ROAD TO REJUVENATION

ELLIOT ZWIEBACH

NEW YORK -- Supermarkets facing center-store shrinkage need to ramp up other revenue-producing options, including pharmacies, natural foods and general merchandise, a panel of industry analysts here suggested during SN's annual Financial Analysts' Roundtable.

Unless supermarkets can branch out, the future looks bleak, participants said. "This is a zero-sum game," said Jonathan Ziegler, San Francisco-based managing director for Deutsche Banc Alex. Brown here, "so all these companies are just involved with high-low promotional pricing, which is totally the wrong way to go to market because all that does is temporarily steal market share from a competitor."

Deborah Weinswig, food and drug chains analyst for Bear Stearns here, took it a step further. "It's a negative-sum game because if you don't start to extend the size of your stores -- if you don't open larger stores and have one-stop shopping and the general merchandise or the natural foods -- then you're going to continue to lose share to the restaurants," she declared.

Expanding a store's offerings is a way to make up for the loss of center-store sales to other distribution channels, Meredith Adler, senior vice president for Lehman Brothers here, said. "What we're seeing is the supermarkets redefining themselves to take share away from other kinds of retailers," she said.

Lisa Cartwright, director for Salomon Smith Barney here, said diversity of offerings is important. "What we're seeing is that supermarkets -- and all distribution channels, frankly -- are starting to look more alike. Everybody's really selling a lot of the same things," she pointed out.

According to Mark Husson, first vice president for Merrill Lynch here, "There's recession in the middle of the store, and all retailers are looking for patches to put over leaky holes in comparable store sales."

The solution, the analysts suggested, might involve further exploring new departments, including the following:

Pharmacies. "Everybody is very committed to pharmacy because it's the one area where you get double-digit sales growth guaranteed because of the aging of the population and the (availability of) new drugs," said Debra Levin, principal at Morgan Stanley Dean Witter here.

According to Weinswig, "Studies show the retail food channel experienced 22% growth in prescription drugs in 2000, so obviously pharmacy has already started to make inroads."

Natural foods. With Whole Foods reporting same-store sales increases exceeding 10%, "natural food certainly remains a fast-growth category," said Gary Giblen, senior vice president and director of research for C L King Associates here. "Supermarkets have gotten a whole lot better in marketing and merchandising natural food, and they're going to continue moving more and more toward natural and organic."

General merchandise. Ziegler suggested retailers develop more in-and-out promotions on general merchandise to create in-store excitement. "You don't get wedded to (general merchandise)," he explained. "You just blow it out, then you go on to the next thing. You also get a pretty good gross profit percentage on it."

The participants also cited fuel centers, banking services and food-service offerings as potential revenue sources.

The roundtable participants also offered their views on a variety of other topics, including the following:

Demographics. Jack Murphy, vice president at Credit Suisse First Boston here, said supermarkets "really haven't done a very good job of capturing the low-income customer" with annual incomes below $25,000 -- a customer who has generally abandoned supermarkets in favor of dollar stores, supercenters and discounters.

Adler said the industry "is still skewed too far uphill, and there's been kind of an unwillingness to go to market to attract the lower end." She said supermarkets have "a huge opportunity" to pursue specific niches, such as Hispanic consumers or lower-income shoppers.

The economy. Ted Bernstein, managing director of Dresdner Kleinwort Wasserstein-Grantchester here, said he expects the economy to continue to be soft, "probably at least through the end of this year."

Levin said retailers have not noted any trading down by consumers. "Private label is growing faster than non-private label, but those trends are not much different than a few years ago," she said. "Where we've seen some softening is on the general merchandise side, but food and consumables have been pretty steady."

Levin said she views the large numbers of store closings by Albertson's, A&P and Winn-Dixie as "a potential breath of fresh air," with closings benefitting both the company eliminating the underperforming assets "(and) whoever is sitting next to those closed stores."

Consolidation opportunities. According to Murphy, Safeway may no longer have the luxury of waiting for the earnings of regional operators to erode to a point where the sellers lower their asking price, in contrast to 18 months ago, "(when) things were tilted toward Safeway sitting very comfortably, letting the EBITDA's of these companies erode away without paying up. But now Safeway is at least as incented to pay up at this point."

The complete text of the first half of the roundtable follows. SN will run the rest of the discussion, which centered heavily on Wal-Mart, in a future issue.

SEEKING TOP-LINE GROWTH

Supermarket retailers have a variety of options to grow top-line sales, including fuel centers, pharmacies, banks, natural food sections and food service, the analysts said.

SN: Let's talk about some of the ways the industry has been trying to grow itself from the top line and expand the overall pie, as opposed to simply buying other companies. DEBRA LEVIN: Most companies are investigating fuel centers, and they're really focusing on pharmacy as well. Neither is really a new aspect of growth, but I think everybody is very committed to pharmacy, because it's the one area where you get double-digit sales growth guaranteed because of the aging of the population and the new drugs. And the fuel centers are proving to be a nice adjunct, though in time, they could suffer from some overcrowding in the big picture. But right now they seem to be working.

TED BERNSTEIN: Pharmacy in particular holds some promise, particularly with the prospect of a Medicare prescription drug benefit and maybe even some ventures by supermarket operators partnering with big PBM's, pharmacy management companies.

DEBORAH WEINSWIG: Studies show the retail food channel experienced 22% growth in prescription drugs in 2000, so obviously pharmacy has already started to make inroads. Kroger is on the cutting edge of what supermarkets are doing in their pharmacies. It has actually started implementing pill-counting technology for the top-selling 90% of its drugs, and I think they're continuing to take it to a different level.

GARY GIBLEN: Natural food certainly remains a fast-growth category. Whole Foods reports an increase of 10.1% in same-store sales, which I think is the envy of any conventional food retailer. Supermarkets have gotten a whole lot better in marketing and merchandising natural foods, and they're going to continue moving more toward natural and organic.

JONATHAN ZIEGLER: To me, the model of how things should be done is the Costco formula, and I think we're starting to see some downstreaming of that concept into the grocery retail channel. What I'm talking about is a treasure hunt -- in-and-out merchandise in general merchandise where you can create some merchandising excitement. You don't get wedded to it -- you just blow it out and you create excitement in the store, then you go on to the next thing. You also get a pretty good gross profit percentage on it.

MEREDITH ADLER: What's interesting is, a lot of people talk about how other channels are trying to take share away from supermarkets, and part of what we're seeing is the supermarkets redefining themselves to take share away from other kinds of retailers. We don't see a whole lot of growth in core supermarket categories because of competitors taking share and also because of deflation. So you're not going to see a lot of growth in those core categories.

LISA CARTWRIGHT: Basically what we're seeing is that supermarkets, and all distribution channels, frankly, are starting to look a lot more alike. Everybody's really selling a lot of the same things. And we're seeing that supermarkets, like discount stores, are actually becoming more cyclical. And I think drug stores are becoming more cyclical and are sensitive to economic downturns because they're selling other things. So in their pursuit of sales growth, staples -- the middle-of-the-store items whose share has been captured by the Wal-Marts of the world -- are suffering, and in response to that, supermarkets are going after general merchandise or more and more seasonal items, as Jonathan was speaking about. But that makes supermarkets more susceptible to an economic downturn.

MARK HUSSON: The point that ought to be made here is, supermarket growth is miserable. There's recession in the middle of the store, and all retailers nowadays are looking for patches to put over leaky holes in comparable store sales. Retailers are a frightfully reactive group. They're all about a decade behind the rest of the world in bringing general merchandise into the stores, and they're doing it screaming and kicking with no particular commitment and with no particular zeal or flair or expertise. I think that if you look at general merchandise as a percentage of sales in U.S. supermarkets, it's in the single digits somewhere, though it varies by retailer. Kroger is probably the best, but the best of a bad bunch. If you look at an Asda or a Tesco, which have got about 18% or 19% of sales in general merchandise, their comp store sales numbers are running about 7%, which are being driven by general merchandise. It's not driven by selling hot dogs or chicken Tandooris or any of that sort of fresh stuff. But in general, U.S. food retailers have been awful at general merchandise. They've allowed everybody else to steal that patch on the consumable side, and they're only just belatedly trying to catch up.

GIBLEN: Fleming is actively pursuing the wholesale business with dollar stores. That's a big new area to pursue. Fleming has been going after convenience stores for a while, and I think that's testimony to the limited growth of the center of the store, which is actually really almost the only business that has any value for food wholesalers, since they don't pick up all the perishables business anyway. So they're reaching farther and farther afield, and the next thing may be something in the pharmacy area. And then we've heard Safeway talk about corporate initiatives that may take them outside the box of food retailing, possibly into some other form of retailing or wholesaling.

ZIEGLER: The trouble is, this is a zero sum game, so all these companies are just involved with high-low promotional pricing, which is totally the wrong way to go to market, because all that does is temporarily steal market share from a competitor, only to lose it again the following week when the competitor is promoting something, possibly the same product. And if they get to be EDLP and function on what products turn and really manage inventory better, they could probably use systems to expand into other areas. But the systems haven't been used yet, though I think they're starting to be, and Safeway is doing things in a different area to try to generate revenue by focusing a little bit on making the store more powerful as a revenue generator. If you go to the checkout line, you'll see the flat screen panels running your total along with advertising at the same time, and Safeway is generating revenue from that. And it's the only retailer I've seen really doing that so far. Mark mentioned Tesco, which really impresses me in what it's doing -- for example, it has its own brand of banking, as well as its own brand of health insurance tied into pharmacy, and I think Safeway is starting to do some of that, too.

LEVIN: You're seeing a lot of banking, with Safeway, Winn-Dixie and Ahold all working with CIBC [Canadian Imperial Bank of Commerce], so there's this thinking about doing bank partnerships. Also, you have the example of Ahold, which really went outside the supermarket industry to do food service, and that's been a big push for it and a successful one to date. So there is a possibility you'll see companies go into related or possibly even nonrelated businesses, as the expansion opportunities and consolidation opportunities unfold and lessen over time.

WEINSWIG: Jonathan said it's a zero sum game, but I think it's even worse than that -- it's a negative sum game because if you don't start to extend the size of your stores, if you don't open larger stores and have one-stop shopping and the general merchandise or the natural foods, then you're going to continue to lose share to the restaurants.

GIBLEN: It gets back to the wisdom of the Europeans, as Mark was saying. Ahold had the experience of doing food service in Europe and then said why don't we do that in the U.S. -- especially because it ran into antitrust problems, which might have accelerated its move into food service. So it's partially strategic and partially reactive but probably a darn good idea -- and Ahold is also doing convenience stores, too, so we'll probably see others doing the same.

NEW NICHES Retailers ought to give more consideration to price-oriented formats that cater to lower-income consumers and increase their assortments of general merchandise items, the analysts said.

ZIEGLER: Another thing we're starting to see is niche markets being created for the lower-income customer, such as Save-A-Lot and Yes! Less, and for the exploding Hispanic population. Vons was very early in doing Tianguis. It's just too bad they were way before their time, and they probably didn't execute it as well as it should have been done. We were at a Minyard's Carnival store in Dallas a few weeks ago, and it was the only store that afternoon that was just jammed with people. So there's a huge Hispanic market out there, and maybe supermarkets have to fragment what they're doing and do more specialty.

ADLER: I agree. When you actually look at demographic data on income levels, you have the feeling that the supermarket industry is still skewed too far uphill and that there's been an unwillingness to look at how you go to market to attract the lower end. You could argue that Wal-Mart supercenters with their great prices have stepped into the vacuum. But it seems to me there's just a huge opportunity, and whether it's specifically Hispanic-oriented or aimed at people who generally have a much tighter budget, there's a significant opportunity there. One of the more interesting things that Fleming is talking about is combining limited-assortment food retailing, like you get at a Save-A-Lot or Aldi, with more of the general merchandise that you see at a dollar store, which is a new way of thinking about things.

JACK MURPHY: It's finally coming around to a lot of the food retailers that companies like Dollar General and Family Dollar have basically been moving further and further into supermarket categories, carrying more and more nonperishable foods and household chemical items and comping at 5%, 6%, 7% or 8% year after year. And these are just huge categories, and what's their core market? It's $25,000 of household income and lower, and it's just a huge untapped potential. These stores are operating basically east of the Mississippi at this point, and they're growing very rapidly. And now we have Fleming finally coming around to looking at them as a customer and maybe creating a new format. But I think Meredith is right in saying the core supermarkets really haven't done a very good job of capturing that low-income customer, which remains a large, untapped potential.

CARTWRIGHT: Not only that, but they fail to realize that the middle and upper demographic also want a good price on some of these items, and they'll shop more than one format. I think that, until recently, they've failed to recognize that people spanning the income levels will shop at more than one format, and they're really aware of prices, especially on items like household products and paper.

ZIEGLER: That's one of the reasons why Food 4 Less, which is operated by both Kroger and Fleming, and perhaps Cub from Supervalu, make a lot of sense -- because they really are cost-effective ways of delivering dry groceries. And if you do that right, you can develop a really strong perishable program around that and get some margin out of it.

HUSSON: What makes these kinds of price-impact formats work is the negative cash flow of hard discount stores like Aldi, with very limited SKUs and with the ability to turn inventory 40 or 50 times a year. But when you look at U.S. food retailers, who have the luxury of fantastic amounts of cheap space, inventory turns have been pathetic -- typically nine or 10 turns a year -- and even if they really work at it, a store might do 13 or 15 turns. Do 50 turns, and then maybe you start to make these concepts work. But historically, the retailer has always been trapped into running SKU ranges that are about 20% to 30% too rich, because they've wanted to give customers a choice. If you take out 20% or 30% of the range, you've still got choice, frankly, and you just turn the stuff faster and it's much more efficient. Retailers have never understood that in America.

But, the great thing about food retailing is you've got a very, very, very frequent visit and frequent experiment. You've got a chance twice a week to change people's minds and to get people used to buying household products or household consumables or household textiles or bedding or even light electric items.

WEINSWIG: Wal-Mart opened its first supercenter in 1988, and it's already the largest food retailer, no matter how you slice and dice it. So I think there's still a lot of time for people to change their format and win the pocketbooks of America.

GIBLEN: Smart & Final has been very successful driving great comps with its hybrid supermarket-warehouse club format, and despite the fact that it's surrounded by Costco and to some extent Sam's, Smart & Final is doing 5% comps.

HUSSON: It's probably a brand positioning question, isn't it? It's too late to become a Wal-Mart on general merchandise, but it's not too late to become a distinctive Safeway on general merchandise. But Safeway has to decide who its customer is and how it goes to market and how it's positioned in the customer's mind, and then position the general merchandise offering around that customer and his needs, rather than trying to sell black-and-white TVs cheaper than Wal-Mart. Again, it's positioning, and Smart & Final has positioned a certain market and covers it very effectively.

ADLER: Your comments about inventory management are probably right to the point, because supermarkets have better velocity in a lot of the food, and I'm sure one of the things that turns them off from doing more general merchandise is that the turns haven't historically been good and they're not good at managing inventory, so the thought of getting into that slow-turning stuff is sort of terrifying.

HUSSON: It is, because it's seasonal merchandise as well, so you have to make a big commitment up front and you've got to watch it gather dust on the shelves until the season really takes off, then you've got to maximize your sales in a short window of time. And you've got this horrible thing called markdowns, and that frightens some as well.

ZIEGLER: What about scan-based trading in general merchandise? Scan-based trading could make it work, because that means you'd have the vendor promote the hell out of an item because he's still going to own it, so you're going to turn your general merchandise faster if you do it on a scan-based trade.

ADLER: Shrink remains the unsolved issue in scan-based trading.

ZIEGLER: You can work that out, though.

SEARCH FOR EFFICIENCIES

Analysts suggested retailers and manufacturers need to work together to make the supply chain more efficient by finding ways to turn merchandise faster.

ADLER: An interesting concept regarding turns that someone mentioned to me is that manufacturers are putting too much product in the case. The cases are essentially too big, and the stores are built so you can empty a case onto a shelf every time you get a case coming in the backdoor because obviously you don't want to put anything in the back room. I asked a supply chain guy in one of the supermarkets whether there were any discussions with manufacturers about shrinking the cases, and he said they're not anywhere near that -- although if you think about it, that could be the answer, and Kroger has talked about it, but its dedicated, slow-turn distribution centers don't handle just traditional break-pack health and beauty aids or general merchandise, but also slow-turn grocery. So why not do that? Why not cut the size of all cases in half, and you could shrink the store to more manageable size for people who are getting older? I don't think anybody wants a big store -- people just want to get everything they want. And they don't even want choice. They want what they want, and I don't know that they necessarily get a thrill out of doing it by having to walk 40 minutes from one end of the store to the other.

HUSSON: What you're saying about pack sizes is dead-right. It just shows the retailer hasn't taken ownership of the supply chain yet.

WEINSWIG: BJ's has been able to actually negotiate. It's a small player, when you look at the Safeways and Krogers and Albertson's of the world, but it's actually been able to work with manufacturers and develop a program called "drive over drive," where they'll have two sets of pallets at different heights that are both easily reachable. So there's no reason why the big three retailers, which have a lot more power, shouldn't be able to work with manufacturers that way.

CARTWRIGHT: They're already working with them to get product coming in with removable boxes so they can just slide the merchandise onto the shelf.

ADLER: I get the feeling that the Flemings of the world are more focused on that kind of handling efficiency than the big chains, who are still happy to do things the way they've always done them.

CUSTOMER CONCERNS

Retailers are becoming better able to merchandise across diverse geographies by decentralizing management, conducting in-store surveys and utilizing point-of-sale data to pinpoint what customers want to buy, the analysts noted.

SN: When we talk about growth, it's clear retailers need to understand who their consumers are. Meredith said customers don't want choice, but they want what they want. How does a national retailer, which operates in so many diverse geographies, deliver on that?

BERNSTEIN: One of the ways Ahold has been very successful is that it generally buys good companies that have good management teams and it leaves those management teams intact, and those management teams are in touch with the markets they are serving. They understand how to merchandise those stores. A classic example of how not to go about that occurred when KKR acquired Bruno's and replaced top management, which resulted in a real clash of cultures there. And what customers wanted -- what they were accustomed to seeing on the shelves -- just wasn't there after that deal was done, which is one of the reasons it failed.

GIBLEN: Supermarkets use frequent shopper cards, where the point is to get really good data so you can micromarket. Nobody's quite there yet, though Safeway is getting there, and some others will get there.

ADLER: I think data is clearly the key, but my sense is there are more psychological or cultural obstacles within companies to doing meaningful neighborhood merchandising. Albertson's talked about it for years because it was so dreadful at it, and I don't think it's made any meaningful progress. And I think managing your inventory, unfortunately, seems to work against neighborhood merchandising. You have to be pretty sophisticated in the end and say only 15% of what sells in a store is truly differentiated while an awful lot of it is similar, and then you have to think about being smart and reducing choice within the other 85% that nobody really cares about -- that's pretty standard. And there's a lot of sophisticated technology and mental understanding about how to get there.

HUSSON: There's a lot of lip service paid to category management, but a lot of the people that do category management are in fact the old buyers who just changed their title. And the buyer ends up trying to sell what he's bought rather than buying what he can sell, and that's always been the problem. The buyer sees the warehouse as a source of money and thinks whatever deal he can make to get the product in the warehouse is great for business and the retail store is just a faucet to drain the warehouse so he can put more deals in the warehouse.

ZIEGLER: But that goes back to what I was saying -- that they all do this high-low promotional BS that moves what the vendor wants to move and they're getting paid for it, but it's not at all what the consumer wants and they're force-feeding the channel.

WEINSWIG: I think one of the ways Kroger has catered to local customers is through its signature stores, where it goes into a community and hands out surveys asking people what they want in that store.

CARTWRIGHT: It's stagnant, though, because it's a one-time thing. It gives an impression that Kroger is making the store right for local customers, but they don't have a dynamic process. None of them do.

HUSSON: And it's usually a matter of asking what it can do for customers in the store and then adding products to its existing range, rather than totally discontinuing the stuff that isn't selling.

ADLER: But I will say, from visiting stores, that Kroger does a better job of at least targeting the way the store looks for the local community.

CARTWRIGHT: That's because of its management structure.

WEINSWIG: Because it's very decentralized.

CARTWRIGHT: And it allows local people to have more of a say in how it runs its stores. I mean, Safeway is going to have a very difficult time transitioning to that.

LEVIN: But one important thing, as these companies get larger and larger through acquisitions, is they are getting the systems right over time. They can get more centralized, so when it comes to procurement, they can do it smarter. The challenge is to get it right with category management and neighborhood marketing, but the opportunity is there with better and better systems, and I think they are making progress using those systems.

MURPHY: One problem is, most of the companies we're talking about here are kind of a patchwork of other companies. These companies have been put together over a long period of time, and their systems are now just getting integrated. Let's see what happens when they have the point-of-sale data and can really scrutinize it in an effective way.

OVERLOOKED INVESTMENT OPPORTUNITIES?

Investors are looking for turnaround stories as they peruse the supermarket sector for opportunities, analysts said -- though they may be looking for the wrong kinds of stories, they added.

SN: During the first half of 2001, the stock market saw value companies outperform the industry's prime growth companies. So where are supermarkets going in the second half in terms of financial performance?

LEVIN: I think there's a real question among analysts, strategists and economists -- and there's real waffling going on -- about whether the recession is a U or a V or an L and about how fast changes are happening. What we've observed watching the industry and listening to what it has to say is that sales have been relatively consistent. If you look at same-store sales for the whole group, they're probably up 1% to 2% on average, although there are extremes above and below that range. And it's a consistent cash-flow business. There have been companies that have both surprised on the upside and the downside, but relatively speaking, it's been fairly consistent. The stock performances, though, can be dramatically different. So we've seen the value stocks do a lot better than the other stocks, and we've had the case where Albertson's had some major disappointments over the last year, and really, at this point in time, even Albertson's management doesn't have a good sense about what its earnings power is and what its true growth rate is. So I think the outlook is mixed, and therefore you tend to gravitate to those stocks that are your favorites when you're recommending stocks. But overall, I think it's still tough going. It's not like there's a huge appetite by investors for any of these stocks right now.

ZIEGLER: We're in a catalyst stock market. People are kind of bored with the supermarket group, and there's no story, so people are looking for names to act as a catalyst for something to happen.

ADLER: I would also argue that people like turnaround stories in this kind of market and this kind of economic environment because there's very little sensitivity to external events. It's all whether a company can deliver on its own turnaround promise, so the value stocks tend to hold up well or are generally even. In the first half we saw them outperform because people perceived they were delivering on some promise. Usually the margins are so thin it doesn't take much to show a dramatic improvement. That's the only explanation I can come up with.

HUSSON: The small caps all got very cheap because when we were in a bull market, we had some analysts -- none of us around this table, I don't think -- who were saying investors ought to buy big market cap stocks because they're liquid and you can get in and out. When that was happening, the small caps got completely ignored, and if the fundamentals weren't great for the likes of A&P and Winn-Dixie, then those stocks got completely ignored as well. And I think that small cap value -- and it's the same across all sectors -- has been one of the only ways of making money in the market this year.

MURPHY: The thing to be very careful with on all these stocks that have done so well in the first half is that some of them are still cheap by traditional metrics. And you can make an argument, in the case of an A&P, that EBITDA margins are low and it's a cheap stock on an EBITDA basis. You can't really make that argument about Albertson's.

GIBLEN: A&P is a cheap stock for good reasons.

MURPHY: The point is that Albertson's and Winn-Dixie are expensive stocks with a lot of earnings risk, and that's where the market starts to scrutinize a little bit more.

ADLER: You could also say that some of the big stocks have better valuations at this point than they did when the first half started. Safeway, for example, has a much better valuation.

GIBLEN: At this point, you can buy Safeway as cheaply as any other stock, and there's not much question that Safeway is the best company in the industry, albeit with some disappointing short-term trends. Maybe that makes Safeway particularly attractive. But a lot of the answers to the question depends on what happens in the market and in the economy overall. If we continue to have a directionless economy, then the Winn-Dixies of the world will continue to do well until they perhaps blow up. But unless a turnaround is absolutely dismissed or negated as a possibility, then those value stocks will continue to outperform the Safeways.

HUSSON: I think what we're trying to say is there are two kinds of stocks. There are story stocks and proxy stocks. The story stocks all tend to be small and less well-covered and there's usually a specific reason for owning them, and the bigger caps are all kind of proxies for the sector, which may be out or in. Safeway could turn in 3% comparable store sales in the next quarter and beat everybody's expectations, but if Nasdaq is running strong and if cyclicals and financials are all running strong, the stock is going to want to perform.

ZIEGLER: Our [stock] group is viewed as a source of funds by many people when they think the economy is going to turn, and yet, because I'm in the business and I try to be positive, I tell people they should look at our group in terms of consumer nondurables and where we stand in that sector because any portfolio manager is going to have to have some consumer nondurables in his portfolio so he can take a chance on some high-risk stocks. I think our group stands out pretty well. We're doing maybe midteen earnings growth and that stacks up well against the food companies, and certainly the pharmaceutical companies are in that range, though they're at higher price/earnings multiples. So I try to turn investor thinking around and make it into a positive.

HUSSON: I agree with you. It's somewhat frustrating that some manufacturer stocks are treated in such a way that, if a company had 6% growth and comes out to 7%, everyone is ready to buy it.

CARTWRIGHT: Aside from the economy, the other issue affecting this industry has been decelerating earnings growth. Two years ago, earnings growth for a company like Safeway was 30%-plus. It was growing earnings through acquisitions and internal projects like rolling out pharmacies or rolling out delis or bakeries. Safeway was doing a lot of things that certainly could be considered turnaround projects, but from 1998 going forward, earnings growth started to decelerate, and from 1997 forward, return on invested capital started to decelerate.

If Safeway keeps doing these little bitty acquisitions, people will keep asking what's next and what's next and then return on invested capital will start to move again. But right now, I think it's going to be stagnant. People will pay for consistent returns, but only if they think it's going to be never-ending. So they're going to pay more for P&G, for example, because it's global and that keeps it churning, and also, when you hit on a new brand, the return on invested capital is incredible.

WEINSWIG: I agree with what you said about the catalyst. I mean, Wal-Mart's been the best-performing stock on the Dow during July. What's the catalyst? Tax checks. Back-to-school. Christmas. But there aren't very specific catalysts you can see along the way for more customer spending at supermarkets.

ECONOMIC CATALYST

The economy is not having a significant impact on the performance of supermarket stocks, though it could be a catalyst that drives more investors toward the sector, the analysts said.

SN: Has the economy affected the supermarket sector?

ZIEGLER: Two of my stocks are doing very well -- Costco, which is at a 52-week high, and Whole Foods, which is at an all-time high -- and both appeal to the same upscale market, with an annual income range of $70,000 or $80,000. They're both delivering really strong comps, and they both have a differentiated offering to the Street, whereas everybody else is pretty much homogeneous. But Whole Foods and Costco have managed to set themselves apart, and in the case of Whole Foods, it's one of the few companies I follow that doesn't compete with Wal-Mart, and Costco doesn't compete with Wal-Mart either, though Sam's is always catching up with it and Wal-Mart is always ahead. So basically, you have these two companies that figured out how to do retailing, and that's why they're at highs, and everybody else is kind of struggling. Now Fleming, obviously, has done a wonderful job converting a process and an operation into a pretty good growth vehicle, and it has some differentiated concepts as well, which I really admire, like EDLP.

ADLER: Whole Foods' numbers were totally surprising -- maybe because it doesn't sell a lot of general merchandise -- but it had absolutely fabulous comp-store sales, and it said sales were still very strong at the beginning of the current quarter, despite the economic environment.

LEVIN: You haven't seen any trading down -- none of the chains is mentioning that. Private label is growing faster than non-private label, but at the same time, everybody's been building that program, and the trends are not much different than a few years ago -- there are just some companies getting better at it, like Kroger adopting best practices with the Fred Meyer label and the Private Selection label from Ralphs. Where we've seen some softening is on the general merchandise side, but food and consumables have been pretty steady.

BERNSTEIN: Isn't there a realization that so many economists at the beginning of the year were projecting this V-shaped recovery that we were supposed to be experiencing by now? To me, the realization of that was nonsense. The economy is going to continue to be soft, probably at least through the end of this year. To me, that's a catalyst to rotate into a more defensive sector. You quit looking for bottom-picks and technology companies that don't generate any income or cash flow, and to me, that's the real catalyst. And looking at the high-yield market, I don't know if it's really a contradictory point -- it's more of an emphasis or re-emphasis on more of the same -- but from 1997 through 2000, 40% of the new issues in the high-yield market were telecom-oriented and venture capital-oriented. And so many of those companies have just gone supernova because they weren't real companies to begin with. So a lot of investors are looking at companies that are dependable cash-flow producers. They don't have to see anybody necessarily knocking the cover off the ball. A lot of investors have turned to the few better quality supermarkets still left in the sector. And in general, they don't necessarily want to see a big turnaround story. There has been one significant turnaround story, and that's Fleming, which has just done incredibly well in both the high-yield and the equity markets. It's tripled. And Pathmark, which is no longer a high-yield stock after it got rid of the excess leverage, has seen its stock double in the course of nine months. But people in our market are, I think, generally more leery of turnaround stories than they are of just consistent producers. Winn-Dixie is a turnaround story, and people are rightfully looking at that and wondering if that's really going to work out.

GIBLEN: The market is increasingly perceiving Wal-Mart as a ceiling on the industry, if not a return-on-capital killer, too. It seems to go in cycles. In the early 1990s, the accepted wisdom was that Wal-Mart was going to annihilate the industry immediately, but that was proven wrong pretty quickly. And then the market was OK with Wal-Mart vs. food retailers for a while. But there are now so many supercenters, and there are getting to be so many Neighborhood Markets, and even the Safeways of the world are getting some meaningful incursions by Wal-Mart.

WEINSWIG: It's not even just Wal-Mart. You've got Target rolling out Super Targets and Kmart with Super Kmart. The CEO of Kmart told me recently he feels sorry for food retailers. He said his cost of labor is approximately 200 basis points less than the food retailers, and he doesn't need to make his money off the food side of the business -- he can make it off the general merchandise side. And that's what Target and Wal-Mart and those other guys are doing, too.

LEVIN: One potential breath of fresh air is store closings as companies focus on returns. Albertson's plans to close 165 stores, Winn-Dixie closed 114 stores and A&P has closed a little under 200 over time. There is enough fragmentation and there are enough weak operators that, as companies focus on returns, they want to use their capital wisely, so if you shrink down the capital base, that benefits whoever is sitting next to those closed stores, and that could help in the near term. And in fact, A&P's same-store sales have been pretty good recently, and Winn-Dixie's have been sad, but if you adjust for the retrofits it did, it is starting to show a little bit of progress. I think part of that is due to getting rid of its worst assets.

MURPHY: That's a great point. Getting rid of some of the weaker stores is a positive development, but capital expenditures are still very high, so while some chains are taking out some of their underperforming assets, there's all this new capital coming on internally, and you have Wal-Mart putting in almost 200 supercenters a year on top of that. So it's very hard to imagine that the returns can get a lot better when growth is nil and the capital has not really stopped pouring into the industry.

ADLER: But Safeway is spending an awful lot of money on remodels -- it's doing 250 remodels a year.

ZIEGLER: This is a cash-flow business so companies have to spend it. That's the trouble with this industry -- it force-feeds growth. Maybe it has to reverse what it did in the 1980s, which is go private with the excess capital.

ADLER: I'm shocked that I get so many questions about leverage. Investors say they are worried about Kroger's leverage, and you want to fall off your chair. These are low-growth, low-return businesses. A certain amount of leverage is the right way to boost shareholder returns, but the equity market penalizes them for being leveraged. Unfortunately, the equity market has one template, one cookie-cutter idea of what a good stock is, and that's a stock with no debt. But these companies have huge cash flows, so they ought to have debt. If they can't generate their returns by spending -- and you don't want to spend $2 billion on capital because you've got a saturated industry -- then leverage is the answer.

GIBLEN: That's one of the reasons Pathmark has done well -- because it got rid of its old financial structure, and now it's a self-contained turnaround story and a probable buyout candidate, and that means you don't have to deal with the industry template. It's its own story.

CONSOLIDATION POSSIBILITIES

Analysts speculated that some supermarket retailers could seek acquisition growth outside the supermarket sector, with drug stores the likeliest avenue, while one analyst suggested U.S. companies ought to think more globally.

SN: What is the possibility there will be further near-term consolidation among some of the larger players in the industry, or between the larger players and other formats?

WEINSWIG: Steve Burd [chairman, president and chief executive officer of Safeway] assured us recently that, within the next five years, Safeway will make a nonfood retailing acquisition. You can hypothesize that it could be BJ's or Rite Aid or any one of 20 other possibilities, but theoretically it will be something it's already an expert at, be it food or drug.

BERNSTEIN: I think it's much more likely you'll see a large supermarket operator making an acquisition of something other than another large supermarket operator, because despite the fact we've had a change in government and probably a change in aggressiveness by the Federal Trade Commission, I think it's pretty tough, within the top four or five chains, to come up with a viable pairing that would pass muster. I think we've seen Ahold admit that by going into the food-service business in the U.S. and proven that's a viable way for a large supermarket operator to grow.

HUSSON: I agree entirely with what you're saying, but what Ahold didn't do is go west of the Mississippi, so it's still left the door open to do something.

SN: What are some of the other realistic combinations, aside from a food-service merger with a supermarket?

LEVIN: I think drug retail makes a lot of sense for the supermarkets, just because they all have pharmacies and they've embraced the pharmacy business. There's nothing in a drug store that's not sold in a supermarket, so there would be synergies. Then the question is, which drug chain? Does Eckerd get spun out of JC Penney? Is that feasible? Rite Aid is certainly a candidate, longer term. Albertson's seems absolutely wedded to the drug retail business, but there's a new management there, so it's certainly open for it to make a decision -- although I suspect it will keep the drug retail and, if anything, try to enhance that business longer term.

GIBLEN: I think it's likely Wild Oats will end up in the hands of a mainstream supermarket that would be interested in acquiring the expertise and some sites. Or Whole Foods could be absorbed, too, although there would be cultural differences.

ADLER: There are not a lot of synergies between a conventional food retailer and a natural foods retailer. There are not that many on the buying side, and there are none on the distribution side, so I think that would be hard. Plus, right now you have Whole Foods valued as a growth company. If you stick it in a much, much bigger company, you're going to lose something, and it's not going to do anything for growth.

HUSSON: The question is, can you get a similar level of return [acquiring an unrelated business]? The answer is that you don't find Rite Aid getting 14 times EBITDA, so that's not going to give you better returns. So you have to come up with a better idea, and though I'm not sure many U.S. food retailers have passports, if they were to get them and get outside of the country and have a look around, it's still not too late to get onto the global stage because that's what the rest of the world has done. But then you've got to ask yourself, if they move outside the U.S. -- even if they get some scale -- are they good enough? My answer right now is, they're probably not.

ZIEGLER: With Tesco and Safeway dipping their toes in the water together, do you think there's anything that could happen there?

HUSSON: I think it's a long way between agreeing to have a first date and planning the nursery. I think that's an interesting idea, though, because culturally, they're quite similar.

ZIEGLER: So do I.

SN: Will the weakening economy cause the smaller companies to be acquired more rapidly, or are those small companies going to be acquired whether or not the economy weakens?

BERNSTEIN: I'm not sure how dependent consolidation activity is on the economy. Part of it depends on how well the stocks of the larger companies are trading to supply enough currency to make acquisitions. And to the extent we're in a climate where defensive sectors are more attractive relative to other sectors, regardless of the relative valuations, these companies are able to have the currency to make acquisitions. But I don't think it necessarily has anything to do with the overall economy. Certainly, the pickings have gotten pretty slim out there in terms of significant multiregional or even regional players to be acquired by the larger companies. But there still are a few, and that's going to happen, though the timing remains a little uncertain. There's been somewhat of a lull here. There hasn't been a whole lot of activity in the last 15 to 24 months, but it certainly will come back because there are still some basically good acquisition candidates.

WHITHER SAFEWAY?

Analysts agreed Safeway cannot afford to wait for earnings to erode at smaller companies before making an acquisition but must instead make acquisitions in the short term to grow its top line.

MURPHY: Steve Burd has said many times that the EBITDAs of the smaller companies are declining, and as that happens, they're going to get less money and those families will be pushed into selling. But the other side of that argument, the buyer side, is becoming the much more interesting piece, which is that companies like Safeway have to buy these guys. As recently as 18 months ago, things were tilted toward Safeway sitting very comfortably, letting the EBITDAs of these companies erode away without paying up. But now Safeway is at least as incented to pay up at this point.

LEVIN: But not to overpay.

LISA CARTWRIGHT: The situation has changed dramatically.

BERNSTEIN: And when you look at the magnitude of the acquisitions Safeway has made, in terms of the size of the companies it has acquired, none of them have been significant relative to Safeway's overall sales volume.

LEVIN: They add up all the time.

CARTWRIGHT: But it's necessary to keep doing acquisitions.

BERNSTEIN: Safeway is based in California and it operates four regional outposts throughout the country, and that's not a way to get synergies; that's not a way to really cut cost out of the business. It has to start growing one or two or more of those regions, it seems to me, by acquiring good regional and multiregional operators in contiguous markets. I think Safeway needs to pull the trigger.

HUSSON: I disagree that Safeway is backed into a corner. I think 15% earnings growth in the last quarter and comp- store growth of 1.7% is pretty good, so it's not backed into a corner. It's got multiple divisions that have EBITDA margins way over 11%, with a handful that are south of 9%, with good reasons for those differences. But there are stacks of opportunity there. There's a stack of opportunity left on shrinkage, and a stack of opportunity left on bringing the private brands into some of these areas. There are all kinds of things that Safeway is just beginning to do. It undoubtedly screwed up some breakaway strategies huge in the last quarter, but when you've got a big, new machine and you're fiddling around with the volume button, you turn it one way and you end up with an embarrassing amount of gross margin and no sales, or you turn it the other way.

CARTWRIGHT: I think Safeway is a great company and the best-managed company in the whole industry, and I think its margins are the highest. But its growth has to come via acquisitions. I'm talking about the long-term picture here. It has to acquire companies now.

ZIEGLER: Safeway should be the highest margin because it's in the most protected markets, and it's just started to fight to get its comps back up. It purposely brought comps down in the last quarter because it had the hurdle with the SG&A ratio, and it purposely wanted gross margin up. It manipulated the Street -- there's no question about it. But those comps are going to go back up when Safeway starts promoting again, and it's doing that with its frequent shopper card.