SOURCE: Rothman Research

Rothman Research

March 18, 2010 10:13 ET

Supermarket Chains Profits Give Investors a Treat

JOHANNESBURG, SOUTH AFRICA--(Marketwire - March 18, 2010) - - Considering the fact that consumer spending is still receding, the revenue visibility for the firms under the services sector remains challenging. At the same time, because of the demanding conditions this sector is facing, companies have done massive cost reductions that have and are expected to provide some cushion to the companies' bottom line. This applies particularly for grocery stores which are seeking leverage of their own private label products as consumers hover to this segment in their quest to squeeze their food dollar. Although private label brands have a negative impact on sales, as they are cheaper, they have a net positive contribution to the retailer because of a great probability for them to carry a higher profit margin; the better the bargain, the more the average consumer purchases; the more purchases, the more profit the company earns.

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Investors have been more bullish on the grocery sector's yearend prospects. Since the start of the year, U.S. supermarket chains have outpaced the S&P 500 Index. Analysts of studied the sector and covers in-depth analysis on major players such as Safeway Inc. (NYSE: SWY) and Kroger Co. (NYSE: KR) -- Safeway shares have gained 15%, and Kroger shares have advanced 10%. The S&P 500 has edged up 0.3%.  Free downloads of the reports on Safeway Inc. and Kroger Co. is available upon signing up at  or

Supermarket chains may be operating on survival mode in the current state of the economy but so far they have been exhibiting some progress. And although everyone must eat, consumers are eating out less, and more often consumers are have homemade meals to lessen their expenditures. "But even if consumers are less apt to gratify themselves on vacations, purchasing cars, furniture or electronics, people always feel a need to 'treat' themselves with something. And it's likely to be food and beverage, especially comfort foods, as they seem to have a relaxing effect in times of anxiety," comments Mathew Collier, senior analyst of

"Established grocers have cut prices to save their customers from drifting to Wal-Mart, and this strategic move appears to have worked," says Mathew Collier, senior analyst of Safeway Inc. recently said its shelf prices are now on par with other traditional grocery stores, while Kroger Co. said it picked up share in most of the markets where it competes with Wal-Mart. Kroger also expects the price wars among supermarkets to moderate. Both grocers issued guarded outlooks, underscoring the uncertain landscape supermarket chains face with U.S. unemployment still high and the vague rate at which inflation will return.

Safeway's cost structure is hugely fixed in nature, and they're at the whim of deflationary trends that squeeze margins. What should be clearly impressive to everyone is their incredible 2009 cash flow performance in the face of such pressures. As the company reduced their borrowing levels, 2009 interest expense dropped from $112.5 million to $98 million. Safeway is in a brutal business and in direct competition with not just Wal-mart, but other sturdy competitors who can cause damaging price wars. Safeway has high pension expenses and ongoing labor disputes. They also are at the whim of wild swings in food costs that are beyond their control, as well as the consumer trade-down effect to cheaper, lower margin products. Safeway fights back on the trade-downs by offering a terrific assortment of their own store branded products, but in categories like liquor and wine they're out of luck.

The big investments in Lifestyle remodels are largely behind them, and the contribution of remodeled stores will become more apparent in the coming years. Safeway's strategy is to grow wallet share, or the percent of a person's shopping that is done at Safeway.

Kroger is the nation's largest supermarket chain, and has benefited from the consumer eating at home more often during the recession. Amidst a crumbling economy, plagued by heavy job losses and waning consumer discretionary spending, Kroger Company reported weaker fourth-quarter 2009 results. The operating environment company saw during the fourth quarter was more challenging than it was anticipated, obscuring strong fundamentals in their performance such as exceptional tonnage growth, market share gains, increases in loyal household count, and good cost control. These fundamentals are important to their long-term success. In the near-term, their financial results are being pressured by factors including persistent deflation, unusually intense competition and the cautious mindset of customers.

Kroger has shown intent to remain competitive on price in order to maintain market share. What concerns us about this is that the firm has not adjusted its cost structure as much as it would have. Management indicated a cut to sacrifice long-term effects for short-term gains, but also it is not able to find as many dollar savings as it had originally planned. This means profitability will be lower than originally expected, given that the pressure on consumer spending should persist as we enter 2010.
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