POSITIVE FEEDBACK

Elliot Zwiebach

NEW YORK -- The supermarket industry may be heading for better times, though the specter of rising gas prices may quash some of the anticipated gains, analysts told SN.

Discussing the industry's prospects at SN's annual Financial Analysts' Roundtable, the participants' comments were among the most positive since the roundtable was initiated 10 years ago.

Their cautious optimism is largely a result of financial improvements at Kroger Co. and Safeway as their efforts to differentiate themselves from their competition take hold and they recover from the impact of the Southern California strike-lockout that ended 18 months ago.

"[But] we must guard against getting too giddy and assuming a permanent turnaround is under way and that the industry has found relevance again," John Heinbockel, vice president of Goldman Sachs here, said. "As you contemplate the outlook for the balance of the year, you have to be selective [because] there are probably as many companies, or more, that are not making progress on the sales front as those that are."

For Mark Wiltamuth, executive director of Morgan Stanley here, sustainability is the big question. "We are still seeing a lot of price discounting and gross margin sacrifice, and one of the big issues for the remainder of the year is to see how much of the recent sales strength reported by a few companies actually translates into sustainable earnings growth. Last year at this time there was some optimism starting to emerge, and we ended up with disappointments by the end of the year."

Gary Giblen, senior vice president and director of research for Brean Murray & Co. here, offered a similar assessment. "There's going to be a wide spread of results, though it's not necessarily predictable who will be the winners and losers. I think results are going to be extremely mixed, and perhaps cautious optimism is one way of looking at what we're seeing. Another way would be to say there's been a dead-cat bounce off the bottom for some companies that are struggling, but the jury is still out on whether it's anything more than that."

Bryan Hunt, director of high-yield research for Wachovia Securities, Charlotte, N.C., said the industry's numbers have looked good over the past few months. "Real sales growth has accelerated over the last six months to produce some of the strongest numbers in the last five years, so the sales picture looks pretty good." But results have definitely been bifurcated, he added. "Companies that have low-end formats aren't doing so well -- they're being pressured because of fuel prices -- [while] in this higher-priced fuel environment, we're seeing convenience stores and grocery stores that sell fuel actually able to pick up a penny or two of margin."

According to Chuck Cerankosky, managing director for KeyBanc Capital Markets, Cleveland, after a period during which "the market concluded this is a dead industry, we're starting to see select companies improve, and I think that reflects better strategies at those companies. So as long as the economy is chugging along, supermarkets will get [the consumers'] discretionary spend -- but that's not guaranteed, especially with some of the unexpected pressures on fuel prices."

Mark Husson, New York-based managing director and global head of consumer research for HSBC Securities, London, said, "Consumer confidence has slowly gotten better and employment has slowly gotten better, and I think the recent improvement in comparable-store sales by a number of retailers is testament to the fact there was a belt-tightening phase as the economy went into reverse, and now it's slowly inching out, half a belt notch at a time. But it's not a great recovery because of escalating gas prices."

Andrew Wolf, managing director for BB&T Capital Markets, Richmond, Va., said the outlook is uncertain. "It remains to be seen if retailers can really claw back most of the gross margin hit they took in 2003 and 2004," he said, adding, however, that his optimism for the near term was reflected in the fact he is recommending Kroger stock to investors -- "the first conventional supermarket stock I've recommended in the last three years," he noted.

For Carla Casella, vice president of high-yield research for JP Morgan Securities, here, retailers are beginning to invest more wisely. "They're working on differentiation, investing in stores, exiting markets where they can't be dominant -- basically reallocating capital a little bit more fairly -- and that's creating stronger balance sheets."

The analysts were divided on how they view the Southern California labor dispute -- which involved a strike against Safeway-owned Vons and subsequent lockouts at Albertsons and Kroger-owned Ralphs that lasted 141 days -- with some saying it was worth it to achieve the savings in labor and health care costs, while others said the loss of sales could be permanent.

For Hunt, only time will tell. "The elongated strike was positive for supermarket operators because it made subsequent labor negotiations across the country easier," he noted, "but in terms of long-term profit growth as a yardstick of success, the answer lies in future operational strategies and investment actions of these operators as opposed to short-term promotional reactions."

Cerankosky said he believes the strike was necessary to level the playing field in terms of labor costs. "The industry had a huge number of alternative distribution outlets, including some traditional retailers, that are non-union with much lower labor costs. If the strike could have been avoided, that would have been great. But you have to deal on a level playing field, and [now] the chains are going to have lower labor costs going forward, though it's going to take awhile to get there."

Husson said the strike was necessary to reduce escalating health care costs. "What would have happened if they hadn't taken the strike and kept on getting double-digit health care cost increases? The industry could have ended up like the airlines or the auto manufacturers, with large organizational structures just to generate cash flow to pay pensions," he noted.

"The strike turned out to be a lot more expensive than anyone would have guessed, and the recovery period has been much slower," Heinbockel said, "[and] the companies probably would have gotten some of the labor savings in other markets anyway, though it might not have happened as quickly. But now that it's over, we have clearly seen the worst in terms of the sales and profit impact, [and] I believe the big three chains will get back to pre-strike levels of profitability over the next two or three years."

Giblen said it's possible the three chains may never quite recover the sales they lost. "The permanent market-share transfer was greater than expected, and longer lasting as well. What the strike illustrated was there are more compelling shopping alternatives than there used to be."

There were no real winners in Southern California, Wolf said. "It was a very tough strike for the industry in lost profits and market share. It's a long time later, and the chains are still down in sales while groups of alternative competitors picked up business. And the union certainly lost too, both financially and strategically."

Wiltamuth said investors were also among the losers. "Investors went into this thinking the strike would be a benign event and might even be a net positive, and now here we are more than a year later and the damage is still there on the income statement."

Among the analysts' observations on other topics during the roundtable:

- Kroger is in the best position of the three major chains to grow earnings "because its strategy is to return to aggressive high-low pricing -- [a strategy that's] not that complicated or risky to execute," Wolf said. According to Heinbockel, "No one will be able to catch up as long as Kroger doesn't get greedy and try to bring too much cost savings to the bottom line, rather than reinvesting them, in any given year."

- Safeway must prove that it can deliver on the promise of its lifestyle stores while trying to work out problems elsewhere, analysts said. "Clearly, execution is something [Safeway] hasn't been particularly good at of late," Husson said. "However, if you took Texas and Chicago out of the equation, I think you'd be pretty impressed by what you saw."

- Albertsons appears to be struggling to find a focused strategy, the analysts said. "Albertsons has a history over the last three years of just throwing stuff against the wall and hoping it sticks," Giblen said. According to Wiltamuth, "[While] Safeway and Kroger have very focused strategies, Albertsons has been trying everything under the sun to get something to work on its income statement, and that's been confusing to investors, and I think a clear message hasn't gotten across to consumers either."

The complete text of the first half of the roundtable follows. The balance of the discussion will be published in a future issue of SN.

The Supermarket Outlook

SN: What is the outlook for supermarket retailers for the balance of the year?

JOHN HEINBOCKEL: I'm selectively optimistic about the industry's prospects for the next 12 to 18 months, and there are some specific factors that underpin my optimism. First, companies with well-conceived differentiation strategies are beginning to see a positive response from customers. In fact, Kroger and Safeway are generating their best identical-store sales in four years, and while we'll have to see how they fare as the comparisons get tougher, I think their strategies will produce long-term market share gains. Second, labor cost increases are clearly beginning to moderate, and that will more than likely accelerate over the next several quarters. Third, I think we'll see the long-awaited profit recovery in Southern California this year. So I actually believe the profit outlook for the balance of the year and into 2006 is pretty good for a select number of companies. Having said that, however, we must guard against getting too giddy and assuming a permanent turnaround is under way and that the industry has found relevance again. Simply put, not everyone has a strategy and an improving sales trend. In fact, there are probably as many companies, or more, that are not making progress on the sales front as those that are. Albertsons, for example, is one where sales have actually gotten worse, not better. So as you contemplate the outlook for the balance of the year, you have to be selective. With that in mind, I think two types of stories will work -- companies whose strategies are leading to a better top line for now, and those special situations where there may be an asset or real-estate play, although there aren't too many of those out there.

MARK WILTAMUTH: I'd have to say I think the structural concerns are all still there. Wal-Mart continues to grow sales of supermarket-related items at a rate of 16% to 17% a year, and by our estimates, it is capturing two market-share points a year, which effectively is all of the growth for the industry, which leaves the conventional grocers to scrap it out for the remaining share. We are still seeing a lot of price discounting and gross margin sacrifice, and I think one of the big issues for the remainder of the year is to see how much of the recent sales strength reported by a few companies actually translates into sustainable earnings growth. Sustainability is the big question for all of us at this table. Last year at this time there was some optimism starting to emerge, and we ended up with disappointments by the end of the year.

MARK HUSSON: I tend to agree with John. But I think another thing to bear in mind in terms of the demand environment is that consumer confidence has slowly gotten better and employment has slowly gotten better, and those are the two things I find most compelling when trying to predict comparable-store sales in supermarkets. I think the recent improvement in comps by a number of retailers is testament to the fact there was a belt-tightening phase as the economy went into reverse and everything was very depressed, and now it's slowly inching out, half a belt notch at a time. But it's not a great recovery because of escalating gas prices.

And I completely agree about the strategies. Food retailers are great at tactics but they're poor at strategy, and Kroger moving down [in price] and Safeway moving up in quality are at least recognizable strategies. There are some companies where there had been an absence of strategy, like at Kash n' Karry in Florida, but it has one now and it's absolutely working, with sales at its converted Sweetbay stores up 40%. So the difference between having a clue and not having a clue is quite stark in this business, and we're beginning to see the winners emerge.

GARY GIBLEN: I would say there's going to be a wide spread of results, though it's not necessarily predictable who will be the winners and losers. I think last year we all felt Food Lion/Delhaize would do well, and then it had a lousy first quarter and all of a sudden a very positive outlook was gone. And Supervalu is now a bit challenged with Save-A-Lot, which has been a big success, though now it's finding that more competition here and there and other factors have made it tougher to get good comps and good results. In fact, Jeff Noddle [Supervalu chairman and chief executive officer] made the interesting observation that you can't really trust the economy because you'd think the tough economy would benefit Save-A-Lot but it doesn't correlate at all, even though it's dealing with lower-middle income customers. Lately, the success of a given Save-A-Lot depends more on the particular competitive environment and market dynamics where the store is located.

So I think results are going to be extremely mixed, and perhaps cautious optimism is one way of looking at what we're seeing. Another way to look at it would be to say there's been a dead-cat bounce off the bottom for some companies that are struggling and have maybe hit bottom, but the jury is still out on whether it's anything more than that.

CHUCK CERANKOSKY: The one thing I see happening again that we haven't seen in a while is (share price) multiples are starting to diverge among the companies we're looking at. If you go back 10 years, to maybe the first time SN did this roundtable, there was a great deal of multiple divergence with respect to individual companies, with the better ones getting the better multiples and vice versa. And throughout this lousy period, we've seen the multiples come together as the market has concluded this is a dead industry. But now we're starting to see select companies improve, and I think that reflects better strategies at those companies.

I believe companies like Kroger and Safeway have better strategies, but one thought in the back of my mind says the economy continues to be on our side because the supermarket today vs. 10 years ago is more economically sensitive. Everybody moved upscale during the last economic expansion, and I think more than a few companies were surprised when people cut back, traded down and explored other trade channels [when the economy slowed down]. So as long as the economy is chugging along, supermarkets will get that discretionary spend, but that's not guaranteed, especially with some of the unexpected pressures on fuel prices.

ANDREW WOLF: I think there is cause for optimism in the near term, but the structural issues the industry faces are not fixed. Looking at the near term, sales have actually gotten a little better with the economy improving. The way I track numbers, I try to get to a real sales growth estimate for the industry, and I believe real sales growth has been positive and has actually shown a little bit of acceleration this year. I also look very closely at the interplay of relative inflation rates for food producers vs. retailers, and on that basis, the last two years have been a very tough time for the supermarkets. With procurement prices going up and the competition engendered by Wal-Mart, it's been a very tough time for gross margin, which has contracted appreciably in that period. Recently, though, the relative inflation rates -- what vendors are charging vs. what retailers have been able to pass through -- have been reversed, and for the first time in over two years, retail prices are inflating at a higher rate than procurement costs. Historically, that ties in pretty well with industry gross margin trends.

How long that's going to endure is definitely open to debate. In past cycles it's endured for about two years -- two years paying on the way up and then two years of claw-back on the way down. That has a lot to do with sticky pricing and issues like that. Now, however, with the competitive environment being more intense structurally, it remains to be seen if retailers can really claw back most of that gross margin hit they took in 2003 and 2004. I've shown my near-term optimism about this development by upgrading Kroger, which is the first conventional supermarket stock I've recommended in the last three years.

CARLA CASELLA: Looking at the industry from a debt perspective, I'd say we're more on the neutral side. Although I agree with a lot of what people here are saying about structural issues, the positive thing we're seeing is that companies seem to be getting religion about managing their balance sheets very carefully, and that's coming out in how they invest in stores. They're doing it in a smart way, and they're grabbing for the strategy as opposed to the tactics. They're working on differentiation, investing in stores, exiting markets selectively where they can't be dominant and putting that money into markets where they can be dominant -- basically reallocating capital a little bit more fairly -- and that's creating stronger balance sheets. They're also focusing on de-leveraging and maintaining their competitive position based on the strength of their balance sheets.

BRYAN HUNT: I also agree with a lot of the comments about structural issues, which are all long term. But things aren't fixed over the short term. We've noticed that real sales growth has accelerated over the last six months to produce some of the strongest numbers in the last five years, so the sales picture looks pretty good. What's interesting about the sales performance is that it is definitely bifurcated. Companies that have low-end formats aren't doing so well, and we think they're being pressured because of fuel prices -- Save-A-Lot is a great example of that, and also the dollar stores. Sales at dollar stores have been weak over the last 12 months as the economy has picked up and as employment growth has increased, and we think if you look at the sales numbers for the dollar stores and the lower-priced formats, they're definitely being pressured by what's happening in fuel, which has made it so expensive for the consumer to drive around and cherry-pick from format to format that it makes the full-service, one-stop format much more attractive. And in this higher-priced fuel environment, where it doesn't pay to drive across the street or a block away to find cheaper fuel, we're seeing convenience stores and grocery stores that sell fuel actually able to pick up a penny or two on margin.

The Southern California Strike-Lockout

SN: One of the big topics in the last few years has been the cost of labor. After the industry went through a five-month strike-lockout in Southern California at the end of 2003 and early 2004, can we point to any lessons learned?

HEINBOCKEL: Well, it was very expensive. Beyond that, it's hard to say. Each company argues that the long-term return on investment, not the near-term cost, is the most important way to assess the impact of the strike. They consistently say the ROI was good, especially if you look at what has happened since the labor dispute ended, with many other concessionary contracts negotiated without strikes. However, it is difficult to get your arms around just how attractive the ROI really is because the strike turned out to be a lot more expensive than anyone would have guessed, and the recovery period has been much slower. The companies probably would have gotten some of those labor savings in other markets anyway, though it might not have happened as quickly. So I'm not necessarily in the camp that the labor dispute was a good thing and the ROI was terrific.

But now that it's over and done with, everyone is moving forward, and we have clearly seen the worst in terms of the sales and profit impact. I believe the big three chains will get back to pre-strike levels of profitability over the next two or three years, though it could happen sooner for some companies. I think it will happen sooner at Safeway, while at Kroger I think it will take longer because I expect Kroger to try to change the pricing paradigm at Ralphs. I think Kroger is going to try to make Ralphs the unquestioned price leader in Southern California, which is the one Kroger market where its stores have been uncharacteristically high-priced relative to its peers. If Kroger does try to change that paradigm, it will delay the profit recovery to some degree, though it will put Kroger in a better position for the longer term.

The one clear, positive thing [since the strike-lockout] is that there has not been a subsequent strike because the union leadership saw what happened in Southern California -- employees lost significant pay on the picket lines and still ended up with draconian concessions -- and that has resulted in more productive negotiations elsewhere. So if the question is, would you want to go through a five-month strike, the answer is a resounding no. But having said that, I think some positives did come out of it.

GIBLEN: On the other hand, the permanent market-share transfer was greater than expected, and longer-lasting as well. What the strike illustrated was there are more compelling shopping alternatives than there used to be, so if the supermarket industry has another strike, you can't assume things will go back to normal once it's settled because in Southern California, Whole Foods picked up sustained market share on the high end, as did Smart & Final on the low end and Stater Bros. on the conventional side.

HUSSON: But the question is, would you rather get shot in the shoulder escaping from jail or endure death by a thousand cuts?

GIBLEN: I'm not saying the strike wasn't worth taking. I'm just saying the consequences in any region must be weighed more heavily by the chain managements because there are so many plausible alternatives wherever you turn.

CERANKOSKY: The strike was unnecessary because the union should have realized what was going on, but it wanted to have the strike and it happened, and what they all ended up with was a very expensive, ugly mess. We've talked about ROIs, but I think the ROIs are inconclusive. The industry faced a very simple situation: It had a huge number of alternative distribution outlets, including some traditional retailers that are non-union, with much lower labor costs. Imagine somebody walking into Wal-Mart and saying, "You can't do vendor stocking." That's inconceivable. But conventional supermarkets have that huge disadvantage in operating costs, and the chains saw it and had to deal with it. If the strike could have been avoided, that would have been great. But you have to deal on a level playing field, and the chain managements did what they had to do to avoid a strike, the strike happened, and now they're going to have lower labor costs going forward, though it's going to take awhile to get there.

WOLF: I think the Southern California strike was a lose-lose proposition. It was a very tough strike for the industry in lost profits and market share. What we know now is that it's a long time later and the chains are still down in sales while groups of alternative competitors picked up business, which is a sort of death by a thousand cuts on the sales side. There were a lot of instances where consumers dipped their toes in the water [to try alternate retail stores] and liked the way it felt, and that's one reason it was a lose proposition for the major retailers. And the union certainly lost too, both financially and strategically.

HUNT: The jury is still out on whether the picketed Southern California supermarket operators are going to reinvest a significant amount of the labor cost savings into price or use those savings to improve and differentiate their competitive positioning. If Ralphs is moving toward a more aggressive pricing posture, we believe the other operators should follow them down this potentially slippery slope. The elongated strike was positive for supermarket operators because it made subsequent labor negotiations across the country easier. But in terms of long-term profit growth as a yardstick of success, we believe the answer lies in future operational strategies and investment actions of these operators as opposed to short-term promotional reactions.

WILTAMUTH: The key point you're all getting at is, was there permanent earnings impairment from the labor dispute that the chains will never really get back? Andrew said it was a lose-lose for the industry and the union, but there's actually a third loser here, and that was the investors. I think investors went into this thinking the strike would be a benign event and might even be a net positive, so they didn't really react and the stocks didn't move on the strike news, and now here we are more than a year later and the damage is still there on the income statement.

HUSSON: But they're still alive. I think the point you're all missing is, what would have happened if they hadn't taken the strike and had kept on getting double-digit health care cost increases? Because that's how the contracts were running on health-care costs, which were already way out of whack with Wal-Mart, even to the point where the industry could have ended up like the airlines or the auto manufacturers, with large organizational structures just to generate cash flow to pay pensions. The fact is, the investors have an investment left and there isn't a hollow shell just generating health care and pension contributions, and that's a direct result of the strike, and I'm sure investors would rather have those stocks than General Motors.

Kroger Co.

SN: Let's talk about specific retailers, starting with Kroger. Its financial fortunes seem to be turning around, so what are its future prospects?

WOLF: I think Kroger is in the best position of the big three to have up earnings and an increased stock price to go with it because its strategy is a return to what the chain represents in consumers' minds to begin with, which is aggressive high-low pricing. Kroger is now aggressive enough to get customers in the store with hotter pricing and promotions and keep them there with good execution. So it's not that complicated or risky to execute. I think a lot of the pain in executing it, at least in the near term, is behind it. But we'll have to see how the competitive environment plays out vis-a-vis Wal-Mart because Kroger is going to see hundreds of new Wal-Marts in the next five years, and we have to see how sustainable its strategy is. But I believe Kroger has the best strategy in terms of staying consistent with what it represents in consumers' minds. It took the company two years to achieve that, by the way, which indicates that even a strategy with only modest risk takes a long time to gain traction for a large company like Kroger.

GIBLEN: I would agree with that. Certainly Kroger invested gross margin earlier than anyone else, and at this point it's beginning to reap the benefits, and hopefully the improvement is really sustainable, though that's not a done deal. And something else that's more subtle but makes a difference is that Kroger has the most harmonious relationship with labor among the big three, and as a result, it gets a little bit of a break in negotiations, and it's been able to go the extra mile a little bit as it goes around the country with labor negotiations and strikes a balance between price and profitability that still eludes Safeway and Albertsons.

HUSSON: I think the good thing about Kroger is that it hasn't messed up the great hand it's been dealt. It has so many No. 1 market-share positions across the country, and because of the way its divisions are geographically contiguous, it's been able to open regional distribution centers and to manufacture private brands that have been a huge bulwark in terms of profitability. Kroger has also kept its banners local, and it's managed through the years to centralize the things that can be centralized while resisting the temptation to homogenize the business, which is good. As for earnings, the key is understanding exactly how executive compensation works -- you incentivize people for one year because they always seem to do what they need to do to get paid bonuses. Last year, when the goal was to generate comparable-store sales, the regional directors were spending money like sailors on shore leave in order to achieve those sales; this year the goal is a mixture of sales and EBITDA [earnings before interest, taxes, depreciation and amortization, or operating cash flow], and I fully expect them to do whatever they need to do.

HEINBOCKEL: Having multiple formats is another key advantage for Kroger because the consumer is more diverse and more complex than ever, and I don't think you can successfully go to market with one format and one banner. To some degree, multiple format capabilities is a hand you have to be dealt because it's difficult to build them from the ground up. Kroger also has a nonfood opportunity its peers really can't match because of the challenges inherent in sourcing and merchandising nonfood products through its Fred Meyer operation, an invaluable in-house sourcing and merchandising arm. So those are two structural advantages Kroger has that virtually no one else has, and when you put them together with the significant pricing edge it has opened up, you could argue that no one will be able to catch up as long as Kroger doesn't get greedy and try to bring too much cost savings to the bottom line, rather than reinvesting them, in any given year.

Safeway

SN: Let's talk about Safeway. Is it on the right track with its lifestyle stores?

WILTAMUTH: I give Safeway credit for its move to push more upscale, but the big question is, is it really differentiating itself from the rest of the market? Its lifestyle formats do dress up the perimeter of the store, but that's not markedly different from what Kroger and Albertsons are doing in their newer stores. So a lot of it will come down to execution and whether Safeway can really deliver on the promises it's making to consumers in its ads.

CERANKOSKY: It's that execution risk again, and I like what I see there. But you've got to tweak it to fit every location, you've got to be in stock and you have to have the quality consistently match what you say in the ads.

HUSSON: I'm a fan of Safeway's, and I remember the last time it had a good long run of comparable-store sales improvements in the 1990s. It started with a remodeling program, and it was able pretty much to hold that store base through the late 1990s and double the industry comps for an extended period of time. But clearly, execution is something it hasn't been particularly good at of late, and it's managed to screw up in the Texas and Chicago markets. However, if you took Texas and Chicago out of the equation and looked at what was left, I think you'd be pretty impressed by what you saw.

The two things Safeway has done well historically that work with an upscale positioning is customer service and workmanship in fresh foods. Even its most aggressive competitor will say Safeway leads the market in customer service by just about any measurement. In fact, it's almost intrusive. And workmanship in fresh foods is something [Safeway Chairman and CEO] Steve Burd has become almost tediously obsessed with in terms of policy and presentation. So I think if you remodel aggressively, offer good service levels and have the workmanship in fresh products that is differentiated, and if you then communicate all that in a way that people can clearly understand your positioning -- all of which Safeway is doing -- then I think you've got a recipe for something that's going to work.

HUNT: I think the risk for operators that are moving toward a fresh format is managing shrink. Some operators that have failed to manage perishables have reverted back to old methods of merchandising and noticed that gross margin improved while sales remained mostly unchanged over the short term. But the reason gross margin improved was that shrink dropped dramatically after these companies reduced [their perishables] stock count. So I believe managing merchandising risk and losing value perception in the consumers' eyes, as retailers move toward upscale, will require stringent measurement and control, or there is potential for short-term margin risk.

HEINBOCKEL: We have a deep respect for most of Safeway's quality/service-oriented strategy, which is, in some respects, much more difficult to pull off than a price-driven one, so if it's done well, it is more defensible. However, we have two primary concerns: First, can the lifestyle format be executed consistently across 1,000 stores, let alone 1,800, because increasing consumer diversity and complexity makes a one format/one banner approach less ideal? Second, can it work with less competitive pricing, both in reality and with respect to perception? Safeway's pricing has fallen behind Kroger's over the past few years, except in Southern California, according to proprietary studies. In addition, building so many nice new stores cannot help price perception. Therefore, the company must be especially diligent in consistently communicating value to the consumer as the lifestyle stores are rolled out.

WOLF: I think Safeway has another strategy it's pursuing along with Albertsons and Kroger, and that's lowering labor costs. At Vons, for example, Safeway is trying to negotiate a labor buyout, but trying to go upscale with your business and downscale with your labor force has inherent risks in it. Those are actually oppositional strategies to some extent. To draw a contrast with Whole Foods, whose employee turnover rates are very low and where there's a strong culture of training and mentoring, if you're going to try to merchandise more like Whole Foods, you may have to upgrade your workforce as well, which is not what I see large chains doing.

SN: Is the fact Safeway is now paying a dividend a positive move?

CASELLA: At 5 cents a share it's just a drop in the bucket, and that doesn't make us worry. If it was any bigger, we would've been nervous about it.

Albertsons

SN: Turning to the third member of the big three, Albertsons: How does its multi-format strategy position the chain long term?

HEINBOCKEL: It's a good thing, in concept, for the long term. However, Albertsons is a far cry from where Kroger is in terms of the maturity of its formats. Albertsons has only about 20 warehouse stores that it's been operating for six to nine months, and they are not at the level of success of Food 4 Less. In addition, it bought Bristol Farms to serve the upscale market, but with just 17 stores, that is still a very limited test. So for me, Albertsons is not really a multi-format operator yet because it just does not have sufficient scale or experience in that area.

The presence of a very successful drug store business is one clear advantage Albertsons has over its peers. If you dive down into its numbers, the drug stores appear to be doing fairly well, especially given robust generic-driven pharmacy gross margin expansion, and that strong performance should continue. However, the down side to this is, once you pull the drug store results out, it becomes crystal clear just how poorly Albertsons' retail food business is doing. Excluding Southern California and excluding fuel, food ID sales are declining an estimated 3%, and food EBIT is falling as well. So the presence of the drug retail business is really not making a huge difference.

As for the dual-branded format and strategy, it's certainly a good idea, and I'm sure it's helping the supermarket pharmacies and over-the-counter drug departments. However, it alone is not the answer. If you do not have a differentiated food strategy, and we question whether Albertsons does, then merely having dual-branding will not save the day.

GIBLEN: Another problem with dual branding is you have aggressive expansion by CVS and Walgreen, so the brand equity of Osco is further limited in a lot of markets. Sav-on [Albertsons' Western drug banner] has more brand equity, but it's been tarnished as well because of continual changes in the course of ownership by Albertsons and before that, by American Stores. So what you have is a dual brand with some limitations, and Albertsons has a history over the last three years of just throwing stuff against the wall and hoping it sticks. I give Albertsons credit for trying new things, but dual branding really was in some sense a diversion from rolling up its sleeves and getting the basics right, as Kroger has done. And now you're seeing some of the people that were hired to do the new outside-the-envelope thinking leaving the company, which makes you think those initiatives had a limited run and now the company perforce has to do the basics, and that's very challenging for it. When Albertsons reported results for the last quarter, it said, "We should get more into price, but we're not getting anything for it so we're not going to invest in it." So it seems that, on the basics, the chain is uncertain as to where it needs to go.

HUSSON: To be fair, Albertsons' current management was, unfortunately, dealt a bad hand by prior management. If you can imagine a deck of cards with 52 different suits, I think Albertsons has them. It has lots of tiny market shares in gazillions of markets around the country but nothing really very big. It has good, strong market shares in two markets -- Chicago, where it inherited Jewel [through its acquisition of American Stores] and where it was fortunate Safeway managed to machine-gun itself in the foot; and Texas, where it managed to get the largest market share in Dallas, which turned out to be one of the most toxic markets in the U.S., which was a bit of bad luck.

WILTAMUTH: I think Albertsons is also challenged by the fact it has spread so many strategies out there. We talked about Safeway and Kroger having very focused strategies, but Albertsons has been trying everything under the sun to get something to work on its income statement, and that's been confusing to investors, and I think a clear message hasn't gotten across to consumers either.

WOLF: When you look at the average market shares for the top three chains, Albertsons has a little more than 14%, compared with about 23% for Kroger and 20% for Safeway, but that's because it has some markets like Sacramento and Bismarck where it actually averages No. 3 and where its share is only around 10%. And then it has a lot of markets where it's not even in the top three, where it's not even in the game. So when you say the underlying productivity of the stores is really rank -- down 2% to 3% and lagging everyone else -- and say these guys can't do anything right, you've got to ask yourself whether Albertsons is perhaps managing the business a little differently. It may need to think about getting out of a market like Phoenix, for example, and using that cash to fund some other markets. In contrast, if you look at the market shares in its top four markets outside California, the most recent data shows Albertsons is actually up in Chicago, Philly and Boston while obviously down in Dallas, where there's just an incredible food fight. The point is, there may be something going on. Larry Johnston [chairman, president and CEO] obviously is somebody who likes to shuffle the deck and has a proven track record of being able to do that.

The Stock Market

SN: Turning to the stock market, a number of supermarket stocks gained ground in the first half of 2005, with Safeway and Kroger showing double-digit gains despite a lackluster performance by the overall market. Does this represent new interest in the sector?

WOLF: I think there are more financial players digging around. And I think there's a little more investor interest, with the buy-side coming around to think of supermarket stocks somewhat as a dependable group.

CERANKOSKY: I think, with very guarded optimism, that there is more interest. I think the industry gave investors sort of a double head-fake -- first with some money starting to flow into it as the economy improved, then with some companies getting hammered by people trading down into other formats. And once we started getting around that bend in the river, we had the Southern California strike, which brought up how costly a work stoppage could be. Some investors thought the strike would last a week or two, but it went 20 weeks. Now they see some sales momentum and earnings that are somewhat better than expected, so their attention is back, but they're being a little careful.

GIBLEN: Certainly the return of Ron Burkle [principal at Yucaipa Cos., which bought a 40% stake in Pathmark] has singlehandedly renewed interest in the group because he's a very savvy retailing investor -- nothing less than "master of the universe" in that regard. In quick succession, he invested in Wild Oats and of course Pathmark, so that could be ringing the bell at least for the bottom of the industry. Then, when Standard & Poors downgraded the stocks, that was the ultimate bell-ringing, followed by the horses leaving and the barn door slamming, and now they're burning down the barn.

Lowered Bond Ratings

SN: What impact will that downgrade on the bond ratings have on the three top chains?

CASELLA: I think it gave the chains a fair warning. We thought S&P might simply let them know it might downgrade them if they issued a big dividend or adopted more shareholder-friendly tactics, and we thought it would be more selective. But after further conversations with them, we found S&P just wanted to emphasize what we've been talking about for years -- that structural issues do have a significant impact on the industry and that the chains shouldn't be rated as high as they were. So this move sent a strong message, though the agency didn't say the chains should be high yield yet, which is what would really matter to the operators. A one-notch downgrade doesn't hurt the cost of financing so much, so this action was only a modest negative.

SN: Perhaps S&P was just behind the times in understanding the structural makeup of what's really going on, and now it's just catching up.

CASELLA: It might have been catching up on the ratings, but it's finally decided the structural issues weren't going away and the chains weren't going to find other ways to compensate for those issues.

CERANKOSKY: They could have been downgraded a good while ago, as you suggested. But if we are right -- at least those of us who like some of these names -- then we're going to see the cash and coverage ratios go up dramatically over the next couple of years, and then the question comes up, will they get an upgrade?

SN: Is it fair to talk about all the chains together?

HUNT: Unfortunately that's the way S&P treated them, although there are definitely differences among them. In my opinion Kroger should undoubtedly be the ratings leader among the three players because it has greater differentiation, greater sales and greater free-cash flow to total debt. Kroger could knock out its total debt balance within six years if it wanted to focus all its free cash on debt reduction. But I think, as Carla said, the agency's actions were a shot across the bow because if you go back over the last five years, Kroger, Safeway, Albertsons and Supervalu combined bought back about $5 billion worth of stock, whereas debt reduction has been somewhat de minimus up until recently. The majority of debt reduction, even at Safeway, came from reducing working capital, which isn't sustainable. So I think what S&P is telling them all is they need to come up with a sustainable formula that allows them to manage their debt as well as reward shareholders, and it just hasn't seen that formula.