SLOW SYNERGIES

ELLIOT ZWIEBACH

Merger integration issues hampered financial performances among the major supermarket players during the second half of 1999, industry analysts told SN.

Although the numbers were generally positive, the analysts said synergies are developing more slowly than anticipated, causing lower than expected financial results.

Among the 10 largest chains with public equity or debt, financial performance in the second half of 1999 was weaker than it was in late 1998, with sales up 12.3% in last year's second half, compared with a 15% rise in the prior year's second half; same-store sales up slightly to 1.8%, compared with a 1.7% increase during the earlier period; and operating income up 14.9%, compared with a 22.5% jump in late 1998, according to SN data compiled from company reports.

According to Ed Comeau, a securities analyst with Donaldson Lufkin & Jenrette, New York, second-half sales were generally lackluster. "The competitive environment was stable, there was no inflation and there were no major changes in the way consumers spent money," he said -- at least until the end of the year, when Y2K concerns boosted sales, he added.

Comeau said Y2K was an issue for some companies, depending on when their fiscal periods ended. "For companies whose year ended in December, the heavy Y2K buying helped the results but hurt in January as people worked down their stockpiles, whereas for companies like Kroger and Albertson's, whose fiscal years included January, Y2K had a less dramatic effect overall."

Chuck Cerankosky, an analyst with McDonald & Co., Cleveland, said second-half results were very strong once integration issues were removed from the comparisons. "The economy helped all retailers, and the good operators continued to do well," he said.

Meredith Adler, an analyst with Lehman Bros., New York, said the second half was a bit deflationary, "though the fourth quarter was really good for the industry across the board, with a spectacular holiday season" -- though not particularly because of Y2K, she noted. "People had money and spent it during the holidays, followed by a big slowdown in sales in January as people ate a lot of leftovers."

In terms of earnings, companies fell somewhere between the strength of Safeway and the struggles of Winn-Dixie, Comeau said, with the two major mergers of 1999 -- Kroger with Fred Meyer Inc. and Albertson's with American Stores Co. -- continuing to dominate much of the industry's attention.

"Those two mergers, and several smaller ones, clouded the earnings outlook during the half in terms of deciphering how well companies were actually performing," Comeau said.

Looking ahead, Jonathan Ziegler, San Francisco-based managing director for Deutsche Banc Alex. Brown, New York, said the integration issues that have dominated the industry's financial assessments for the past few months should dissipate going forward. "For the majors, the bulk of integration issues are behind them, and they are coming out of the woods. So we should see some gradual progress over the next few quarters," he said.

Comeau said he anticipates few near-term changes in financial performance among the leading chains during the first half. "We'll continue to see relatively modest sales in a stable competitive environment, with nothing very dramatic or different from the second half of last year," he said.

According to Cerankosky, the first half of this year should exhibit few if any differences from the second half of last year. "With the economy we're in, there seems little chance that sales will take off or drop off significantly. But it will be up to individual managements to maintain customer counts and average transaction sizes, and we will still see some effects of previous acquisitions impacting results in a positive or negative way."

Adler also said she expects results going forward will continue to be company-specific. "We look for more strong numbers from Safeway and Kroger, and while Albertson's won't disappoint, expectations have been lowered compared to where people thought they'd be a year ago. And Winn-Dixie is having a lot of problems that started at least two quarters ago ,and those will go on for a while."

But it's hard to pinpoint what underlying trends will affect results this year, Adler added. "We're not seeing anything specific so far. The only issue I'm concerned with, more than Wal-Mart, is the strong economy, which prompts people to shift more to eating out -- though with higher gas prices, we may see people eating out less because they'll have less disposable income as gas prices take away that extra $20 or so each week."

What follows are analysts' comments about second-half financial results on a company-by-company basis:

KROGER CO., Cincinnati, with second-half sales down 0.5% (due in part to changes in the company's reporting period that excluded several weeks of sales at Fred Meyer Inc.), same-store sales up 2.8% in the third quarter and 2.4% in the fourth quarter, and operating income up 7.1% for the half.

Cerankosky said Kroger continued to generate strong positive same-store sales during the half as a result of its merchandising programs. "Kroger is very effective at using a mix of store formats and merchandising strategies, making strong price statements where that's what's needed and emphasizing perishables quality and store conditions where that is needed," he explained.

The growth in operating profits reflected margin expansion that was partly a result of integrating the Fred Meyer operation, with its strong mix of general merchandise that boosted fourth-quarter results, Cerankosky added.

According to Comeau, it will probably take Kroger several more quarters to work down some of its integration issues. "Earnings are OK, but while the company's goals of 16% to 18% earnings gains per year are reachable, there's less certainty Kroger can achieve those levels because of inventory issues and the challenge of assimilating Fred Meyer without any further missteps," he said.

Comeau said synergies from the merger with Fred Meyer have developed more slowly than had been an ticipated. "The synergies the company outlined at the time of the merger were conservative, but with a high debt load, it's been very tough to achieve that projected growth rate of 16% to 18%," he said.

He also said it is unclear what effect the loss of key Kroger people will have on future results, particularly the departures of Robert Miller and Mary Sammons, former Fred Meyer chairman and president, respectively, both of whom left Kroger for positions at Rite Aid earlier this year.

ALBERTSON'S, Boise, Idaho, with sales up 3.7% in the half, comparable-store sales up 2.2% in the third quarter and 2.8% in the fourth, and operating income dropping 2.2%.

Comeau said Albertson's second-half results benefitted from its aggressive efforts "to rip out American Stores' infrastructure. The financial-reporting system that was in place at American was not reliable, and Albertson's was flying blind for most of the third quarter, with the result that it didn't have as close a handle on its conversion efforts or marketing. However, it fixed most of that in the fourth quarter."

The problems were particularly acute in California, where the conversion of Lucky Stores to the Albertson's banner in late fall affected results, he added.

Same-store sales during the half benefitted from inclusion of the chain's stand-alone drug stores, which have higher comps than the supermarkets, Comeau pointed out; without the drug stores, Albertson's comps in both periods would have been up by about 1.5%, he noted.

"But the worst is probably over for Albertson's, and it should start to get back into shape by the fourth quarter of this year."

According to Adler, Albertson's invested heavily in its West Coast operations, which helped sales during the half. But the government-ordered divestiture of 145 stores had a negative effect on overall sales, she added.

Cerankosky said the sale of so many stores was equivalent to divesting a regional chain, "and that process disrupted operations and created a lot of personnel issues, besides reducing the store base over which to spread flxed costs."

SAFEWAY, Pleasanton, Calif., with sales up 21.5% (following the acquisiton of Randall's Food Markets, Houston, in the fall), same-store sales up 1% in the third quarter and 3.7% in the fourth, and operating income up 24%.

Cerankosky said Safeway was somewhat distracted during the second and third quarters by integrating Carr Gottstein and Dominick's, "and it lost some focus on generating same-store sales. But once the company refocused its attention, comps and overall sales improved."

According to Comeau, Safeway appeared to integrate the Randall's acquisition "fairly seamlessly. It had previously made some missteps integrating Carr Gottstein and Dominick's, but those were virtually resolved by the time it acquired Randall's," he added.

"Safeway tends to take tough steps first when it buys a company, get the acquisition folded into its programs and then move forward. So there tends to be some early indigestion, but there wasn't much of that with Randall's."

AHOLD USA, Chantilly, Va., with sales up 16% for the half (due largely to completion of the acquisition of Giant Food, Landover, Md., last fall), comps up 1.4% in the third quarter and 2.7% in the fourth, and operating income up 35%.

Adler said the big jump in Ahold's operating income for the half was a result of significant improvements at Giant, where prices were lowered, which also resulted in strong comp-store sales gains. "Ahold used best practices to lower its pricing structure and started doing more coordinated purchasing with other divisions," she noted.

WINN-DIXIE STORES, Jacksonville, Fla., with sales down 0.2%, comps down 2.7% in the first quarter and 1.1% in the second, and operating income down 66.4%.

Winn-Dixie's problems are likely to last a long time, Adler told SN. "It had a very bad second half, with the single biggest problem being that it built a lot of big stores and doesn't know how to run them efficiently."

However, the chain is beginning to do things "that make sense," Adler said, "like moving toward centralized procurement and focusing more on store-level productivity. About 65% of its stores are new, but they're running with too much labor."

According to Comeau, Winn-Dixie's financial performance continues to be "a real problem," in part because of the competitive environment in which it operates, particularly competing with Wal-Mart, and in part because of its everyday-low-price strategy, "which is a one-legged stool that just doesn't work. Companies that rely solely on price, like Winn-Dixie and Albertson's, don't have a lot of success stimulating sales.

"So getting Winn-Dixie turned around will be a tough proposition and a tall order to fill," Comeau said. He said he expects the company "to restructure and retrench, purging its store base and doing an A&P-style restructuring that could involve selling some divisions."

DELHAIZE AMERICA, Salisbury, N.C., with sales up 7.2% in the second half, same-store sales up 2.5% in the third quarter and 0.8% in the fourth, and operating income up 2.5%.

Cerankosky said the fourth-quarter comps reflected competitive challenges, including more promotional activities by combination-store operators and the growth of supercenters in Delhaize's operating area. "But Delhaize has probably the best expense controls in the industry, and it has benefitted internally from its category management efforts that have resulted in strong margin improvements, so even if same-store sales are impacted, earnings have generally been strong."

According to Comeau, the chain's financial performance was on target, "though there was some pressure on sales when the company cut back the number of 24-hour stores."

The chain expects to complete its acquisition of Hannaford Bros., Scarborough, Maine, in May.

A&P, Montvale, N.J., with sales down 0.4%, same-stores sales up 4% in both the third and fourth quarters, and operating income up 78.1%.

Comeau said assessing A&P's results is complicated "because of a host of one-time charges [related to Project Great Renewal, its ongoing program of upgrading core stores and closing underperforming units], which makes it difficult to ascertain where the trends actually are. But its core operations were probably flat in the second half."

Adler said A&P's closure of small, underperforming stores hurt sales in the second half. But upgrading its remaining store base and making improvements in operations resulted in a jump in comps, she noted. "The closed stores generated a lot of losses, and eliminating them has helped A&P remove costs from distribution, manufacturing and overhead."

PATHMARK STORES, Carteret, N.J., with second-half sales up 3.6%, comps up 1.4% in the third quarter and 2.2% in the fourth, and operating cash flow up 3.6%.

Pathmark spent most of the second half in a holding pattern, waiting for Federal Trade Commission approval of its agreement to be acquired by Ahold USA -- a deal that fell apart at the end of the year.

However, Pathmark management was never distracted by the pending deal and proceeded to strengthen the company's merchandising, pricing and overall positioning, which paid off during the second half, Amil Schiaffino, a high-yield analyst with Scotia Capital, New York, told SN.

"ShopRite was very aggressive in pricing at the end of 1999, which made it tough for most other operators in the area, but Pathmark was immune to some extent because it had put the right programs in place early on," Schiaffino said.

Competitive pressures before those programs took effect had hurt comps in the prior year, he added, "so the comparisons were easier during the second half of 1999."

HANNAFORD BROS. CO., Scarborough, Maine, with sales up 3.8%, comps up 1.9% in the third quarter and 2% in the fourth, and operating income up 10.6%.

Cerankosky said Hannaford's aggressive store-opening program in late 1998 helped results at the end of 1999 "and reflected the company's success at operating combination stores."

Adler also said Hannaford's store-expansion progam helped boost overall sales. "But while it was a decent half, Hannaford has been facing increasing competition in the Northeast."

She also said results were affected by the company's home-delivery service, HomeRuns, which had been a money-losing operation for years. Hannaford sold its majority interest in the dot-com company earlier this year. "Without HomeRuns, Hannaford's business is doing fine, but HomeRuns' losses were up during the half," Adler said.

PENN TRAFFIC CO., Syracuse, N.Y., with sales off 10.5% in the second half, comps up 0.4% in the third quarter and 0.7% in the fourth, and operating cash flow up 37.5%.

Ted Bernstein, a high-yield analyst with Grantchester Securities, New York, said the decline in Penn Traffic sales for the half was largely a function of the sale or closure of nearly 30 stores during 1999. "However, the company managed to eke out same-store sales gains because comps were easier once it eliminated most of its underperforming stores," he noted.

Comparing Penn Traffic's financial performance in the second half of 1999 with results in the prior year's second half is like comparing apples and oranges, Bernstein pointed out, "because in the second half of last year Penn Traffic was just emerging from a Chapter 11 restructuring that eliminated a lot of debt, while a year earlier it was a company sliding into bankruptcy."