PATHMARK'S TRAILBLAZING WAYS

Elliot Zwiebach

CARTERET, N.J. -- Pathmark Stores here is blazing a trail for the long term.

Despite widespread industry speculation over if or when Pathmark might be acquired, the chain's new top management team is planning for the long-term future by moving ahead on developing a new store prototype that will debut in 2004; improving performance at weaker stores through an executive-oversight program; implementing programs to lower costs; and keeping the stores price-competitive in one of the most competitive regions in the country.

Moves such as these position the company well to move into the future, Eileen Scott, the company's chief executive officer, told SN in an interview.

"Because of the things our management team has done in the last nine months, we are very well-positioned for a time when the economy turns around," she said.

Her optimism was echoed by Frank Vitrano, the chain's president and chief financial officer, also interviewed by SN.

"We've screwed down the expense line in the last 12 months in terms of head counts and store buyouts, and we've made technology investments that have improved store-level productivity. Those efforts will make all the difference in Pathmark's future," he said.

Asked how long that future may be, given all the speculation about being acquired, Vitrano tackled the question directly: "We're clearly running the company for the long term, and everything you'll hear today [in the SN interview] is clearly aimed at running Pathmark, growing Pathmark and expanding the store count and our presence in the Greater New York-New Jersey-Philadelphia metropolitan area.

"That being said, people have always asked that question [about being acquired] of Pathmark because they have identified our strengths and made note of our strategic value, particularly in terms of store locations and high-volume operations, and they recognize us as a valuable franchise.

"Pathmark is not for sale, but if an offer comes along at what might be considered a reasonable price, the board would consider it."

With Pathmark stock trading at around $7.50 per share, industry observers told SN the chain might consider offers in the range of $15 to $20 per share. According to Vitrano, "When you're a public company, you get valued every day." He declined to comment on price speculation.

Industry analysts questioned by SN offered different opinions on the timing of any potential acquisition.

Gary Giblen, senior vice president and director of research for C L King Associates, New York, said it's almost inevitable Pathmark will be acquired, and possibly within a year, "because it's the most attractive acquisition candidate in the industry. It's in a geography that's Wal-Mart Supercenter-proof, it has a great deal of urban expertise that's being sought by many companies, and it has the ability to improve operating cash flow beyond the 4.7% level it's now at."

Giblen said New England-based Shaw's Supermarkets would be the most logical acquirer, although cases could be made for Albertsons, Delhaize, Kroger and Safeway as possible buyers, he said.

Mark Husson, first vice president of Merrill Lynch, New York, said any sale of Pathmark seems unlikely in the near term. "It will stay independent for a while, at least as long as the economy remains down. Given the price of Pathmark stock right now, I doubt anyone would pay more than $20, and I think the new CEO has to be given a fair crack of the whip to see what she can do for the company."

Jonathan Ziegler, principal at PUPS Investment Management, Santa Barbara, Calif., also said he believes any acquisition of Pathmark is likely to be later than sooner.

"Pathmark is an attractive, valuable property within the industry for its people and for the high density of its geography, but no one is in an acquiring mood right now," he told SN, "and I don't see anything happening at Pathmark for more than a year -- certainly not till people have currency once the stock market turns around."

On the Front Burner

Putting acquisition speculation aside, Pathmark's two top executives told SN they are pursuing several initiatives, including the following:

Adding natural foods, expanding ethnic foods, and giving more space to general merchandise to bolster sales.

Improving product quality and efficiency by going to bakeoff products, case-ready meats and, at some stores, self-scan checkouts.

Shoring up its store base in urban and suburban areas.

Installing new technology to help category managers.

Assigning executives to mentor individual stores.

Pinpointing stores with problems and trying to implement best practices to resolve them.

Pathmark operates 143 high-volume supermarkets in New York, New Jersey, Pennsylvania and Delaware, all within 100 miles of its base here in what executives like to call "Pathmark Country."

Sales in 2002 fell 0.6% to $3.9 billion, and comparable-store sales declined 1.7%. However, in the first quarter ended June 4, sales jumped 2.9%, and same-store sales climbed 1.9% -- the first quarter of positive comps in four periods -- while net earnings fell 57% to $900,000, or 3 cents per share, following a onetime charge of $3 million for a labor buyout. Without that charge, earnings would have been up 85%.

With second-quarter financial results to be issued Sept. 4, Scott and Vitrano said they were unable to talk about financial projections for the year, although Vitrano said comps could be up as much as 1%, compared with last year's decline. Some industry analysts told SN they project comp-store sales will rise 0.8% for the second quarter.

Pathmark stores average 52,500 square feet, though the company operates locations as large as 68,000 square feet. Sales per square foot are $738, among the highest in the industry, according to the chain's Web site.

Pathmark remains a high-low operator in a high-low marketplace, a marketplace without any Wal-Mart Supercenters. The closest Supercenter to a Pathmark store is in Monroe, N.Y., about 35 miles from the chain's store in Westchester County, N.Y.

Although Pathmark executives said they know of no plans for Wal-Mart to move any closer to "Pathmark Country," that day is inevitable, Scott acknowledged.

"We don't believe it's a question of will they come but of when they will come," she said, "and we believe we are already well-positioned to compete with Wal-Mart because of the unique things we do.

"We believe if a chain has an identity that's recognized by customers, it can more easily withstand the appearance of Wal-Mart Supercenters in its marketplace. We already operate stores across a wide demographic that encompasses units in upper-income areas like Greenville, Long Island, Marple, Pa., and Edgewater, N.J.; and in inner-city areas like Harlem, Newark, Camden and Philadelphia."

For years, Pathmark labored under a heavy debtload following a leveraged buyout in 1987. It anticipated financial relief when it agreed in 1999 to be acquired by Ahold, but an unwillingness by the Netherlands-based retailer to accede to a Federal Trade Commission request to dispose of most of its other New York-area stores caused the deal to be canceled.

To resolve its fiscal situation, Pathmark opted in 2000 to go through a prepackaged Chapter 11 to rid itself of $1 billion of debt and reduce annual interest payments by $75 million, enabling the chain to begin putting money back into the business.

According to Vitrano, "We had both hands tied behind our backs for the 13 years before the restructuring. We were in hibernation, and now we're breaking out."

Scott and Vitrano, who were promoted to CEO and president, respectively, in October, are Pathmark veterans, each with more than 30 years with the company. They succeeded Jim Donald, who spent six years as chairman, president and CEO before leaving to become president, North America, at Starbucks.

Up Through the Ranks

Scott, 50, came up through the ranks on the merchandising side, joining Pathmark in 1969, working in the stores and later overseeing sales and advertising, nonfoods and pharmacy, merchandising and distribution, and finally store operations. Vitrano, 47, joined the company in 1972, and advanced on the financial side from auditor to budget analyst to director of risk management to treasurer and chief financial officer.

"We're known entities to the people in this organization," Scott said of the management transition, "and frankly, we think that it's good for them to feel comfortable with us."

Scott oversees merchandising and store operations, while Vitrano is responsible for the financial area. "We're not tripping over each other," Scott said. "Frank clearly brings an expertise to the organization that I don't have, and I bring an expertise that he doesn't have, so the board felt it was a strong combination."

Steve Volla, a board member since 1995, who has the longest tenure as a director, was named non-executive chairman at the same time Scott and Vitrano were promoted last fall.

Asked why the company split the titles of chairman, president and CEO three ways, Scott replied, "These are changing times, with non-executive chairmen at more companies, and the board recognized that as a good move in terms of best practices corporate governance."

Pathmark had separate presidents and CEOs for years, she added.

One major difference between Donald's tenure and theirs has been the change in the economy, Scott pointed out. "We pride ourselves on being low-cost operators, but in situations where the economy slips and consumers are spending less, we really need to take another look at things."

Management's biggest challenge has been the economic downturn, Scott said. "When Pathmark emerged from the restructuring, we moved ahead and invested in sales and marketing programs, and for the first three quarters of 2001, we had same-store comps over 3%.

"Then 9/11 happened and the economy turned, and since then, we've lost some momentum because of the macro issue of the bad economy and the tough challenges that has created. But we're taking up the challenge at Pathmark, and even with a weak top line, we still must protect the bottom line.

"So Frank and I took a hard look at the end of 2002 and into this year, and what we came up with was the need for a reduction in head count at the main office and a labor buyout at the stores." Those efforts eliminated 72 positions at the office and 130 positions at stores.

2004 Prototype

Scott said the chain's executive staff is working on the design for the company's 2004 prototype store, which will feature new natural and organic foods departments; additional ethnic merchandising; and increased general merchandise, including more space for seasonal displays.

The prototype is scheduled to make its debut late in 2004, probably somewhere in New York, she said. "We still have two more stores opening this year that will have the 2002 prototype, though there may be a couple of small differences in those two as we move toward the new prototype," she said.

Pathmark began testing natural and organic sections with 1,500 items at 10 stores in mid-2002, Scott said, "and we now believe it's the right department to introduce at a majority of our stores, though we're still trying to determine our space requirements."

The section is at the front of the produce section at nine of the 10 stores and at the back of the section at the other one. Pathmark has decided to keep it up front, Scott said, "but with just 10 stores, we still need to determine the right number of items and whether to devote more square footage to certain categories -- soy milk, for example, which is the biggest category in the section.

"We're still playing with the model to see what's right, though we think we'll probably need 800 to 1,100 square feet to do it as a separate department."

The move toward natural foods is a logical step, Scott said, as items in that category become more mainstream. "We believe it's something that will help identify Pathmark as a unique and innovative store," she said.

Vitrano said Pathmark will probably add natural and organic sections to some existing stores as they are remodeled. "When we do renovations, we look at the concepts under development for the next prototype and see what makes sense. Natural and organic foods has more of an upscale appeal, so we would consider putting it into renovated stores in some middle-to-upper income areas."

In terms of adding more ethnic or international food varieties, the goal is to cater to the demographic mix in each store's neighborhood, Scott said. "We need to make the right specialty assortment available, particularly in some inner-city areas where we need to micro-manage to each demographic to determine the right assortment."

Pathmark also sees opportunities in increasing square footage for seasonal general merchandise, she added. "We've moved into categories like outdoor furniture during the summer, and we need to display it properly to generate sales. We can also use more room for Christmas displays, but there's not enough room in the current prototype."

Scott said Pathmark is also looking very carefully at the service delis in its new prototype "to see if we are focused for the future to the degree we need to be, particularly in prepared foods, which we believe will continue to grow. And while the design for the new prototype is not done yet, we want to make sure prepared foods have the right amount of space and the right offering."

The 2004 prototype will also feature a new decor package. "The one we're using now is six or seven years old, and it's time for us to change." The new design will feature more graphics and a different color scheme, with less white and more bold colors, she said.

Pathmark is studying other operators around the country for additional ideas, Scott said. "We're looking at what's going on outside our marketplace to see what we can learn. For example, we're looking at Southern California and Texas for ideas for ethnic merchandising; we're also looking up in Canada for some general concepts in use there; and we're looking all over at different ways to do deli, which is an absolute growth department."

Pathmark revises its prototype every couple of years. "Over the last six or seven years, we've formalized the process of working on the prototype every other year, and we're constantly staying on top of trends," she said.

The 2002 prototype of approximately 54,000 square feet -- about the same size as the 2004 models will be -- involved a redesign that put the perishables power aisle on one side of the store, which represented a marked change from the 2000 prototype, which had perishables in the middle, flanked by groceries and nonfoods, Scott said.

Growing With Perishables

"Featuring perishables, primarily produce, as the main attraction when customers enter gives the store a terrific starting point," she said.

"Pathmark is all about perishables -- that's what we've built our image on the last few years -- and produce is the beginning of that. We've re-engineered the produce department in the last two years at the same time we've made a major effort to train our associates better, with all members of the executive team going through class and job training and an ongoing training process to raise everyone's awareness of produce. For store-level associates, part of the training was designed to enable our people to be available to answer consumer questions."

Scott said it's hard to pinpoint the results "because we've had a lot of things against us in the produce area recently, from a wet spring to a summer in which we've had problems with product availability. But we're generally pleased with the program."

As part of the chain's cost-cutting effort, Pathmark converted two years ago to what it calls an "easy bake program," essentially a bakeoff where breads, doughnuts and muffins, among other items, arrive at the store pre-made and ready for baking.

The items are made for Pathmark "by suppliers with whom we worked for a long time to get the recipes and quality right," Scott said. Reducing the amount of baking done at store level was a way to deal with a shortage of qualified bakers, she said, "and this approach also saves on labor, on equipment and on capital."

Bob Oberosler, vice president, store operations, for Pathmark's New York-New Jersey area, told SN, "This method creates a consistent quality across all stores, and it also enables us to stay in stock all the time."

In a similar effort to improve efficiency, Pathmark sought to counter the shortage of qualified meat-cutters by switching to case-ready beef at 17 high-volume stores about a year ago.

"We're big believers in the case-ready concept because it gives us a full variety 24 hours a day, and we hope to expand it to all stores if we determine that it works," Scott said. "So far, the results have been encouraging in terms of customer shopping patterns, with a slightly larger portion of customers shopping the case-ready departments, which speaks well to the continuous availability of product."

According to Oberosler, using case-ready beef frees up meat personnel "to spend time in front of the case talking to customers and answering their questions about what to buy and how to cook it, and we've gotten positive customer response about being able to spend so much time talking with the butchers."

None of the stores have service meat counters, "but we're going to put service operations in two of the case-ready stores to see if it enhances the operation," Scott said. The departments are to debut sometime at the end of this year or early in 2004.

Pathmark has also sought to improve front-end productivity by installing self-checkouts at 70 stores, setting a goal for each location in terms of the numbers of customers who use the system. "In many cases, we've been able to drive self-scan usage above our goals," Scott said. "When we initially installed the self-scanners, we were not hitting our goals, so the management team began walking the floors and talking with customers, and when lines become backed up, we bring customers over and guide them through the self-scan process, and now we're exceeding our targets."

After a year of self-checkout installations, 24% of customer transactions and 9% of sales go through the system at those 70 stores, Scott said.

Future Cap Ex Plans

In terms of store growth, Pathmark has pursued a modest program since emerging from its restructuring in 2000.

There are plans at Pathmark to spend $95 million on capital investments this year, compared with $120 million in 2002 and $124 million in 2001.

The reason for the reduction, said Vitrano, is the more difficult economic conditions. "We also want to spend within our means this year. We're not looking to add debt. Accordingly, when we look at our capital spending program, we are tailoring it to match the cash coming in and our investments in stores," he said.

Pathmark opened four new stores in 2001, seven in 2002 and one so far this year, with two more scheduled to open during the fourth quarter -- a store in the New York borough of the Bronx, and a replacement store in Bethpage on Long Island, N.Y.

Asked why new-store growth has been so slow, Vitrano replied, "One criteria for opening new stores is that each one must make money. There are enough examples in the industry of companies that opened stores that were not profitable. But it's our view that we can source three to five stores a year and they will be profitable."

The required rate of return for Pathmark to approve a new store site is 13%, he said.

The company completed 24 store renovations in 2001, but cut the number back to nine last year, "after we recognized a downturn in terms of what customers were willing to spend," Vitrano said. Pathmark plans 16 renovations this year.

At the end of 2002, 82% of Pathmark's stores had been built new or been renovated in the prior five years, Scott said. "Our goal is 90%, and we have the financial flexibility to get there within two or three years."

All new stores will continue to be within a 100-mile radius of the corporate office here. "Ten percent of the U.S. population lives in Pathmark Country, and we believe there's plenty of room for growth within our existing stores' four walls because our boxes are built to do a lot of business. In addition, we can grow in the suburbs, where population is growing, as well as in urban areas, many of which are still underserved by modern supermarkets. So we see a whole lot of growth potential," Scott said.

Another of Pathmark's post-restructure strengths is its ability to invest in technology, Vitrano said. "We underspent for a lot of years, but in the last two we've spent $60 million on technology, replacing our front-end point-of-sale equipment, installing self-checkouts at half the stores, upgrading our communications network, and replacing financial systems.

"And we're going to continue making investments going forward. Right now, we've begun the three-year process of installing the Lawson merchandising system to replace our 30-to-35-year-old legacy system to provide category managers with the tools to manage their departments better. It's a five-stage process that we've begun by replacing direct-store-delivery systems and new-item masters."