Supermarket Stocks: Going Stale?


By Amy Tsao Over the last decade, the three publicly traded national supermarket chains -- Kroger (KR), Safeway (SWY), and Albertson's (ABS) -- scooped up dozens of smaller outfits, transforming themselves into the industry's biggest players. But their size hasn't prevented them from suffering as even bigger rivals emerge on the scene. They would be Wal-Mart (WMT) and Costco (COST), whose stores combining general merchandise with food have been unprecedented successes.

The supermarkets have been fighting back by spiffing up drab-looking stores and adding unconventional merchandise and services like $1 items and in-store banks. Kroger seems to have the most fans among analysts, with more than half of those who track the supermarket sector rating it a buy or strong buy at its Oct. 4 closing price of almost $19. That's up 20% this year.

UPHILL BATTLE. However, all three supermarket chains still struggle to hold their own against the mega-retailers. "I was hoping all the margin investment would have been enough by now, and the companies would be more competitive," says Standard & Poor's analyst Joseph Agnese, who sees no great upside for any of the Grocers Three. (Agnese doesn't own their shares, and S&P doesn't perform banking services.)

Investing in the sector calls for a long-term view. Price-earnings ratios on all the stocks are depressed, trading at around 11 times earnings-per-share forecasts for both 2003 and 2004. Smart investors may not want to get too excited about the apparent discount, however. The similarity between current and future p-e ratios suggests that Wall Street isn't expecting profit growth to budge much from already lackluster levels. What's more, "we see more margin pressure over the next year," warns Agnese.

Supermarket stocks have been a turbulent ride over the last five years, down about 45% as a group. So far in 2003, Albertson's, now around $21 a share, is down about 7%, and Safeway, trading in the $23 range, has slid about 1%. The majority of analysts polled by earnings-tracker First Call give the two stocks ratings of hold or lower.

LAST TO REACT. Albertson's is the least favored. While the stock is the only one of the three that comes with a dividend payment, "I would be nervous about the business itself and how sustainable it is," says Bernstein Research analyst Mia Kirchgaessner, who rates it underperform. She notes that the Boise (Idaho) outfit's store base is spread such that it isn't a dominant player in any single market. Agnese, who rates it avoid, says it's the riskiest outfit in the group. "They were the last to recognize and react to the price difference with Wal-Mart," he says.

Momentum has slowed for Albertson's in recent weeks. On Sept. 9, Merrill Lynch lowered its stock rating to sell, from neutral, citing the supermarket's rising labor costs. On Oct. 1, credit-rating service Moody's Investors Service downgraded Albertson's long-term debt rating to its second-lowest, fearing that its efforts to improve sales and market share may not bear significant results soon. The chain's net income last year rose 72%, to $865 million, while revenues fell 6%, to $35.6 billion.

Safeway, based in Pleasanton, Calif., also has an aisle-full of issues. It's trying to sell its 113-store Dominick's chain and exit the Chicago market. And improvements have been slow to emerge from a centralization of its product-ordering processes, says Kirchgaessner. Like its peers, Safeway is investing heavily in promotions and marketing strategies intended to increase store traffic -- all at a cost to profit margins.

Last year, Safeway's net income fell by more than half, to $569 million, on $32.4 billion in revenues. (Kirchgaessner doesn't own shares, and Bernstein doesn't perform investment-banking services.)

TOP GROCER. With 42% of its stores enjoying dominant market positions, Kroger probably has the best long-term position of the three, says Kirchgaessner. "I personally would play Kroger because that's where the leadership is," she argues. She rates its shares outperform and has a $21.50 price target. Kroger's operating margins of 4.6% in the first quarter of 2003, though lower than the others, have stabilized, while Safeway and Albertson's have seen margins fall sharply in that quarter, the analyst says.

Still, Cincinnati-based Kroger is by no means immune from industry woes. It, too, has been using price-cutting and promos to lure shoppers. In its recent earnings report, Kroger CEO David Dillon said it remains focused on building share by "reducing the price gap with discount operators and widening our price advantage over traditional competitors in many markets." This strategy had modest success: Kroger last year reported an 18% rise in net income, to $1.2 billion, on a 3% rise in revenues, to $51.7 billion.

Yet, before 2003 is out, all three chains will begin serious negotiations involving expiring union contracts. That, figures S&P's Agnese, could further pressure results, as the negotiations may become difficult. In general, grocery-store fundamentals won't get much better for some time, says Tom Compernolle, a vice-president at Cap, Gemini, Ernst & Young. He predicts that these three will bubble along for years with no stellar results.

WATCH PHOENIX. Consider that Wal-Mart is just at the beginning of its grocery-store buildout. It has converted only about half of its old discount stores to supercenters, and it has a smaller supermarket-like format in the pipeline. Compernolle recommends watching the battle in the Phoenix metropolitan area, where all three chains are competing with Wal-Mart and smaller regional players. "What happens in those markets may be a predictor." (Compernolle is consulting with two major supermarket chains.)

Here's one wild card: A solid pickup in the broader economy could provide a lift. "If that gets better, so will the group," says Kirchgaessner. But a stronger consumer alone won't offset these supermarkets' daunting vulnerabilities. Tsao covers the markets for BusinessWeek Online and writes for the Street Wise column


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