INFLATION PREPARATION

JON SPRINGER

NEW YORK -- Supermarkets have traditionally done well during periods of food inflation, but it might get tougher this time around.

Rising energy and commodity costs are sending prices soaring on items throughout the store. While meat prices spiked late last year, more recently commodities like milk, eggs, chicken and butter are rising or are expected to rise. Prices are also climbing on center store staples such as rice, cereal, baked goods, frozen items and cooking oil, retailers say.

"We are seeing movement on prices throughout the store, more so than we've seen in the last year-and-a-half at least," Ron Pearson, chairman, Hy-Vee, West Des Moines, Iowa, told SN last week. "I don't know if that constitutes a big number that will pass through the system or not."

Recent evidence suggests there's more food inflation to come. According to calculations from the Earth Policy Institute, Washington, food prices will likely be higher in the second quarter, with soybean prices hitting 15-year highs and wheat and corn seven-year highs. When this year's grain harvest begins in May, world grain stocks will be down to 59 days of consumption -- the lowest level in 30 years, EPI noted.

Wheat futures for May, which traded as low as $2.90 a bushel within the last year on the Chicago Board of Trade, have recently topped $4 a bushel, a climb of 38%. Similarly, the price of corn is up by 36%; rice, 39%; and soybeans doubling from just over $5 per bushel to more than $10 a bushel, EPI noted.

The group said demand brought on by global trade, and environmental factors impacting production, are contributing to higher prices. Livestock products using soybeans and corn for feed are sensitive to grain price fluctuations as well.

Packaged goods manufacturers including Hormel Foods, Bird's Eye Foods and Kraft have recently said prices for their products would increase beginning next month. Those companies cited rising energy and commodity prices.

Supermarket operators say that in most cases, they are confident their higher costs can and will be passed along to their shoppers. But results are mixed so far. Given the extremely competitive environment, increases will have to be made cautiously and while keeping an eye on volatile changes in commodities and the sticker shock they could cause.

"It's been our practice and frankly the practice of all the retailers that we compete with, that when you get cost increases, particularly if they're modest, those get passed on. And more often than not, they get passed on with the same gross margin rate," Steve Burd, president and chief executive officer, Safeway, Pleasanton, Calif., told analysts in a recent conference call.

Food inflation, estimated between 1% and 3% this year, would represent the first real increases in food since 1996, noted Mark Husson, an analyst for Merrill Lynch, New York. Husson said inflation, which he expects to come at the low end of that estimate, would generally stand to help supermarkets as long as they pass along increases while maintaining percentage margins. "If you have a 32% [profit margin] category selling at $1, next year it can be a 32% category selling at $1.02," he told SN. That labor cost inflation generally lags the pricing cycle "will give earnings a kick" in the meantime, he added.

Noting the recently reported positive same-store sales trends at food retailers including Kroger, Delhaize and Supervalu, Husson said food inflation is one component of a favorable economic cycle starting up again for supermarkets. "These retailers were supposed to be dead in the water a year ago. They don't look dead to me."

Not all observers are as optimistic, however, saying that price increases may come at the expense of market share and a bigger pricing gap with low-cost operators like Wal-Mart Stores, Bentonville, Ark.

"The old theory that food inflation would produce a large impact on the bottom line for supermarkets is being dashed upon the rocks. It really hasn't happened," Gary Giblen, director of research for C L King & Associates, New York, told SN. "In the old days, food inflation was a plus. But given a more competitive environment, you can't pass it on."

Price competition with competing formats was not as acute during the last round of food inflation, Giblen noted.

"I think [price increases] will be neutral-to-minimally positive to the bottom line of supermarkets in the short term," he added. "In the medium term, it's probably negative because prices are going up, and for sure supermarkets will raise prices more than Wal-Mart, Costco and other more efficient classes of trade."

Giblen said he expects consumers will become more price sensitive in coming months, even as the economy improves. "There's been an odd paradox over the last few years in that consumers were spending lavishly even as the economy was poor," he contended. "That's because interest rates were low and they were living off refinancing their homes."

Price increases thus far have been difficult to pass along in certain regions, and certain commodity spikes came too fast for some retailers. In Southern California, where strikes recently hobbled supermarket profits, grocers are already sacrificing margins to win back customers on price. Delhaize Group, Salisbury, N.C., said recently that inflation boosted its first-quarter sales at its Hannaford Bros. stores in New England but that the company was forced to keep prices stable in its Food Lion and Kash n' Karry units in the competitive Southeast.

"Because of the price competitiveness, we have not seen the ability to pass [price increases] on and maintain our low-price position that is fundamental to our operating model," Rick Anicetti, CEO of Food Lion, told analysts in a recent conference call. He added, however, that he expected the chain could pass along increases going forward.

For A&P, Montvale, N.J., increases for certain items like eggs came too rapidly and steeply for the chain to pass the costs to retail, Christian Haub, president and CEO, noted in a conference call recently. "We're seeing inflation right now continuing in the meat category -- beef and now poultry are starting to move up, and we are seeing particular pricing pressure in the milk category," Haub said. "If you think about all the by-products that come with [milk], butter and ice cream and other areas, clearly one of my concerns is that depressing gross margin in the short term, or just not giving us the ability to recover the cost increases quick enough."

Eileen Scott, CEO, Pathmark Stores, Carteret, N.J., said similar velocity in meat increases prevented the retailer from passing all its costs as quickly as it absorbed them. Scott said the company is also preparing for the possibility that volatility in that category will decrease. "Right now we are seeing meat inflation and we are seeing inflation in dairy products, but it doesn't necessarily mean that those inflated categories are going to be inflated for all of the year," Scott told analysts in a recent conference call.

While slight food inflation should help matters, supermarkets have to try to avoid deflation, said Jeff Noddle, chief executive officer of Minneapolis-based Supervalu. "We know that [deflation] can be a very difficult climate to manage in," Noddle told investors recently. "We think a 1% to 2% inflation number is a more normalized rate of inflation, and I think the industry can absorb that. When it begins to move up above that, I think consumers begin to change and react in their shopping patterns, in a way that's very hard to predict."

While officials from Wal-Mart have been adamant about not raising prices -- "We're not raising prices, and we don't intend to," CEO Lee Scott said in a recent conference call -- that hasn't been the case when it comes to food, analysts and observers say. "We have seen big-box stores in our markets passing along price increases on bread and milk and those things," said Hy-Vee's Pearson.

"There's no cheap herd of Arkansas cows out there that yield their milk and carcasses for way below market cost," added Husson. "[Wal-Mart] may not be raising prices overall, but in certain commodities they will have to. We don't live in a consequence-free world; their gross margins would get slaughtered."

The pressure not to pass along price increases will be on the supermarket operator, not on competing formats, said Andrew Wolf, an analyst for BB&T Capital Markets, Richmond, Va.

"The underlying trend is that of the supermarket customer comping down and the supercenter customer comping up. The guy who's less likely to pass along higher prices is the guy having trouble getting people into his store," Wolf told SN. "All Wal-Mart needs to do is maintain its spread."

Wal-Mart maintains an approximate 15% price advantage over traditional grocery stores on food, according to Jon Hauptman, vice president of Barrington, Ill.-based Willard Bishop Consulting. "If and when Wal-Mart decides to raise prices, they'll still maintain their advantage on supermarkets on food items," Hauptman said.

Increases among branded center store items will be generally easier to manage than commodity price changes, observers say. And promotional support from manufacturers will help a stealth transition.

"Supermarkets will demand more effective, targeted promotions from their suppliers that are tailored to their particular markets or shoppers," predicted Hauptman. "These targeted promotions could in some ways reduce the shopper impact of price increases in the short term."

Over the longer term, analysts caution that higher prices, even after passed through successfully, shouldn't be viewed as a panacea.

"I reject out-of-hand this idea that 'merchandise costs are up, therefore the industry's going to do better,"' said Chuck Cerankosky, managing director, KeyBanc Capital Markets, Cleveland. "If doing better in food retailing was just a matter of marking up prices, why wait for cost-push inflation? It's because competition is pushing costs in the other direction.

"The opportunity for the industry isn't just passing along prices, because they'll all work their way through eventually," he added. "It's getting consumers to buy more when they're in the store."

Rising Cost of Food in the Basket

Retail prices for food at the supermarket rose in the first quarter of 2004, according to the latest American Farm Bureau Federation marketbasket survey. The survey on the total cost of 16 basic grocery items showed an increase of $2.41 from the 2003 fourth-quarter survey. Below are 10 items from the survey and their price increases.

Category: Price/Quantity; Increase*

Vegetable oil: $2.76 per 32-ounce bottle; 48 cents

Corn oil: $3.09 per 32-ounce bottle; 46 cents

Apples: $1.22 per pound; 24 cents

Whole fryers: $1.24 per pound; 22 cents

Pork chops: $3.42 per pound; 19 cents

Eggs: $1.57 per dozen; 19 cents

Cheddar cheese: $3.46 per pound; 9 cents

Bacon: $3.00 per pound; 9 cents

Russet potatoes: $1.96 per pound; 6 cents

Bread: $1.36 per 20-ounce loaf; 5 cents

Increase comparison is made from fourth-quarter 2003 to first-quarter 2004.

Source: American Farm Bureau Federation, Washington

Reading the Pulse of Inflation

Based on recent interviews and conference calls, here is what food retailers are saying about recent price inflation and its potential impact on margins and consumer spending.

Ron Pearson, chairman, Hy-Vee, West Des Moines, Iowa: "We are seeing movement on prices throughout the store, more so than we've seen in at least the last year-and-a-half. We have seen big-box stores in our markets passing along price increases on bread and milk and those things. Consumers are shocked at first, but then again they haven't really seen price increases in quite some time on a permanent basis."

Steve Burd, chief executive officer, Safeway, Pleasanton, Calif.: "It's been our practice, and frankly the practice of all the retailers that we compete with, that when you get cost increases, particularly if they're modest, those get passed on. And more often than not, they get passed on with the same gross margin rate."

Christian Haub, CEO, A&P, Montvale, N.J.: "If we look at some areas where we had pretty heavy and fast inflation, we've not been able to pass all of that on at retail. Eggs are a very good example. Beef and now poultry is starting to move up, and we are seeing particular pricing pressure in the milk category."

Eileen Scott, CEO, Pathmark, Carteret, N.J.: "Right now we are seeing meat inflation and we are seeing inflation in dairy products, but some indicators tell us that these had peaked and that we may see some downward changes on that some time during the course of this year. Some piece of [meat inflation] was able to be passed along, [but] we aren't able to pass it along as quickly as we had absorbed it."

Jeff Noddle, CEO, Supervalu, Minneapolis: "The most important thing for us is to avoid deflation. We know that that can be a very difficult climate to manage in. We think a 1% to 2% inflation number is a more normalized rate of inflation, and I think the industry can absorb that. When it begins to move up above that, I think consumers begin to change and react in their shopping patterns, in a way that's very hard to predict."

Rick Ancetti, CEO, Food Lion, Salisbury, N.C.: "What we are beginning to see now is a lot more categories involved from fresh to frozen. What [consumers'] tolerance is, whether or not that's 1%, 2% or more, I don't have visibility into that at this point other than, I think consumers are becoming very aware that retail food prices are going to change somewhat into the future."