CONSTRUCTION DELAYS

Mark Hamstra

The traditional supermarket industry is recycling itself.

Supermarket companies are shifting their investments away from new-store openings and into remodels, and store-count growth among the largest traditional food retailers is increasingly comprised of acquisitions of existing stores rather than the construction of ground-up sites. Meanwhile, nontraditional operators are continuing to build new stores at a dizzying pace.

In 2004, for the first time in at least five years, Pleasanton, Calif.-based Safeway closed more stores than it opened. That fact reflects a broader trend in food retailing: Many of the major supermarket operators recognize that much of the U.S. market is over-stored and that investing in new stores simply does not earn enough of a payback.

"There's been a flattening out of the top line, and a flattening of [cash flow], and probably a flattening out of the return on invested capital that comes from the new stores," said Jonathan Ziegler, analyst, J.M. Dutton & Associates, El Dorado Hills, Calif.

A survey of the industry released earlier this month by Food Marketing Institute, Washington, revealed that capital expenditures have declined steadily during the past several years, from 2.99% of sales in the 12-month span through the first half of 2001 to 2.45% of sales in the 12-month period through the first half of last year. The survey found that supermarket companies' return on assets -- a measure of the performance of their stores -- declined from 3.78% to 3.2% during that same time period.

Ziegler and other analysts said they believe the three largest traditional operators -- Kroger, Safeway and Albertsons -- may have increased the threshold for performance that new stores must be projected to attain before construction can begin. As Wal-Mart Stores, Bentonville, Ark., continues to open hundreds of new supercenters every year, the projections for those new traditional supermarkets have become more and more gloomy.

A recent study by Willard Bishop Consulting, Barrington, Ill., forecast that the food retailing market share for traditional supermarket operators would decline to less than 50% by 2008, down from about 56.3% in 2003. The bulk of that market-share growth is expected to come from nontraditional supermarket operators, especially Wal-Mart.

"There are fewer opportunities to open new stores without confronting Wal-Mart," Ziegler said. "You had more virgin territory five years ago than you have now because of Wal-Mart's expansion. When you pencil out a new project, you'd better have a firm estimate of what Wal-Mart's going to take from that market."

Better Returns on Remodels

With new stores costing up to $10 million to build and often taking several years to get through local planning boards, supermarket companies are finding that they may get more bang for their buck from remodels and relocations of existing stores, while at the same time selectively closing stores where they feel there is little hope of ever reaching an acceptable return.

"It's hard to justify the projections on which new stores are based when they are losing market share," said Andrew Wolf, analyst, BB&T Capital Markets, Richmond, Va. "You've got to fix what you've got before you start adding even more."

Safeway in particular has cut back on new-store development as it focuses on its new "lifestyle" format, which involves a complete revamp of the produce department, an expanded natural and organics selection, and an increased emphasis on prepared foods.

At the end of fiscal 2004, Safeway had fitted 142 stores with the new look, or 8% of its store base. By the end of the current fiscal year, the company said it expects to have converted 450 stores to the format. All new and remodeled stores feature the new design. (SN will examine the returns on investment in this and various industry remodeling efforts in an upcoming issue.)

Safeway, which over the past five years has opened 318 new or replacement stores, in that time has shuttered 214, for a net gain of 104 units. Last year, however, the company opened only 33 new and replacement stores and shuttered 49, for a net decline of 16 locations.

In 2005, Safeway said it expects to spend approximately $1.4 billion in capital expenditures, open approximately 30 to 35 new stores and complete approximately 275 to 285 remodels. The company did not disclose how many stores it planned to close.

Albertsons, Boise, Idaho, and Kroger, Cincinnati, also have cut back on new-store construction in favor of remodeling, relocation and the acquisition of existing stores.

In a filing with the Securities and Exchange Commission earlier this month, Kroger said it projected that it would spend between $1.6 billion and $1.8 billion on cap-ex in 2005, down from $2 billion last year and $1.9 billion in each of the two preceding years.

"Most amounts were used to construct new stores," Kroger said in the filing.

By contrast, in describing its spending plans for 2005, Kroger said the company would focus on "remodels, merchandising and productivity improvements."

Last year, the company opened 44 new stores and relocated 14, while closing another 44 stores, including 19 that had been relocated.

Growth Through Acquisitions

The reduction in cap-ex may also be a reflection of Kroger's strategy to make fill-in acquisitions of existing stores. Kroger has acquired more than 30 individual stores or small groups of stores in the past two years in various markets where it has a strong presence.

Albertsons, too, has grown through the acquisition of existing real estate, and has moved toward market segmentation. The company said its purchase of Bristol Farms last year could provide a vehicle to introduce to more upscale markets, while its new Extreme Inc. division rolls out the Super Saver banner to serve lower-income consumers.

Albertsons had projected capital expenditures of $1.6 billion in 2004, but instead spent only about $1.3 billion. For the current year, capital expenditures are projected to be between $1.3 billion and $1.4 billion.

In 2005, "Cap-ex will be weighted toward high-return remodels and technology projects, with less capital used for new stores," Larry Johnston, chairman and chief executive officer, Albertsons, said in the company's fourth-quarter earnings conference call with analysts.

Analysts said the shift toward remodels makes sense because, among other reasons, they generate quicker sales improvements at lower investment levels.

"I think remodels generate the best returns, mainly because they cost less, and also because they have an immediate clientele, and you can probably win more customers from competitors," said Ziegler. "A new store takes longer to reach break-even. I think when companies are deciding where to invest their capital, remodels come out ahead of a new store."

Chuck Cerankosky, analyst, KeyBanc Capital Markets, Cleveland, said new-store development will vary by market and by individual company, as a reflection of each company's overall strategy.

"I think we're reaching a point here where cap-ex is going to reflect a particular company's perception of where it can grow or how fast it can grow," he said.

Kroger, for example, has been building upon its strengths by acquiring new stores in markets where it already has a dominant presence, as exemplified by its purchase of several Winn-Dixie-owned Thriftway stores in the Cincinnati market last year. It is also segmenting its strongest markets by converting some stores to its Fresh Fare format to serve more upscale consumers and rolling out its Food4Less banner to reach consumers at the opposite end of the income spectrum.

"Kroger is clearly looking at a number of formats in any market where they have a dominant position," said Cerankosky. "They are very adamant about maintaining a critical mass. They want to maintain mass but segment the market."

Although new-store openings have declined to a trickle, the decision to build could be influenced by the overall market conditions.

"If you are in a market where the population is exploding, like Las Vegas, that would be a market where it would be silly not to build new stores," said Ziegler.

Delhaize Boosts Cap-Ex

Among traditional supermarket operators who are increasing their capital expenditures in 2005, Delhaize Group, the Brussels, Belgium-based parent of Food Lion, Kash N' Karry and Hannaford Bros., said it planned to spend about $550 million on cap-ex in its U.S. operations. That includes the ongoing conversion of its 100-store Kash N' Karry chain to Sweetbay Supermarkets and the opening of an unspecified number of new Food Lion and Hannaford Bros. stores.

Total cap-ex for both the U.S. and Europe is projected to be about $780 million. Last year, Delhaize spent about $637 million in total, up from about $583 million the prior year.

Some of the smaller, privately owned operators like Wegmans Food Markets, Rochester, N.Y., and H.E. Butt Grocery, San Antonio, may also be increasing their capital expenditures for new-store development, analysts said.

One of the nation's fastest-growing chains, Publix Super Markets, Lakeland, Fla., said in a filing with the SEC that its cap-ex has actually declined in recent years. The company spent $403.4 million on cap-ex in 2004, and it plans to spend about $400 million in 2005, with plans to open 45 new stores.

Capital expenditures in the preceding four years have ranged from $558 million to $656 million, and the company has added about 50 to 60 net new stores per year. Analysts said they expect Publix to continue to roll out new stores at a fairly rapid pace, however, despite the decline in capital expenditures.

Nontraditional Growth

Most of the growth in the retail food industry, however, is projected to come from the nontraditional players like supercenter operator Wal-Mart, limited-assortment segment leader Save-A-Lot and natural foods specialist Whole Foods.

Wal-Mart was expected to spend about $11.5 billion on cap-ex in the year that ended Jan. 31, and based on its projections for new-store growth in the current year, it was expected to spend at least that much again in the current year.

The company last year said it planned to open about 240 to 250 new supercenters in the United States in the fiscal year that began Feb. 1. About 160 of those will be relocations or expansions of existing discount stores. Another 25 to 30 Neighborhood Markets are planned, plus 30 to 40 Sam's Clubs.

Combined with plans for international growth, the company said it expects an increase of 55 million square feet of new retail space, an 8% increase over the 655 million square feet the company had at the end of its most recent fiscal year in January.

Minneapolis-based Supervalu and its licensees were expected to open more than 100 Save-A-Lot stores in fiscal 2005, which ended Feb. 25, and the company said in recent conference calls that even more stores were in the pipeline for the current fiscal year.

Capital expenditures at Supervalu totaled $235 million through the first three quarters. Spending at the start of the year was projected at about $400 million to $425 million, including about $300 million for retail store expansion. That compares with $371.5 million in the preceding year, including about $305 million in the retail division.

A report issued last week by PlanetRetail.net, London, projected that Save-A-Lot could increase its store count to more than 2,000 locations by the year 2009.

Austin, Texas-based Whole Foods Market also is expanding as fast as it can without compromising on its execution, analysts said. In a conference call with analysts this month, John Mackey, chairman and CEO, said the 166-store chain has 58 stores in development, representing a 56% increase in square footage. He said the company would pursue 15% growth in square footage per year.

"Whole Foods is consistently reporting double-digit same-store sales growth, and that in itself justifies aggressive unit expansion," said Edward Aaron, analyst, RBS Capital Markets, Denver. "For traditional supermarkets, it's hard to justify the kind of unit growth that Whole Foods is planning, just because the economies don't make much sense."

Capital expenditures are expected to be between $300 million and $320 million in the current fiscal year, which will fund the construction of 15 to 18 new stores.

Analysts said Whole Foods' capital expenditures have been increasing both overall and on a per-store basis because the company is opening larger stores and is opening more stores in urban areas. This month, the company opened its largest store to date, an 80,000-square-foot prototype at its new headquarters building in Austin, and it also opened a three-story, 50,000-square-foot location in Manhattan's Union Square, its third site in New York City.

Scott Van Winkle, analyst, Adams Harkness, Boston, pointed out that the company also "spent big money" on a new second-floor store in Cambridge, Mass.

"If you look at their returns on invested capital in the stores, they are rising," he said. "There is an absolute return that is easy to measure on these capital expenditures, and that's what makes this concept so attractive to investors."

INVESTMENT ALLOCATIONS

Company

Fiscal Year; Capital Budget; Change; Projects

Wal-Mart Supercenters

2/1/05-1/31/06; $12B*; 4%; 80-90 new 160 expansions/relocations

2/1/04-1/31/05; $11.5B; * 202 net new

Kroger

1/30/05-1/31/06; $1.6B - $1.8B*; -15D new, 165 remodels*

2/1/04-1/29/05; $2B; 32 net new**, 135 remodels

Albertsons

1/31/05-1/31/06; $1.3B - $1.4B*; 3.8%; 25-30 new, 100 remodels*

1/30/04-1/30/05; $1.3B; 59 new, 186 remodels

Safeway

1/2/05-1/3/06; $1.3B; -$1.35B*; 3.8%; 33 new, 280 remodels

1/4/04-1/1/05; $1.3B*; 32 new, 132 remodels

*Estimate; ** Includes acquisitions, net of closings; Source: Company filings, analyst estimates