HEY, BIG SPENDER

JON SPRINGER

Better profits - amid ever-increasing competitive pressures - have retailers reaching into their wallets again.

The capital-spending budgets of publicly traded food retailers will increase this year as compared to last, company filings show. But once again, rather than paying for land and new buildings, the vast majority of capital expenditures will go toward renovating existing stores.

These trends, analysts say, are driven not only by improved sales and profits during 2005, but also by a need to reinvent the physical plant to better compete in a retail environment where nontraditional operators such as Wal-Mart Stores and Whole Foods Market are outspending and outgrowing them on a percentage basis.

"After years of ratcheting down capital expenditures, we're seeing a boost this year," Andrew Wolf, an analyst for BB&T Capital Markets, Richmond, Va., told SN. "We're seeing that because profits are up. It's classic capitalistic behavior.

"It's not going to be a huge thing, but I wouldn't be surprised if capital spending peaks in '06 and '07. The companies have decided what's working for them at the same time a cyclical profit recovery is happening. That's what's spurring higher spending."

Kroger, Cincinnati, said it expected to spend around $1.8 billion this year after spending around $1.3 billion last year, when its top line was up by 7.3% and the bottom line climbed to $958 million following an annual loss of $104 million in fiscal 2004. Pleasanton, Calif.-based Safeway saw a similar rise in sales in 2005 - 7.2% - and a slight tick in earnings it attributed to aggressive moves to address its store base through renovations and brand renewal. Safeway expects its capital spending will increase around 14% this year to $1.6 billion as it quickens the pace on an already substantial number of renovation projects in 2006.

"The industry is doing a little better, so retailers have better cash flows and more money to spend," Jonathan Ziegler, analyst, JM Dutton & Associates, El Dorado, Calif., told SN. "When things aren't so good they pull back a little and when things are better they can spend more. Cap-ex is a lead-lag indicator that way.

"I think stores overall have been pretty dull, so if the industry is changing and coming to life again with more-inspiring stores, then that's a good thing."

Other retailers, including Delhaize America, Salisbury, N.C., and A&P, Montvale, N.J., say they will ramp up spending this year behind ambitious renovation programs. Like Safeway, both companies hope to use renovations not only to improve the look and condition of their stores, but also to create new identities that will differentiate them from traditional and nontraditional competitors alike.

"With Wal-Mart running 500 new stores out there in the next three years, the question is, 'How do you stay in the race?'" Richard Kochesperger, a professor of food marketing at St. Joseph's University, Philadelphia, told SN. "Wal-Mart opened 69 stores in January alone; that's a number you can barely swallow. So how do you stay in the race? Well, you either have to open new stores or reposition the ones you have."

On a percentage basis, the retailer with the largest increase in capital spending this year will be Supervalu, Minneapolis, which is scheduled to acquire 1,124 stores from Albertsons shortly. Supervalu officials say the former Albertsons assets will be the focus of around $1 billion in renovations this year, coming off a year when Albertsons put the brakes on spending as it explored a sale. Jeff Noddle, Supervalu's chief executive officer, mentioned also that Supervalu would change the way it spends on its new assets, devoting less to technology and systems and more to the stores themselves.

Safeway's Aggressive Program

According to figures released recently by Food Marketing Institute, Washington, store renovations continue to gain on new-store builds as the traditional supermarket's preferred investment. FMI's Facts About Store Development report, based on survey responses from retailers, reported that 5.7% of all grocery stores were under renovation in 2004 - up from 4.9% in 2003 - while new-store build remained flat. FMI projected 9% of stores underwent major remodels in 2005.

Retailers tend to generate better returns on remodels than new stores, analysts said, in part because new-store development is costlier and more time-consuming. Retailers like Safeway, in fact, are closing more stores than they open as they focus only on those with a chance of generating better returns.

While company policies of remodeling stores on a consistent basis (generally every six to nine years) remain the most common reason retailers remodel stores, three in 10 stores were remodeled to meet the needs of changing market demographics, FMI said.

"I think there's a lot of change going on in the industry with respect to the focus on the customer, and being more customer-specific," Ziegler said. "That may take expenditures to put stores in a place where they can cater to that demographic."

Safeway, undergoing a chainwide shift to "lifestyle"-branded stores, has been the most aggressive in this regard, analysts said. The retailer plans around 280 remodels this year, along with 20-25 new stores, in a capital budget of $1.6 billion. Safeway completed around 291 lifestyle flips and 21 new stores last year, which Safeway CEO Steve Burd suggested is about as many as the retailer can handle. "We're about as aggressive as we can get," Burd told analysts in a conference call earlier this year.

Safeway at year-end had completed lifestyle renovations in around 26% of its stores.

"If they could do them all tomorrow they would," Kochesperger said. "Safeway is betting the ranch on [lifestyle stores], so they have to turn them as quickly as they can."

Despite the ambitious plans, Safeway is also learning to reduce the costs of renovations through more efficient spending, and is also spending less money on infrastructure, particularly in information technology, according to Robert Edwards, Safeway's chief financial officer.

"We do have a concentrated effort to minimize cap-ex where we can, but not to do anything that reduces or minimizes the increased sales we're getting from the lifestyle stores," Edwards said in a conference call earlier this year.

Deliberate Pace at Kroger

Kroger said it plans between 30 and 40 new stores and around 150 to 175 remodels in fiscal 2006. But its rollout of alternative formats is considerably more deliberate than companies like Safeway or Delhaize. The latter said it would increase capital spending by around 23% in fiscal 2006, largely as it rushes to complete the conversion of former Kash n' Karry stores on Florida's Gulf Coast to the Sweetbay brand.

Kroger's alternative formats are growing slowly. The Marketplace stores, which combine food and general merchandise in a larger box resembling Fred Meyer, has been under development at Kroger since 1999, when the first Fry's Marketplace opened in Arizona. The retailer today operates 27 Marketplace stores in three states, and plans to open two near its home base in Cincinnati this year.

Kroger closed more stores (66) than it opened or relocated (52) in 2005. It wound up completing 147 remodels - fewer than the 165 it projected - but opened eight more stores than it forecast at the beginning of the fiscal year. Overall capital spending was $1.3 billion in 2005, below earlier estimates of $1.8 billion.

"We feel that we have some additional opportunities with remodels and our plan is to get more remodels in '06 vs. '05," Rodney McMullen, Kroger's vice chairman, told analysts in a conference call last month. "That said, we will continue to focus on being tighter on capital than looser on capital."

At 2.1% of sales in 2005, Kroger's spending was among the lowest in the industry, observers noted. "Kroger has never been one to jump into the deep end, but if you read between the lines, perhaps some of the stores aren't hitting their numbers. If that's happening you have to take your foot off the gas pedal," Kochesperger said.

Another observer, who asked not to be identified, said the industry has seen many retailers fail in part because of overinvestment in faulty concepts: "In the years before Winn-Dixie got into bankruptcy, they were trying to identify themselves as something else, spending millions of dollars getting away from their niche. That's what got them into trouble - bad decisions."

Perry Caicco, an analyst for CIBC World Markets, Toronto, said Kroger "has never been the leading spender in the industry by any means. That does cause some issues - there's a wide range of Kroger stores that don't look sharp as a result."

In general, Caicco said, U.S. retailers tend to underspend their counterparts in other parts of the world. "And it's hard to say why - they all have pretty good cash flow," he said. "I think they've been more focused on the investor, and when their share price is under pressure they're thinking, 'Let's make sure we pay a dividend and use free cash to get the debt down.' But as they do that, the store base isn't materially improving from a fixturing and ambiance point of view."

New Spending for Albertsons

With a low-cost store base, efficient distribution business and sufficient debt to mind, Supervalu has spent conservatively in recent years: $325.7 million in cap-ex in fiscal 2005 - down 12.3% from 2004 and 26% from 2003, company filings show. The addition of more than 1,100 Albertsons stores will change that.

At 2.9% of sales, Noddle estimated Supervalu's $1.1 billion planned capital spend would rank between that of Safeway (3.6%) and Kroger (2.75%) this year. The $1.1 billion figure combines Supervalu's planned expenditures with money Albertsons planned to devote to the stores it sold to Supervalu, he added. In its filings, Albertsons estimated 2006 cap-ex of around $1 billion.

While Albertsons' capital spending in recent years was largely behind technology, Noddle said Supervalu would devote the vast majority - around $1 billion - to renovations at the retail stores it expects to acquire.

"I think Supervalu has to justify making this acquisition and that means making the new stores work for them," Ziegler said. "My sense is that that's going to require some cap-ex. I've been in a variety of Albertsons stores, and while many are state-of-the-art, there are also some real depressing ones. So I think Supervalu is going to pour money into those remodels and try to make them hum better than they did under Albertsons."

While filings show Albertsons spent every bit as freely as its competitors in recent years - around $1.1 billion annually in 2003 and 2004, and around $900 million before putting the brakes on spending last September - it devoted more resources than its peers on technology, observers said.

"Albertsons spent an immense amount of capital - well over a third - on things that never touched the stores," Caicco said. "They believed it would save the company."

While observers agreed Albertsons probably needed more investment in technology than its peers, they were less certain as to its ultimate results. "They had a very ambitious plan for the supply chain but we ultimately don't know where that's at, after their main architect [Clarence Gabriel] left the company a year ago." Wolf said.

Ultimately, poor results from Albertsons' other investments - certain new stores, for example - were probably more damaging to results, Kochesperger said.

"Albertsons was so far behind the other companies with technology, it was playing catch-up," Kochesperger said. "It's possible that investing in it could have helped them jump ahead of the competition but I don't know that. What we do know is that at the same time, they were building new stores that weren't so good."

Cap-Ex Scorecard

Retailer: FY06 Cap-Ex Budget; FY05 Cap-Ex/as a % of sales; Change; '06 Projects

Kroger: $1.7 billion; -$1.3 billion/2.1%; 31% to 46%; 30-40 new stores;

1.9 billion 150-175 remodels

Safeway: $1.6 billion; $1.4 billion/3.6%; 14.3%; 20-25 new stores;

280 remodels

Albertsons: $900 million-; $900 million/2.2%; up to 22%; Not specified

$1.1 billion

Supervalu: $1.1 billion*; $326 million/1.6%; 206.7%; $1 billion of the

budget is for retail stores

Delhaize: $700 million; $570 million/4.2%; 23%; 54 new stores; 158 remodels

America

A&P: $200 million; $150 million/2.5%; 33%; 70 format conversions

Harris Teeter: $193 million; $116 million/4.5%; 66.4%; 18 new stores; 7 remodels

Wild Oats: $55 million-; $28.3 million/2.6%; 94% to 112%; 10 new stores; 6 remodels $60 million

Whole Foods: $340 million-; $324 million/0.7%; 5% to 11%; New store development;

$360 million equipment; IT

Loblaw: $1 billion (Cdn.); $1.2 billion (Cdn.)/4.3%; -16.73 openings/expansions

*Supervalu '06 budget combines Supervalu capital budget plus cap-ex for the 1,124 Albertsons stores it has agreed to acquire.

Sources: Company filings, comments, estimates