SHIFTING TIDES

Elliot Zwiebach

NEW YORK -- The next few months should be interesting ones for the industry's top three chains, given leadership changes at Albertsons and Kroger Co. and leadership challenges at Safeway, a panel of industry observers told SN during its eighth annual Financial Analysts' Roundtable.

Among the issues tackled in this, the second of three installments from the roundtable discussion, were the departure in July of Peter Lynch as president and chief operating officer of Albertsons, Boise, Idaho; the promotion of David Dillon to chief executive officer of Cincinnati-based Kroger Co. in June and his pending promotion to chairman sometime next year; and the ongoing pressures faced by Steve Burd, chairman, president and CEO of Safeway, Pleasanton, Calif.

Among the analysts' comments:

Regarding Albertsons, Gary Giblen, senior vice president and director of research at C L King Associates, New York, called Lynch "the soul of the company and the author of many of the strategies and tactics that were under way, [and] there has to be something going wrong for Larry [Johnston, the company's chairman] to grab the reins that quickly and have every function reporting to him."

Lisa Cartwright, managing director of Salomon Smith Barney, New York, pointed out that Lynch's three-year contract happened to be up, and with Johnston two years into his position heading Albertsons, he probably felt he had learned all he could from Lynch.

However, Andrew Wolf, managing director of BB&T Capital Markets, Richmond, Va., said he believes Albertsons' operations have remained fairly static for the last couple of years, "so doesn't it make sense to relieve a guy [Lynch] who didn't fulfill his obligations?"

Regarding Kroger, Mark Husson, first vice president at Merrill Lynch, New York, said Dillon's ascension at Kroger is ironic, since he came to Kroger when it acquired Dillon Cos., Hutchinson, Kan., in 1983. Dillon operated fairly independently from Kroger for years, Husson said, so with David Dillon now heading Kroger, "[It's] sort of the poacher turned gamekeeper who's now in charge, [and] it will be very interesting to see how it develops."

Regarding Safeway, Mark Wiltamuth, executive director at Morgan Stanley, New York, said the chain needs to "get back to a point of stability" by focusing on "nuts-and-bolts execution" after dealing with challenges over the past year involving central procurement and shrink reduction.

Cartwright said Safeway has also been overly distracted by turmoil at three acquired chains: Dominick's in Chicago, which it is trying to sell; Randalls in Texas; and Genuardi's in Philadelphia. "The management style demonstrated by Steve Burd was perfect in a post-LBO [leveraged buyout] environment, but in the post-acquisition period, Safeway really needs to rely on the next layer of management, all the way down to the store level, and I'm not sure that's where its strength lies."

The analysts also discussed Ahold, Winn-Dixie and A&P; the fallout from the demise of Fleming; and expectations for capital spending through 2004. Among their observations:

Wiltamuth said the retail divisions of Ahold U.S.A., Chantilly, Va., are unlikely to feel any major impact from the accounting problems of its Netherlands-based parent company, "but the bigger question is, will the parent company start tapping some of [those divisions'] cash flow to solve its problems elsewhere? That's something to watch."

Giblen said it appears Ahold may be pulling back on store expansion plans and cutting back on labor costs, though he said he didn't think either move would have a significant impact on results.

Speaking of Winn-Dixie, Edouard Aubin, retail analyst with Deutsche Bank, New York, said the Jacksonville, Fla.-based chain may be committing too much capital spending in markets with weak market shares. However, Meredith Adler, managing director of Lehman Brothers, New York, said she believes Winn-Dixie has stabilized its market share positions and should have no particular capital constraints.

Adler also said A&P, Montvale, N.J., may have to consider some divestitures "[because] they're not positioned well in a lot of places, and while there are no short-term liquidity issues, there are certainly long-term liquidity issues."

The demise of Fleming as a wholesale player is unlikely to result in Minneapolis-based Supervalu picking up a lot of new volume. "Fleming was guaranteeing leases and lending money to some retailers that weren't able to stand up," Husson said, "and Supervalu wants almost none of those customers."

Adler said she expects Supervalu to pursue more third-party distribution business, adding she's aware of one vendor "who doesn't have a great supply chain itself that's talking to Supervalu."

Part 1 of the roundtable was published on Sept. 1. The text of Part 2 of the roundtable discussion follows. SN will run the conclusion of the discussion in a future issue.

ALBERTSONS

SN: Let's talk about some supermarket operators individually, beginning with Albertsons. Will the departure of Peter Lynch as president and chief operating officer of Albertsons have much impact?

GARY GIBLEN: Larry Johnston [chairman and CEO] has accomplished some good things that made a ton of sense, including selling the New England drug stores, selling off pockets of stores in smaller markets in the Southeast and thinning out the Texas store base, so I give Albertsons an "A" for divestitures. But other things really haven't been improved that need to be improved. Their pricing is still too high, their stores are still very bland, and although they've made an effort to operate some distinctive stores, including kosher and Hispanic stores, their core store base is still not competitive in terms of merchandising, and I think they lack the management to bring it forward. And the loss of Peter Lynch is a very major loss. On a scale of one to 10, it's a 20 in terms of its negative impact on Albertsons. By his own design, Larry left General Electric without developing knowledge of retailing, and he admitted very publicly he relied on Lynch to run the company. Larry is really concentrated on very, very broad brush strokes on strategic, organizational and motivational things, whereas Peter Lynch was the soul of the company and the author of most of the strategies and tactics that were under way.

MEREDITH ADLER: Lynch was not the architect of all those things -- he was the champion, the quarterback.

GIBLEN: If Albertsons had promoted someone to take over Peter Lynch's position, then you could understand his departure as an inevitable development after not getting the CEO spot or something like that. But there has to be something seriously going wrong at Albertsons for Larry to grab the reins that quickly and have every single function reporting to him.

ADLER: It was the board's decision. I don't think it was Larry's decision.

LISA CARTWRIGHT: My understanding is that he pushed for it.

GIBLEN: Larry has a lot of fans on the board, including those who hired him, and the board isn't necessarily making the right decision.

CARTWRIGHT: What about the fact that Peter's contract was up? It could have been as simple as Larry saying he now knows what he is doing.

GIBLEN: Then why did Larry say, in every single investor meeting, that Peter Lynch was the soul of the company -- that Peter was the quarterback and Larry was just the owner of the team?

CARTWRIGHT: Because I think Larry knew when he came in and took that job that he was taking a job that Peter wanted, and in order to keep Peter there so that he could learn from him, Larry had to make him feel like he was an integral part of the company. Peter Lynch was already under contract when they brought Larry in -- he had a three-year contract -- and he was a year into it when Larry came in, so they put him on the board to placate him because he didn't get the CEO spot.

GIBLEN: Albertsons could have saved millions in stipulated payouts if Lynch had left in early December rather than late July, so something is fishy. If he had left and taken another job, then I could say, OK, this is natural, but to have him make such a sudden departure.

CARTWRIGHT: I agree, I thought it was odd, too. But the fact that his contract was up indicates it could simply have been Larry saying, I feel like I've gotten my feet wet and why renew it?

ANDREW WOLF: On the one hand, Albertsons' operations haven't gone anywhere. On the other hand, Peter Lynch was in charge of Albertsons' operations, so doesn't it make sense to relieve a guy who didn't fulfill his obligations?

CARTWRIGHT: You could argue that the operations Peter Lynch oversaw, including Jewel and Acme, were the ones that were successful. He wasn't the guy who went into multiple markets with No. 3 and 4 market shares and with stores in bad locations that didn't operate that well. That wasn't Peter Lynch.

WOLF: It was for the last two years. When he was at American Stores, he turned around Acme and came in with a great reputation.

GIBLEN: Those were strategies that were beginning to work before Larry Johnston came in. They were falling into place for the rest of the company, although they haven't offset other strategic problems to produce wonderful results.

WOLF: Albertsons has the worst food comps among the Big Three, so I'm not sure if it's a good thing or a bad thing, but it's logical to assign responsibility to the guy whose job it is to do that.

CARTWRIGHT: But why send that message out to the Street? Albertsons said Peter was let go to cut costs. The guy was making about $1 million a year -- did Albertsons' financial performance hinge on getting rid of Peter now?

SAFEWAY

SN: Turning to Safeway, what do they need to do to get it back together?

MARK WILTAMUTH: Safeway needs to focus on execution. The central procurement issue has been a real challenge for them over the last year. There was also one point last year where they had an issue with aiming their team at shrink reduction, and it ended up resulting in sales disappointments. So they need to get back to a point of stability. Operating supermarkets is all about nuts-and-bolts execution, and that's where they need to be spending their time right now.

CARTWRIGHT: I think Safeway has also been distracted by the chains it acquired. I think the management style demonstrated by Steve Burd [chairman, president and CEO] was perfect in a post-LBO environment where the company followed a blueprint that focused on cutting costs, lowering prices and remodeling stores, which worked in every market. But in the post-acquisition period, Safeway really needs to rely on the next layer of management, all the way down to the store level, and I'm not sure that's where its strength lies.

SN: Does the company need to bring in somebody new to refocus its efforts?

CARTWRIGHT: I think Safeway's bench strength is not as deep as it is at other chains, but I'm not sure that a new manager with an entrepreneurial spirit would actually want to go work at Safeway because I don't think the environment there is conducive to that kind of spirit.

SN: Is it time for Burd to step aside?

CARTWRIGHT: No, I don't think so. And I think there's a lot of support for Steve on the board right now and a history of working with him. I think the board recognizes that a good portion of Safeway's problems is related to the economy. And you have to hand it to Steve for admitting to making some mistakes with acquisitions and then leading the company in trying to correct them. I think the board wants to see how he executes after Safeway disposes of Dominick's and makes the appropriate changes at Randalls and Genuardi's.

ADLER: I'd also add that for a company to be successful in this industry going forward, it has to be able to envision the changes that need to happen, and I believe Steve understands what Safeway needs to do. He's pursued central procurement as a solution and taken a tough stance on labor, and I believe he thought acquisition might have been a solution as well. But he's got good vision, there's no question about that.

KROGER

SN: Will the management change at Kroger make a difference in the company's direction?

GIBLEN: Operationally, it's just as seamless as any change could be. Dave Dillon was working intimately with Joe Pichler all along, so it represents zero change in the strategy.

MARK HUSSON: I think there has been some change because if you remember, Kroger's acquisition of Dillon was the acquisition that was never integrated. Dillon Cos. was sticking out like a sore thumb for close to a decade -- it did all its private brands differently from Kroger, it was using Topco and different systems and there were all kinds of things that were different. So it's really ironic that Dave Dillon is now in control -- sort of the poacher turned gamekeeper who's now in charge of trying to make the economies of scale work and trying to keep all these divisions at heel and adhering to the corporate programs. I think it's actually an extremely ironic position and one where it will be very interesting to see how it develops.

AHOLD U.S.A.

SN: With regard to Ahold, will the accounting problems at the parent company in the Netherlands eventually affect the U.S. retail operations?

ADLER: A Tops store manager told me they've had to cut labor at store level because they had profit issues, so apparently it could have an impact on retail. However, Tops had some accounting problems of its own, so maybe it's been more hard hit than other Ahold divisions. The store manager also said sales were an issue for some Tops stores, although his particular store was doing well.

WILTAMUTH: The U.S. retail divisions of Ahold are cash-generating, self-financing machines, but the bigger question is, will the parent company start tapping some of that cash flow to solve its problems elsewhere? I would sense not, but that's something to watch because they've got good brands in the U.S., with Stop & Shop and Giant doing relatively well. They're struggling with difficult supermarket operating environments just like everyone else, and that may explain some of what Meredith was hearing, but I think the bigger issue to watch is where the cash flow is going.

WOLF: Ahold never integrated its retail operations with U.S. Foodservice. At one time, there was supposed to be a procurement synergy that was going to produce $30 million or so, but U.S. Foodservice told me long before the [accounting] blowup, by the way, that they never got a nickel of synergies out of it, so it's not like there's some great integration that they've got to unravel here. U.S. Foodservice can be sold and I think nothing will happen to the retail divisions, which are essentially a group of very good regional chains. Unlike Safeway, Ahold was wise enough not to really tamper with its better retail acquisitions.

GIBLEN: It does appear, though, that they're pulling in their expansion a little bit. They've given up options on some good sites in the New York metro area, and while that's good for the competition, it's unlikely to have a major direct impact on Ahold. All the stores have cut labor, as far as I can tell, which might hurt them but only in a minor way because the cuts are limited.

A&P

SN: How about A&P?

ADLER: A&P has to make some tough decisions. They're not positioned well in a lot of places, and while there are no short-term liquidity issues, there are certainly long-term liquidity issues. I don't think they are ready, though, to do the really difficult things. One thing they could do is sell all of their U.S. operations and keep Canada because Canada is profitable, but there are no buyers for the U.S. operations, and while there are buyers for Canada, it doesn't make sense to sell it. Some pieces might have some value, but the biggest piece of the business is New York metro and Philadelphia, and while Super Fresh [in Philadelphia] isn't making any money, I think A&P New Jersey makes money and Waldbaums [in Long Island, N.Y.] makes money. But they have a lot of challenges, and there's no clear solution.

WINN-DIXIE

SN: How is its turnaround going?

EDOUARD AUBIN: One thing I don't fully understand about Winn-Dixie in terms of the current strategy is, when you have a high financial leverage the way they have today and when you have a very low level of profitability, why would you consider expanding, particularly in markets with weak market shares? I would prefer them to retrench in certain markets -- that's not the only solution to increase profitability, because they need to solve other issues like supply chain and so forth, but clearly the potential increase in cap-ex that was outlined by management recently is questionable in my mind.

ADLER: I would have to disagree with the leverage issue. Winn-Dixie is not particularly leveraged, certainly not compared to where they were.

AUBIN: It's my understanding that 98% of Winn-Dixie's stores are leased, so the entire debt is off the balance sheet. I think they have something like $500 million on their balance sheet, but if you capitalize their leases, you're talking about $2.4 billion, so clearly, in my mind, they have a leverage issue.

ADLER: Nobody puts leverage in the supermarket industry without putting leases on the balance sheet, but Winn-Dixie is not particularly leveraged. When you look at where they were or even compare them to other chains, I don't think they're leveraged. We can talk about profitability or the risks of adding new stores that are immature and how that will pressure profitability -- I mean, it's a typical problem in this industry that if you don't build stores in markets that are growing, you will automatically lose share, and their returns are terrible. So the real question is, does it make sense to put more capital where the returns are not good? But I don't see leverage as a constraint, though certainly the historical returns and the ability to generate returns are a constraint. Of everything I've heard them say, they've done the right things. But is it too late?

SN: Is it too late?

ADLER: My own crystal ball is cloudy, but we looked at some data that said Winn-Dixie's market-share positions, even in the markets where they're No. 2, are not strong, or you could say they're competing against a very strong No. 1. Even in the Florida markets, their market share is probably less than 20%, but I can't see them exiting Florida. They closed half their stores in Louisville and Lexington a while ago, but they haven't said anything about doing any more divestitures. I think they've stabilized their market shares, but you have to wonder what the returns are to have so few stores in those markets.

WOLF: Their exposure to Wal-Mart Supercenters is already very high, with about 60% of their stores this year increasing to 66% next year, and their customers are almost identical to a Wal-Mart customer, and all they would have going for them is the location convenience a supermarket offers, so I would say, of all these big chains we're talking about, Winn-Dixie is the most vulnerable.

FLEMING

SN: We've all just witnessed an incredibly sad event in the industry with the virtual demise of Fleming. What impact will that have on wholesaling -- and independent retailing -- going forward?

GIBLEN: It means some retail capacity will be going away because Fleming had some bad corporate retail, and those stores might disappear rather than get acquired. I think Fleming had company-specific problems of a vast nature, and what happened was a reflection of that.

HUSSON: But some of that business is walking wounded, I think. Fleming was guaranteeing leases and lending money to some retailers that weren't able to stand up because they were missing a leg and an arm and simply propping each other up. You kick away one crutch and the whole lot comes tumbling down. How much of this kind of carrion is actually worth it? And Supervalu wants almost none of those customers that are out there right now. We know there are lots of people banging on the door, but Supervalu wants nothing to do with them.

ADLER: I've been told Supervalu already has two-thirds of the regional chains that aren't quite big enough to be self-distributing, and Supervalu says those chains have actually been holding up pretty nicely. Fleming's business was very skewed toward individual mom-and-pop type businesses, though it did have some chain business in some regions. But it's hard to see that Fleming going out of business creates a long-term opportunity for Supervalu to grow its business. There's a one-time opportunity to pick up some of the lost business, but wholesaling is truly a declining industry, and you could argue that both Fleming and Supervalu were trying to develop pieces of self-distributing businesses that could be outsourced efficiently, and I could argue that both Fleming and Supervalu are probably trying to sell the big chains on making changes.

So for Supervalu, it's almost worse to be the only major wholesaler left because that's going to make it tougher to convince people they ought to change their entire business model. Fleming was actually helping in that process because if you knew there was some competition, people might be more willing to make a change if they felt they had choices.

GIBLEN: But they do have choices with third-party logistics companies like Tibbett & Britten or Christian Salvesen.

ADLER: I'm not sure those companies are exactly the same in terms of their services and sets of offerings. And there may be opportunities for Supervalu that are unrelated to the retail business. I know of one vendor who doesn't have a great supply chain itself that's talking to Supervalu.

GIBLEN: I just think it's pretty darn good for Supervalu in the sense of picking up more volume. The incremental profit contribution of volume to a wholesaler is very great because it absorbs heavy fixed overhead of trucks and distribution centers. Fleming's demise also reduces some level of irrational competition. Fleming was low-balling everything to get business -- that's how they got Kmart and that's how they did themselves in.

Lehman Bros., New York, requested that SN run the following disclosure statement in connection with publication of the SN Roundtable:

Meredith Adler covers Kroger, Safeway, Albertsons, Winn-Dixie, A&P, Whole Foods Market, Supervalu and Nash Finch. Meredith Adler does not sit on the board, nor does she own any stock in these companies. Lehman Bros. has an investment banking relationship with Safeway, A&P and Nash Finch. Lehman Bros. does not own 1% or more of any of these companies. Meredith Adler is not aware of any material conflicts with regard to these companies.