REBUILDING THE STORE 2004-03-08 (1)

MARK HAMSTRA

Many of the major supermarket operators plan to continue investing heavily in capital expenditures in 2004, despite analysts' warnings that these companies need to rein in their spending.

Spending on remodeling projects is expected to continue to grow, while new-store construction is expected to remain nearly flat for many traditional operators. Some food retailers, including Safeway, Pleasanton, Calif.; Winn-Dixie Stores, Jacksonville, Fla.; and A&P, Montvale, N.J., are increasing their remodeling budgets significantly above year-ago levels as they undertake large-scale efforts to revamp certain departments and revitalize long-neglected stores.

Kroger, Cincinnati, said it would maintain cap-ex spending around prior-year levels, about $1.9 billion to $2 billion, and Albertsons is expected to record a slight increase, to $1.38 billion from an estimated $1.2 billion this year. Through the first three quarters, Kroger said it spent $1.65 billion on cap ex, while Albertsons spent $892 million.

The larger chains are expected to continue to seek expansion partially through fill-in acquisitions of individual stores or small groups of stores in markets where they already have a strong presence.

"I don't see a huge change in capital spending this year," said Jason Whitmer, analyst, FTN Midwest Research, Cleveland. "You might still see the trends point more towards remodels than new stores. I think that will continue."

He said he does expect to see shifts in the cap-ex spending patterns of some food retailers. For example, Albertsons will likely divert some cap-ex investment toward the development of its new price-impact format, which the company recently said it was going to introduce in multiple markets.

He also said he sees a trend toward supermarket companies building larger stores. "I think everything they are looking at is over 35,000 square feet and more like 100,000 square feet," he said. "I think you're seeing some defensive trends out there in terms of putting up a barrier against Wal-Mart. I think in a lot of stores they are looking to create a one-stop shopping experience."

Overall, however, Whitmer sees more emphasis on merchandising within the stores than on capital spending. For example, he sees the trend continuing toward placing branded departments -- such as Toys "R" Us and Office Depot -- within supermarkets.

Chuck Cerankosky, analyst, McDonald Investments, Cleveland, said he also expects chains to refocus their cap-ex spending somewhat without increasing their totals.

"You might see some of them discussing cap ex as flat, but in reality they might be slowing down new construction and using the difference to pursue consolidation, that is, purchasing sites at a pretty good price from somebody who's selling some sites. The thrifty chain who's making a buy-vs.-build decision could very much opt to buy."

While Cerankosky expects to see fill-in acquisitions continue, he said the trend toward buying individual locations and smaller groups of stores is likely to continue.

"The chains have shown a true price sensitivity," he added. "I think new-store development is going to be looked at closely because it's going to be competing with what's available in terms of existing sites."

Both Kroger and Albertsons last year acquired small groups of individual stores as smaller players exited from markets where the national chains already had a presence. Kroger last year acquired four Cub Foods stores from Supervalu, Minneapolis, in the Denver market, six stores from Eagle Food Centers in Illinois, and 13 Michigan and Ohio Food Town stores from Spartan Stores, Grand Rapids, Mich.

Albertsons, meanwhile, acquired four stores in Texas and Utah from Fleming Cos., Dallas.

Analysts expect that trend to continue as more and more stores become available.

"There are a lot of properties for sale," said Cerankosky. "You've got Eagle and Penn Traffic, Bi-Lo and Bruno's, and I don't think anyone would be surprised if Winn-Dixie and A&P announced additional store sales."

He said he expects food-retailing companies to remain focused on technology spending as well.

"I don't see that changing," he said. "If a company needs distributional infrastructure, they'll spend on that."

Mark Wiltamuth, analyst, Morgan Stanley, New York, said "investors would applaud reductions" in cap-ex spending by the largest publicly traded supermarket chains.

"In our opinion, adding new grocery capacity to an already mature industry only increases competitive intensity and leads to falling returns in the long run," he wrote in a recent report.

He said investors would rather see the chains reduce cap-ex spending to increase their free cash flow and use the funds to offer a dividend. Currently, Albertsons is the only one of the "big three" supermarket chains to offer a dividend.

Cap-ex spending by Safeway, Kroger and Albertsons has exceeded depreciation and amortization by about 20% to 60%, according to Wiltamuth. "We would expect this in a growth industry, but not in the more mature food retail industry," he wrote. He estimated that the major supermarket chains are investing 40% to 60% of their cap-ex spending on new-store growth.

He agreed with other analysts that supermarket companies are best served by seeking fill-in acquisitions in existing markets as an alternative to building new square footage in new markets.

"Adding selling space without adding infrastructure costs enables retailers to spread their fixed costs over a broader base of sales, thereby boosting returns," Wiltamuth wrote.

Increasing Spending on Remodels

Safeway recently said it would increase its cap-ex spending by as much as 50% in 2004, which would fund about 45 new stores -- only five more than it built in 2003 -- but would more than double the number of remodels, from 75 in 2003 to between 160 and 165 in 2004.

Late last year, the company began expanding the perishables departments of some of its stores in Northern California.

"We're excited about what we can do in the stores," said Steve Burd, chairman, president and chief operating officer, Safeway, during a recent earnings conference call. "And so, that would basically call for us to step up the capital in 2004 over and above the $936 million we spent this year."

In response to an analyst's question, Burd said Safeway was not planning extensive remodeling efforts at its Dominick's division in Chicago, which the company recently decided to keep after attempting to sell it for most of last year.

"We actually think that our remodel expenses in Dominick's will be lower than what they will be in other parts of the company," he said.

Other chains that are stepping up their capital expenditure plans with more of an emphasis on remodels than new-store construction include A&P and Winn-Dixie.

Winn-Dixie, which is undertaking a sweeping overhaul of its operations that includes an extensive remodeling program, is planning a total of 700 "makeovers" as part of the effort. The makeovers include upgrades to the perishables departments and improved lighting. In a recent filing with the Securities and Exchange Commission, Winn-Dixie said it had spent $21.5 million on the image makeovers for 98 stores, or about $220,000 per store. It anticipates spending about $165 million to complete the program.

In fiscal 2004, which ends June 30, Winn-Dixie expects capital expenditures to be about $275 million, up about 56% from $176.7 million a year ago.

And A&P, which, like Winn-Dixie, also has been struggling with increasing competition and a deteriorating asset base, said it plans to step up cap-ex spending on remodels in the coming fiscal year after cutting back in the current year. It is also speeding up the pace of converting stores to the Food Basics price-impact format.

The company said it expects cap-ex spending to be about $150 million in the fiscal year that ended Feb. 28, down from previous projections of $175 million. That figure was down from $220 million in the preceding year.

"The lower spending reflects our prudence in the timing of projects," said Mitchell Goldstein, chief financial officer, A&P, in a conference call with analysts discussing the company's third-quarter results. "We will be accelerating spending on remodels and on Food Basics conversions, and we anticipate capital spending in fiscal 2004 to be up very substantially."

Goldstein said cap-ex spending has only been about 60% of depreciation during the past three years in the U.S., and through the first three quarters was only about 40%.

"That was OK for a short period, but we can no longer continue to milk the asset base," he said.

Alternative Formats Worth the Investment

For many alternative-format food retailers, new-store construction provides a better return than it has for traditional supermarket operators.

Wal-Mart Stores, Bentonville, Ark., unveiled plans last year to spend more than $12 billion in capital expenditures in the current fiscal year, which began Feb. 1. That spending would cover 410 to 440 new stores, including 200 to 230 supercenters in the U.S., about 140 of which would be relocations or expansions of existing discount stores. The company also plans 35 to 40 Sam's Clubs, 25 to 30 Neighborhood Markets and 130 to 140 overseas locations.

Although the company said it had not yet released its cap-ex figures from 2003, through the first three quarters of last year it spent $7.4 billion.

Wiltamuth estimated that Wal-Mart is going to continue to grow its grocery sales by about 20% per year.

Costco Wholesale Corp., Issaquah, Wash., also has been maintaining a relatively heady pace of new-store construction, although it has shifted its focus toward development in existing markets. The company is planning 25 new membership clubs in the current fiscal year, which ends in August, and is increasing its cap-ex spending by nearly 20%. Costco opened 23 new stores last year.

"For the clubs, their focus right now is more on market development than on new-market entry," said Cerankosky.

Wiltamuth estimated that club stores overall are growing their grocery sales by about 8% per year.

The largest natural-foods chains, Whole Foods, Austin, Texas, and Wild Oats, Boulder, Colo., have also been more aggressive than traditional supermarkets in opening new stores.

"Whole Foods can't open them fast enough," said Whitmer. "There's so much demand for their product and their brand and their image. They would love to open up as fast as they can."

Whole Foods, which operates 145 supermarkets, last month said it has signed leases for 41 new stores averaging 45,000 square feet. The company has been adding about 10 new stores per year. Historically, it spends about $8.6 million per store, exclusive of inventory, the company reported in a recent financial filing. In the first quarter, which ended in January, the company spent $88.4 million on capital expenditures, up from $55.1 million in the year-ago period.

"There's no reason Whole Foods should be shy about opening in new markets, given its high sales activity with new stores," said Cerankosky.

Wild Oats, meanwhile, has been engaged in both remodeling and new-store construction as it embarks on an aggressive growth strategy and attempts to roll out a new store design at the same time.

"It's still a company being turned around," said Cerankosky. "It's past a 'save the company' mode now and it's very much in 'grow the company' mode with the new management team. They're filling out existing markets where they flat-out need more stores and also entering new markets."

Supervalu also is expected to continue the aggressive rollout of its Save-A-Lot format. The company and its licensees opened 93 new stores last year, remodeled 50 locations and added four distribution centers for the Save-A-Lot chain. The company spent $259.9 million on cap ex through the first three quarters of the year that ended in February after spending $410 million in the prior year.

Investment Allocations

Company: Fiscal Year; Capital Budget; Change; Projects

Wal-Mart Supercenters: 2/1/04-1/31/05; $12B; 4.3%; 80-90 new, 140 conversions

Wal-Mart Supercenters: 2/1/03-1/31/04; $11.5B*; x; 228 new conversions

Kroger Co.: 2/1/04-2/1/05; $2B*; 5.3%; not available

Kroger Co.: 2/1/03-1/31/04; $1.9B*; x; 100 new, 165 remodels*

Costco: 9/1/03-8/31/04; $900M-$1B; 30%; 25 new

Costco: 9/2/02-9/1/03; $766M; x; 23 new

Albertsons: 1/30/04-1/30/05; $1.38B*; 13%; not available

Albertsons: 1/31/03-1/29/04; $1.22B*; x; 80 new, 198 remodels*

Safeway: 1/4/04-1/3/05; $1.24B*; 32%; 45 new, 160-165 remodels

Safeway: 12/28/03-1/3/04; $936M*; x; 40 new, 75 remodels

*Estimate

Source: Company filings, analyst estimates