Challenges Ahead

ELLIOT ZWIEBACH

The short-term economic outlook for supermarket operators remains bleak, though there may be some reasons for optimism in the longer term, a panel of industry analysts said during SN's 13th annual Financial Analysts' Roundtable.

With a combination of high inflation, rising energy prices and the weak housing market hitting consumers all at once, an ongoing move to trade down seems inevitable, the panelists said during the discussion, which took place recently at SN's offices in New York.

“Unfortunately you have rising food inflation in a difficult economy, which is not good,” John Heinbockel, managing director for Goldman Sachs, New York, pointed out. “And you've got an incredible tax on the consumer from an energy standpoint.”

According to Mark Wiltamuth, executive director at Morgan Stanley, New York, “We are in a trade-down economy, [and] the 4% to 5% in food-cost inflation at retail is causing some sticker shock in the store.

“People are trading out of restaurants into grocery; out of grocery down to the clubs and discounters; and within the grocery channel we're seeing trading down into private label and from higher-priced grocers to lower-priced grocers. So there will be some winners within the group — primarily the companies that are best-positioned in private label and in pricing in general.”

Low pricing may be the key to positive results, Gary Giblen, executive vice president of Goldsmith & Harris, New York, also noted. “You absolutely have to be on the low-price side of things, [though] even that may not be enough to avoid the further problem of trade-downs out of grocery into clubs or other formats outside of the supermarket,” he said.

But most decisions on pricing strategy have already been made, Wiltamuth added. “Grocers have already gone through that big price-cutting phase, and they're a little closer to some of the discounters, but now the whole system seems to be slowing.”

Meredith Adler, managing director for Lehman Brothers, New York, said it isn't clear how much of the slowdown in the economy is a function of consumers changing retail channels and how much is due simply to people changing their shopping habits within the supermarket. “The scary thing is, we have this change in behavior, we have a fearful consumer, and yet the job market has not turned terrible.”

Carla Casella, managing director of high-yield research at JP Morgan, New York, said the job market may be showing signs of slowing as well. “This is definitely a consumer-driven slowdown, [where] there's no consensus [because] data is choppy. We are just starting to see the slowdown in jobs data, and this is likely to continue to get worse through year's end.”

What makes the current economic challenges different from previous slowdowns is the housing crisis, Giblen pointed out. “Generally, the highest priority people have is to keep their house from foreclosure, and if you're putting every cent toward the house, you will probably cut back on food,” he explained.

But the outlook is not totally bleak, the analysts noted.

“All this talk makes it sound like it's Armageddon for the grocery stores,” Wiltamuth said. “But in relative terms, [supermarkets] are still doing great compared to the rest of retail.

“Comps that are flat to slightly down [among supermarket companies] are nothing compared with what's going on with other retailers, who are seeing negative 6%, 7% or 8% in same-store sales, and double-digit declines for some.”

Heinbockel said he agreed: “On a relative basis, this sector has held up a heck of a lot better than just about any other retail sub-sector.”

Going forward, supermarkets can hope for the best because of “two important silver linings,” Heinbockel pointed out.

First, fuel and pharmacy — two top-of-mind concerns among consumers, he said — represent only small percentages of total revenue, “[but] both drive incremental customer traffic into the stores. So in theory, you can get a solid traffic boost from a modest margin investment or a fairly good promotional return-on-invested capital.”

Second, while it may be premature to think supermarkets can win back all the share they've lost to restaurants over the past 30 years, “you are getting and will continue to get some of that share moving back into the supermarket format, primarily because the economics are better,” Heinbockel said.

Giblen believes private-label sales may also offer a silver lining for supermarkets. “A vibrant private-label strategy can protect earnings because of the offset of high margins [it provides],” he explained.

In addition, because the high price of gas makes it difficult for some consumers to drive long distances to supercenters and other low-price operators, “they have to shop locally, which is good for supermarkets and other medium- or small-box players,” Giblen added.

Part One of the roundtable discussion follows:

SN: Looking back at last year's roundtable, nearly all the analysts had a fairly positive outlook on how the industry would perform. We were beginning to see some inflation, but most of the panel was pretty confident that supermarkets would be able to weather the inflation reasonably well. So the first question is, what changed in the market between then and now?

GARY GIBLEN: To paint a broad canvas, the consumer has been so badly battered that, whereas initially supermarkets benefited from trade-downs from restaurants and QSR/fast food, now the pressures are so great that the trade-down is going right through the supermarket level to dollar stores, warehouse clubs and Wal-Mart supercenters, and that has hurt supermarket sales. On top of that, inflation in commodities and food has been so great that it's gone beyond the moderate level that is favorable to supermarkets to an unfavorable degree where supermarkets are caught in the middle. They have to accept some increases from suppliers but don't feel they can fully pass them on, and that puts them into a margin squeeze.

JOHN HEINBOCKEL: I think when you look back in history, every time personal consumption expenditures have gotten hit reasonably hard, so has food consumption. And the primary reason for that, I believe, is, if you look at the typical household budget and the things you're going to spend money on, food is certainly in the top five, and it's probably one of the few things where there is some degree of flexibility. There's not much you can do about your mortgage or your car payment or maybe even education expenditures, but you certainly can do something about food spending. And so I think when you add to that the unprecedented pressures of energy costs — which could get worse this winter with home heating oil — plus food inflation and the fact that Americans have always had a low savings rate, the consumer is in bad shape. And the supermarket is not immune to that, though on a relative basis, this sector has held up a heck of a lot better than just about any other retail sub-sector.

MARK WILTAMUTH: At this point, we are in a trade-down economy. People are trading out of restaurants into grocery; people are trading out of grocery down to the clubs and the discounters; and within the grocery channel we're seeing trading down into private label and from higher-priced grocers to lower-priced grocers. So there will be some winners within the group — primarily the companies that are best-positioned in private label and in pricing in general. You have to be low-priced, and the key for investors to focus on right now is who is low-priced in this environment.

MEREDITH ADLER: I don't think we have enough data to say how much of the slowdown in sales is a function of people going to other channels and how much of it is people changing their behaviors within the store. Supervalu actually quantified it and said it's about 1% of sales — they said they lost a percentage point of sales simply from people actually changing their shopping habits within the store. And the scary thing about it is that the employment numbers are still holding up as well as they are, so we have this change in behavior, we have a fearful consumer and yet the job market has not turned terrible.

WILTAMUTH: Looking at some of the data out there, you can see the trade-down to the clubs and the discounters. The traffic numbers at some of the clubs have been up 3%, and BJ's traffic has been running up 5% to 6%, so that to me is a clear sign there's been some trading out of grocery going on.

ADLER: I didn't mean there wasn't any. You just have to remember how many clubs there are in the country vs. the number of grocery stores. So the impact is there, and the law of small numbers says the clubs could show very big improvements in sales without it having a big impact on any one supermarket. And the dollar stores have a very strong consumables sales impact as well, but again, they're not very big — maybe $1 million of sales a year.

I've also had some questions lately about what happened to put the squeeze on consumer credit. The contrarians say if people could shop at the grocery store with cash, that would provide some bottom-line profits for the supermarkets because credit is expensive. But now the question becomes, how much more food do people buy because they're using credit? I don't think it's a lot, but that's an opinion.

HEINBOCKEL: What's interesting, as we said earlier, is that when the economy first turns down, the low-income customer gets hit and begins to trade down before the middle-income customer is hit, but the further along you get, maybe [a chain like] Food Lion picks up some trading-down benefit, as that tide of pain increasingly flows into the middle class.

WILTAMUTH: We've even seen trading-down from upper-end consumers. We did a big survey of club customers, and the upper-income club customers were trading out of grocery into clubs, while lower-end customers tended to use discounters more because they didn't want to pay the club membership fees and they didn't like the fact you had to pay such a big dollar amount to exit the club store. So there's definitely some trade-down going on at the upper end also.

GIBLEN: There's also meaningful regional variability — in the Southeast, for example, where absolute income levels are among the lowest and where gas prices are a real gut issue because of the spread-out distances involved. So you're seeing considerable trade-downs to dollar stores, which typically are right in the neighborhood of the shopper. It's revealing that weekly sales in the Southeast clearly fell off as the rebate checks were received and then exhausted. We saw that recently with Wal-Mart, the dollar stores and [the discount store] Fred's. And then there were the Delhaize results, where Food Lion, which already is a low-priced supermarket, wasn't low-priced enough to staunch the poor sales trend, and the blow-up at Winn-Dixie, which had to over-promote and kill margins to keep sales positive.

In the housing-bust markets like California, Arizona and Florida, it's especially clear, as Mark said, that you absolutely have to be on the low-price side of things. And even that may not be enough to avoid the further problem of trade-downs out of grocery into clubs or other formats outside of the supermarket.

SN: How is the current slowdown different from previous downturns?

CARLA CASELLA: This is definitely a consumer-driven slowdown, whereas the most recent previous downturns have been driven by the business side of the economy. A business-driven slowdown would be more defined by layoffs, reduced capital spending and facility closures. But because this slowdown is consumer-driven, it somewhat explains why a year ago at this time we were saying things were better. Although people are worried about the consumer, there's no consensus. In a consumer-driven slowdown, data is choppy. We are just starting to see the slowdown in jobs data, and this is likely to continue to get worse through year's end.

WILTAMUTH: The last slowdown for grocers was in 2001, when I think many of them were a little out-of-bounds on price relative to the big discounters, and the slowdown in the economy really shone a light on the price disparity between the Wal-Marts of the world and the conventional grocers, so there had to be a big price adjustment. The grocers today have already gone through that big price-cutting phase, and now they're a little closer to some of the discounters, but now the whole system seems to be slowing.

CASELLA: Not everybody has made price adjustments.

ADLER: But I would also say that it's a little hard to look back at the last slowdown in the early part of this decade because we also had Wal-Mart adding a lot of capacity during that time. And anybody will tell you, if Wal-Mart adds 35 stores to a market that's fully stored already, it's going to have an impact on sales due to a combination of their lower pricing as well as market capacity. But they're not opening capacity at quite the same pace as they were.

GIBLEN: Another difference this time around, which harks back to something John said, is that there's a housing crisis occurring around this recession, so generally the highest priority people have is to keep their house from foreclosure. If you're not particularly well off and you're putting every cent toward the house, you will probably cut back on food.

ADLER: And it may be the same people who are being careful about what they're spending on food who are using their stimulus checks or whatever to go buy TVs or other electronics. Electronics clearly don't seem to be discretionary the way they used to be, but not everybody is poor if they're going out and spending $800 to $1,000 on a big-screen TV.

HEINBOCKEL: This is the first consumer slowdown like this since the early 1990s, and we haven't even seen personal consumption expenditures trough out, as they have normally done since 1990. And if you compare now to then, food inflation is accelerating, whereas in 1990 it was coming down, and I think the recession choked it off a little bit. Now it's accelerating, so unfortunately, you have rising food inflation in a difficult economy, which is not good — though if the economy was healthy, it would be a real plus. And then secondly, you've got an incredible tax on the consumer from an energy standpoint, and though it feels better today because oil has backed off the last few weeks, it's not clear where that's going to go over the long term. So you could argue that, to some extent, the consumer is in worse shape today than he was in 1990.

WILTAMUTH: And these are real pocketbook issues. When you fill up your gas tank and you see the pump go over $100, that gets your attention, and I think the 4% to 5% in food-cost inflation at retail is also causing some sticker shock in the store and driving some trading down within the store. So a lot of factors are really hitting the consumer right now.

When Will It End?

SN: Do you get a sense of how long it's going to last?

HEINBOCKEL: A lot of people say two things: First, that when housing prices bottom and stabilize, that will be good for the consumer. When is that? That's hard to tell. Second, if energy prices continue to back off. There's no question that if we went back to $80 or $90 for a barrel of oil, or below $3 a gallon at the pump, that would be very positive psychologically — and in reality — from where we've been. Get those two things better more quickly; otherwise, we will likely bounce around the bottom for a while.

CASELLA: It's unemployment, too — we're not near the peak of unemployment. The one piece of optimism here is jobs and wages, but once unemployment goes over 6% or so, that could be difficult, and it's getting close now.

ADLER: Our economist thinks the bottom in housing won't come until the end of 2009, and that may be the point at which it simply stops going down, so it may be here for a while, at that level.

GIBLEN: And there's also a school of thought, because this is all so scary, that people won't rebound back to their normal habits. For example, if someone has lost his house or knows someone who has, that's a shocking event, and that person will be more thrifty in the future. But that's an unknowable right now.

But there are some silver linings for supermarkets now if they tap into the right strategies. For example, if you have a vibrant private-label strategy, that is absolutely key. Steve Burd [Safeway chairman, president and chief executive officer] basically said Safeway's sales are continuing to go south, but it can protect its earnings because of the offset of high margins provided by private label.

ADLER: That's not the entire offset.

GIBLEN: No, it's one real offset, in addition to slashing expenses. Another factor helping some supermarkets is that they are usually within a three- to five-mile trade radius of where people live. It costs about 30 cents to drive a mile now, and if you're in the Southeast and you have an absolutely low income and long distances to travel, there are people who literally cannot afford the gas to go to the Wal-Mart supercenter 30 miles away, so they have to shop locally, which is good for supermarkets and other medium- or small-box players.

HEINBOCKEL: There are two important silver linings here for supermarkets. One, they can take an acceptable margin hit on both gasoline and pharmacy, with $4 generics, to drive incremental customer traffic into the stores, because these businesses represent relatively small percentages of total revenue and are top-of-mind with consumers today as targets for savings. So in theory, you can get a solid traffic boost from a modest margin investment or a fairly good promotional return-on-invested capital.

Two, there are opportunities to win back some market share from restaurants, which we referenced earlier. For a long time, there had been a big societal shift of food consumption out of supermarkets and into restaurants, and although I think it's premature to say you'll get the opposite shift back — because after all, that was a 30-year process — I think you are getting and will continue to get some of that share moving back into the supermarket format, primarily because the economics are better.

Price Wars?

GIBLEN: Do you think price wars will erupt because of inflation?

ALL: No.

HEINBOCKEL: I just think the managements of these companies today are too smart. In the past, you didn't always have that. The economics never worked, and when you consider what kind of incremental comp you need just to pay for a 25- or 50-basis-point investment in gross margin and break even, you will never get it. Price wars are inherently value-destroying in nature, and companies are highly unlikely to proceed down that path.

ADLER: In addition, the structure of the markets has changed a little bit, and today you have more duopoly-type markets than you did years ago, so price wars make no sense because all retailers do is trade market share and bring gross margins down. The last time we had a price war, we had a more fragmented industry, where there was somebody to take share away from.

GIBLEN: The only monkey wrench in that general line of thinking would be if Wal-Mart used food as a minimum-margin traffic draw.

ADLER: But food is 50% of Wal-Mart's business now, and it's not like it's at the margin the way it used to be.

GIBLEN: They can build traffic and then get people to buy higher-margin stuff.

HEINBOCKEL: In a tough economy, that won't happen. I think they have become very rational in terms of wanting to show a nice profit increase.

GIBLEN: I don't disagree, but I think there's a possibility they would “football” at least some food if they were to decide now is their chance to become the preferred shopping venue for all people short of the Rockefellers.

Customer Responses

ADLER: I have a question that ties into this discussion of inflation. Jeff Noddle [the chairman and CEO of Supervalu] said on a conference call that customers are accepting the price increases being put through at the stores, but at some point he said there's going to be a big consumer pushback. I was trying to figure out what form that pushback would take. Would it be trading down to private label, trading down to other venues, buying more product on deal, cherry-picking deals, many of which they've already done? What else is there? And of course, we're seeing fewer items in a basket, but are people actually eating less or just shopping elsewhere? Does anybody have an idea what other form a pushback would take?

WILTAMUTH: The only thing I can think of is this: The packaged food manufacturers know that in the categories where they put the big price increases, they might start seeing some notable declines in consumer demand or a dramatic shift to private label. So far, I think some of the packaged food players have gotten away with price increases because they've shrunk the package size without increasing the shelf price, and the consumer hasn't completely noticed. Right now, the packaged goods companies are all talking about rolling through these high single-digit to low double-digit increases, but we're only in the middle of the wave of increases coming through, and things could change if prices continue to increase.

HEINBOCKEL: Looking at the [Information Resources Inc.] data, price is up and volume is down, as you would expect. And if price goes up more, volume will go down more.

WILTAMUTH: The IRI data is also showing that private-label growth is 8% to 10%, while branded items are only up around 2%, so you can clearly see the down-trading to private label that's going on. Private label has gained a full percentage point of market share over the last year.

ADLER: It seems to me it's already happening, and I think it's spooked a lot of people.

WILTAMUTH: The packaged food companies have not really seen big disappointments.

ADLER: Yet.

WILTAMUTH: So maybe we're going to have to see something happen on that side. All the investors in consumer packaged goods stocks are saying things like, “Oh, all the price increases are going through — good news!” And then when you ask about the private-label pressure, they say, “Well, it will be someone else's brand that'll go down — maybe the Tier 2 brand that gets hit.” So I think when the top tiers at these food companies start feeling some demand pressure or clear incursions from private label, then maybe you'll see some backing off on the price increases.

GIBLEN: In answer to Meredith's question, I think the other thing that could kick in — though none of the managements want to talk about this on public conference calls — is more shrink. It's a sad fact, but outsider theft and employee theft definitely go up during hard times. That's especially costly because it's not just a trade-down — it's out the door with zero margin.

WILTAMUTH: All this talk makes it sound like it's Armageddon for the grocery stores. But in relative terms, they're still doing great compared to the rest of retail. Comps that are flat to slightly down are nothing compared with what's going on with other retailers, who are seeing negative 6%, 7% and 8% in same-store sales, and double-digit declines for some of them. Grocery is still relatively defensive, but the problem for the stocks is that investors expect them to be defensive, and when they don't show up to be defensive, the stocks get punished.

ADLER: It seems like people didn't want to believe there is no such thing as recession-proof. Recession-resistant is more accurate, which is what we're seeing right now, but not recession-proof. The problem is, investors see consumer packaged goods companies getting away with price increases and they say, “I want safety, so I'll move to the packaged goods companies because supermarkets don't have that safety.” Now it could catch up, and the CPG companies could be in the same boat.

Safeway

GIBLEN: A lot of it is psychological, I think. Steve Burd carries a lot of credibility, and he has been remarkably prescient in seeing major shifts in trends before they are generally recognized. So for him to be in a situation where he has to guide comps down for two quarters in a row indicates things are really moving very fast — and scarily — in this environment.

WILTAMUTH: At this point, Safeway is really in an awkward position because they've just spent five years repositioning their whole brand to be upscale, and now they're looking at a market that is very price-sensitive, and it's going to be difficult for them to go back and lower their price image now that they've made the store look so upscale.

HEINBOCKEL: I don't think that's an issue. I think Safeway is kind of like Target — you position your business for the long term, and if the next 12 to 15 months are tough because the market is price-sensitive, you live with that. You accept a flat comp, you protect earnings as best you can and you position yourself for an eventual upturn. While you're waiting, you tweak but don't radically alter your value proposition because more competitive pricing probably has to become a greater part of the long-term equation anyway.

A company in that position has a choice: It can invest in shelf price or in promotion. If it invests in promotion, it helps sales right away, though it doesn't change its price image as much; if it invests in shelf price, it takes longer to get a response but it's more sustainable. I think that's how you need to invest in this environment. You will not get an immediate response, but it will position you much better for an eventual upturn in consumption. That's the approach I expect Safeway to take.

ADLER: But that's not what Burd said. He said he wanted to drive traffic. He didn't care about price image — he just wanted to drive traffic. Where I would disagree about Safeway is this: It's fine to say you're going to be more upscale and position yourself against Wal-Mart if that worked really well. But Kroger has created a much better price image, and it's also done a nice job improving the shopping experience. And when you ask, what's going to be the differentiation for Safeway — I think the lifestyle stores are nice, but are they that much nicer than a Kroger? And so it's a strategy, and perhaps it means they're going to fall behind because Kroger can spend the capital and invest in price.

So I would argue that Safeway made a mistake by hanging onto earnings this year. Can Safeway do all that cost-cutting, and not give it back, not try to improve its cost position in a significant way but simply hang onto the earnings?

HEINBOCKEL: The problem with not protecting earnings, though, is that you probably will not get a good return at the end of the day, because I don't think you can change your price image in just one year. Hence, you either invest too little to make a difference or really have to gut earnings to make customers notice. And it's even tougher to change one's price image in a consumer downturn with accelerating food inflation. To meaningfully change your price image, you have to be prepared for something like five years of sub-par earnings. That's what you do as a private company, but you can't do that as a public company. I think you have to protect earnings to a degree and then position yourself for an upturn, because you could easily earn 10% or 15% less and your comp wouldn't be any different in this environment.

ADLER: In this environment — I don't disagree with that. But in my view, Safeway is postponing the inevitable and relying on the assumption that everything they've done is going to get them what they hope to get once the recovery happens, whenever it happens, because the competition is not sitting still. It's sort of unbalanced to emphasize shopping experience at the expense of value.

Kroger Co.

GIBLEN: It's hard, and I don't think it's 100% crystal-clear that Kroger has totally cracked the code either. Clearly, they're nicely positioned at the moment, but they have yet to put together more than one or two good quarters in a row. The last quarter was excellent because they got a perfect combination of margin and sales, but they could very well be off-kilter the next time around, just as they have in recent quarters.

ADLER: Fuel definitely did not help them last year.

GIBLEN: It could be fuel, but a hidden time bomb is pharmacy. People are taking fewer prescription drugs — they're actually cutting back on drug consumption or halving the doses, and Kroger is pharmacy-heavy. So that could hurt Kroger's results at some point.

ADLER: Interestingly, the $4 generic program obviously was designed to solve that to some extent. But for Kroger, pharmacy is profitable — or at least it's not unprofitable — because they've learned to leverage their fixed costs very well. So it's not exactly a loss leader — it's a traffic driver, but it's not necessarily a loss leader.

GIBLEN: It's not a lot of margin, but if the dollars of pharmacy consumption go down because people are cutting back on non-acute pharmacy needs, that could hurt Kroger more than it would, say, Supervalu, for whom pharmacy is a small portion of the mix.

WILTAMUTH: Half of that 5% to 6% comp from Kroger is coming from traffic, so their lower prices are winning.

HEINBOCKEL: But they changed their price image in a non-inflationary environment, and now they're reaping what they sowed. It's almost like they couldn't have drawn it up any better if they had tried, so they're very fortunate. And to some degree, you'd have to say the current environment doesn't exactly fit what Safeway is doing strategically — it doesn't mean it's fundamentally wrong, but it's tougher when you're not in sync with the customer's mind-set. Kroger is and Wal-Mart is, and that's a nice position to be in.

Ahold

SN: How is Ahold doing, with its new focus and new emphasis on price in the Northeast?

CASELLA: One thing about Ahold is, they finally got rid of all the operations they were trying to sell — Tops and their foodservice holdings and some international assets. I think they're finally down to a business where they can say, “This is our core,” and they can actually find a new course, and we might see a little bit better strategizing, where they don't have to worry about ancillary businesses.

I cover them from the debt side, and we actually like Ahold. But it's more from a debt perspective because of the cash flow and the fact that it's likely to get upgraded soon to investment grade if they continue to pay down debt.

But from a performance perspective, in the U.S. and internationally, I think we're going to continue to see mixed results. I think right now they seem to be doing better in the Northeast. At one point, we really questioned whether Ahold's pricing strategy there was going to work. We thought it might just kill margin. But it turned out to be all right, and consumers are responding to it, so it's probably the start of a little bit of a run there.

ADLER: One of the things Ahold has proven is that you can't export management style — maybe you try to, because they moved their Stop & Shop management to Giant-Landover and it did not work; and then they took management away from Stop & Shop and that hurt, and so they were left with not a whole lot; and Giant-Carlisle kept doing OK, in part because they weren't involved in those other things. So I think it's been a hard slog for them.

HEINBOCKEL: I think they have found religion on pricing now, at least in the New York market. They've been very good about actually taking pricing down. We used to find them priced above A&P and Pathmark, but now they're lower, so they've done it in reality. And they've done a very good job communicating that to the customer, and I think it's now a focus — almost to the point where you worry, will they be too price-oriented and lose some of what made them special on the perimeter? So they've executed the price repositioning well, but it has impacted margin, and I think you have to be prepared to accept that if you want to fundamentally change your price image.

ADLER: Has the volume offset it?

HEINBOCKEL: It takes a long time. Look how long it's taken Kroger to get to where they are.

SN: And is it more difficult in this environment?

HEINBOCKEL: Yes. I think it's tougher to change your perception when you cut your prices 10% and then inflation pops them back up, because the consumer is confused. They have no idea what the right price of something is, so I think it's much harder to change your perception in an inflationary environment. Now if it was a soft economy with no inflation, that would be fine because you could more easily change your price image. But we have this funny cross-current where the economy's weak and food inflation is picking up, so I think you're kind of stuck if you want to change your perception, and it's very tough.

CASELLA: Then again, when you're low-priced in a market in this environment, you're getting some traffic just from people going to the lowest-priced operator, so it's good if they can get below A&P and Pathmark.

Delhaize

SN: How are the Delhaize companies in the U.S. doing?

ADLER: Hannaford is very well-positioned. They've always had a kind of unique thing, with a good price image and a great image on quality, so I'm not too worried about them. Again, they're not recession-proof, but I think they're going to be fine. Food Lion really does suffer from being in very low-income areas, and it's still being shopped frequently as a convenience store.

CASELLA: I was surprised how hard Food Lion got hit, though, because they're known to be low-priced so they could have done better, and that's been a little scary. It's probably due to the Southeast economy.

GIBLEN: Food Lion is pretty close to the consumer in terms of neighborhood locations, so its performance signals bad news. But Sweetbay [in Florida], which is a smaller part of the equation for Delhaize, is positioned wrong. They're kind of stuck in the headlights like Safeway is — they did a reasonably good job of improving a characterless chain, Kash 'n Karry, but now they're positioned on the pricey side, so that's probably going to be a drag for Delhaize.

ADLER: Interestingly, Delhaize has talked about fewer items in the basket at Food Lion, but they're not seeing that at Hannaford or at Sweetbay, so they're obviously targeting a customer that isn't as financially strapped as the rural North Carolina customer is.

SN: Winn-Dixie seems to be doing better, but the times are tough, so where do they stand?

ADLER: They are moving ahead very aggressively to implement their strategies. I think they're very forward-thinking — it's certainly tough, and they've got some of the toughest competition out there. But they do have the capital to do remodels, and the remodels are, on the average, very successful. They're getting double-digit, mid-teens kinds of sales lifts at the remodeled stores, so they're probably going to be OK for a while — though there may come a time where they've gotten as much as they're going to get from those remodels, but we're still a long way away from that point. And they're involved in some merchandising initiatives that are kind of cutting-edge, so I think they're looking for many different tools and methods to drive their business.

GIBLEN: But now they're very heavily concentrated in Florida, and that's tough because that's the epicenter of the housing market problem. Traditionally, they've had a blue-collar audience, and of course they're trying to change that with the remodels, but still their core customers would be average-income customers, and that makes it tough. But while they're doing everything within their control intelligently and skillfully, it may be too little, too late.

ADLER: I'm not so sure they're necessarily going to move away from the blue-collar customer. I visited a Hispanic store they opened in Miami, and it was a really nice-looking store, and I think they're trying to be as targeted as they can be.

GIBLEN: One thing that helps them is that Publix has sort of gone on automatic pilot, so I think they get a little reprieve from the normal intense pinpoint pressure that Publix would bring to bear.

ADLER: Plus, there's a lot of low-hanging fruit at Winn-Dixie in terms of inefficient operations.

CASELLA: And remodeling. They gained a lot of share last year. Tough market this year, but they have been gaining share since they emerged from bankruptcy.

Whole Foods Market

SN: Talk about the challenges Whole Foods is facing.

WILTAMUTH: The stock has really been struggling over four issues: the slowing of same-store sales; the margin pressure in the core business; the unusual items and expense drag from the Wild Oats merger; and balance-sheet concerns, including negative free-cash flow. That's a lot to overcome.

ADLER: I might add a fifth issue — whether their judgment about capital in general is wise and whether they have the right disciplines around investing capital. My view is they don't.

WILTAMUTH: I think two of those issues are going to start getting better — I think the store drag they were getting from new and relocated stores will start to go away, and I think now that they are anniversarying the Wild Oats merger, they're going to start seeing some of those issues shift back toward the positive.

But the big issue on the stock is that the same-store sales number is continuing to erode. They're still positioned as the premium of the premium players out there, so the trade-down economy really hurts them, and until that stabilizes, that sales deceleration is going to really dictate where the stock goes.

ADLER: And they have fewer tools than other food retailers because they're not traditionally a promoter. They have been doing a lot more promotion and advertising in some places, including television ads in the Midwest, which is very expensive when you're a niche player and have only a handful of stores.

GIBLEN: The irony is that their price-value relationship is actually good. If you're buying high-quality food, their prices really aren't bad. It's a bit like the Stop & Shop example that Meredith brought up — there's no way Whole Foods is ever going to be perceived as a well-priced chain. That's really a shame, but that's the way it is, and it may well come home to haunt them.

ADLER: I would also say they made a choice when their fortunes were at their greatest. Any retailer can choose among good-better-best in a category, and I think they went for “best” for a long time, so the price-value relationship might not be that bad, but the customer doesn't want to buy “best” all the time, or they're increasingly showing they don't, so now Whole Foods is associated with premium when the customer is avoiding premium. And that's going to be really hard to overcome, and I don't know how a retailer tells customers it's changed.

Plus, they built the cost structure around the revenues that were generated by premium, and they have not articulated very clearly how they change their cost structure in a lower sales environment — either because it's forced on them or because they actively sell more frozen fish, or whatever. They have to become more efficient.

GIBLEN: They're loud and proud about how much labor they're adding into the Wild Oats stores, which is the right thing to do long term, but they're a little bit too proud about it and jeopardizing nearer-term financial results.

HEINBOCKEL: The question long term is, how do you make the Whole Foods brand economically accessible to more people? And can you do that? Maybe the answer is you can't do it and shouldn't try to do it because a) you'll be giving gross profit dollars away to people who don't care about price, and b) the image is too extreme, the brand is too extreme and you can't effectively bring it back to the middle. Maybe the answer is to develop a second brand, as the apparel companies have done and as several food retailers have done as well — a second brand that's geared to a customer of more modest means. Quite frankly, we thought that when they bought Wild Oats, one of the reasons was to get Henry's, and Henry's was going to be that format. So we were very surprised when they sold it. I think that would have solved some problems.

WILTAMUTH: I think at this point, you don't change the zebra's stripes. Whole Foods is so differentiated and so set apart from the market, it can't play the price-value game like the big boys do. They're just going to have to tough it out and wait for the consumer to come back to them.

ADLER: When they bought Wild Oats, so many of the stores they were planning to open in their own pipeline were across the street from Oats locations that they had to close a competitor to help boost early results, which was a reasonable solution to the problem of committing to too many leases on stores that were too big. I like the strategy — it's not a bad one. It was only what they paid that concerned me. And they actually said on a conference call that they're only going to get to $900 per square foot by relocating the Wild Oats stores, not by improving results at the stores they acquired. And they have to spend a heck of a lot of additional capital to get that new store up and running, on top of what they paid for the Wild Oats stores, and in my view, that's not getting the Wild Oats stores to $900 per square foot.

GIBLEN: To be balanced, Whole Foods has done an excellent job developing a two-tier private-label program, which gives them some resonance for a somewhat price-sensitive or value-oriented customer. That's been offset by the tidal change in the economy, but the private label does help because you can buy natural products for the same price as you would at a conventional store.

WILTAMUTH: Except they don't get private-label margin gains vs. the rest of the store.

GIBLEN: No, it's not helping their margin the way they have built private label.