Grocery Stocks Could Give Indigestion

Traditional chains, losing shares to lower-cost rivals, are not safe harbors as the economy struggles.

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Whole Foods Market Inc. announced that it plans to purchase Wild Oats Market Inc. in hopes of competing with larger food chains that have started to introduce organic and prepared foods to their inventories.

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Even in a recession, people still have to eat. So, it's a seemingly logical conclusion that supermarkets selling everyday necessities would have some staying power even if Americans rein in spending during a recession.

Unfortunately for investors, it appears to be an incorrect one so far. Slower consumer spending and ongoing competition from nontraditional rivals have share prices falling at most of the country's big, publicly traded supermarket chains. Shares of Supervalu, the nation's second-largest chain, have slumped by 27 percent over the past year. Kroger and Safeway, the No. 1 and No. 3 chains, are off 9 percent and 19 percent year over year as well.

Broadly, grocers are suffering a bit of a hangover. Through most of 2006 and early 2007, stocks in the sector saw some of their strongest price appreciation in the past five years, thanks to some compelling fundamentals. Supervalu bought Albertsons in 2006, cementing its spot as a sector powerhouse. At the same time, Kroger and Safeway focused on becoming more efficient operators or remodeling stores to appeal to shoppers wooed by more upscale offerings.

Before the economy started to wobble, it even seemed they might win a round or two in a long (and losing) battle against low-cost interlopers like Wal-Mart, specialty retailers like Whole Foods Market, and even big chain drugstores that have been wresting huge chunks of market share from traditional food retailers. But the slowing economy and record prices for dairy, wheat, and gasoline have taken their toll on stock prices and corporate profits. "The industry is somewhat recession resistant, but I wouldn't use the word recessionproof," says Neil Stern, a principal with retail analyst McMillan Doolittle.

For much of this year, industrywide revenue is expected to limp along, with grocers getting a bit of help from declining sales at restaurants as food prices rise but struggling for meaningful price increases as profits get squeezed between higher wholesale inflation and fierce competition. Gross margins, always slim, are expected to tighten further through 2008 at the Big Three, according to Credit Suisse.

But the news isn't all bad. Analysts at Willard Bishop, a consultancy, say that while traditional grocers are still expected to see their total share of the market drop to 37 percent by 2011 from 44 percent in 2007, the drop is slowing compared with the early part of this decade. That most likely means the better grocers will have a fighting chance to defend their territory, but they won't be able to match growth rates of superstore rivals. Willard says compound annual growth rates for traditional grocers is likely to average just 1.4 percent between 2006 and 2011. For superstores, the rate is 10.7 percent.

Here's a look at how the big names might fare this year:

Possibly the best of the big three is Safeway (SWY). While its shares hit a 52-week low on Monday, the firm has successfully stocked its shelves with more convenient prepared foods plus higher-quality meat and produce and is steadily upgrading all of its stores to its new "Lifestyle" format. Bank of America analysts tagged Safeway with a "buy" rating last month, citing a mix of competitive pricing and results from upgrades to its stores that take aim at the likes of Whole Foods. Analysts predict the result could be respectable earnings-per-share growth of around 12 percent for the next three years. Safeway also sports a price-to-earnings ratio of around 14, compared with Whole Foods' richer 27. In addition, Safeway recently mentioned the possible sale of its Blackhawk gift card unit, which sells cards for retailers like Nordstrom and Starbucks at kiosks in its grocery stores, a move analysts say could be positive for the stock.

Wall Street analysts are more bearish on Supervalu (SVU), which bought Albertsons in 2006 and is in the midst of digesting that deal. Its store upgrades haven't kept pace with more nimble rivals. After reaching nearly 50 a share last July, shares now trade around 28. The chain says it can increase same-store sales at 1 to 2 percent this year, though analysts are waiting for some signs of a pickup before buying into that prediction.


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  • Kirk Shinkle

    Kirk Shinkle is a senior editor for U.S. News Money and manages the Best Funds portal. Follow him on Twitter @KirkS or email him at kshinkle@usnews.com.