INDUSTRY STOCKS GET BACK ON TRACK IN FIRST HALF

Mark Hamstra

Some investors apparently think there's hope for the supermarket industry, despite the seemingly endless onslaught of nontraditional competition and the difficult balancing act of growing sales and profits.

The first half of 2005 saw most food-retailing stocks gain some ground, driven by a range of factors. A few -- like Pathmark, A&P and Spartan Stores -- saw huge increases amid the promise of change brought on by outside investment or asset sales.

The nation's two largest natural/organics retailers also surged in the first six months of 2005, as investors viewed them as a format that was strongly differentiated from price-oriented competitors selling food. The same reasoning may have been behind the gains recorded by Safeway and Kroger in the first half -- both of which notched double-digit percentage increases in their stock price -- as their strategic shifts drove them to post results that beat analysts' expectations.

Altogether nearly half -- 14 out of the 30 total -- of the stocks tracked by SN notched double-digit gains in the first six months of 2005, a time when the market overall stubbornly refused to budge.

Not all the supermarket stocks were along for the ride, however. Eleven food retailers and wholesalers saw their stock price fall, including Wal-Mart Stores, with a decline of 9.65%, which helped drag the SN Composite Index below break-even level, at -3.58%.

That was still ahead of the Dow Jones Index, which fell 4.24% in that period, but it lagged behind the Standard & Poor's 500, which slid only 0.89%.

Six stocks tracked by SN fell in double digits, including some of those that turned in weaker-than-expected financial performances in the first half, like Delhaize and Smart & Final. Albertsons also was among the losers, with a decline of 12.93% after the company posted a disappointing first quarter and investors failed to see a clear plan for distinguishing the company's stores, analysts told SN.

"It was the typical rich tapestry of supermarket results -- they are rarely all good or all bad," said Mark Husson, a New York-based analyst with HSBC Securities, London. "What we really need is for consumer confidence to improve. One of the big problems of this whole expansion is that job growth has been anemic for the past four years, and jobs have been a huge part of the consumer-confidence numbers. Consumers are still not sure about outsourcing and downsizing, and it's really been a plague on consumer confidence."

The stock market overall was "directionless" in the first half, said Jonathan Ziegler, an analyst with J.M. Dutton & Associates, El Dorado Hills, Calif.

"There's nothing to seize on to get you excited," he said. "You have high interest rates, high energy prices, a soft European economy, a slowing U.S. economy, and when you put it all together, there's no reason to get excited about U.S. stocks."

Perry Caicco, an analyst with CIBC World Markets, Toronto, said he thinks the run-up of Kmart's stock and its subsequent merger with Sears may have caused investors to take another look at the retail sector, including food retailers.

"People were talking about the underlying real-estate values of these companies," he said. "Institutional investors were looking at these companies and saying, 'Could you privatize these companies and realize profits out of them that way? What's the [leveraged buyout] math?"' he said. "There's a lot of that talk whenever you get assets that are perceived as distressed, and it certainly hasn't hurt the stocks."

Varied Strategies

The three top gainers for the year all benefited from the promise of capital infusions, as A&P, the industry's top-growth stock at midyear, put its profitable Canadian division up for sale; Spartan Stores, the No. 2 gainer, was driven up by an investor who tried to pressure the company to sell itself; and Pathmark Stores, which absorbed an investment from Yucaipa Cos., the Los Angeles-based investment firm that previously strung together a series of acquisitions that became Kroger's West Coast operations.

Perhaps the most significant gains of the first half, however, were recorded by Kroger and Safeway, which investors seemed to reward for making progress on their well-defined strategies to sharpen their competitive edge.

Kroger, which saw its stock rise about 11%, to close on June 30 at $19.03, last month said its strategy of cutting costs, driving sales through low prices while maintaining its service levels helped drive a 12% increase in first-quarter profits. The stock performance followed a decline of 5.24% in 2004. Safeway, meanwhile, also surprised analysts and said its remodeling program was driving sales gains in the first quarter. Its stock was up 15.37%, to $22.59, in the first half, more than reversing a decline of 9.9% in 2004.

"Both Kroger and Safeway have found the beginnings of a formula that's working to differentiate themselves from the competition," said Husson of HSBC. "They are very different strategies, but each one is equally valid."

Caicco said he thinks the market may be exhibiting some irrational exuberance when it comes to industry stocks.

"With both Safeway and with Albertsons, certainly there was no performance in the first quarter that led anyone to believe that their earnings estimates would rise for the year," he said. "Kroger obviously had a little-better-than-expected first quarter, and it's probably the first time in a long time we've seen a company actually exceed its earnings estimates. But I think in many ways investors are rooting for the stocks -- it sounds crazy, but they are looking for small positives.

"Safeway's lifestyle stores are obviously a big hit, so I think people are looking at Safeway and saying, 'There's a company that's generally headed in the right direction.' You can't strategically say that it's wrong. The question is, what is it worth?"

He also noted that although Kroger had strong results in the first quarter, it is "a company whose results can be volatile."

"The right answer is to wait and see," he added.

Ziegler expressed similar views, saying there were some reasons for both caution and optimism.

"Yes, Kroger had some pretty good numbers, but I don't think the supermarkets are out of the woods yet," he said. "But, I think there are some very good opportunities for supermarkets to rationalize their businesses. One of the things I'm excited about, and I've been advocating this for many years, is that supermarket companies have got to move toward an everyday-low-price strategy and move away from being promotional, and we're starting to see that. That's very encouraging to me."

Regional Powers

In addition to A&P, Spartan and Pathmark, several other regional players also performed well in the first half of 2005.

Among them were Village Super Markets, the 23-unit ShopRite operator in New Jersey and Pennsylvania that saw its stock rise 46.2%, on top of a 20% rise in 2004; Ruddick Corp., Parent of the Harris Teeter chain, which had a gain of nearly 19% in the first six months of 2005 after gaining more than 21% last year; and Ingles, which was up 12.5% through June 30 after surging 20.64% a year ago.

As previously reported by SN in an analysis of profitability in the June 13 issue, many of these smaller, regional players are executing well in meeting their local customer base's needs.

Another company that posted double-digit gains in the first half was Sobeys, Stellarton, Nova Scotia, which rose about 18%, to $40.72, after a 3.6% rise last year. According to Caicco, Sobeys' stock performance was attributable at least in part to the belief by investors that A&P's Canadian operations would be a good fit for the company.

"Sobeys, I think, is rising on the thought that they are in strong position to acquire those assets in Canada, and I think that's appropriate," he said. "I think the company is very well-positioned for that, plus I think the company has started to stabilize its core business a little better than it has in the past. They've put up some decent results recently -- certainly their sales results have been very strong."

Caicco said he didn't think Sobeys would have trouble financing such a transaction, which he said would bring "an immense amount of synergies." A&P's 235-store Canadian operations, which include a successful Food Basics franchise operation, are expected to sell for between $750 million and $1.3 billion.

A&P has not yet disclosed the names of any bidders for the division, which operates primarily in Ontario. Metro-Richelieu is seen as another potential buyer, although Caicco said he doesn't expect that Montreal-based company to acquire a significant portion of A&P's stores.

Gainers

Following are the top five industry stocks through the first half of 2005, in terms of percentage gains.

- A&P, Montvale, N.J., up 192.35% to $29.06, following a gain of 22.02% in 2004.

After months of speculation, A&P finally disclosed in May that it would seek to divest its Canadian division and funnel the proceeds toward refurbishing its core business in the Northeast. It also said it would exit the Farmer Jack business in Michigan and outsource its distribution to C&S Wholesale Grocers, Keene, N.H., which also supplies A&P rival Pathmark.

"You have to give A&P credit for doing all the right things," said Caicco of CIBC. "They made three extremely tough decisions -- putting the Canadian division up for sale, getting out of Michigan and getting out of distribution -- all of which will have a material effect on the financial strength of that company."

- Spartan Stores, Grand Rapids, Mich., up 127.44% to $14.67, after a gain of 32.8% in 2004.

The regional wholesaler benefited from an investment by New York-based Loeb Partners, which began acquiring the stock late last year and pushed Spartan to put itself up for sale, saying the company was undervalued. Loeb has since been selling its stake. Loeb also said it would propose two nominees for Spartan's board of directors, but it later withdrew those would-be nominations.

Spartan laid the groundwork for the Loeb investment with its performance improvement under the management of Craig Sturken, chairman, president and chief executive officer, who revamped the company's operations and led Spartan to post net income of $18.8 million on sales of $2.04 billion in the most recent fiscal year, vs. a loss of $6.7 million on sales of $2.05 billion in the preceding year.

"I think Sturken's good work in getting the firm righted operationally also had something to do with the share price," said Peter Lewis, director of research at Towle & Co., St. Louis, one of Spartan's largest investors. He noted that although Loeb placed a $15 price target on the shares and has been reducing its position, the shares seem to be holding their ground at close to that number.

"It's not all external forces," he said. "You have to give management some credit."

- Pathmark Stores, Carteret, N.J., up 53.42%, to $8.76, after a loss of 23.55% last year.

"The company put themselves up for auction last year when their numbers turned fairly soft, and that's the reason why they probably underperformed last year, because their performance was probably worse than most operators out there," Ziegler said. "Then there was a long period where they had their banker out there looking for bids, and then Yucaipa emerged as the winner, and that has affected the stock."

The $150 million investment by Yucaipa Cos. helped drive the stock price for several reasons, Ziegler explained, including Yucaipa's track record in the industry.

"They are very sophisticated, so I think the institutional investors said, 'Well, if this company is buying in, then there must be something there that we don't see."

Ziegler said investors also may be intrigued by how Yucaipa and its lead investor, Ron Burkle, have said they want to leverage the Pathmark investment to consolidate the food retail business in the Northeast. Ziegler said the fact that Pathmark and A&P use the same distributor leaves the door open for some type of consolidation between the two chains.

"With A&P's presence in New York City and Connecticut, there's definitely grounds for some discussions to go on there," he said.

- Village Super Markets, Springfield, N.J., up 46.2%, to $53.80, after a gain of 20.38% last year.

The Shop Rite operator has seen steady sales gains from remodeled and replacement stores and from aggressive promotions.

Through the first three quarters of the company's current fiscal year, sales were up 4.6%, to $730.5 million, and same-store sales increased 4.2%.

- Wild Oats, Boulder, Colo., up 33.29%, to $11.45, following a drop of 31.86% in 2004.

In May the natural-foods chain upped its projected comparable-store sales to between 3% and 4% for the year, from previous projections of 2% to 3% gains. It also said gross margins are projected to improve to 30% of sales by the end of the year, up from 28.9% in the first quarter.

"We are starting to see some improvement, albeit from relatively low levels," said Edward Aaron, an analyst at RBC Dain Rauscher, Denver, at the time of the earnings release.

Losers

Following are the bottom five industry stocks through the first half of 2005, in terms of percentage gains.

- Delhaize Group, Brussels, Belgium, down 21.64%, to $59.50, after a gain of 48.61% last year.

The company disappointed investors in May with first-quarter results that were weaker than expected, which the Food Lion operator attributed to aggressive price competition in the Southeast. It also said its comparable-store sales growth outlook for the year for Delhaize America would be barely positive, in the range of 0.5% to 1%.

The company also said its investments in the Victory Supermarkets chain in New England and the Sweetbay banner in Florida are not yet generating enough benefits to pay for their costs.

"The reason for the stock's performance is twofold," said Patrick Roquas, an analyst with Rabobank, Amsterdam, Netherlands. "Firstly, [fourth-quarter 2004 and first-quarter 2005] results in the U.S. substantially lagged expectations, both in terms of sales and margins. Combined with a strong share performance during 2004, investors took profit."

He said the company's Belgian operations saw gross-margin pressure in last year's fourth quarter due to high shrink levels, price investments and higher labor costs.

Jerome Samuel, an analyst with Ixis Securities, Paris, noted that Delhaize's revised earnings guidance for 2005 indicates that the company expects little or no earnings growth this year.

"[First-quarter results] were a big letdown, reflecting dull trading conditions and fiercer competition in the U.S.," he said. "As a result, management has taken on a much more cautious tone."

- Arden Group, Los Angeles, down 18.77%, to $79.28, after gains of 27.48% last year.

Arden's stock also seems to be the victim of profit-takers after the company's run-up last year, when sales benefited from the labor dispute in Southern California.

In the first quarter of this year, ending April 2, which compared unfavorably with the strike-impacted first quarter of a year ago, same-store sales fell 21.3%, the company said. Total sales fell by the same amount, to $116 million, and net income slid 35.9%, to $5.5 million. Arden operates 18 Gelson's Markets stores in Southern California.

- Smart & Final, Vernon, Calif., down 15.11%, to $12.25, after gains of 42.76% in 2004.

Like Arden, Smart & Final enjoyed a surge in sales and profits in 2004 thanks to the 20-week strike-lockout at the major traditional supermarket chains in Southern California. That led to difficult comparisons this year, as the company reported a decline in net income for the first quarter, ending March 27, of 48.4%, to $3.2 million, on a sales increase of 1%, to $427.6 million. Comparable-store sales were also up 1%.

"They had a disappointing first quarter," Ziegler said. "It was a horrible comparison. I don't think there's a problem. I think the company's being well-led, and I think they've got a great role in the market."

He said he thinks Smart & Final's new-store-opening plan could benefit the company's results going forward.

- Albertsons, Boise, Idaho, down 12.93%, to $20.68, after a gain of 5.43% in 2004.

"Albertsons doesn't seem to have as clearly defined a strategy [as Kroger and Safeway]," said Husson of HSBC. "At the moment it is to try to cut some costs and get out of the markets it doesn't make any sense to be in, but that's not a strategy, that's a collection of tactics."

The company posted strong net-income growth in the first quarter, ending May 5, when it said it chose not to invest in price to drive sales. That led to what analysts said were weak underlying comparable-store sales increases, excluding gasoline and the recovery from the labor dispute in Southern California.

- Fresh Brands, Sheboygan, Wis., down 12.58%, to $6.75, after a decline of 29.55% in 2004.

Despite reversing a loss in year-ago first quarter by posting a profit in the 16-week period that ended April 23 of this year, Fresh Brands said it continued to face sales pressure from competitors.

Wholesale sales were down about 4.2%, to $140.7 million, while corporate retail sales fell 7.5%, to $79.7 million. Same-store sales were up 0.9% in the period.

The Big Three

Albertsons; Safeway; Kroger

(see chart)

Stock prices at the close of trading on the dates indicated.

Source: www.nasdaq.com

Half-Year Stock Results

Retailers/Wholesalers

Close 1/3/2005; Close 6/30/2005; Amount Change; Percent Change

A&P: 9.94; 29.06; 19.12; 192.35

Ahold (ADR): 8.13; 8.18; 0.05; 0.62

Albertsons: 23.75; 20.68; -3.07; -12.93

Arden Group: 97.60; 79.28; -18.32; -18.77

BJ's Wholesale Club: 28.50; 32.49; 3.99; 14.00

Costco Cos.: 47.90; 44.73; -3.17; -6.62

Delhaize (ADR): 75.935; 9.50; -16.43; -21.64

Foodarama: 39.75; 35.75; -4.00; -10.06

Fresh Brands: 7.72; 6.75; -0.97; -12.58

Ingles: 12.24; 13.77; 1.53; 12.50

Kroger: 17.15; 19.03; 1.88; 10.96

Loblaw Cos.: 71.06; 72.31; 1.25; 1.76

Marsh: 12.99; 14.19; 1.20; 9.24

Metro-Richelieu: 24.15; 26.67; 2.52; 10.43

Nash Finch: 37.23; 36.74; -0.49; -1.32

North West Co.: 28.89; 33.25; 4.36; 15.09

Pathmark: 5.71; 8.76; 3.05; 53.42

Ruddick: 21.48; 25.53; 4.05; 18.85

Safeway: 19.58; 22.59; 3.01; 15.37

Smart & Final: 14.43; 12.25; -2.18; -15.11

Sobeys: 34.50; 40.72; 6.22; 18.03

Spartan Stores: 6.45; 14.67; 8.22; 127.44

Supervalu: 33.65; 32.61; -1.04; -3.09

Target: 51.80; 54.41; 2.61; 5.04

United Natural Foods: 30.46; 30.37; -0.09; -0.30

Village: 36.80; 53.80; 17.00; 46.20

Wal-Mart: 53.35; 48.20; -5.15; -9.65

Weis Markets: 38.65; 38.79; 0.14; 0.36

Whole Foods: 93.71; 118.21; 24.50; 26.14

Wild Oats: 8.59; 11.45; 2.86; 33.29

INDICES

Dow Jones: 10729.43; 10274.97; -454.46; -4.24

S&P: 1202.08; 1191.33; -10.75; -0.89

SN Composite: 1997.41; 1925.94; -71.47; -3.58

Retailers: 1809.71; 1745.58; -64.12; -3.54

Wholesalers: 613.43; 579.28; -34.15; -5.57

SOURCE: DATA NETWORK, HUNTINGTON, N.Y.

Gains & Losses

Companies listed by change in percentage

Close 1/3/2005; Close 6/30/2005; Amount Change; Percent Change

A&P: 9.94; 29.06; 19.12; 192.35

Spartan Stores: 6.45; 14.67; 8.22; 127.44

Pathmark: 5.71; 8.76; 3.05; 53.42

Village: 36.80; 53.80; 17.00; 46.20

Wild Oats: 8.59; 11.45; 2.86; 33.29

Whole Foods: 93.71; 118.21; 24.50; 26.14

Ruddick: 21.48; 25.53; 4.05; 18.85

Sobeys: 34.50; 40.72; 6.22; 18.03

Safeway: 19.58; 22.59; 3.01; 15.37

North West Co.: 28.89; 33.25; 4.36; 15.09

BJ's Wholesale Club: 28.50; 32.49; 3.99; 14.00

Ingles: 12.24; 13.77; 1.53; 12.50

Kroger: 17.15; 19.03; 1.88; 10.96

Metro-Richelieu: 24.15; 26.67; 2.52; 10.43

Marsh: 12.99; 14.19; 1.20; 9.24

Target: 51.80; 54.41; 2.61; 5.04

Loblaw Cos.: 71.06; 72.31; 1.25; 1.76

Ahold (ADR): 8.13; 8.18; 0.05; 0.62

Weis Markets: 38.65; 38.79; 0.14; 0.36

United Natural Foods: 30.46; 30.37; -0.09; -0.30

Nash Finch: 37.23; 36.74; -0.49; -1.32

Supervalu: 33.65; 32.61; -1.04; -3.09

Costco Cos.: 47.90; 44.73; -3.17; -6.62

Wal-Mart: 53.35; 48.20; -5.15; -9.65

Foodarama: 39.75; 35.75; -4.00; -10.06

Fresh Brands: 7.72; 6.75; -0.97; -12.58

Albertsons: 23.75; 20.68; -3.07; -12.93

Smart & Final: 14.43; 12.25; -2.18; -15.11

Arden Group: 97.60; 79.28; -18.32; -18.77

Delhaize (ADR): 75.93; 59.50; -16.43; -21.64

SOURCE: DATA NETWORK, HUNTINGTON, N.Y.