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03/20/2013

How long will the market rally Last?

Grocery retailers have shared in the largess this year as U.S. stocks rallied, pushing both the S&P 500 and Dow Jones Industrial Average to new records.

The Dow Jones Industrial Average hit 14,559.65 on March 26, topping its all-time high set in 2007, ahead of the global financial crisis. The S&P 500 index rose to its own record of 1,569.19 on March 28, up from its previous all-time-high closing price of 1565.15 set on Oct. 7, 2007.

But food retailers don't always shadow the S&P, leaving some to question how long the rally for food retailers will last. While the S&P Food Retail Index rose 11.0 percent in the 13 weeks ended Feb. 8, outpacing the 10.5 percent increase for the S&P 1500, the food retail index's 2012 increase of 7.1 percent fell short of the S&P 1500's 13.7 percent climb, due to higher food costs and increased competition from supercenters and alternate channels.

Currently grocery retailers and wholesalers remain in a fierce fight for market share, unmitigated by the stock market rally, which should allow them to breathe a little easier, equity analysts say.



"There is always a fight for market share."

–Joseph Agnese,

S&P Capital IQ

"There is always a fight for market share," says S&P Capital IQ equity analyst Joseph Agnese, and Walmart's grocery price discounts "makes it that much tougher" for other retailers. Consumers are wary of rising gas prices and food inflation, which moderated last year but are expected to increase this year, he says.

Analysts told Retail Leader that Kroger, Safeway and Costco appear better positioned for the coming year than Supervalu, Fresh & Easy and Ahold, which are more likely to look for savings than expansion opportunities.

"We believe the best-positioned retailers are those who cater to high-income and low-income demographics," wrote analysts at S&P Capital IQ in a research note. Grocery retailers who aim at the high-end are better able to pass along cost increases or traffic gains as consumers trade down from traditional competitors, they say.

Walmart (NYSE: WMT) still is on top on a sales-volume basis, while Costco Wholesale (NASDAQ: COST) continues to gain shoppers with its discount pricing, and most recently the dollar stores – Dollar General (NYSE: DG) and Family Dollar (NYSE: FDO) ­– have challenged traditional supermarkets with their entry in the sector.

At the same time, U.S. wages are stagnant, and consumers face rising gas prices and food inflation. Those costs moderated last year, but are expected to increase later this year, says Agnese.

Cost containment "still is the path to growth" for grocery retailers, says Michael Keara, formerly an equity analyst at Morningstar.

Looking at some of the top names in the food retail group, analysts say Cincinnati-based Kroger (NYSE: KR) shares are holding their own. As of March 8, Kroger stock had outperformed the S&P 500 stock index, with the grocery retailer up 18.2 percent year-to-date.

Kroger's same-store sales topped expectations for fourth-quarter growth logging an increase of 3.0 percent, excluding fuel. Net earnings for the quarter were 88 cents per diluted share.

For full-year fiscal 2012, Kroger's identical sales rose 3.5 percent, excluding fuel. Net earnings for the year totaled $2.77 per share. Total sales rose to $96.8 billion, or 7.1 percent, from year-ago figures.

Kroger – with 2,424 supermarkets and department stores, including City Market, Dillons and Food 4 Less – said it expects identical supermarket sales growth, excluding fuel, of 2.5 percent to 3.5 percent for fiscal 2013.

Supervalu (NYSE: SVU) in March sold its Albertsons, Acme, Jewel-Osco, Shaw's and Star Market stores – and related Osco and Sav-On in-store pharmacies – to an affiliate of Cerberus Capital Management, for $3.3 billion in cash and debt.

S&P Capital IQ's Agnese says the sale "will provide the company with the opportunity to focus management efforts on achieving sales growth at discount chain Save-A-Lot," as well as stabilizing its distribution and pared retail businesses.

But Supervalu management's operating flexibility "will remain constrained by a highly leveraged balance sheet through full-year 2014," Agnese says, despite new capital provided by Cerberus.

A week after the sale closed, Supervalu announced 1,100 layoffs in a cost-cutting move. The company now consists of its Independent Business unit, a food wholesaler which serves 1,950 U.S. stores; Save-A-Lot, a discount grocery with approximately 1,300 stores; and regional retailers Cub Foods, Farm Fresh, Shoppers, Shop ‘n Save and Hornbacher's.

Keara ranks Kroger as the No. 2 grocery retailer, under No. 1 Walmart, but he expects No. 3 Costco to soon take its place, with Kroger falling to No. 3.

"Safeway (NYSE: SWY) and Supervalu are not opening stores," Keara says, but are instead closing or divesting them. Kroger is now starting to re-open stores, but not at the pace Costco is. "It's only a matter of time given the continued new unit growth and higher same-stores sales before Costco is No. 2," he says, adding that Target (NYSE: TGT) "is already No. 4."

Grocery retailers still "need to get more price competitive. ...Since food is a commodity, the lowest price will win the day," says Keara.

STOCK PERFORMANCE
GICS Sector: Consumer Staples Sub-Industry: Food Retail

Based on S&P 1500 Indexes Month-end Price Performance as of 01/31/13
NOTE: All Sector & Sub-Industry information is based on the Global Industry Classification Standard (GICS)
SOURCE: S&P Capital IQ

"Walmart and Costco drive more volume than grocers now [with the exception of Kroger], so they can demand relatively better pricing power," he notes. In addition, "it will be difficult [for traditional supermarkets] to cut their cost structure to a level below the non-union mass merchants," he says.

But analysts at Deutsche Bank say Safeway (NYSE: SWY) is coming on strong. Safeway's "Just for U" loyalty and fuel rewards programs are gaining traction and are expected to be augmented by its Wellness initiative, which includes customer-focused pharmacies set to be launched later this year.

Safeway's fourth-quarter earnings, reported at $1.06 per diluted share. The company, which also operates regional chains Vons and Randalls, reported identical-store sales rose 1 percent for the period; excluding fuel, they were up 0.8 percent. The company cited the calendar shift of New Year's Eve and the shift to generic drugs as a drag on sales.

Agnese said he is intrigued by Safeway's "Just for U" digital loyalty platform because it not only lets Safeway directly target offerings to individual consumers and learn their shopping habits, but it also allows the grocery retailer to discount prices in a way that is concealed from competitors like Walmart.

Deutsche Bank analysts, in a Feb. 21 report, also were upbeat about the "Just for U" program, calling it one of the "upside risks" to Safeway shares that "could drive accelerated identical-store sales."

Safeway Chairman and CEO Steve Burd is set to retire at the company's annual stockholders meeting May 14.

But Safeway also is in a period of management transition. The company announced Jan. 2 that longtime Chairman and CEO Steve Burd will retire at the company's annual stockholders meeting May 14. His replacement has not been announced.

Agnese says he prefers Kroger's outlook to Safeway's. Kroger "has done a great job staying close to pricing," a response to Walmart's aggressive entrance into the Midwest grocery retail space, he says.

Agnese sees Safeway as particularly vulnerable to lower-cost competition in California, where Safeway has its largest foothold, with approximately 30 percent of its stores in the state. Dollar General stores are aggressively entering the market and targeting Safeway, he says.

About 75 percent of Dollar General sales come from staples also carried by grocery stores, Agnese estimates, and Walmart's smaller express stores also are on a growth spurt.

In the past, Safeway targeted upper- and middle-income shoppers. "That worked well for a while, but not now," he says.

Netherlands-based supermarket retailer Ahold, which operates in the U.S. as Stop & Shop, Giant Food and Giant Food Stores and owns Internet-based home shopping and grocery delivery business Peapod, has benefited from its multiple formats. In July 2012, Ahold acquired 16 Genuardi stores from Safeway in the Philadelphia area, which are being converted to the Giant Food Stores brand.

But equity analyst William Mack, with S&P Capital IQ, cautioned in a February report that Ahold's U.S. banners, primarily Giant and Stop & Shop, "operate in a highly competitive environment and are mostly skewed to uninspiring demographics."

"In this low-growth environment we think management will more aggressively look to cut costs," Mack said.

From an equity analyst's standpoint, Whole Foods Market (NYSE:WFM) presents "a whole different story," Keara says. As the first certified organic grocer in the United States, and with 32 to 38 planned store openings per year (an estimated 7 to 9 percent growth in square footage over the next five years), Whole Foods should capture a disproportionate share of organic food industry sales, Keara says.

"It's one of the remaining companies in our defensive retail space with meaningful store growth remaining, but in a niche market thus far," Keara said in a research report, noting that dollar stores also are increasing square footage growth.

Whole Foods' comparable-store sales were up 7.2 percent in fiscal first-quarter 2013, although down from an 8.5 percent rise in the previous quarter.

But as with all retailers, risks loom. In the case of Whole Foods, those include a slowing of the organic food trend, particularly if a sluggish economy forces consumers to "trade down," and if traditional grocers and wholesale clubs more aggressively pursue the organic food market, Keara said.

Looking ahead, no one knows for sure how the year will wind up for grocery retailers. S&P Capital IQ analysts have a neutral outlook on the food retail sub-industry sector for 2013. Many retailers haven't passed along higher costs, preferring to protect market share by sacrificing margin. The result is continued earnings risk until the economy improves sufficiently to encourage shoppers to purchase higher-margin items.

Freelance writer Suzanne Cosgrove has covered commodities for Thomson Reuters and Knight-Ridder Financial News and has served as a real estate editor for the Chicago Tribune and as the Chicago bureau chief for Market News International.