ROUGH RIDING

CHRISTINA VEIDERS

Financial performance during the first half of the year became a delicate balancing act for the Top 10 publicly traded supermarket companies.

The challenge was to grow the top line while keeping margins and earnings strong, said analysts. The first half came under increasing competitive pressures from alternative formats and traditional supermarket chains that ratcheted up promotional pricing. Economic uncertainty gripping the country began to impact food sales for some during the latter part of the period. Safeway began to report softness in its top-line sales and trading down by shoppers.

Debra Levin, principal, Morgan Stanley Dean Witter, New York, said that what has affected the margins is overstoring in the marketplace. "Over time, as traditional operators and supercenters build more units, it just gets incrementally that much tougher," she said.

As a group, the 10 companies saw sales rise 11.8% from a year ago, while average same-store sales rose 1.7%, compared to 1.2% in the prior year. Meanwhile, operating income increased 9.7% for nine companies, excluding Delhaize America. This year's operating income for Delhaize America was not available due to the U.S. operation being incorporated under the Belgian-based Delhaize Group.

This year the Top 10 playing field changed with the now-defunct Grand Union falling off the list, replaced by Harris Teeter, which scored $1.2 billion in sales during the period, compared to Grand Union's $1.1 billion in sales last year for the same period.

For the most part, the companies turned in expected results, said most of the analysts.

Chuck Cerankosky, an analyst with McDonald Investments, Cleveland, who follows Kroger and Albertson's, said, "The biggest chains have the most opportunity to develop the economies of scale that will reduce their operating costs and allow them to grow earnings faster than sales."

For Mark Husson, first vice president for Merrill Lynch, New York, performance generally fell short. "It shows some capacity issues right now in the face of a slowing economy."

There were no surprises turned in by the big three multiregional chains. Safeway and Kroger met earnings and Albertson's improved slightly as it attempts a turnaround.

The two European-owned food retailers -- Ahold and Delhaize America -- appear to be benefiting by acquisitions of food-service companies and Hannaford Bros. with Food Lion, respectively.

Pathmark's performance continued to draw praise from analysts, while Winn-Dixie drew disappointment for downgrading its earnings estimates for the remainder of the year. Going forward, analysts expect the climate to get more intense. Weak performance expectations are due to a weakening economy, rising job layoffs and consumer confidence falling into the dump.

"Consumers are worried about their jobs and they are cutting back on their spending, including at grocery stores," said Deborah Weinswig, food and drug chains analyst, Bear Stearns, New York.

"Consumer confidence is a factor. There is none," said San Francisco-based managing director Jonathan Ziegler for Deutsche Banc Alex. Brown, New York. "Therefore, you have a couple of cross currents. Trade-downs, as Steve Burd [Safeway] mentioned in a recent conference call, to peanut butter and jelly from lunchables and then to meal stretchers. But you also will have trade-offs from restaurants to supermarkets and to private label."

Jack Murphy, vice president, Credit Suisse First Boston, New York, said, "The environment is tough and sales have already been tough to come by. As you look out, it will be more of a challenge to generate the top line."

However, one bright spot is labor, noted Ted Bernstein, managing director, Dresdner Kleinwort Wasserstein-Grantchester, New York. "With the weakening environment you could see a lot of that pressure on wage rates [as it related to tight labor] be alleviated," he said.

According to Gary Giblen, senior vice president and director of research, C L King Associates, New York, tough times will separate the good operators from the bad. To manage, he said, "you have to have a lean cost structure. Safeway has defined the gold standard on that and some others follow pretty well. You have to be executing well, which is a challenge for somebody like Albertson's. They are still far from good in their execution." Giblen and others also noted the importance of a strong private-label program in a stressed economy.

However, Levin noted that Safeway's sales most recently have been a little soft and less than expected. "Safeway has found in several of their markets that there has been a lot of new square footage and this is hurting them in those markets, and in third quarter they have cited a shift in consumer spending -- less red meat and more chicken. Even though this is a very stable sector, there are soft cyclical elements to it," she said.

Murphy questions whether Safeway can sustain its growth. "Can they continue to get the large gross margins to continue to generate large growth and earning per share?" he asks. "It's going to be tough to do given there is expense pressure at Safeway. They really need to get gross margin just to grow margin and it's going to be tough to do in this environment."

DELHAIZE AMERICA, Salisbury, N.C., with sales increasing 42.8%, and comparable-store sales rising 3.9% and 0.1% in the first and second quarter, respectively.

Operating income figures for the first half were not available for the U.S. operation due to Delhaize America's incorporation into the Delhaize Group. For the second quarter ending June 30, EBITDA rose 46.4% over the 13-week comparable period.

Analysts agree that Delhaize -America is benefiting from the synergies with the Hannaford Bros. acquisition. Performance appears to be meeting analysts' expectations.

"Even though they overpaid for Hannaford Bros.," said Husson, "some of the things we hoped Hannaford would teach Food Lion has started to happen. That is inventory return. The Food Lion business used to be a very forward-buying and deal-buying culture. Whereas Hannaford Bros. used to have some of the fastest inventory returns in U.S. food retailing. We've seen Food Lion go cold turkey on forward buying and start to go down the straight and narrow path of just-in-time food retailing. The results have been very impressive up till now and earning numbers are slightly better than people thought."

Said Levin, "The acquisition of Hannaford Bros. seems to be going smoothly and the synergies seem to be ahead of schedule."

Giblen said Delhaize has been able to gain share from some weaker players in the Southeast like Winn-Dixie. "It's an excellent operation. It's like 'steady Eddie.' The story here is the synergies and how quickly they can cross fertilize best practices of Hannaford into Food Lion and vice versa," Giblen said.

WINN-DIXIE, Jacksonville, Fla., with sales falling 4%, operating income rising 10.2% and identical store sales decreasing 5.3% and 5.2% in the first and second quarter, respectively.

Winn-Dixie's recent lowering of earnings estimates and a shift in dividend payment from monthly in advance to quarterly in arrears caught some by surprise and for some it sounded a foreboding warning of tough times ahead despite big efforts and investments made to restructure the company.

"The pre-announcement that they are going to miss their prior earning's target is very significant. So much so, it calls into question the first half," said Murphy.

"Management has put together a very aggressive turnaround in a very tough market that is right in the middle of Wal-Mart country. Despite spending over half a billion dollars, we haven't seen any significant increases in sales. They need to get sales gains to justify that spending," he said.

Said Husson, "Winn-Dixie has been a big disappointment. We believe Al Rowland [president] understands what he has to do in terms of cost cutting. The stores look a lot better and they've taken out a lot of very high-cost departments inside the stores and their cost-control story is still very strong. Unfortunately, sales haven't responded."

Husson believes that sales haven't responded because customers aren't convinced that Winn-Dixie has the prices that are as low as the competition or the service that is as good as the competition.

Levin believes the chain will continue to struggle. "The issue is they are in markets where they have such strong supercenter competition. Supercenters probably compete against 90% or more of their units. Plus, they have strong traditional competition, particularly from Publix in the Florida market."

Giblen said he had predicted Winn-Dixie's situation is dire. "It's one of worst debacles in history of industry. I just don't see much of a future for them. I think they will end up dismembered; different regional groups will get bought out by other chains. I don't think they have any prospects of remotely resembling any way they are now configured."

A&P, Montvale, N.J., with sales increasing 5.7%, operating income declining 31.5% and comparable store sales increasing 2.8% in the fourth quarter and 3.8% in the first quarter.

Results are for the period paralleling the first six months of the calendar year, A&P's fourth and first quarter, excluding its Great Renewal charges. A&P released results of its second quarter on Oct. 12, after deadline for this report. The company's notes that, based on its 16-week first-quarter performance, it is doing better than last year. However, analysts predict a tough road ahead.

"Most recently, they've done a strong job of improving sales trends. That is encouraging," said Levin. However, she sees tougher competition in A&P's markets with Ahold's conversion of the Edward's banner to Stop & Shop and the purchase of a number of Grand Union units, also under the Stop & Shop banner.

"A&P's earnings have been plagued by weak operating margins for a long time, plus they are in the middle of the second phase of their restructuring program, which is very costly. They are redoing all their systems and it's a program that will take quite awhile to implement. We expect that earnings will remain pressured for quite some time," said Levin.

"This is one of those companies that's been a continuous chronic underperformer in food retailing, but with ambitious plans to help solve that problem. Rather like Winn-Dixie, they've got rid of troublesome divisions, closed unprofitable stores. I am sure that job isn't finished yet," said Husson.

According to Bernstein, A&P still has lot of work to do to address the deficiencies in its store base. "While they've invested a lot of money in attempting to do that through their Great Renewal project, I don't think they've seen the kinds of returns they need to get yet. Last quarter they did show improvement. Can they continue that rate? The competitive environment in the markets they operate is pretty tough, particularly in the metro-New York area. They have their work cut out for them," he said.

"In terms of profitability, A&P is still a gigantic question mark," said Giblen. "Project Great Renewal keeps getting more and more protracted. It's more a matter of execution rather than strategy. Project Great Renewal is the right idea, but they have to be able to run good stores day to day and there is some shortfall for them to do that."

PATHMARK STORES, Carteret, N.J., with sales increasing 6.8% and EBITDA falling 2.6% and same store sales up 3.1% and 3.5% in the first and second quarter, respectively.

Pathmark is a leader in its markets and drawing praise from the analysts.

"It's another situation where Pathmark has come out of a transition after filing bankruptcy. Now it's becoming a real company," said Ziegler.

"They're driving sales and market share at a time when their competition is in disarray. Every single competitor has problems," said Giblen.

Bernstein noted that Pathmark has always been a great operator and that it had a balance sheet problem and not an operating problem. "I think they are the best-positioned supermarket operator in the Northeast now because when I look at the rest of the market it's in disarray to some degree," said Bernstein. "Pathmark has excellent store locations, and they are merchandising well. They are doing a great job."

Bernstein, as others, expect Pathmark's track record will make it an attractive acquisition candidate.

While Pathmark can be very successful on its own, Giblen believes Pathmark can benefit more in buying power and cost of goods to be part of a much bigger company.

PENN TRAFFIC, Syracuse, N.Y., with sales up 2.9% and EBITDA increasing 1.3% and same store sales rising 0.4% and 0.7% in the first and second quarter, respectively.

With approximately 10% to 12% of its sales from wholesale, according to the company, Penn Traffic is considered a retailer that operates approximately 220 stores. Analysts give them an "A" for effort.

"To their credit they've gotten out of negative comp store sales and are now showing some stability in their profit margins," said Giblen, who questions whether they can maintain this direction "given a less then first-rate store base."

Said Bernstein, "While they've done a good job in putting things together following their restructuring, which is due to a change in top management, I think their relatively flat performance is a reflection of the fact they are in some tough markets and against some tough competitors like Kroger in Columbus. They have their work cut out for them to hold their own."

"You have to give them credit for running very hard to stay in place, but eventually, I think, they'll run out of steam," added Giblen.

HARRIS TEETER, Matthews, N.C., with sale increasing 7.2% and operating income up 11.5% and comparable store sales growing 2.5% and 1.6%, respectively.

Analysts view the retailer as solid.

"They began to do very well at retailing, but for a long time they spread themselves too thin around the Southeast. They sold stores to Kroger in Atlanta and they are now concentrating their efforts in the Charlotte market. They're starting to focus back on areas in which they've got significant density," said Husson.

"They've got a good value proposition. Wal-Mart's swept through those market areas too and Harris Teeter has been able to differentiate with their high-quality fresh offering and service levels," added Husson.

Giblen calls them steady. "It continues to be a solid operator. It has a very strong customer franchise and adequate, but not amazing, profitability. I think their future as well is to be part of a bigger company."