SUPERMARKETS NEED A RALLY 2004-09-06 (2)

ELLIOT ZWIEBACH

NEW YORK -- Supermarkets may need to play more offense to improve their financial results and the performance of their stocks, a panel of industry analysts said here at SN's ninth annual Financial Analysts' Roundtable.

Despite an upturn in the economy and the return of inflation, the industry's performance has remained on a downward cycle, the analysts said, with few signs the industry is close to catching the wave of an upward cycle anytime soon.

According to Mark Husson, managing director of the New York office of HSBC Securities, London, one way for the industry to turn things around would involve being less defensive in the way it allocates resources. "There aren't enough chief executive officers out there that are sufficiently competent [in spending capital] and what it will look like in five years' time to start committing large amounts of capital to the marketplace and building more superstores and accepting the offensive," he said.

John Heinbockel, vice president of Goldman Sachs, New York, said one offensive strategy supermarket companies might pursue involves more investment in prices and promotions and in labor and service "to take advantage of the food retail market's fragmentation and [to] gain incremental share."

Heinbockel singled out Kroger and Supervalu as two companies playing offense: "Kroger because of its early and consistent investment in price and its ability to develop and roll out price-impact stores and significantly expand its nonfood merchandising offerings, and Supervalu because a very large percentage of its business is in discount formats and [because] it's investing at the margin in superior ... formats and businesses."

Another chain that's seizing the initiative is Safeway, Husson pointed out. "[Safeway] already leads the majors on just about every criteria in terms of service inside of the store. Now it's making a fairly brave attempt to remodel its stores to emphasize the freshness and to increasingly abandon the center-store tins and packets and commodity areas."

For Gary Giblen, senior vice president and director of research for C L King Associates, New York, some chains are succeeding in the current economy, including H-E-B, Publix and Whole Foods, "[which] brings up the question that maybe it's not the whole industry that is so badly off. It's a question of the relevance of an Albertsons or a Safeway. Maybe they are questing for the impossible dream in that they are just too plain vanilla."

Whether or not the dream is impossible, few retailers are experiencing anything but nightmares, the analysts pointed out.

"The economy has gotten better, and the real underlying sales growth of major conventional supermarket chains has not done anything," Andrew Wolf, managing director of BB&T Capital Markets, Richmond, Va., said. "It has not improved along with the economy, [and] that is really not a good harbinger for the future."

According to Mark Wiltamuth, executive director of Morgan Stanley, New York, "Now that the economy is coming back, we are getting this cyclical upturn, though we just haven't seen it yet in supermarket results."

Whatever sales growth may have occurred has reverted to Wal-Mart Stores, he added. "Wal-Mart effectively took all of the growth in the industry, and the shares simply shifted around among conventional supermarkets. Wal-Mart won the market-share battle and is gaining two share points a year, which is profound growth in a mature industry."

Even inflation isn't helping results, the analysts said.

According to Wiltamuth, "[Cost increases are] not coming through to the net income line, we're not hearing any positive comments from management in the conference calls, [and] we're seeing same-store sales numbers that are below the inflation numbers -- all of which are signs that retailers are not putting the price increases through or that they are losing volume. Either one of those conclusions is bad for the industry.

"We are still in an environment where the grocers are cutting prices to try and increase their competitive position. So you've got a group with no pricing power that's getting hit with double-digit cost increases in many categories. Even in the best of worlds, they can't put their prices up that fast to keep in step with the cost increases."

Alternative Squeeze Play

One factor making it tough for supermarkets to pass through all the price increases is the pressure from alternative formats, Bryan Hunt, vice president of the fixed-income division at Wachovia Securities, Charlotte, N.C., pointed out. "There are so many general merchandise retailers in the food business who are willing to take the short-term pain to get the elasticity growth and demand, whereas most supermarkets cannot take the short-term pain.

"Beef and dairy are a larger percentage of supermarket sales [than at] Wal-Mart and the wholesale clubs. Retailers with a larger percentage of general merchandise can take the hit in the short term to capitalize on the elasticity of demand in those categories to make up for the margin loss. If the elasticity does not materialize, the profit pinch is rarely seen due to the relatively low mix attributable to those categories."

Margaret Cannella, managing director of JP Morgan Securities, New York, said supermarkets are doing what they can to shore up their financial results. "Supermarkets have really been very diligent about battening down the hatches with regard to their capital structures and reducing the amount of financial risk they have historically assumed ... [to boost] their credit profile in the face of weak operating conditions and a competitive environment that intensifies each year."

Analysts offered little hope that things might change anytime soon.

Husson sounded the most optimistic note when he said, "Never in the history of this country have there ever been more clubs, supercenters, discount stores, dollar stores and other general merchandisers selling food, and yet comparable-store sales are improving. [So] it should be the worst period of time for food retailing, not an improving period.

"But the employment picture is slowly improving and food retailers are slowly improving, and while no one could pretend this is a growth industry or that it's going to get anything better than single-digit improvements in terms of earnings-per-share growth, the cash flow is very good and has held up well."

Wiltamuth was more pessimistic, noting comps are negative when fuel is excluded. "Couple that with what's going on with the margin sacrifice, and negative comps plus negative margins are bad news for earnings in my book," he said.

According to Heinbockel, "I don't think food sales are necessarily going to get much worse from here on out, but I'm concerned they are not going to improve significantly in the next six to 12 months. I don't think it's going to get a lot worse than it is now, [but] it's probably not going to get a lot better either."

Hunt said continuing pressure from Wal-Mart, Costco and dollar stores "will [make it] difficult for most supermarket operators to post sales and earnings rebounds similar to past economic cycles due to the fragmented shopping patterns of consumers."

Giblen said he believes supermarket stocks could be on a cusp, "but it remains to be seen whether the numbers are going up or whether we'll have another cascade of earnings markdowns. I happen to think we'll have yet another decline because of the multitude of sins that were covered up in the Southern California strike.

"As soon as we have some clean numbers, it should be much clearer how the industry is really doing -- either a big turnup or, more likely, a further fall."

According to Wiltamuth, "The group has been nothing but a value trap. The stocks look cheap, investors start to take a position, and then they are further disappointed with more downward earnings reviews. We've been cutting our earnings estimates on this group for at least two years."

Heinbockel said he believes supermarket stocks are basically stuck in neutral. "In the short term, there's probably not enough bad news out there to push them below the low end of the range, nor is there enough good news to force them above the high end of the range. So they trade within this range, and you can make a good return with this strategy. If you focus on companies that are competitively positioned and you time your entry points right, you should make money over the long term."

Part 1 of the roundtable follows. The second part of the discussion will be published in a future issue of SN.

FINANCIAL OVERVIEW

SN: Let's get started with an overall assessment with where things stand in the industry today. How do you view the financial performance and positioning of conventional supermarkets in both the near term and maybe the slightly longer term?

ANDREW WOLF: I recently looked at the last six quarters of same-store sales of the big three supermarket chains, and I took out inflation and fuel and the impact of the Southern California strike to get to a real number that is potentially a proxy for volume, and what I found was really interesting. In the last six quarters, the number has stayed at about minus 3% on average.

So here we are. The economy has gotten better in that period of time, and the real underlying sales growth of the major conventional supermarket chains has not done anything -- it has not improved along with the economy. That is really not a good harbinger for the future, particularly when the economy slows.

But the results are what they are. There has really been no improvement in the underlying sales productivity once you strip out inflation. I'm not saying inflation is negative because there is a positive financial benefit to inflation eventually when product cost increases are passed through. What I am saying is, when you strip it out and look at what's really going on in this mass-market type of business, tonnage on a comparable-store basis is still negative. And for a retailer selling mass-market products, you just can't get operating leverage on that kind of inflation. Unfortunately, that's just the way it is. That's the state of the industry right now.

MARK HUSSON: I don't think you've got enough information to say what tonnage is. You can't just strip inflation out because that's inflation in the cost of goods, not inflation for retail, so there's a question as to how much inflation is actually in the retail line, and we don't know that because they won't tell us the degree to which they've been reducing prices or not passing the cost increases through. My guess is, since Americans aren't eating noticeably less, that we're probably flattish or maybe slightly up.

But what's more important than averaging six quarters in trends is finding the trend is improving slightly. Over that period of time, although the overall economy has improved, the employment picture has only just started to improve, and employment is the closest corollary to sales in this industry that we can find. Employment picks up and sales pick up, and this has been one of those nasty jobless recoveries and there are still plenty of people, like John Kerry, talking about outsourcing and the fragility of the employment picture in the United States, so that's a refinement to the picture.

MARK WILTAMUTH: The economy has recovered a lot. We haven't really seen a material pickup in any of the chains' financial performances. I think the big picture problems remain, including the competitive challenges of Wal-Mart [Stores], club stores and other alternative formats. If you look back at the statements made in this forum last year, there was a lot of speculation that the pendulum had swung too far in terms of worrying about Wal-Mart and the cyclical downturn on the way down. But now that the economy is coming back, we are getting this cyclical upturn, though we just haven't seen it yet in supermarket results.

HUSSON: The employment cycle is the most important thing because looking at gross domestic product is pretty irrelevant to the way people buy food, so I don't think we've seen a really significant pickup in the economy in the way that people experience it -- particularly people picking up their paychecks every week.

JOHN HEINBOCKEL: Oddly enough, we've found a pretty high correlation between real personal consumption expenditures and real food-at-home consumption, and surprisingly so. We've found that food consumption is not defensive, as you might think. The correlation is particularly sharp on the way down, but it's there on the upside as well. For example, at a cycle trough, where real personal consumption expenditures drop 1% to 2%, you might see food-at-home consumption actually decline. The only reason I raise this point is that real PCE is under some pressure, and the June numbers were fairly weak. We've been cautious about the consumer for a while, and while we don't think it's going to get a lot worse than it is now, it's probably not going to get a lot better either, and therein lies the challenge. I don't think food sales are necessarily going to get much worse from here on out, but I'm concerned they are not going to improve significantly in the next six to 12 months.

WOLF: Then why do you have a higher rating on the supermarket group than Goldman Sachs does on the entire retail group?

HEINBOCKEL: It's largely a function of two factors. First, although not completely defensive, the supermarket business is less discretionary than most retailers' business, and second, valuations are not especially demanding. We believe supermarket stocks are in a trading range, and we are at the low end of that range.

MARGARET CANNELLA: From my perspective, looking primarily at fixed income instruments -- in plain terms, bonds -- the performance of the supermarkets has been as you've described. Supermarkets, more so than other retailers and maybe more so than other industries, have really been very diligent about battening down the hatches with regard to their capital structures and reducing the amount of financial risk they have historically assumed. Whether you're talking about companies that have had very high-quality credit for a long time, like Kroger, or companies that sort of fell into disrepute, like Ahold, they have all very much focused on using their cash in a different way than they did before -- to focus on reducing debt in addition to focusing on the shareholder. And from my perspective, that's been interesting because I think the supermarkets are boosting their credit profile in the face of weak operating conditions and a competitive environment that intensifies each year.

HUSSON: It's interesting that the decision of whether or not to spend cap-ex depends on the anticipated return on their investments, as well as the desirability of having a defensive balance sheet. And I also think there aren't enough chief executive officers out there that are sufficiently competent in that area and what it will look like in five years' time to start committing large amounts of capital to the marketplace and building more superstores and accepting the offensive.

GARY GIBLEN: The fact remains that the performance of Shaw's, or private companies like Publix, Wegmans and H-E-B or specialty companies like Whole Foods is much better than the large public ones that we usually focus on. There are actual numbers available on many of them that indicate they're doing pretty well, with positive comps. So it brings up the question that maybe it's not the whole industry that is so badly off -- it's a question of the relevance of an Albertsons or a Safeway. Maybe they are questing for the impossible dream in that they are just too plain vanilla. They have acquired healthy chains and made them overly standardized and unhealthy. The mega-challenges lie mostly with the largest chains, which are the public companies Wall Street follows.

BRYAN HUNT: What's different about this recession from the one over 10 years ago is that Wal-Mart, Costco and the dollar stores were not major competitive forces. The competitive landscape has changed dramatically, and I believe it will be difficult for most supermarket operators to post sales and earnings rebounds similar to past economic cycles due to the fragmented shopping patterns of consumers.

HUSSON: If we had had this conversation back in 1993, we would have been saying, "Well, Costco had 8% or 10% comp-store sales, and this is the end of civilization as we know it, with consumers changing their shopping patterns." But I think Costco has come full circle from a more vigorous recovery back in 1994 or 1995, when it had negative comps for two years. That sort of cyclical pattern is expected. John is dead right when he talks about belt-tightening, but there has been no dramatic belt-loosening. Everyone goes through the belt-tightening phase, and it takes sort of a long time to loosen your belt. You can't do it in a bubble.

Perhaps what we ignore is that the late 1990s was a bubble in many more industries than just technology. Maybe food retailing went through something like a bubble too, working off a base that really wasn't very helpful, and maybe the comp-store sales expressed against that base were necessarily going to look weak for a while until we got back to real food consumption. But don't forget, belt-tightening is followed by a period of belt-loosening, and although it's not as dramatic as belt-tightening, it happens.

WOLF: Can I clarify something? When I said same-store sales in the last six quarters have been down about 3% in real terms, I was using the Consumer Price Index, not the Producer Price Index or the inflation that companies talk about. Obviously, I agree with John that there are some discretionary items inside the supermarket, but I agree only up to a point, and the point is this: I still think it's an early-cycle industry; it's food and the numbers back me up. I take the government's numbers for the grocery store class-of-trade and the rate of inflation, and I get to a real number. The industry has real growth, but real growth for this industry peaked in the third quarter last year, and it was pretty good at 2.5%. Now it's back to 1% this year, year-to-date, which is about its long-term average. So I think discretionary spending is a secondary issue. I don't think you can say that what drives the demand for supermarket sales in a mature, rich, generally growing economy such as ours is some kind of growth factor, whether it's GDP or jobs.

HUSSON: So you're using CPI food-at-home?

WOLF: I'm using an index that includes CPI food-at-home, which is about 65% of the weight, and other sub-indices, such as prescription drugs and sundries.

HUSSON: You talk about inflation of 3%, but I don't know any retailers who have inflation of 3%. I'm not saying I disagree with you; I just disagree with the statistics.

WOLF: These are the government statistics, and you're welcome to attack them.

HUSSON: Actually if you look back, they have actually restated some of the series recently.

WOLF: But the reason the CPI statistics are up, obviously, is because a lot of commodity costs, such as beef, are up, although supermarkets may not be passing it all through.

WILTAMUTH: If you look at the sales growth of the industry and hold that up against the growth in supermarket sales that Wal-Mart had last year, Wal-Mart effectively took all of the growth in the industry, and the shares simply shifted around among conventional supermarkets. Wal-Mart won the market-share battle and is gaining two share points a year, which is profound growth in a mature industry.

IMPACT OF INFLATION

CANNELLA: If inflation can sometimes be beneficial, what is the impact?

WILTAMUTH: I actually haven't agreed with that. I know some of the analysts in this room have been advocating that case, but to me, when there is a cost increase in a category that doesn't have any pricing power, you're really just looking at margin pressure in the near term. I just don't view it as a positive. You see the evidence that it is not coming through to the net income line, we're not hearing any positive comments from management in the conference calls, we're seeing same-store sales numbers that are below the inflation numbers -- all of which are signs that the retailers are not putting the price increases through, or that they are losing volume. Either one of those conclusions is just bad for the industry.

CANNELLA: There have been cases recently where they have been able to put price increases through -- I'm thinking of a category like meat last year. You can't answer the question "is it good or is it bad" in a blanket kind of way because it very much depends on the products that are involved, which makes it much more complex.

WILTAMUTH: And also what your competitor is doing, which matters probably more than anything, because if you talk to the companies, they will say there are some categories in which they can put increases through but it depends on what the competition across the street is doing. We are still in an environment where the grocers are cutting prices to try to increase their competitive position, so you've got a group with no pricing power that's getting hit with double-digit cost increases in many categories. Even in the best of worlds, they can't put their prices up that fast to keep in step with the cost increases.

HUSSON: The most important thing in food retailing is to remember -- rather like the Eskimos, who have 45 different words for snow -- that there are 45 different kinds of inflation. So you have to be a lot more specific as to what kind of inflation you're referring to.

WILTAMUTH: The management teams seem to be coming up with a lot of definitions for price reduction, the most popular of which seems to be "margin investment."

HUSSON: Commodity inflation is inescapable because Wal-Mart has to buy meat in the same place that everybody else does. Normally a price increase is a negotiation between yourself and your customers, with all your competitors sitting in the same room, and you just have to put the price up when it goes through. Dairy is a good example. The price increase has pushed through quite well because in many states there's pricing legislation on dairy. However, in general terms that negotiation with the consumer is difficult in this kind of environment, where the consumer is still concerned and where job growth is still weak and concerns about security of jobs is so tough and where the consumer pushes right back and says, "I'm not going to buy this stuff; I'm going to buy less of it. I came to buy $5 worth of beef, and I'm going to buy $5 worth of beef. "

WILTAMUTH: There's a big difference between demand-driven inflation and cost- or supply-disrupted inflation like what we are seeing.

HUSSON: Exactly. This is bad inflation. There is good inflation. Good inflation is inflation on consumer packaged goods at 2% or 3% or 4% a year, but I've seen precious little of that. That's what we're hoping to see. And to the extent that I think there is some beef in Dinty Moore beef stew, perhaps some of that cost increase could end up being passed through to some of the prices on the shelves, though it's going to take some time.

WILTAMUTH: If you look at commodities like beef and chicken, they all look like they're going to be high for at least another year, and we are not going to make any money telling investors how to play the supermarkets based on what's going on with meat-pricing.

HUNT: The dramatic spike we saw across all proteins and dairy was unhealthy for supermarkets because the pace of cost increases was not fully covered by price increases by retailers and restaurants alike. I think what separates the marketplace today is that there are so many general merchandise retailers in the food business who are willing to take the short-term pain to get the elasticity growth and demand, whereas most supermarkets cannot take the short-term pain. Beef and dairy are a larger percentage of supermarket sales relative to Wal-Mart and the wholesale clubs, and retailers with a larger percentage of general merchandise can take the hit in the short term to capitalize on the elasticity of demand in those categories to make up for the margin loss. If the elasticity does not materialize, the profit pinch is rarely seen due to the relatively low mix attributable to those categories.

GIBLEN: I agree that Wal-Mart can decide that meat is a high-visibility item and therefore it will not pass on the inflation, and after gaining traffic, it can make it up in productivity or by raising the price of foot powder by a penny or something. There are a lot of places where they can offset it, though usually it's in productivity. Of course, those productivity gains are really tough to come by, especially for tradition-bound and unionized supermarket chains.

HUSSON: I agree with you that these items are a smaller percentage of the total [among discounters], but the idea that Wal-Mart makes certain economic decisions about pricing on commodities to drive volume is somewhat outdated. I think Wal Mart itself says that's a silly idea, so I disagree -- Wal-Mart has become more like a food retailer. I think retailers themselves say that if Wal-Mart is passing its increases through, you have to do it too or else your whole economic model collapses. You can't not pass the price increase through.

WOLF: Wal-Mart actually told me that the only reason their beef pricing was roughly 50% below market, when they only needed to be 20% below, was because they had a really good contract and they were pricing on a markup basis rather than a spread basis, so they were leaving a little too much on the table. They also told me that, like any other food retailer, they will raise a price if a manufacturer comes in and can justify why he has to raise the price -- because ingredient costs or fuel costs are up -- and a lot of big manufacturers have started to announce pretty big price increases.

HUNT: Does a processed food company go to Wal-Mart with a price increase first, or does it go to Wal-Mart last?

WOLF: No, you go to Wal-Mart as you go to everyone else, and Wal-Mart, like some others, wants to know your cost of production, and they are pretty nosy about that stuff, and if costs are going up and it's justified, then Wal-Mart will take the price increase. Certainly they price on a markup basis. Of course, they have to do that -- they have to have a spread. But they have two spreads -- a markup because they have to make a profit for the shareholders and a spread vs. everyone else to keep the customers coming back.

SUPERMARKET STOCKS

SN: How are supermarket stocks positioned right now, and what's the outlook?

WILTAMUTH: We are still underweight on all the major grocers, and we are concerned about the long-term secular growth outlook for the industry. From where we are sitting, the group has been nothing but a value trap. The stocks look cheap, investors start to take a position and then they are further disappointed with more downward earnings reviews. We've been cutting our earnings estimates in this group for at least the past two years, and at this point we are still concerned about price reductions and the market-share battle going on.

SN: What could these companies do to improve their prospects?

WILTAMUTH: I'd like to see them play more defense, play more of a cash-cow strategy where they cut their capital expenditures, pay a dividend and drop their growth rates down to something that is low and sustainable where you could go to a portfolio manager and say, here is a grocer that is going to have 5% earnings growth and pay a 3% dividend -- something that sounds more like a consumer-staple name that has predictable characteristics. Right now, we have no defensive characteristics in this group.

GIBLEN: We're also at the cusp of something that will define things better. A year ago at this time, it seemed that perhaps the industry was making a big turn, but it didn't happen. It totally disappointed. And now it seems like there's renewed hope -- hope springs eternal during the summer and early fall. But it remains to be seen whether the numbers are going up or whether we'll have another cascade of earnings markdowns.

I happen to think we'll have yet another decline because of the multitude of sins that were covered up in the Southern California strike. Ironically, that strike was a negative event for the industry, and very costly, but a big boon to the stock prices. That's because you can't tell what's happening with the gobbledygook of the financials because anything can be shoved off and credited to the strike along with the other write-offs the companies have wheeled out at the same time. As soon as we have some clean numbers, it should be much clearer how the industry is really doing in the third and fourth quarters of this year -- either a big turn up or, more likely, a further fall.

HUSSON: We're going through a period of time where we've had a very weak employment picture, and let's not forget that the alternative formats have a lot of new space and there's been a lot of market-share shift because Wal-Mart has opened 700 supercenters, yet comparable-store sales are improving. If you think about where we are now, never in the history of this country have there ever been more clubs, supercenters, discount stores, dollar stores and other general merchandisers selling food, and yet comparable-store sales are improving. If the structural argument is true, then that shouldn't happen. It should be the worst period of time for food retailing, not an improving period. But the employment picture is slowly improving and food retailers are slowly improving, and while no one could pretend this is a growth industry or that it's going to get anything better than single-digit improvements in terms of earnings per share growth, the cash flow is very good and has held up very well.

WILTAMUTH: I would argue that we as analysts focus too much on same-store sales growth in this industry. There is this hyper-focus on the comp trend because the comps have been negative. If you take out the fuel, the comps have been negative -- improving sequentially, perhaps, but still negative. Couple that with what's going on with the margin sacrifice, and negative comps plus negative margins are bad news for earnings in my book.

HUSSON: But again, if you take out Southern California -- and we don't know enough about Southern California to know whether or not they are using it as a Band-aid to hide worse things -- but if you take the companies at face value and take out Southern California, then the rate of earnings reductions has slowed down dramatically just as comp-store sales have improved.

WILTAMUTH: But it's still negatives on top of negatives.

HEINBOCKEL: As I mentioned earlier, I think supermarket stocks are range-bound. In the short term, there's probably not enough bad news out there to push them below the low end of the range, nor is there enough good news, particularly with respect to the top line, to force them above the high end of the range, so they trade within this range and you can make a good return with this strategy. We have chosen to do that.

Now, over the longer term, say the next two or three years, I think you have to invest in companies that can win a market-share battle. These companies will continue to make relatively heavy investments today in both price/promotion and labor/service to take advantage of the food retail market's fragmentation and gain incremental share. When I think about which public companies can generate above-average topline growth and win a market-share battle profitably, we like Kroger and Supervalu -- Kroger because of its early and consistent investment in price and its ability to develop and roll out price-impact stores and significantly expand its nonfood merchandising offering, both of which came from the Fred Meyer merger; and Supervalu, not just because of Save-a-Lot, which everybody talks about, but because a very large percentage of its business is in discount formats and it's investing at the margin in superior return-on-invested-capital formats and businesses.

I think you've got to be really selective in this business, but if you focus on companies that are competitively positioned and you time your entry points right, you should make money over the long term. You might do better with other names in the short term, reflecting the trading opportunities I mentioned before, but this is how we would invest for the longer haul.

WEIGHING IN ON PRICE VS. SERVICE

HUSSON: I think John makes some excellent points. Yet, some in the industry keep banging the drum that service is important, and differentiation and segmentation are important. But we know that price is only third or fourth on the consumer's wish list of what they actually want. Convenience is what they want first. It's funny how service comes above price. Whether consumers are lying when these questionnaires are coming out, I don't know, but service comes above price until a recession hits, when people are tightening their belts and price may sneak up above service, but it goes back again when people can afford what they really want, which is not to schlep out dozens of miles to a big inconvenient store.

With that as a backdrop, then, shouldn't we be giving Safeway some credit for a pretty brave repositioning effort on the branding side? It already leads the majors on just about every criteria in terms of service inside of the store, and now it's making a fairly brave attempt to remodel its stores to emphasize the freshness and to increasingly abandon the center-store tins and packets and commodity areas and let the people who are equipped to have large amounts of shelf space and variety and very little in terms of service have that bit of the market. So I think if this repositioning works for Safeway, then it probably has the greatest upside for a stock recovery.

WILTAMUTH: Safeway is also layering that on top of two years of management execution problems.

HUSSON: I'm not denying that at all, but the stock market is not all about castigating managements for all past failures or we'd never be able to get out of bed in the morning. It's more optimistic. It's about looking forward to what's next.

WOLF: I think a company like Safeway would trade a lower cost structure for service, but because I think there's essentially a stalemate between organized labor and the industry, then trying to differentiate on service is your only alternative. I think the potential flaw with what Safeway is doing, even if it's well-executed, is the possibility that it may not get the customer count up and the lift-up to leverage the increased cost structure of the investment. Certainly, there's almost the absolute certainty that in the short run, you put costs in -- the training, better merchandising and all that stuff -- and the manpower. If you're going to merchandise better, you're going to have a lot of people in the store. So I think this is probably the right strategy, and as Gary pointed out earlier, companies like Harris Teeter and Publix have more of a service element that's helping them win. But again, Safeway is going to have to win back customers, I think, for that approach to actually work out.

HUSSON: Sure, but we're not talking about an awful lot here. You take a few of the good retailers who sell what they choose to sell, and maybe winning back customers would boost food sales by 1%, 2% or 3% a year, and maybe that's what they need to get to where you're talking about, to get leverage on the cost structure. Three percent is less than one item in the basket in addition to what customers are buying already, and I bet there would still be some residual belt-tightening.

WOLF: On the stocks, I'm pretty much thinking, as John is, that they are in the trading range now. I think this is as good as it gets in this period, because the economy has improved and it already has helped the real sales growth for the industry. I think what occurred recently was that Kroger in particular experimented with sharper pricing and it didn't really work because it didn't bring up customer counts. Kroger does have the best sales in the industry among the "big three," so it's worked to some extent, but I don't think it really impacted the customer counts, and I think they've sort of backed off from more price investment.

We're at a point now where the industry is a little less price competitive. One or two years ago, there were a lot of major price wars around the country, but I think there are less of them today. It's obviously not uncompetitive, but I think we've peaked the most competitive price environment. And last year I posed the question of whether gross margins would go up or not, and it turned out that they didn't. They certainly didn't if you include Southern California, and without it, who knows? But you can see now, if you believe the companies as they strip out what they say they've invested in Southern California, that gross margins have pretty much flattened out. So I think we're at a point, with Kroger backing off somewhat from trying to get customers in the door by being very promotional and increasing customer count, the pricing environment in the industry has gotten a little better.

What that means for the stocks is, you're going to have better nominal same-store sales, but because of inflation, there's a lag and they've continued to pass through the price increases, so you're going to have what's going to look like a stabilizing gross margin but you're going to have the issues that Mark brought up -- that cost structure is still tough for the industry and real growth is not going to be good enough to leverage it, so you're going to have a picture that looks less bad, and people will trade around that, frankly. The relative price-earnings ratio of the industry has expanded because the industry has reached an inflection point where things have gotten less bad. But in simplistic terms, I don't believe things are actually going to get good. I think things are going to get less bad, but I just don't see them getting good to the point where you say, "Hey, this is an investable industry with sustainable earnings growth."

GIBLEN: You don't have to speculate into the future to see what will happen. In a way, the future is the present in the form of Pathmark. Pathmark is well-managed and operates in a very controlled, competitive environment without supercenters or other alternative formats and it is a co-market-share leader, and it should be doing great. But what has happened is, it's had disappointing results all year and had to bring estimates down because, although it's making progress on same-store sales, that's been completely negated by the cost of labor and benefits. Pathmark has done the labor buyouts, and it's done all the things it can to address it, yet to no avail.

HUSSON: But its same-store sales have done great.

GIBLEN: They've gone from negative 1% to positive 1.5%. But again, to no benefit on the bottom line, no earnings growth.

HUSSON: And that's in an environment where you haven't had supercenters. But that's interesting, and I think when you see the margin pressure in that market and the comp-store sales going down in that market, with the lack of alternative formats, it's probably much the same, if not worse, on the gross-margin side. The retailers have been castigated for their performance against alternative formats, but I think it's just a function of cycles. When sales go soft and comp sales go soft, belts get tightened, inflation disappears and retailers think they're the only ones promoting like crazy, with the result that gross margins go down, everybody else promotes like crazy and gross margins go down some more, though not enough to make a big difference for consumers or big changes in the way they shop. Then things get less worse, and the retailers think, "Oh, well I must be doing something right, maybe I'll just ease off the pedal a little bit," and then gross margin gets a little better, shrinkage gets a little better, gross margin goes up again, and the consumer buys more. But what's really happened is, you've gotten less price competitive and the comps are improving, but it's just a cycle.

All we've been talking about for the last three years is massive structural shifts, and while it's true there have been some structural shifts, to say it's all Wal Mart is just a massive gross over-simplification, particularly when two-thirds of Wal-Mart stores are in small-town America. So yes, Wal-Mart did pick up all these dollars last year, but they didn't pick them up in markets where these retailers were operating.

SN: Let's hear from the non-equity analysts on this subject.

CANNELLA: We have a neutral weighting on the supermarket sector in both our high-yield and our high-grade businesses. Among high-grade companies, the bond market has a love affair with Kroger, which in our opinion is the most stable of the companies from a credit viewpoint. The bond market values Kroger's pre-eminent position in more markets than any of its competitors, and it also values Kroger's carefully articulated financial policy, with one-third of its cash dedicated to debt reduction and two-thirds to share repurchase. By contrast, Albertsons' financial policy is much less transparent, and Safeway's financial policy seems to err toward higher debt levels. Thus, in the bond market, where the credit spreads of supermarkets have been relatively stable vs. the [general] market since the end of the strike, Kroger currently trades best, with Albertsons and Safeway not far behind. We do not currently find a lot of value in these relationships. More interesting plays may be found in the high-yield market. Although Ahold continues to prove itself, we highly recommend Delhaize, which we believe has the potential to be upgraded to investment grade over the next few years.

HUNT: We have the industry rated an underweight. The sector always trades rich, in my opinion. For the roughly 18 companies we track, we are forecasting that cash flow is going to drop in the 5% to 7% range for the year, and the credit stats are going to deteriorate for the industry despite reduced capital spending and a focus on debt reduction. With credit stats deteriorating for the whole sector and the sector trading rich, we don't see a lot of upside to the bonds in the context of a competitive environment. There are some selective names that we think are interesting due to individual credit stories improving, such as Delhaize America; Nash Finch, which we believe may refinance in the next few months; and Ingles Markets, which has deleveraged nicely over the last three quarters.

HUSSON: What's Ingles' story?

HUNT: Ingles overlaps more than 50% with Wal-Mart, and the company's two biggest competitors after Wal-Mart are Bi-Lo and Winn-Dixie, which has had some operating issues of its own. Ingles has also introduced a savings card, changed management and focused merchandising on higher-margin fresh categories. In the most recent period, its same-store sales were up 6.5% and EBITDA increased 30%. They're going to take leverage down more than a full crank this year, so it's a nice accretion of entity value. There are some [other] healthy operating stories in the market, including Roundy's, which has performed very well since its original issuance in June 2002.

ELECTION IMPACT

SN: What impact will the upcoming presidential election have on the industry?

GIBLEN: Looking at the broad stock market, it's hard to tell. The initial conventional wisdom was that Kerry was bad for the market, but now the possibility that he could win has been pretty much discounted by the market, so it doesn't matter anymore. It doesn't matter how many polls show him gaining on Bush. -- the market doesn't react anymore. On actual issues, Kerry is more inclined toward minimum wage increases, which is bad for the industry.

WOLF: Sometimes a switch in administrations can affect the Federal Trade Commission, which could affect supermarkets. I think generally the Bush administration has loosened up a little bit. I think the FTC has challenged some things, and it hasn't been completely distanced from it, but I think it has loosened up a little more than it did during the Clinton administration.