IMPEDIMENTS TO GROWTH

Elliot Zwiebach

NEW YORK -- Pressures from labor costs may be the industry's greatest challenge as it competes with Wal-Mart and other non-union operators, according to participants at SN's eighth annual Financial Analysts' Roundtable here.

Those concerns, which the analysts expressed when the roundtable took place in early August, have been realized by the industry in the last few weeks with labor strikes in Los Angeles, St. Louis and West Virginia (see related strike news in this issue).

Speaking at the roundtable, Andrew Wolf, managing director at BB&T Capital, Richmond, Va., said non-union retailers will always have the advantage over traditional supermarkets. "I believe this is the root problem for the supermarket industry, and I don't know if there's a solution that can come fast enough," he said.

Mark Wiltamuth, executive director at Morgan Stanley here, said it will take years for conventional operators to reduce union cost structures because operators have "three- and five-year labor contracts, and unions don't want to cede any ground immediately. [Retailers] may never get to the market cost structure."

Yet it works both ways, Meredith Adler, managing director at Lehman Brothers here, pointed out, noting that contracts negotiated when labor was in short supply gave supermarkets some protection. "There seems to be some evidence that [Safeway's] total labor costs went up more slowly than market labor costs because those contracts [negotiated when labor was tight] gave them some protection," she said.

Among other topics tackled during this third installment of a wide-ranging roundtable discussion were the likely direction of financial and stock performance in the next few months; whether retailers should be expanding capital spending; and what kind of industry consolidation may lie ahead.

The seven analysts' observations included the following:

On financial performance, most said they expect prices on supermarket stocks will continue to fall. "I think the group still has some downside risks based on margin contraction," Wiltamuth said. "If the economy recovers strongly, we will see a bounce in the performance of the stocks and ... some improvement on margin, but we're still facing pressures on the cost side from pensions ... and rising health care expenditures."

Lisa Cartwright, managing director at Salomon Smith Barney here, said she believes Albertsons' stock will be lower, Kroger's will be higher, and Safeway's will be "just about the same." Wolf said that, while stocks "have had a big rally in the last few months, I think they're now discounting at least flat earnings in 2004."

According to Edouard Aubin, retail analyst with Deutsche Bank Securities here, "Returns are a function of supply-and-demand relationships, but a year from now, we're going to have maybe 220 [or more] additional supercenters in the U.S., so ... the supply is not slowing down [and] there is no way returns for the industry are going to improve, even if the economy picks up moderately."

On capital spending, Aubin said supermarkets need to reduce cap-ex to maintenance levels to avoid adding too much capacity to the marketplace. "If you look at the cap-ex programs of Albertsons and Safeway today, they are not far away from maintenance levels -- that is, they are not growing anymore," he noted. "The only one still growing is Kroger. So the conclusion is that the capacity of the industry to cut its cap-ex programs further is fairly limited."

Wiltamuth said he agreed that supermarkets should not be devoting cap-ex to capacity expansion. "I believe they could all stand to cut back on their capital expenditures, and be a little more disciplined and focus on returns," he explained.

However, Mark Husson, first vice president of Merrill Lynch here, said companies need to invest heavily in their businesses. "It's the job of senior management to take money, invest it back in the business and get a return, and [they shouldn't stop] just because it's not fashionable to add capacity to the market," he said.

On mergers, the analysts said they would prefer to see more consolidation, but not major mergers. "If anyone tries to make any big acquisitions, the market will slam those companies, even if it involves one of the major chains buying a large regional player," Cartwright said. "I think it's been proven that companies are not getting value out of acquisitions, and they'd be better off working to improve the supply chain or their distribution, or to pursue market fill-ins to close the gap with Wal-Mart."

Gary Giblen, senior vice president and director of research for C L King Associates here, said there may be some mergers "that would be blessed by the market. But it would be an uphill battle."

"More likely than mergers," Adler said, "I think we will see some consolidation happening, or maybe it's better to call that 'concentration,' where you have share moving to bigger players."

Wiltamuth expressed a similar viewpoint. "To get really good returns, you have to have strong local market share, so I think you'll see companies doing fill-in acquisitions in local markets to buttress their existing positions, and I think you'll also see some people exiting markets where they have a No. 4 or No. 5 market share position."

COST PRESSURES

SN: What are some of the cost pressures the industry is coping with?

ANDREW WOLF: There are real cost pressures on every line of the income statement. We've got negative same-stores sales, we've got gross margins that are being sacrificed to try to salvage same-store sales, we've got SG&A that's rising because of union and other wage cost increases and benefit costs -- it's like everything but the tax rate seems to be in question on the income statement right now.

MARK WILTAMUTH: I think all the companies are trying to work on their cost structures. They're imposing cost-cutting campaigns where they can. Safeway has been the most vocal about addressing the union cost structure, but I think it takes a long time to work those issues down just by virtue of the fact that these are three- and five-year labor contracts and unions don't want to cede any ground immediately, so labor and benefit costs will be a problem for some time. One of the biggest components of rising costs has been rising health care benefits, and that's affecting all industries. Supermarkets are not immune to that, and the fact they have union contracts reduces their flexibility to address these rising costs.

LISA CARTWRIGHT: But they are getting more two- and three-tier contracts.

MEREDITH ADLER: You could also argue that they start at one level on labor costs, but to get to where the market is, which is a lower level, they have a lot more opportunity, and you could argue that some players who are closer to the market level today are seeing it go up and are going to have a harder time. There's nothing to fix -- they're just going to have to live with it. But I agree that with a contract, it makes it really hard to realize that. WILTAMUTH: They may never get to the market cost structure, and that will be a structural disadvantage.

ADLER: But we saw some of that during the period when labor was in short supply, and although Safeway has turned around and completely said the opposite thing, there seems to be some evidence that its total labor costs went up more slowly than market labor costs because those contracts gave them some protection. So it works, and it can work both ways.

WOLF: Safeway said its labor costs are 5% to 10% above non-union competition, and that doesn't even include work rules, which create additional inefficiencies, and that has to be fixed. The non-union operator, whoever it is -- Costco, Wal-Mart Supercenters, the independent supermarket down the street -- can operate a similar format, selling the same products but with an enormous cost structure advantage. I believe this is the root problem for the supermarket industry, and I don't know if there's a solution that can come fast enough. The flip side of it is trying to unionize Wal-Mart, which I think is going essentially nowhere. The UFCW has done corporate campaigns in the past that a lot of us are aware of, and they essentially broke Food Lion as a growth chain. But I think Wal-Mart is just too strong for them.

PERFORMANCE OUTLOOK

SN: With so many pressures, what's the outlook for supermarket performance in the next year or two?

WILTAMUTH: Everyone has to eat, and everyone has to buy their food somewhere, but that doesn't mean they are good investment vehicles, and it doesn't mean the companies are going to have rising returns over time. If you listen to investment analysts, you might think the world is coming to an end, but we're just looking at the stocks. What are your predictions for stocks next year -- higher or lower? I think lower.

MARK HUSSON: Higher.

CARTWRIGHT: Well, it depends on who it is. I believe Albertsons will be lower, Kroger will be higher, and Safeway will be just about the same.

WILTAMUTH: I think the group still has some downside risks based on margin contraction, particularly gross margin contraction.

ADLER: I do see some risk at Safeway, but I'm not sure it's for as long as 12 months -- it just depends on what happens to the economy because Safeway got backed up into its numbers for this year.

CARTWRIGHT: The thing with Safeway is that so much of what went wrong was with specific acquisitions, so there's more risk at Safeway. But the upside is actually probably greater if they actually do turn it around because they are in so few markets and they're very leveraged to the economy.

WOLF: The stocks have had a big rally in the last few months, and I think they're now discounting at least flat earnings in 2004, with valuations at about six times estimated 2003 EBITDA. I think you need a strong economy for them to get out of the current investment-in-gross-margin mode. On the cost structure side, it doesn't look that good because health care costs keep going up. So the stocks have already discounted flat earnings next year.

ADLER: The reason Kroger lowered the values for this year is because they said prices would go up, and they wanted to cover market-wide cost increases on health care -- but prices didn't go up. But if we got a strong economy next year, what are the chances that health care costs are still going to go up? If we start to get a meaningful recovery where consumers begin to feel things are getting better, what are the chances that these guys will be able to cover some of these market-wide costs without raising prices?

WOLF: Well, they are raising prices, just not as fast as product costs are inflating. That's why I know there's a margin squeeze. So if the economy gets good and they can start passing through increases in product and health care costs, then their nominal comps may improve, but only in a very strong economic recovery. And with a strong economic recovery, things might be in place in 2004 for some gross margin recovery, but I don't think they could fully pass through both product cost and health care cost inflation.

WILTAMUTH: I think if the economy recovers strongly, we will see a bounce in the performance of the stocks, and we will probably see some improvement on margin, but we're still facing pressures on the cost side from pensions, which will still be working against all the companies because of the poor performance in the stock market and the discount rates that are going to be applied to those pensions, and we're still seeing rising health care expenditures. So I think, overall, it will be tough to get overall operating margin to go up dramatically. I think if the economy is very strong, you could see same-store sales pick up, and you could see some improvement in gross margin, but I'm still a little concerned about the operating margin. The key question in this whole scenario is when do people get off the price-cutting game? If the economy gets better and they're not seeing a lift in sales, they're going to continue to invest in price reduction, and that's going to be a concern.

CARTWRIGHT: I think Kroger is really the only one who's invested in material cost-cutting nationwide. I don't think Albertsons has, and I think Safeway has really been very focused on where they've done it. The misses on the gross margin line have everything to do with execution and not having the huge growth in private label they had in the last recession, so I actually think that if two-thirds of costs are fixed and we get a bounce-back in the economy, then we will definitely see flat operating margins. But I'm just not as optimistic that we're going to get a big bounce. I think we'll get sort of a medium bounce, with numbers ending up flat.

EDOUARD AUBIN: At the end of the day, the returns are a function of supply-and-demand relationships, and maybe the economy is going to pick up and people are going to trade up. But a year from now, we're going to have maybe 220 or 230 or 240 additional supercenters in the U.S., so one thing is for sure -- the supply is not slowing down. So in my opinion, there is no way returns for the industry as a whole over the next 12 months are going to improve, even if the economy picks up moderately.

GARY GIBLEN: Even if the economy picks up a little bit, it's not the roaring 1980s, so people will be very penurious and it will be fashionable to keep your pocketbook closed, so the spending bounce-back might not be that much.

CARTWRIGHT: When you get that cyclical bounce-back, it's just a question of whether the stocks work for a while until people come back to this idea that the negative secular trend is there. That's basically what we're talking about with regard to stock price performance over the next year.

ADLER: Supply and demand is regional, it's not national, so it will depend on individual companies.

CAPITAL EXPENDITURES

SN: What's the outlook for capital spending over the next few months?

AUBIN: Well, we're talking about maintenance cap-ex, and some companies have kept their cap-ex fairly significant. To what extent can they cap their cap-ex further? Safeway indicated its maintenance cap-ex is around 3% of sales, and some other players are talking about 2.2% of sales.

ADLER: I don't think spending 3% of sales for cap-ex is maintenance level. That maintains the business, but it also includes some square-footage growth in markets where there is real growth. If you want to see what maintenance cap-ex looks like, you can go to 1% to 1.25% of sales.

WILTAMUTH: The major supermarkets continue to devote cap-ex to capacity expansion. I believe they could all stand to cut back on their capital expenditures, and be a little more disciplined and focus on returns.

ADLER: It depends on what they're spending their capital on. I would argue that Albertsons has to spend capital, but not on new capacity -- it needs to spend capital on upgrades. Its strong markets like Philadelphia or Northern California -- strong in theory, anyway -- are starved for capital.

HUSSON: It's the job of senior management to take money, invest it back in the business and get a return, and if they can do that on a risk-adjusted basis and get a decent return on invested capital, you shouldn't let them stop just because it's not fashionable to add capacity to the market. If you've got a weighted average cost of capital of 8% and you're getting a risk-adjusted return of 12%, then that says you should do it.

MERGERS

SN: Can we expect a pickup in the number of industry mergers this year and next?

WILTAMUTH: I don't anticipate we're going to see many mergers because I think there's still a price disconnect between the buyers and the sellers. All the sellers saw the multiples being paid in the late 1990s -- 10 to 12 times EBITDA -- so companies that are thinking of selling are thinking they're worth 10 or 12 times EBITDA, while potential buyers see their stocks trading at only five times EBITDA. In addition, investors look back on the previous mega-mergers as value-destroying acquisitions, so the market is going to be very skeptical of anyone who steps up to try and do a merger. The price either has to be very low, or there has to be some incredible cost savings to pull it off. And really, to get the big cost savings, you have to have some geographical overlap, and that raises anti-trust and regulatory concerns.

GIBLEN: Given that the industry is in a tough but more stable mode now, you may see some deals that do make sense. Pathmark, for example, would be attractive as one obvious candidate. In contrast to a year ago, I think things are at least stable enough that deals can be done targeting regional chains.

WILTAMUTH: We'd probably see more of these fill-in acquisitions where someone picks up 10 or 15 stores. Actually, I think that from a returns perspective, that's a lot better than adding new capacity to the industry, and I think we'll see more of that. Kroger's done a fair amount of it, and there could be more.

ADLER: More likely than mergers, I think we will see some consolidation happening, or maybe it's better to call that "concentration," where you have share moving to bigger players. A&P has been downsizing, Winn-Dixie did some of that a couple of years ago, and I think we'll continue to see more of that. It does pose a challenge for Albertsons, which is likely to divest some stores and buy others.

WILTAMUTH: I think that raises the question of returns again, and to get really good returns, you have to have strong local market share, so I think you'll see companies doing fill-in acquisitions in local markets to buttress their existing positions, and I think you'll also see some people exiting markets where they have a No. 4 or No. 5 market share position and no hope of becoming No. 1.

CARTWRIGHT: If anyone tries to make any big acquisitions, the market will slam those companies -- even if it involves one of the major chains buying a large regional player. I think it's been proven that companies are not getting value out of acquisitions, and they'd be better off working to improve the supply chain or their distribution, or to pursue market fill-ins to close the gap with Wal-Mart.

GIBLEN: I think maybe there are a few mergers or a few deals that would be blessed by the market. But it would be an uphill battle. I suppose it's just a matter of how managements present a deal that will determine if they can sell it.

Lehman Bros., New York, requested that SN run the following disclosure statement in connection with publication of the SN Roundtable:

Meredith Adler covers Kroger, Safeway, Albertsons, Winn-Dixie, A&P, Whole Foods Market, Supervalu and Nash Finch. Meredith Adler does not sit on the board, nor does she own any stock in these companies. Lehman Bros. has an investment banking relationship with Safeway, A&P and Nash Finch. Lehman Bros. does not own 1% or more of any of these companies. Meredith Adler is not aware of any material conflicts with regard to these companies.