THE HIGH COST OF RETAILING

SN STAFF / Reporting by: Elliot Zwiebach / Christina Veiders / Maria Tortoreto / Jon Springer / Mark

Amid signs that the economic growth of the first half of 2006 may cool down in the second half of the year, food retailers said rising cost pressures on their businesses show no signs of abating.

In phone interviews with SN during the past two weeks, several supermarket executives cited the high cost of fuel and other expense pressures as being among their biggest challenges in the first six months of 2006, and they said costs are a primary concern as they prepare for the final six months. They also said consumers appear to be eating out less, to the benefit of supermarkets, and are increasingly interested in high-end products like organics and speciality foods.

Ric Jurgens, chairman, president and chief executive officer, Hy-Vee, Des Moines, Iowa, said his company "saw significant increases in our expense categories caused primarily by higher interest rates, rising fuel and utility costs, and the increase in prices for construction materials."

Like other operators, he said Hy-Vee has put extra effort into cutting costs. "Our decentralized system tends to encourage people at every level of our company to participate in reducing expenses wherever possible," he said.

Many retailers have implemented measures to help reduce their fuel costs for delivery, as diesel prices have risen about 20% over year-ago levels.

"We have seen substantial increases in our cost of operations," said Mike Proulx, president and chief operating officer of Bashas', Chandler, Ariz., which operates a fleet of about 300 trucks.

To help offset increased fuel costs, Bashas' has negotiated futures for fuel, and it experimented with bio-fuel combinations, which utilize additives in regular diesel to burn less oil.

"We've re-engineered our fleet over the last three or four years in terms of aerodynamic design to cut wind resistance, and we've put regulators on the trucks so drivers cannot go over or under a certain speed, to maximize fuel consumption," Proulx said. "We've also looked at adjusting the amount of air pressure in the tires to reduce resistance. We're doing these things in little bits, but they add up."

Even Stater Bros., Colton, Calif., where the average haul is only 40 miles, has been seeking to reduce fuel expenses by "consolidating our loads as much as possible and sending the trucks out at times when traffic is lightest, to save on the increased fuel that's used up driving in heavy traffic," said Jack Brown, chairman and chief executive officer.

Retailers that depend on wholesalers for their distribution also have been hit by higher fuel costs, and are seeking to maximize their truckloads and cut back deliveries.

Tom Jamieson, president and CEO, Jamieson Food Stores, Uniontown, Pa., a customer of Supervalu, Minneapolis, said his company is "looking at any way possible to consolidate trucks from Supervalu. We are looking at going from five deliveries and maximizing the truck to get it down to four deliveries."

Likewise, Richard Juro, president and CEO, No Frills Supermarkets, Omaha, Neb., a customer of Minneapolis-based Nash Finch Co., said he is also seeking to cut down on the loads it receives.

"We are trying to make sure that our trucks are full, and that we aren't getting any deliveries that we don't need," he said.

Rich Niemann Jr., CEO, Niemann Foods, Quincy, Ill., said his company is "working to become more efficient" to minimize fuel costs. "The first phase is to get our average cube up on our trailers, and additional action will be taken."

Other Costs

Several retailers noted that other expenses are also rising, such as utilities, medical insurance and construction costs.

Joseph Azzolina, president and CEO, Food Circus Super Markets, Middletown, N.J., and chairman of the Foodtown co-op, said most retailers in his area seem to be raising prices slightly to offset higher utility and fuel costs. Construction costs have also gone up, which some retailers attributed to high demand caused by the rebuilding efforts along the Gulf of Mexico in the wake of last year's hurricanes. China's booming economy may also be straining building-material supplies, Azzolina said.

"Those in the construction field tell me that concrete has gone up 30%-40%, and steel has gone up because China is absorbing a lot of that material," he said. "It will be harder and harder to build new stores. It's going to be tough to build from ground up, but recycling older stores will be easier."

Jamieson, who operates Shop 'n Save and Save-A-Lot stores, also said costs for building materials have been a burden.

"Construction costs are up 20%," he said. "That is an issue right now, especially as you try to build Save-A-Lots from the ground up. I am still waiting to see what happens to construction costs, and hopefully we won't have a bad hurricane season."

Jeff Reasor, president and CEO, Reasor's, Tahlequah, Okla., said he is looking to fill in some of the area around his 13-store chain, and expects construction costs to be up as much as 30% over what they were a year or two ago.

Neil Golub, CEO, Price Chopper Supermarkets, Schenectady, N.Y., said his company has opened five stores in the past several weeks, despite the higher costs for building materials.

"Since all the storms last year, construction costs have gone up about 10%-20%, depending on the area," he said. "That has had a significant effect on stores you already planned. But if you want to do it, you have to find a way."

He also agreed that retailers are feeling pressure from increased product costs. "Anything with fuel, oil or petroleum-based materials will get built into the cost of all packaging materials," he said. "You'll see that over a longer period of time as manufacturers adjust, and as we adjust with our private label to the cost of packaging. Fuel for trucks has increased and it is an increase that we absorb."

At least one operator said he is nearing the end of his rope, however.

"What we're worried about in New York City is that our expenses keep rising - whether it's energy or occupancy costs or labor contracts," said John Catsimatidis, chairman, Red Apple Group, parent of the Gristedes chain. "The question becomes, at what point do supermarkets become uneconomic to operate? There's a possibility we may do some things with the real estate, because our real estate values are probably 300% of the enterprise value of Gristedes. We love the food business, but we're businesspeople too."

Pressure on Consumers

Some retailers see a silver lining in the rising cost of gas prices, as consumers may be cutting back on restaurant dining and making fewer excursions to supercenters.

At Stater Bros., Brown said he is seeking to turn consumers' concerns over high gas prices to his company's advantage. Stater plans to run ads promoting vacations close to home or in the backyard "and feature ad items people can use for barbecues or dinners at home to save time and gas money."

Jamieson said his company launched two fuel rewards programs with Sunoco and Go-Mart to offer consumers discounts at local gas stations in exchange for buying groceries. The company is keeping an eye on Tops Markets, Buffalo, N.Y., which he said is launching a fuel rewards program, and Giant Eagle, Pittsburgh, which Jamieson said has the "best fuel rewards program in the country."

Reasor's also plans to get into the fuel rewards business - it recently started building a fuel center at a newly constructed store in Catossa, Okla., that it hopes to leverage as a marketing vehicle to tie in with grocery sales.

Supermarkets also seem to be realizing some benefits as consumers shift their shopping patterns to adapt to higher prices at the pump.

"We're seeing same-store sales up because customers are buying more judiciously, with fewer trips and larger orders," said Proulx of

Bashas'. "It also seems like they're making fewer trips to restaurants or fast-food places, and there appears to be a move toward more food consumption at home."

Mark Oerum, a partner in HOWS Markets, a four-store group based in Pasadena, Calif., said his company's sales have benefited from consumers' reactions to higher gas prices. "It's been good for business because people are doing less driving and going out less, and we see a direct correlation between that and our sales," he explained.

Jamieson said he has noticed that some stores his company operates in one-store towns have seen sales growth recently, "so I am thinking that people may not be traveling to larger-format stores -like Wal-Mart and may be staying in town more. We think they may be cutting down on their mileage."

Cal Miller, president and CEO, Associated Grocers of Florida, Miami, agreed that supermarkets may be accruing sales as consumers cut back on their driving, and he noted that his company has also made an effort to reduce fuel costs for its workers.

"We just bought vans that pick employees up from the train stations, and we are promoting car pooling, all of which is working out quite well," he said.

In a recent conference call with analysts, David Dillon, chairman and CEO, Kroger Co., Cincinnati, said high gas prices "are a slight positive" for Kroger because of its convenient locations.

"It also may be - and this is speculation on my part - because our customers realize that they can prepare food at home less expensively than they can pay for it in a restaurant," he added.

Business Outlook

Supermarket executives are optimistic about their businesses in the second half, and while most said they do not predict the economy to grow at the same pace it did in the first six months of the year, neither do they expect it to experience a precipitous decline. Many said they expect sales of higher-end items like organic and speciality foods to do well despite the pressure of consumers from high gas prices.

Juro of No Frills said the economy is humming along in Nebraska, and the increasing popularity of ethanol-based fuel is only helping the corn-rich state.

"The ethanol industry will be a nice boost for all of Nebraska," he said.

He expects three to four new Wal-Mart Supercenters to open in his area in the next six months to a year, however.

"We just focus on what we do best and what Wal-Mart is not strongest in," he said. "We're looking at sprucing up our stores. We just finished one remodel, and we're looking at remodeling or replacing two others in the next year."

The company has also added fresh sushi in one store, located in an area where there are a lot of professionals, and said initial results are positive. The company may roll that program out to other stores in the future.

Several retailers said they are expanding their selection of natural and organic foods and boosting their perishables and prepared-food offerings, either as means of differentiating themselves from Wal-Mart Stores or to remain competitive with Whole Foods Market.

Brown of Stater Bros. said he expects growth to continue in perishables and health-related products, and Stater is planning to add an organic private-label line from Topco to meet those concerns. "I told our people two years ago that health issues should be a marketing point for us, and we've increased our produce offerings to more than 700 items, compared with an average of about 450 at most chains. You don't see any wide bodies at Whole Foods, and many of the people who shop there bring their kids who are learning about good health, so supermarkets like us have to adapt."

Oerum said HOWS also is seeing significant growth in perishables.

"We sell only Choice and Prime beef, and sales have been outstanding, even though beef prices are up," he said. "And produce keeps growing and we keep buying bigger and better-quality items, which has prompted us to source some products beyond Southern California."

Golub said growth areas for Price Chopper also are expected to include natural and organic foods. "They have a growing marketplace," he said. "It is significant enough that you have to keep increasing your assortment."

Reasor said his company has seen strong gains in same-store sales in the first half, which he attributed in part to a sales decline at the Albertsons stores with which he competes and in part to improvements in his own company's execution. He expected sales gains to continue through the second half of the year.

Like other operators interviewed by SN, he has seen increasing demand for higher-end products like organics and specialty foods, as well as value-added products like heat-and-eat prepared foods. The chain has a reputation for high quality and value pricing, he said, noting that it sells more Certified Angus beef per store than any other retailer in the country. Now the company is looking at adding organic and naturally raised beef as well.

Due to the expected impact of four new Wal-Mart Supercenters that are slated to open in his trading area in the Pittsburgh region, Jamieson of Shop 'n Save will attempt to recoup sales lost from core categories by focusing on others. His stores have added four pet and four party sections, he said, consisting of four gondolas and occupying about 2,000-3,000 square feet.

"With Wal-Mart coming in, we are looking at any alternative dollars and whatever we can capture in additional rings at the register," he said. "We hope to trade off on some of sales we may lose on traditional grocery items." He added that Wal-Mart Supercenters affect about half of his stores.

Miller of AG of Florida said the company's new distribution facility in the Bahamas should boost that company's general merchandise and HBC offerings in the second half.

Brown of Stater Bros. said the company has been keeping a close eye on the Albertsons stores in Southern California, which were part of the group acquired by Supervalu.

"We took the time to visit some Supervalu operations in Indiana to be sure we're ready for a new competitor operating with an old, familiar name," he said.

He said he may be interested in buying some of the Albertsons locations, if Supervalu elects to scale back its operations in the region.

Looking ahead to the second half, "the boots will be on the ground" in terms of Supervalu operating the Albertsons stores, Brown said.

He said he's also looking at Tesco and its plans to begin opening 15,000-square-foot formats in 2007 in Southern California, "and that will be interesting to see."

John Catsimatidis chairman, Red Apple Group

Estate Tax Tops CEOs' Legislative Concerns

Congress has come close in recent weeks to reaching an agreement on the permanent repeal of the estate tax - one of several issues food retailing executives said they would like to see addressed in this year's midterm election campaigns.

Other issues that industry leaders told SN they were concerned about included the minimum wage, the high cost of gasoline and credit card interchange fees.

Last week the Senate shelved a vote on the estate tax, which is being phased out but is scheduled to return in 2011, after the House approved a compromise that would have put some limits on the tax. The levy is assessed on inherited wealth.

Joe Azzolina, president and chief executive officer, Food Circus Supermarkets, Middletown, N.J., described the estate tax as "double taxation."

"Some senators don't understand," he said. "They should eliminate it completely because we worked our tail off to develop our company. We paid our taxes off as we were doing it and we have to pay it again when we pass it to our children. That is what kills family businesses."

Richard Juro, whose family inherited No Frills Supermarkets, Omaha, Neb., when his father-in-law died last year, echoed Azzolina's sentiments.

"It's been a real problem for us," he said. "We'd like to see it changed both for us and for any family-owned companies."

Neil Golub, president and CEO of family-owned Price Chopper Supermarkets, Schenectady, N.Y., also said he would like to see the estate tax permanently repealed.

"There is a lot of negotiating going on, and hopefully it will result in some significant changes that will allow family businesses to remain healthy," he said. "We are looking forward to that if it does happen."

Retailers also said they would like to see some legislative action on credit card interchange fees.

"I think the area we have most concern about is the hidden fees that are charged to us through interchange rates by the credit card companies," said Ric Jurgens, president and CEO, Hy-Vee Supermarkets, West Des Moines, Iowa. "It seems as though the ratcheting up of rates continues with virtually no end in sight, and we are probably going to need governmental intervention to bring some sense to the entire process."