SMOOTH SAILING 2006

ELLIOT ZWIEBACH

Retailers enjoyed strong financial results during the first half of 2006 - as high gas prices prompted many consumers to eat in rather than out and to stay closer to home to shop - though the second half may be a little tougher, analysts told SN last week.

Financial results in the first half of 2006 for the 10 largest supermarket chains with public equity or public debt showed significant improvements over the first half of 2005. Total sales for the half increased 5.2%, compared with an increase of 3.2% for the first half a year ago; same-store sales rose an average of 2.8% in the first quarter this year, compared with an average gain of 1.8% last year, and second-quarter comps also were up an average of 2.8%, compared with an average increase of just 1% a year ago; while operating income climbed 7.5%, compared with gains of 5.4% in the first half last year.

(Because Albertsons, which was included in last year's comparisons, was sold to two different buyers in early June, before the end of the first half, accurate sales figures could not be determined, and SN excluded it from this year's list.)

The first half of 2006 represented a "perfect storm" of positive events that helped boost financial results, according to Jonathan Ziegler, a Santa Barbara, Calif.-based analyst for J.M. Dutton Associates, El Dorado Hills, Calif.

"The economy was strong, and Albertsons was in a state of flux [prior to its sale] that helped Kroger, Safeway and most other conventional operators that competed with those stores," he pointed out.

"Then you had gas prices ratcheting up to historic highs in terms of absolute dollars, and the cost of keeping gas tanks full prompted people to eat more meals at home rather than drive to a restaurant. In addition, the dollar stores didn't execute very well - perhaps due to the strong economy or to their weak perishables offerings - and all the negative publicity Wal-Mart has been getting may have shifted some people's paradigm and moved them back to shopping with more traditional operators.

"And even with inflationary pressures on food vendors that raised their costs, the economy was strong enough that grocers were able to pass the increases along and still achieve remarkable same-store sales numbers."

The second half has continued most of those trends, other than rising gas prices, Ziegler added, "though it will be tough for retailers to match the first-half comps."

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., said the first half of the year "was probably the best half for supermarkets since the late 1990s" for several of the same reasons Ziegler cited: "a decent economy; the rise in gas prices that slowed restaurant sales; and ongoing industry consolidation, including the impact of Albertsons' pending sale on the ability of its competitors to maintain strong sales and earnings growth."

Wolf said he believes industry sales have peaked, "and with the economy slowing and gas prices moving back down, consumer traffic will go back to restaurants and we might see some diminution in same-store sales growth, though sales will remain generally better than they have been through most of the decade."

Chuck Cerankosky, an analyst with FTN Midwest, Cleveland, said the growing strength of the economy during the first half and the ability of supermarket operators to keep costs down augurs well for the second half.

He said he was glad to see sales driving first-half results at most companies. "I don't want to see companies boosting their numbers because of margin expansion. I want to see results improve because customers are showing up at the stores, and that was the case during the first half for several companies."

Looking ahead, he said some consumers "might feel a pinch in the next few months because of a tightening in the housing market and rising interest rates, but overall, consumers should be feeling better about the economy, and chains that are already well-positioned with consumers should see earnings growth."

Cerankosky said the lessons retailers that sell fuel learned when gas prices were high - that aggressive merchandising works - should serve them well during the second half. "It seems consumers are always looking to save money on gas, regardless of what the price-per-gallon is, and cheap gas helps build loyalty, and when you combine that with better promotions inside the store, you have a powerful value proposition."

Bryan Hunt, a high-yield analyst with Wachovia Securities, Charlotte, N.C., said chains with more services to offer, including gasoline, outperformed those without gasoline during the half, "and that carried over into the third quarter without altering shopping patterns. But with a rebound in consumer confidence and an easing of gas prices, more people will go back to eating out, and some softening in the pace of same-store sales at supermarkets is inevitable, though I don't see consumers trading down."

Mark Husson, New York-based managing director for HSBC Securities, London, said falling gas prices raise questions about the industry's performance in the second half.

"Supermarket operators in general saw their numbers pick up in the first half as some of the strategies they've put in place over the last couple of years began to bear fruit," he pointed out. "Those strategies were launched during a period when the overall economy was weak and produced weak sales, but the strong results generated in the last few quarters in a stronger economy should continue going forward.

"What we don't know, however, is to what extent first-half results were affected by strategies like lower pricing and better service at Kroger stores or Safeway's move to lifestyle stores and how much they were affected by consumers reacting to high gas prices and staying closer to home to shop.

"Most of the positive impact undoubtedly came from the improved retail execution, but with gas prices coming down, the question is whether consumers will begin making those long trips to discount stores again, and we don't know that yet."

Retailers who had a definite plan for making their stores more exciting to shop saw better top-line results during the first half, said Karen Short, an analyst with Friedman Billings Ramsey, New York, "and if you're a good operator and your merchandising is right, you should be able to have good sales going forward, regardless of the economy, while retailers with poor merchandising programs will continue to be weak."

Analysts' observations on the first-half results for each company follow:

KROGER CO., Cincinnati, which saw first-half sales rise 8.6% to $34.6 billion, comparable-store sales jump 5.8% in the first quarter and 6.2% in the second, and operating income increase 8.7% to $1.1 billion.

Kroger benefited during the half from its ability to control costs through sales gains, Husson pointed out. "Anytime your sales growth is north of 2.5%, you ought to be covering your regular cost growth, and Kroger did," he explained. "Some of those cost improvements certainly came about because of higher gas prices, but Kroger was able to take those gains, plus gains from better procurement, and reinvest them back into pricing and then use that stronger price impact to generate above-average sales growth."

Cerankosky said Kroger has made a conscious effort over the last few years to drive the top line through better pricing and better promotions, "and it's compounded that effort by identifying markets in transition where it can go after market share more aggressively - places like Indian-apolis, where Marsh is having problems, or any of the markets in which Cerberus acquired Albertsons stores."

He said Kroger's strong profitability reflects its ability to leverage more fixed costs with its sales increases, "and it has chosen to reinvest some of those profits in better pricing and promotions and allowing some to drop to the bottom line, though the amount will vary from quarter to quarter."

Ziegler said Kroger is also benefiting from its multi-banner approach, "which really enables it to pick up strong sales at all income levels."

SAFEWAY, Pleasanton, Calif., where sales in the half increased 4.8% to $18.3 billion, comps rose 1.7% in the first quarter and 4.5% in the second, and operating income was up 17.1% to $699.9 million.

Ziegler said Safeway's lifestyle remodels are a great improvement over what the company was previously presenting to consumers, and Cerankosky echoed that sentiment when he told SN, "It's clear the lifestyle format has legs. And those remodels, which are getting such a positive return on sales, are also providing the company with higher operating profit margins."

Husson said Safeway has benefited from an ongoing process of re-engineering the quality of perishables at all stores, not just at the lifestyle remodels. "With better product quality, consumers have a more positive image of the chain, and as a result Safeway has been able to get existing customers to do a greater portion of their weekly shopping with them rather than going to other places."

The increase in operating income reflects Safeway's ability to recover in weak-profit markets, Husson added - not at Dominick's in Chicago, where profits are still down, he noted, but at Randalls in Texas, where it has corrected past mistakes, and the Vons stores in the post-strike Southern California market.

AHOLD USA RETAIL, Quincy, Mass., with first-half sales dropping 1.3% to $12.1 billion, comps falling an estimated 0.8% in the first quarter and rising an estimated 0.6% in the second, and operating income increasing 6% to $620 million.

Patrick Roquas, an analyst with Rabo Securities, Amsterdam, said Ahold's results in the U.S. continued to be highly volatile during the half, as they have been for the last two years. Three of the chain's operating banners experienced better results - Giant Foods of Carlisle, Pa.; Giant Foods of Landover, Md.; and Tops Markets, Buffalo, N.Y. - he said, though comps were flat at all banners except Giant of Carlisle.

Ahold was able to engineer improvements at Giant of Landover through better shrink control, Roquas pointed out; however, margin pressures hurt results at Stop & Shop - an issue the company sought to overcome with the introduction late in the third quarter of a value improvement program.

The value program will be introduced gradually, possibly taking two or three years to implement, to limit the impact on margins, according to Claudie Casimir, an analyst with Ixis Securities, Paris.

Just after the end of the half, Ahold announced plans to seek buyers for 46 Tops stores in northeastern Ohio.

DELHAIZE AMERICA, Salisbury, N.C., whose sales rose 4.4% to $8.5 billion in the half, comps jumped 1.7% in the first quarter and 3.4% in the second, and operating income increased 6.3% to $437.9 million.

Wolf said Food Lion in the Southeast benefited from cleaner stores, sharper execution "and the upgrading of merchandise at a measured pace," while Hannaford in New England benefited from its expansion into Massachusetts - "a market where inconsistent execution at Shaw's and higher pricing at Stop & Shop are providing good opportunities for sales growth," he pointed out.

Hunt said the Food Lion stores are benefiting from their overlap with Winn-Dixie and Bi-Lo stores that are closing and the merchandising changes being made at Southern Family Markets, a group of former Bruno's stores operated by C&S Wholesale Grocers, Keene, N.H. With the addition of two new formats - Bloom and Bottom Dollar - "Food Lion now has a portfolio of brands it can use to address the demographics in markets that have changed," he pointed out.

Pascale Nachtergaele, an analyst with Delta Lloyd Securities, Antwerp, Belgium, said the company benefited from a strong performance at Food Lion and an improving trend at Hannaford, while the ongoing cost of converting its Kash n' Karry Stores in Florida to the Sweetbay banner kept financial gains there in check.

Sales in all divisions were better than expected, she added, resulting from improved in-store execution, market initiatives in existing stores, accelerated openings of new stores and market renewals, while Hannaford was helped by a price investment program it characterized as an offensive initiative designed to increase market share rather than a defensive reaction to competition.

Casimir said Delhaize is using sales growth and market-share gains more than margin improvements to boost earnings, "with margin gains being reinvested to improve price competitiveness. This push for growth, combined with a good positioning of store formats and excellent cost controls, represents the most relevant and most lucrative strategy for the long term."

A&P, Montvale, N.J., which saw sales on continuing operations drop 5.1% to $3.7 billion (following the sale of its Canadian operations last summer), comps rise 1.4% in the fourth quarter and 1.5% in the first, and operating income, adjusted for the Canadian sale, increase 59.1% to $98.3 million.

Short said the sales declines resulted from more than 40 store closings, most of which occurred in Michigan, while the rise in comps were largely due to a significant boost to A&P's business in New Orleans, where its 23 Sav-A-Center stores experienced first-quarter increases of more than 20%.

A&P is also benefiting from cost-cutting moves, Short noted, including the transition from self-distribution to using C&S as its supplier, and from "more creative, more aggressive" pricing moves by Eric Claus, installed late last year as chief executive officer. "Claus likes to mix it up and be more proactive on pricing rather than reactive and to do what's right for A&P while keeping the competition guessing," she explained.

WINN-DIXIE STORES, Jacksonville, Fla., where sales on continuing operations were up 4.6% to $3.3 billion for the first half, comps rose 6.7% in the third quarter (with numbers unavailable for the fourth), and an operating loss amounted to $29.5 million.

The chain is continuing to work its way through Chapter 11 bankruptcy, which it filed in February 2005, with an emergence anticipated later in the fall, a spokesman told SN. Winn-Dixie was operating 539 stores at the end of its fiscal year in June, compared with 913 stores a year earlier; the company has subsequently closed or sold 19 more units.

WHOLE FOODS MARKET, Austin, Texas, which saw sales climb 19.5% to $2.7 billion for the half, comps rise 11.9% in the second quarter and 9.9% in the third and operating income jump 27.4% to $166.5 million.

Whole Foods has continued to achieve strong results, Ziegler said, "despite going up against the most difficult comparisons in the industry, and it has a whole cadre of stores that are still in the early stages of maturing that will continue to help raise results going forward."

Husson said, "Whole Foods continues to execute at the top of its game, though its strong sales gains won't go on forever."

He said the company anticipates tougher comparisons to result in weaker numbers through the second half and beyond "because the stores are so busy they can't handle much more capacity, because the company has cycled past the sales pickup it enjoyed during the Southern California strike-lockout and because consumers are starting to slide down [in their buying preferences] again."

The gains in operating income are beginning to narrow the gap with sales gains, Husson added, "and the company expects that gap to continue to narrow."

Wolf said Whole Foods' sales experienced "a modest deceleration" as volume within its niche starts to normalize. "Sales growth is still going to be above average but the comparisons will be tougher and sales, while not really falling, may already have peaked," he noted.

PATHMARK STORES, Carteret, N.J., whose first-half sales dropped 0.1% to $2 billion, comps fell 0.1% for the first quarter and rose 0.5% for the second and operating income fell 64.1% to $7.4 million.

"It was not a good half for Pathmark," Short said, "although it was better than the second half of last year."

She said Pathmark introduced a series of merchandising initiatives at the end of 2005 that were being implemented when John Standley was named CEO, "and he decided those shifts were too aggressive and reversed course, which left some disorganization at store level and some confusion among customers and made the company lose traction. By making changes more deliberately on a department-by-department basis, as it's doing now, Pathmark saw slightly better numbers in the second quarter."

The drop in operating income was due to higher labor costs and higher pension costs, plus a non-cash stock-compensation expense, Short pointed out.

Hunt said Pathmark is "definitely in a turnaround mode, and despite some sequential improvement from the first to the second quarter - largely due to resolving some shrink issues as it modified its merchandising - it is continuing to fight issues on the cost line" related to insurance, utilities and transportation.

"What makes the challenges so difficult to overcome is there is no population growth in its markets. Pathmark customers have traditionally been value shoppers, and getting them to try new merchandise integrated into the stores is more of a stretch than for its competitors. And while the chain's basket size has grown over the last three quarters, it's not dragging in incremental customers.

"Further, Pathmark doesn't have the advertising dollars to communicate its story, and it probably shouldn't spend that kind of money until the majority of its stores have been remodeled and remerchandised," Hunt said.

STATER BROS. MARKETS, Colton, Calif., with sales for the half up 3.9% to $1.7 billion, comps rising 0.4% in the second quarter and 2.3% in the third, and operating income climbing 7.7% to $47.8 million.

Sales per store at Stater are among the industry's highest, at $20 million-plus per store per year, Hunt pointed out.

"Stater tries to maintain a strong price-value image, but every year it has one quarter where it gets more aggressive with promotions, and that occurred in the third quarter this year," he noted. After avoiding involving itself in a mini-price battle between competitors Ralphs and Vons during the second quarter - and seeing comps suffer while maintaining its gross-margin levels - Stater jumped into the fight in the third quarter and saw comps rise while gross margin fell 100 basis points, Hunt said.

Also helping the company boost sales was the addition of the pharmacy business Stater acquired from its former pharmacy partner, he added.

The rise in operating income would not have occurred, Hunt added, without a one-time expense in last year's second quarter involving a $5 million bonus payment to Jack Brown, chairman and CEO, for the job he had done refinancing the company. "That skewed the data, and without that item in the comparison, operating income would have been down from the prior year," he pointed out.

HARRIS TEETER, Matthews, N.C., a division of Ruddick Corp., Charlotte, N.C., whose sales rose 10.4% to $1.5 billion for the half, comps increased 3% for the second quarter and 3.2% for the third, and operating income rose 11.5% to $64.1 million.

Cerankosky said the chain has seen sales climb as it's added significant new square footage, "and what's surprising is how fast that square footage has ramped up and how little cannibalization it has caused. Harris Teeter seems to have the right vehicle at the right time in markets where companies like Bi-Lo and Winn-Dixie have closed a lot of stores.

"Harris Teeter has fine-tuned its operation over the years and positioned itself well for the long term as its core markets have moved away from price operations to serving a demographic that's more likely to look for quality, service and convenience," he added.

Operating profits at Harris Teeter benefited during the half from the fact the company operates its own distribution, "so as it adds more sales, it's able to leverage those sales more efficiently," Cerankosky said.

2006 First-Half Financial Results

Below are financial results for the 10 largest supermarket chains with public equity or public debt. Although reporting periods vary, the table represents sales, operating income and same-store sales for the two quarters most closely paralleling the first half of calendar year 2006, encompassing the first and second quarters for Kroger Co., Safeway, Ahold USA Retail, Delhaize America and Pathmark Stores; the third and fourth quarters for Winn-Dixie Stores; and the second and third quarters for A&P, Whole Foods Market, Stater Bros. Markets and Harris Teeter.

Name: Sales (in billions); % Change; Operating Income (in millions); % Change; 1Q Comps*; 2Q Comps*; Dates

Kroger Co.: $34.6; 8.6%; $1,144; 8.7%; 5.8%; 6.2%; 1/29/06-8/12/06

Safeway: $18.3; 4.8%; $699.9; 17.1%; 1.7%; 4.5%; 1/1/06-6/17/06

Ahold USA Retail: $12.1; -1.3%; $620; 6.0%; -0.8% (est.); 0.6% (est.); 1/2/06-7/1/06

Delhaize America: $8.5; 4.4%; $437.9; 6.3%; 1.7%; 3.4%; 1/1/06-7/1/06

A&P: $3.7; -5.1%; $98.3**; 59.1%; 1.4%; 1.5%; 1/1/06-6/17/06

Winn-Dixie Stores: $3.3; 4.6%; ($29.5)-; 6.7%; N/A; 1/12/06-6/28/06

Whole Foods Market: $2.7; 19.5%; $166.5; 27.4%; 11.9%; 9.9%; 1/16/06-7/2/06

Pathmark Stores: $2.0; -0.1%; $7.4; -64.1%; -0.1%; 0.5%; 1/2/9/06-7/29/06

Stater Bros. Markets: $1.7; 3.9%; $47.8; 7.7%; 0.4%; 2.3%; 12/26/06-6/26/06

Harris-Teeter: $1.5; 10.4%; $64.1; 11.5%; 3.0%; 3.2%; 1/2/06-7/3/06

* Same-store sales comparisons, adjusted for the Easter holiday and excluding fuel.

** Earnings before interest, taxes, depreciation and amortization (EBITDA).