the West Coast seems done, there's a big gap in the middle there.

Levin: I think Safeway is the most focused about getting acquisitions done. And I think Ahold certainly would love to get a company like Publix if it gets the opportunity, and then Western Europe really has to be taking a big part of its time, because there should be opportunities there as things change.

But I think it's interesting that no one has mentioned Kroger and Albertson's, and the reason is they're so busy right now. Kroger has a big transition with Fred Meyer, which still isn't done integrating its own former acquisitions, and Albertson's has this huge process in front of it integrating American Stores. So I think that sort of takes them out of the running for the moment, though both would be opportunistic, and they would certainly do a deal, even if it's just a 10-store or 30-store chain -- nothing would prevent them from doing that. But in terms of doing anything sizable, I think certainly over the next year to year and a half, both of them are going to want to focus on making sure the transitions go well, because, realistically, that's a big process.

Ed Comeau: I think Albertson's will be involved with whatever's available for sale. My guess is it's not going to be the top bidder, but it will be very active, even though it does have a lot on its plate.

Giblen: Another active acquirer will be Supervalu, perhaps not in the immediate term but certainly well before next summer. It has the desire, and it should have the financial capability after absorbing Richfood, and it's an intrinsic part of Supervalu's strategy to get the mix more towards corporate retail. Supervalu has some excellent, successful retail formats now, like the Sav-A-Lot limited-assortment stores, and it can really expand that with Richfood and use other assets that it's acquired toward that end.

Husson: Another perhaps less obvious acquirer is Shaw's/Sainsbury, which has said it wants to get to $10 billion in sales as quickly as it can. Star Markets only gets it a small way there.

Another one would be Publix. When you're sitting there with $1 billion on your balance sheet and looking for the next big market to attack, the thought process must be, "do we want to go through another Atlanta?" Publix was ultimately very successful in entering Atlanta, but it's a huge effort to do that, and, at this stage, I think Publix can see the number of really good fits slimming down quite quickly and I don't think it's going to be long before it does something.

Ziegler: One thing that's interesting is Steve Burd's response to the idea of Safeway going international when he said that, if he was based in the Netherlands, he'd come to the United States too. but if he's here, he has absolutely no need to go abroad -- and I don't see any domestic companies making sounds about global expansion, even though there are a lot of mouths to feed in other parts of the world. But right now it seems like it's all really domestic.

Levin: But the U.S. is still a fragmented market. Even if different regions are consolidating and consolidated, there's still a lot of opportunity when you look a the big picture, and I think a lot of companies are very cognizant of that and there are still a lot of smaller and private companies out there who over time will be thinking through issues, be it competitive issues or family issues, regarding whom to pass the torch to as generations age.

Adler: But if you look at the acquisitions that have been done and make a list of them, it's surprising how many of those companies were owned by financial buyers. A disproportionate number of transactions we've seen have involved motivated sellers who had an exit strategy, so to me there's still a question of what's going to motivate private companies.

Comeau: I don't disagree with you, but I'd imagine you'd have to assess a company like Giant Eagle or certainly H-E-B or Schnuck the next five or 10 years and determine what the management transition looks like, if there is a transition plan and how much capital should they put in. I mean, in this environment you have to really get very serious about making sure you have the right systems, making sure you're investing in the business. It's no longer the family company that you can just nurture along and enjoy running -- the business is being taken to another level, and some of these companies will have to decide whether they are ready to jump on that and pursue that strategy or whether to take advantage now of arguably the highest valuation that this industry has seen in terms of merger and acquisition activity. I think the companies are all wrestling with those decisions, and each one of them has to come up with its own answer.

Giblen: To build on Ed's point, Seaway Food Town is a company that's doing pretty well, and there's no urgent operating pressure for it to sell out, but it has publicly announced it is considering financial alternatives that include selling the company just to be competitive and to keep up with the pace of change in the industry.

Adler: I met with Seaway maybe two years ago, and it was obvious to the CFO at the time that it needed to do something, but it's interesting that it took him two years to convince the rest of the organization. It shows you that the pace of consolidation has moved very quickly. We're talking in terms of months, yet when you talk to some of these companies, things are moving much more slowly for them.

Giblen: It just seems to be the general environment as well, because there are a lot of perfectly OK independents that have sold out to Spartan. Why? Because of lack of management succession, family issues and so forth. Even without a specific catalyst, you can achieve a rapid change in the pace of consolidation, and I think that's what's happening.

FINANCIAL PERFORMANCE

SN: This wouldn't be a financial analysts' roundtable if we didn't talk a little bit about financial performance. Let's discuss the outlook for the industry and the financial health of the industry for the next six months or a year.

ZIEGLER: You've got a heating up of world economies, which I guess for a while has attracted investors to other sectors, because this one [supermarket stocks] is so amazingly domestic. On the other hand, it could be good for the group, tangentially, if commodity prices start getting a little bit higher because of the demand offshore, and that would have a positive impact on nominal reported same-store sales, which could probably be good for the industry.

And if the economy slows, then perhaps people would start looking at this sector as being a good mid- to high- earnings growth sector with relatively low risk in a slowing economy. So I guess I'm an optimist.

Adler: I would say the surprise has been the extent to which the industry has managed to de-couple earnings-per-share growth from sales, especially since the industry is perceived as being able to execute extremely well. There's been a tremendous amount of under-management, in my view. You've got companies like Safeway finding ways to lower expenses even as there's been absolutely no tailwind from inflation, and I'm comfortable saying that, even 12 months out, you will continue to see that, even with some of the risks of hiccups from integration.

Bernstein: The contrasts between the [high-yield] companies I cover and the [equity] companies that everyone else covers is remarkable in that over the last one or two years, the returns have generally been extremely good in supermarkets, assuming you can pick the ones who are going to be targets -- and it's the high-yield operators who are the targets, not the consolidators.

What's happened among the high-yield issues is that, as the better companies have been acquired or have merged out of the sector, we've gotten an increasing concentration of weaker issues, for the most part. So going forward, other than the fact supermarkets remain a relatively defensive investment deal, I don't think I'm quite as optimistic as I was last year.

I think the investment approach of choice over the last couple of years among bond investors -- fixed income investors, high-yield investors -- has been to pick the guys that are going to get bought. But I think the pack's been pretty well picked over, and if you haven't been bought yet, it's because either you don't want to sell or nobody wants to buy you. So that leaves the perpetual question that you have in high-yield of what the strategy is going to be for the leveraged issues -- are they going to grow out of it, or are they going to be acquired out of their leveraged balance sheet, or what? And if you aren't operating well, if you aren't producing good results, it's difficult to grow out of.

Giblen: There's a cycle of enthusiasm, euphoria perhaps, about the acquisitions and then the reality sets in that it takes a lot of work to make them work well. We saw that with Kroger and Albertson's trading up on the early news of their acquisitions [of Fred Meyer Inc., and American Stores Co., respectively], then the long time it took for the FTC clearances certainly took the wind out of the sails of the stocks, then the stocks performed better, especially Kroger, after the acquisitions were finalized, and now they've been waning a little bit because there's not a whole lot of news and many of the acquisition benefits are back-ended and likely to come in the latter part of the first 12-month period. With Safeway, the stock lost momentum when it seemed as though it might take a while before the company made further acquisitions, then the stock perked up with the Randall's announcement as well as some other factors that pertain to perception of a high internal growth rate at Safeway.

So looking at the next six months, it could be a little slow-going for some of the companies because you're not going to have a lot to hang your hat on. With Albertson's and Kroger -- certainly great stores in the intermediate and long term -- there probably won't be a whole lot of excitement in the short-term.

Comeau: The market we're in is so much different than when these mergers were announced last year that it's hard to make an operating comparison.

The companies have performed in terms of their operations, and the mergers, while being delayed, did close, and I don't think there have been any big negative surprises other than maybe Albertson's having to divest more stores than anticipated and clipping maybe a nickel or a dime off earnings.

But the environment was so different nine months or a year ago in terms of the way the markets were looking and where people were looking to invest and in which sectors. Supermarkets and drug stores were probably the only games in town for a lot of U.S. investors. That, coupled with the announcements of and excitement over the acquisitions, led those stocks to a pretty high level, relatively speaking, and they've basically been giving it all back since the end of the year.

SN: Do you think the macro environment of the stock market is going to have more to do with where prices go than the individual stories for the time being?

Comeau: It's hard to know, but probably, yes.

Levin: I think there was a really pronounced change when you had a real focus on cyclical stocks this year. I know Morgan Stanley as a firm is still very much a believer in cyclical stocks out-performing the market.

Given that supermarkets have more domestic and defensive characteristics, those stocks have undeniably suffered. But the performance of the stocks has been affected by the real lack of inflation -- in fact more deflation recently -- though you have really seen the earnings by and large come through because the companies have gotten really better and better at finding synergies to benefit from consolidation.

The key thing to remember is that the acquisitions that have been announced really will benefit these companies, not just for one year but really for three to five years. Safeway probably is still benefiting incrementally, although to a smaller extent, from the Vons acquisition, which was done in 1997.

I think going forward, you should still see very healthy earnings growth. But how that earnings growth is perceived by the market is the big question, and I think right now we're still in a period when investors are looking elsewhere. They're just not as fond of the supermarket sector right now.

Husson: I think if you take that idea about the multiyear benefit and so on, what has to happen is it has to become obvious to the market that supermarket retailers are developing pricing power inside their marketplaces and that there is a structural kind of seismic shift going on in this country in the whole of fast-moving consumer-goods distribution in favor of food retailers, because that's the only way you're going to keep gross margin continuing to move forward.

If you can find that pricing power and define it somehow as maybe the manufacturer or the consumer losing power, with better organized, more rational competition and more rational pricing, and if retailers are less likely to give away stupid amounts of gross margin to the consumer in brushfire promotions -- which is pricing power as well, to a certain extent -- and if the retailers are developing this pricing power from both sides, along with private brand -- and taking control of categories is part of that -- then I think there is still some real internal momentum inside the group, which despite the lack of inflation can keep this gross-margin miracle still moving forward.

Adler: If you look at one of the side benefits of consolidation, I think you see a general slowdown in new-entry activity, and that in general reduces the number of price wars. It's interesting that when I talk to investors, I don't get questioned much about very extreme competitive environments, but you can't yet make the argument that we're seeing that shift in power that Mark talks about -- with the retailers really getting more powerful -- because everybody brings up Wal-Mart.

There are an awful lot of people who don't want to listen to the answer that, at least where Wal-mart is today with its format, there are some real-estate limits, so you'll say, "the competitive environment is really getting better fundamentally," and they'll say, "but Wal-Mart's coming."

Comeau: I don't think people are negative on supermarkets for any fundamental or competitive reason. Even believers of everything Mark and Meredith are saying, which I pretty much agree with, still don't buy supermarket stocks.

Giblen: The whole margin-expansion story and balance of power shift has really been happening over the years. The mergers are one step further, but at the same time, they just offset consolidation in other parts of the supply chain. That whole story has been there, and I just see the stocks moving more on an individual basis.

Comeau: Investors really aren't looking at the fact that the size of the whole industry is changing.