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SUPERVALU Inc. (NYSE:SVU)

F3Q10 Earnings Call

January 12, 2010 10:00 am ET

Executives

Kenneth Levy – Vice President of Investor Relations

Craig Herkert – President and Chief Executive Officer

Pamela K. Knous – Executive Vice President and Chief Financial Officer

David Oliver – CFO, SUPERVALU Supply Chain Services

Analysts

Deborah Weinswig - Citigroup

John Heinbockel - Goldman Sachs

Meredith Adler - Barclays Capital

Edward Kelly - Credit Suisse

Scott Mushkin - Jefferies & Co.

Neil Currie - UBS

Mark Wiltamuth - Morgan Stanley

Operator

Welcome everyone to the SUPERVALU third quarter earnings release. (Operator Instructions) Now I would like to turn the call over to Ken Levy, Vice President of Investor Relations. Sir you may begin your conference.

Kenneth Levy

Thank you. Good morning and welcome to SUPERVALU’s fiscal 2010 third quarter conference call. I am pleased to have recently joined SUPERVALU as the Vice President of Investor Relations and look forward to working with you in the future.

With me on today’s call are Craig Herkert, SUPERVALU’s Chief Executive Officer and President; Pam Knous, Executive Vice President and Chief Financial Officer and David Oliver, CFO OF SUPERVALU Supply Chain Services. Following prepared remarks from Craig and Pam, we will open up the call for a question and answer session. Thereafter Craig will return with some closing remarks.

As you know, the information presented and discussed today includes forward-looking statements which are made under the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. The risks and uncertainties related to such statements are detailed in our fiscal 2009 10-K. Today’s call will be available for replay on our website at www.Supvervalu.com. David and I will be available after this call for any additional questions.

I will now turn the call over to Craig Herkert.

Craig Herkert

Good morning. Thank you for joining us today. With the start of the New Year I want you to know that I am approaching fiscal 2011 optimistically. This isn’t because I see a robust pick up in the economy because frankly I don’t. It is because I believe SUPERVALU is running its business better and that means we are in control of our own destiny.

Let me be specific here. The work streams we previewed with you in October are showing traction and that makes me confident that they will deliver meaningful and visible results in the year ahead. I am pleased to announce that SUPERVALU reported net earnings of $0.51 per diluted share on net sales of $9.2 billion for the third quarter, exceeding the consensus estimate. These results were achieved against significant economic headwinds and consumer spending trends which have heightened competition throughout our industry.

You have heard me say that grocery retail is a simple business and I believe that our results show we are getting back to basics. Clearly defined areas of accountability are helping to fuel more intelligent data driven decision making throughout our organization. Today SUPERVALU’s associates understand better their respective roles and responsibilities and I am proud of their accomplishments and dedication to improving the shopping experience for our customers.

This quarter’s earnings performance reflects our progress on initiatives we set into motion early this year. Our margins held up well which is the direct result of improved communications and stronger relationships between our corporate merchants and our banners. In general we saw more effective promotional spending which helped to stabilize gross margins and we also benefited from good expense controls.

Even with this meaningful progress work still remains. I am not satisfied with the same store sales performance but believe that our company is gaining momentum on key initiatives and behavioral changes that are designed to improve sales in fiscal 2011 and beyond as they are implemented across our company. My objective is to position the company for long-term, sustainable growth.

While Pam will discuss details of our financial performance shortly I do want to touch upon four items that I view as particularly important to the quarter.

First, the quarter was a tough quarter and one in which we made difficult decisions in terms of striking the right balance between sales and promotional investment. I am pleased to report we achieved the appropriate balance and our results validate these decisions. As you may recall our retail gross margins were off 60 basis points in the second quarter and 80 basis points in the first quarter when compared to last year. Clearly our promotional activities during the first half of the year were costly and did not produce the sales and margin results we had hoped for.

In contrast to the first two quarters our third quarter retail gross margins were off by only 10 basis points relative to the prior year. At our very core we remain a promotional retailer as our promotional mix increased by 350 basis points compared to last year. However, we will not sacrifice margins for promotional activities which we do not believe will influence long-term customer loyalty. Rather, our goal is to offer everyday pricing that customers believe to be fair and merchandise that is relevant to the local markets we serve.

Second, we are making progress in narrowing the gap between our regular shelf price and our promotional pricing. I can say this because our pricing surveys validate this effort. To date, price improvements have been driven through centralized decision making, the consolidation of vendors sometimes even leading to exclusive providers and leveraging the scale of our 4,300 store network. Fair pricing is top of mind at SUPERVALU and I am pleased with the progress we have made this quarter.

Third, it is important to note that segment EBIT margins improved in the third quarter relative to the prior two quarters. Third quarter retail EBIT excluding the benefit of Salt Lake City was 3.5% compared to 3.9% last year but well ahead of the 2.5% last quarter and the 3.1% in the first quarter. Our supply chain business also achieved its operating goals even after fully transitioning to target business delivering 3.1% compared to 3% a year earlier. I recognize that one quarter is not a winning streak but I am starting to count.

Finally, SUPERVALU is fulfilling its long-term commitment to reduce debt and regain financial flexibility. With our exit of the Salt Lake City market the company reaped $150 million in after-tax proceeds. These funds have been applied to outstanding debt and through the end of Q3 debt is down over $300 million. We remain on target to pay down $700 million in fiscal 2010.

As a backdrop to the quarter, the overall industry remains challenged by the economic environment, heightened competitive activity and deflationary pressures. Deflation continued in November with the CPI Food and Home Index declining 2.9% year-over-year. This figure was generally in line with October’s reading and driven primarily by dairy and produce. Further I believe the value orientation of today’s shopper is secular and will remain with us for the foreseeable future.

Industry wide we are seeing increased promotional activity targeting the thrift conscious consumer. In my 30 plus years in retail I have never witnessed the intense level of price reductions and promotional activity now occurring. My belief is that the recent industry trend towards lower pricing is here to stay. However, a hyper promotional environment can encourage routine cherry picking and may not in my view necessarily build long-term brand equity. This trend has only intensified an already competitive landscape.

Consumers have become adept at tracking weekly advertisements and executing with surgical precision the purchase of those items that maximize their own savings. Accordingly price tactics once used to drive foot traffic and tonnage are now driving lower transaction size and margin erosion.

I am sure many of you are wondering how this tough environment will impact SUPERVALU’s full year earnings guidance. To that I would respond that our earnings outlook for the fourth quarter fully captures the competitive retail climate and today’s thrift conscious consumer. We entered the fourth quarter with many headwinds including weak sales trends. However, we continue to focus on the basics of food retailing, placing the customer at the center of everything we do. We remain comfortable with the earnings guidance previously provided for fiscal 2010 of diluted earnings per share within a range of $1.95 to $2.05.

Now I would like to turn my attention to the long-term outlook for the company and in so doing add more color to the vision that I outlined in our last call. SUPERVALU possesses many unique strengths including a diverse network of owned and supplied stores. My vision for the company builds upon these tremendous assets integrating SUPERVALU’s multiple distinct businesses to better serve our customers. As I said, future growth for the company will emphasize geography over ownership or banner and be driven by long-term strategic impact rather than by quarter-to-quarter sales and earnings. I am optimistic about the future of this company and believe there is significant uncapped value here.

My goal as the steward of the stockholder is to capture the value for our investors, customers, [ability] of independent retailers and employees. The principles that guide my decision making at least at a high level can be summarized as follows: Maximize the strength inherent in our diverse formats. Effectively leverage our size and scale. Nurture the unique brands we posses. Create a sustainable competitive advantage that is relevant, differentiated and compelling for our customers. Finally, deliver financial results indicative of a growth company.

Over the long-term as we execute against this vision of America’s neighborhood grocer, we will improve on our return on invested capital by maximizing the value of our diverse store network and asset base. We will diligently review our existing portfolio and will take action to monetize assets where it makes sense. As I have said in the past, SUPERVALU is capable of producing long-term financial results characterized by top line annual growth of approximately 4%, annual improvement in EBIT of 8%, bottom line growth of 10% annually and a return on invested capital of 15%.

While these goals will not be reached overnight, they are achievable by making fundamental changes to the management of our company and weaving together the fragmented operations of our traditional retail, hard discount and wholesale businesses.

As CEO one of my primary responsibilities is to build a leadership team that will execute on SUPERVALU’s new vision. I am happy to announce today that three new executives have joined our team. The first is Steve Jungmann who will serve as the Executive Vice President of Merchandising. Steve brings 25 years of sales and marketing experience to SUPERVALU including a long tenure with Kraft and his most recent work with Solo Cup Company. His deep knowledge of consumer behavior and corporate planning will aid him in overseeing merchandising for all of our retail banners.

Next, Chuck [Golias] will be SUPERVALU’s Group Vice President of Strategic Planning. Chuck brings over 20 years experience in operations in strategic management and has held leadership positions at Home Depot and General Electric.

Finally, Keith Wyche joins us as President of Cub Foods. Most recently, Keith Led US operations for Pitney Management Services and brings 28 years of strong leadership experience to our company. Steve, Chuck and Keith strengthen SUPERVALU’s management team and I look forward to their contributions as members of my leadership team.

Last quarter I shared with you the major tenets of my vision for SUPERVALU. Among these was my decision to operate our multiple, distinct businesses as one cohesive entity. This is a departure of how SUPERVALU has historically viewed itself so I would like to spend a bit more time discussing the strategic benefits of this new operational paradigm.

As you know, SUPERVALU is a large company serving a wide range of customers in neighborhoods nationwide through both owned and affiliated locations. No one format we operate can effectively meet the varying needs of consumers in all the markets we serve. However, our complimentary operations in multiple formats are a key strength that both differentiates SUPERVALU from other retail competitors and provides us significant flexibility in addressing the local needs of each market.

In the second quarter we talked about Chicago as a specific example of this opportunity. As I have traveled across the country I have seen a number of other markets where a traditional retail format does not necessarily resonate with all of the customer preferences in that market. In these markets there are niche ethnic players, high end retail operators and other independent stores that do an excellent job in serving their diverse customer base. The differentiator for these retailers is that they are hyper-local. They exist to serve a narrow segment of the population and know their customer’s needs intimately.

For example, some of the Hispanic retailers I met during my trips operate in-store tortillaria’s and offer vast arrays of meats and cheeses as well as freshly prepared foods tailored to their neighborhood customers. Partnering with these local entrepreneurs will allow SUPERVALU to capture incremental market share that today is not available to our traditional retail banners.

While we have a meaningful retail presence in many major markets across America, focusing on hyper-local independents will offer SUPERVALU another incremental growth opportunity that leverages existing capabilities without having to invest in retail store locations. Again, this is incremental growth that would not come from our retail banners as they exist today and it is a unique growth opportunity available only to SUPERVALU.

I should also point out that our Sav-A-Lot format is another brand not present in many of these markets and will represent a catalyst for growth over the long-term. By thinking about business holistically rather than by banner or ownership we will be more agile and better able to capitalize on expanded market opportunities.

Among the growth vehicles that SUPERVALU possesses, none is as potent as Sav-A-Lot. I am committed to doubling the size of this hard discount format over the next five years. As you saw in this morning’s press release, next year’s capital plan calls for a doubling of Sav-A-Lot’s new store openings. We continue to refine our execution with the opening of each new store and have approved an aggressive growth plan for fiscal 2011 which includes opening 100 locations, leveraging our existing network across the US.

We believe the current commercial real estate market only enhances the already strong growth opportunities available to Sav-A-Lot. Over the past four months our real estate team has been working at a feverish pace to fill our pipeline. Already we are seeing interest from new prospects to license Sav-A-Lot stores and we continue to market locations to existing licensees. We believe our ability to grow both licensed and corporately owned stores will ensure that Sav-A-Lot achieves its growth targets and maximizes the potential of this format.

As we look to the future, speed and simplicity will be SUPERVALU’s mantra especially from an operating perspective. We will shine a light on inefficiency and bureaucratic decision making to streamline operations and facilitate operations. As I commented last quarter we are embarking on a metamorphosis that will redefine and reposition the company over the long-term. Going forward we will be America’s neighborhood grocer, a company that is focused on the consumer with fair everyday prices partnering with the finest independent retailers in the country operating with a lower cost structure, ruthlessly allocating capital, leveraging our national scale while remaining locally relevant, operating with best in class systems and easier to do business with.

We will honor our pledge as stewards of the environment and return to an investment grade company. Since the second quarter we have taken actions to eliminate redundancies, make decision making more transparent and bring uniformity to information systems and business reporting activities.

I would like to highlight our progress on these areas to illustrate how SUPERVALU is coding speed and simplicity into its corporate DNA and everyday interaction with its customers. We are now bringing more clear, more visible value statements to consumers in our stores. Our promotional areas and grocery end caps are much simpler. Displays have been limited to two significant sale items to draw attention to the best values we offer.

We streamlined procurement of advertising by centralizing decision making and negotiating better distribution and print rates for our weekly circulars. We remained on track to complete SKU rationalization across our retail network within the next 15 months. Let me add that SKU rationalization is going well. During the quarter we completed the review of 15 product categories that will be implemented beginning in February. Among the categories we looked at was bath tissue. To give you some insight into this category each national brand offers multiple distinct varieties of tissue and historically SUPERVALU has carried 4-5 pack sizes in each assortment.

This package creates inefficiencies in stocking and visual noise for the customer. By February we will have pared back tissue SKUs by 25%. This will reduce the number of package sizes across brands but still keeps those varieties that are most relevant to our customers. This will increase holding power for our best selling items and add space for SUPERVALU’s owned brands. If you think about what this does, it makes shopping easier because it reduces clutter and more clearly defines choices for consumers. It also makes it easier for our store associates who manage inventory and logistics.

Consider this, the changes in this one category will eliminate one supplier from our operations, reduce stored inventory by one pallet and trim in-store labor associated with maintenance. Now multiply these savings by 1,200 stores in a traditional retail network. You can see where I am going. With each category review and implementation SUPERVALU drives savings and improves the shopability of our stores.

Finally, we have implemented new guard rails around our owned brand pricing. We are no longer bashful in endorsing our wide assortment of owned brand products with more prominent positioning on our shelves and representation on our displays.

The last thing I want to cover is SUPERVALU’s most recent store level customer satisfaction survey. I introduced this survey on our last call and am delighted to report that for the second consecutive quarter customer scores improved by 300-600 points when asked about the quality and freshness of our perishables, courtesy and friendliness of our checkers, if they would recommend us to others and our overall price competitiveness. I will also add that Sav-A-Lot stores are showing similar upswing.

As always, I appreciate your continued interest in SUPERVALU and believe that the positive traction you have begun to see this quarter is a good indicator of future trends and underscores our commitment to getting back to the basics of retail.

With that let me now turn the call over to Pam for additional information on our financial results.

Pamela Knous

Thank you Craig and good morning everyone. In addition to providing some comments on the third quarter which ended December 5th, I will also cover SUPERVALU’s financial condition and outlook for the fourth quarter.

Let me begin with observations that touch upon today’s operating environment. First and foremost unemployment remains high and the behavior of today’s consumer can best be characterized as cautious. With national unemployment sitting at 10%, a level not seen since the summer of 1983, many Americans are concerned about their financial future and have responded to this uncertainty by changing their shopping and savings habits.

Consumer confidence which is closely linked to the labor market has improved slightly but it is languishing near historical lows. Interestingly, the conference board which publishes this index attributes the modest improvement in recent months to a decline in the percent of consumers expecting business conditions to worsen as opposed to an increase in percentage of consumers expecting it to improve. In short, less bad seems to be the new good.

This environment poses practical challenges for consumers as well as for retailers. Consumers remain concerned about their jobs and have become even more value conscious in making every day decisions. Retailers have responded by investing in price, increasing promotional activity, reducing inventories and adjusting staffing to accommodate today’s consumer.

Compounding these challenges we have also seen five consecutive months of year-over-year deflation in the CPI Food and Home Index, a trend that benefits consumers but it pressures the top line of food retailers. The general sentiment seems to be that inflation will return in 2010 and we expect to begin cycling deflation in varying produce in our fourth quarter.

With that as a backdrop let me turn my remarks to our third quarter results.

As Craig stated, we are pleased to announce that SUPERVALU’s third quarter earnings per diluted share were $0.51 which included a $0.06 gain from the sale of stores in the Salt Lake City market and a $0.01 charge for previously announced store closures. Adjusting for these two items, our earnings per share of $0.46 exceeded First Call consensus of $0.40 and compares to earnings per share of $0.62 a year earlier before $14.57 in non-cash impairment charges.

As Craig stated, quarter three was a tough quarter. Net sales were $9.2 billion compared to $10.2 billion last year, a decline of 9.4%. The change in year-over-year sales was driven by our exit from the Salt Lake City market, the impact of previously announced store closures, the transition to self distribution by the Target Corporation and negative 6.5% ID sales.

The fall in identical store sales was attributable to a 2% decline in customer count and a 4.5% drop in average basket size. So what makes up the 4.5%? Consistent with my comments on our second quarter the quarter three transaction size was again impacted by high levels of deflation accelerating by 40 basis points over quarter two to approximately 1.2% in quarter three. Deflation was most pronounced in the dairy and produce categories.

Trade down remained a factor as customers continue to look for ways to stretch their shopping dollars. Overall, we estimate the impact of trade down was about 100 basis points. One favorable side effect of this behavior was improved penetration of our owned brand products which increased slightly to 17.6% of sales and now represents 21% of total units sold. Initial fourth quarter data shows continued improvements in owned brand penetration highlighting our merchant’s increased focus on first tier labels.

We continue to see approximately ½ items less per transaction. This trend was driven by the same factors I spoke to last quarter namely the consumer’s adherence to shopping lists and a reduced willingness to add impulse items to their baskets.

Lastly, to comment on the change in customer count to negative 2% in quarter three we were not surprised to see this slight decrease over the quarter two run rate of 70 basis points as it is the direct result of our decision to eliminate ineffective promotions. Our ID sales guidance for full year F10 is approximately negative 5% as the fourth quarter is trending comparable to the third quarter.

Turning to operating earnings, we delivered good results despite a challenging environment. Excluding one-time items in both periods, retail food operating earnings were 3.5% of sales in the third quarter compared to 3.9% a year earlier. Supply chain operating earnings were 3.1% of sales in the third quarter compared to 3.0% a year earlier.

Let me provide some additional detail on these results beginning with retail food. The 40 basis point change in operating earnings is composed of a 10 basis point decline in gross margin and a 30 basis point increase in expenses as a percentage of sales. The gross margin rate during the quarter primarily reflected price and promotional investment which was partially offset by a lower LIFO charge. The gross margin rate was down only slightly to last year as we did a good job balancing our promotional spending during the highly promotional holiday period.

On the expense side the largest driver of the 30 basis point increase was lower sales. Yes, expense reductions were a focus during the quarter and excellent progress was made. However, these results were not sufficient to offset reduced sales leverage.

I would like to share various initiatives on which we are currently working to improve SUPERVALU’s cost structure as we strive to achieve the 50 basis point selling and administrative reduction we have targeted for the long-term.

First, workforce productivity. So far this year, metrics for time per item and time per customer as well as overtime hours improved concurrent with front end customer satisfaction scores. Next, reductions in store capital costs. Both traditional and hard discount remodel costs are down an average of 10-30%. We are also driving lower energy consumption. Energy costs are down 2% through efforts that include lighting retrofits and installation of case curtains to reduce cold air loss during off hours.

Finally, we are reducing in-store costs. We are leveraging SUPERVALU’s scale to save dollars in restoring goods and services not offered for resale including floor maintenance, in-store product demos, bag and print services. I do want to also comment that our supply chain team did an excellent job managing operations in the quarter and posted a 10 basis point improvement in operating margin as a percent of sales year-over-year. Efficiency initiatives fully offset the completion of Target’s previously announced transition of certain volumes of self distribution.

As well, in the third quarter we saw the cumulative benefit of standardization of our distribution centers, the consolidation of the east coast operations and the mechanization of our Lancaster facility.

Let me now turn to our financial condition starting with capital spending. This quarter we opened one new traditional store, our Shaw’s Chestnut Hill location which Craig spoke to on our last quarter call and it is off to a great start. And we completed 24 major store remodels. At the end of Q3 almost 70% of our stores were either new or newly remodeled within the past seven years and we expect to finish with this year close to this level.

This morning’s release provided guidance on fiscal 2011 capital which includes new customer facing initiatives designed to drive sales. We commented last quarter that we are now comfortable with the overall condition of our facilities and consistent with our customer focus vision are now turning our attention to new merchandising activities within the four walls of our stores. We expect to touch well over 300 locations in fiscal 2011 with these activities allowing us to be locally relevant with compelling differentiated offerings yet not requiring the level of capital investment captured in our seven year metrics.

It is particularly exciting for me to share the coming year’s capital plan which doubles the number of Sav-A-Lot store openings relevant to fiscal 2010 as we begin the task of doubling the size of our hard discount format. Since we launched this growth objective late in October I have met personally with a number of Sav-A-Lot licensees in their respective markets to learn about their businesses, understand their growth objectives and hear what we can do to support their growth. We are confident with our new focus on Sav-A-Lot growth we will achieve 100 openings in fiscal 2011.

Turning to the balance sheet, SUPERVALU remains on plan to reduce debt by $700 million in this fiscal year. In fact, year-to-date through last week we have reduced total debt by $580 million and have reduced over $1.6 billion in total debt since our acquisition of Albertsons in 2006. We remain in compliance with our debt covenants including the most restrictive levels that take effect as of the end of the fiscal year.

For the trailing 12 months, EBIT excluding impairment and non-operating charges totaled $1.4 billion. Depreciation and amortization was $1.0 billion. Net rent expense was $0.4 billion and total debt including capital leases was $8.2 billion reflecting the typical seasonal [inaudible] peak. We finished the third quarter with approximately $1.5 billion in total borrowing capacity available to us under our revolving credit and AR facilities.

As we look towards future debt maturities we have sufficient cash flow and available borrowing capacity to meet our fiscal 2011 obligations which total approximately $1.2 billion. Our senior credit facility expires in June of fiscal 2012. As we think about replacing this facility we recognize that today’s credit markets indicate less favorable rates than we presently have. We are actively engaged with our banking partners to determine the appropriate time and manage a replacement facility and expect it to reflect terms indicative of our strong cash flows.

As you likely recall when we announced the exit of the Salt Lake City retail market we stated that the overall impact of the transaction would be negligible to our results. As a recap, we did record approximately $0.04 of impairment charges in the second quarter. The transaction closed in the third quarter netting a $0.06 gain and we expect an additional $0.01 in exit costs in the fourth quarter for a full year favorable net impact of $0.01.

We affirm fiscal 2010 guidance for net earnings per diluted share in a range of $1.95 to $2.05 on a GAAP basis and $2.01 to $2.11 on an adjusted basis when excluding costs related primarily to previously announced store closures. Based on this outlook our fourth quarter GAAP earnings guidance is $0.56 to $0.66 per diluted share and compares to adjusted earnings of $0.81 in the fourth quarter of last year which excludes $0.06 for the 53rd week.

In April, as we have traditionally done in the past, we will provide guidance for fiscal 2011 sales and earnings per share as well as our debt reduction targets. As promised last quarter, we will also provide additional disclosures in terms of operating metrics and market share to improve transparency into our retail, hard discount and wholesale businesses.

Let me close by saying the balance of this year will be challenging. We made real progress in the third quarter in stabilizing our margins and we remain focused on retail basics to better meet the evolving needs of our customers. I look forward to updating you in April on our fourth quarter results and our outlook for fiscal 2011.

I will now open up the call for your questions and following Q&A Craig will provide some closing remarks. Thank you.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Deborah Weinswig – Citigroup.

Deborah Weinswig - Citigroup

Very impressive performance on the gross margin side. Can you just help us think about the investments made in the third quarter from a promotional perspective and what that did with the top line and maybe help compare and contrast that to the first and second quarter?

Craig Herkert

I would say what we tried to do, I may have mentioned in the past we have a very strong analytics team here at SUPERVALU and what we are doing today, we have our work to do but what we are seeing in the third quarter is a better integration of that analytics group into our ad planning process. I don’t know that I want to market by market or week by week and talk about a particular program but we are getting a whole lot better each week at not running programs but frankly might drive traffic but only cause the customer to buy that item and then leave.

What we are interested here in doing is driving loyalty and traffic with customers who actually want to do their shopping in our stores. So we look at our promotional spend as a vital, important part of who we are but it is only part of who we are. We have arguably as many or more work streams going on today to address all of the other parts of the store experience so the consumer can make a choice to shop at our stores based on more than just the weekly ad. But again I want to be clear the weekly ad is important to us and we are trying to get smarter and better about what we put in that ad. I am not sure if I answered your question.

Deborah Weinswig - Citigroup

It sounds like going forward that there are part of it is centralized marketing and merchandising that SUPERVALU has put together but you have the analytical capabilities to basically be more effective with your promotional calendar in terms of driving sales through more effective gross margins?

Craig Herkert

Exactly right. I think we are using the talent that we have here, the skills and the data that we have but again I want to be clear we would self profess that we have more to do in that area. We are on our way which is good news.

Deborah Weinswig - Citigroup

What is the impact because obviously you have a loyalty card in a lot of your stores but you don’t in the Sav-A-Lot stores. What impact does that have on the analytical capability?

Craig Herkert

Actually the analytics team by the way I am referring to is mostly about traditional retail stores so X Sav-A-Lot, Shane and his team have a lot of great research but they don’t live and die on a weekly ad to the same degree that our traditional stores do. As you know Sav-A-Lot is primarily an EDLP retailer so when I speak about all this ad and analytics stuff I am really referring to our traditional banners which are run here out of the Minneapolis St. Paul area as opposed to Sav-A-Lot which is run out of St. Louis.

Deborah Weinswig - Citigroup

With regard to customer accounts, I don’t know if you can also help us think about what happened in your traditional banners versus the Sav-A-Lot banner as well?

Craig Herkert

No, we don’t break that out right now.

Deborah Weinswig - Citigroup

Last question, and this is more 10,000 foot view, what do you think the impact is of the not only high penetration but the growing penetration of food stamps?

Craig Herkert

It is interesting. I don’t know that I can speak to that particular thing. Maybe we have some data but I will say this…particularly in Sav-A-Lot stores we know with clarity the percentage of our customers that are currently unemployed and on some form of government assistance, and that may be inclusive of food stamps or another program, it is higher than we have ever seen it before. I don’t know if we can declare the number but it is extraordinarily high number and it is at the highest level we have seen since we have been measuring it.

Deborah Weinswig - Citigroup

I think in the release and also during the call it would seem the increase in selling and administrative expenses was more attributable to the reduced sales leverage than the kind of savings achieved from ongoing cost reduction initiatives. So where are we in terms of the ongoing cost reduction initiatives?

Pamela Knous

We didn’t actually give out a specific basis point impact to that and clearly you don’t see it in our numbers. So our objective as we talked about on the Q2 call is that once we return to a more normalized environment you will actually see that 50 basis point improvement. So with the work streams we have in place and the new disciplines we have around these areas once they start to turn we are going to be disciplined not to add back in costs that we have worked so hard to take out.

Craig Herkert

Let me say it another way. I am actually pleased with the progress this team is making. Without giving you the numbers, we do track it. We track it very granularly. We track it a lot. We are making very nice progress. I am very proud of the progress this team has made on that. Clearly with the sales challenges we face it is difficult for you to see it but we do see it because we track the dollars as well as the percent.

Operator

The next question comes from the line of John Heinbockel - Goldman Sachs.

John Heinbockel - Goldman Sachs

If you look at I know some of your divisions are doing better than the negative 6.5. Some are doing worse. If you look at that and then market share loss, there has been some market share loss here, how would you describe or categorize the state of the brands right now? Some of them clearly seem to be in some trouble and maybe losing relevance. How do you think about that?

Craig Herkert

I would say I don’t know that I would necessarily agree with the supposition in your question. To be honest with you I don’t know that we see brand challenges. Interestingly, Pete and I look at this religiously daily we get our sales reports. We keep trying to look for trends that would say either a part of the country or a particular banner and gosh I can tell you I don’t know that I see that. On the positive side I would say what Pam mentioned in her script and that is we are seeing some nice improvements in our price gap relative to traditional competitors in many of our markets.

In fact I think the last report only had one market where we would be sort of the high priced player. In every other market we are not and in most markets we are not by a significant percent which is really good news and we see continued progress on that front and we see continued positive feedback from customers. The customer scores I referred to earlier, that is customers telling us what they think of us. That is not an internal thing. I think that ought to be read as good news that the customers are continuing to say good things about their experiences and the pricing at our stores. So sorry to dance around your question a bit but I don’t know if there is any one place that I would say we are more troubled with than another.

John Heinbockel - Goldman Sachs

Is it just a timing delay that the progress you are making internally hasn’t shown up with the customer voting with their feet yet and shopping? Do you have a typical experience where there is a certain delay between that improvement and when you see it in your profit and relative share performance?

Craig Herkert

Sure. I think we actually talked about this last time too. We think this is a long-term proposition what we are doing. I would like for customers to be responding more quickly. I am not surprised. The stuff we are working on is on one hand fairly simple stuff. The SKU rationalization, the pricing, the narrowing of the gap between our promotional price and our regular shelf price. That said, with 50,000 SKUs and thousands of stores in our network it is time to get all these things executed and we are trying to do them thoughtfully and in a manner that is not disruptive to our consumers. So I think as we talked about before we are looking at a year or 18 months as we roll out all of these initiatives.

What I said in my script and I really believe, I love the pace at which I see this company moving. SUPERVALU associates have embraced this idea. We are moving at a very fast clip but this is going to take some time for us to both execute the programs and then once they get executed have our customers really sort of see the breadth of that which we are doing. So I can point to one-off situations where we address the pricing things but that might not be enough to change customer behavior. It is only when she sees that change across a broad range of categories in our stores. The fixing of the bathroom tissue category is incredibly important for us but it alone won’t change customer perception nor will it change operational efficiency enough to matter. But if I do that in a bunch of categories and I will and I will do so in the next 15 months, I think that is when the customer notices and you will be able to see it then in the metrics.

John Heinbockel - Goldman Sachs

Finally, where do we stand with the organizational structure to allow you to holistically manage your markets? When do you think the bulk of that will be in place?

Craig Herkert

That is a good question. I am really pleased with the additional team members I highlighted a moment ago. I am just thrilled with the quality of talent we have been able to recruit here. So that is step A. I think the rest of it is sort of evolutionary rather than revolutionary. I don’t know that I would say there is a point in time that we would look to you and say we are done with our organization and we have it exactly in place. I guess I would say stay tuned and we will continue to evolve as we learn internally how best to structure ourselves to meet the goals that we set for ourselves.

Operator

The next question comes from the line of Meredith Adler - Barclays Capital.

Meredith Adler - Barclays Capital

I would like to talk just a little bit more about the SKU reduction effort and maybe you could go into more detail about what this means for vendors. Do you find the ones that are still around are being more supportive in terms of their promotional monies or the fact that even if you are reducing the SKUs from them they are able to make that more effective for you in terms of promotion?

Craig Herkert

Great question. Actually let me hit on a couple of things. I will start with particularly owned brands. We have seen some great success as we have looked at consolidating suppliers with some of our owned brand categories and we have seen really, really good benefit and cooperation partnership with our supplier partners clearly with the ones who end up getting the business. I mentioned in some cases we have consolidated vendors. That would clearly be in the case of some of our owned brands. I am pleased with what the owned brand team is accomplishing in that area.

Let me take the case of the bathroom tissue regarding a broad range of categories. I think we have seen this and we actually had a good walk through with the executive team just yesterday where we looked at a number of categories where the team has actually gone through this process. Primarily what we are seeing is not the elimination of brands but elimination of redundant sizes or packs. Bathroom tissue would be a great case study here.

We actually eliminate one tertiary brand but in all the brands that matter to our customer we don’t eliminate a brand and we did not eliminate a variety. What we eliminated maybe was a pack count because we had gotten to where we were carrying virtually every pack count available. That caused us to be really inefficient in that in many cases we couldn’t even get a full case on a shelf at a time which as you know that means I am picking stuff in the back room or moving it somewhere. So we sort of set some rules in place about what we have to get on the shelf. I will tell you when we actually looked at the shelf yesterday the clarify for the consumer, the clarity of the offering I think is so improved versus where we were I don’t think the consumer is going to look at it and say that we have taken any choice away.

In fact, I think what we look at is we now see the consumer will look at better choice. So that is that. On the vendor side, I guess it is a mix. When I was talking to our business development managers yesterday I think the vendors, the bigger and better ones, they know we have to do this. I have actually talked to a couple of the CEOs. I wouldn’t lie to you and say they are comfortable but I would say they know we have to do this and they understand we have gotten to where we are inefficient. I think to the degree we are partnering with them they are embracing this and saying what we can actually do is sell more products because we will be in stock on the weekends. We will be in stock at 4 o’clock on a Saturday afternoon and Sunday afternoon and we will have the right brands the consumer is looking for so ultimately this will be a win. I hope I have answered the question there.

Meredith Adler - Barclays Capital

Obviously it is going to be a work in progress. Another question I have maybe is a bit more for Pam. You are certainly keeping open the idea that you will sell assets if it is appropriate. Salt Lake was obviously a good opportunity because of less money. Maybe talk a bit about how you look at selling a piece of a division. Southern California has all these scattered pieces to it. Does it make sense with distribution and advertising to carve off any piece of it or would your goal to be as fixed in as much as it as you possibly can and keep it all?

Craig Herkert

I can take that one. What we are doing is really kind of exciting. Andy Herring is leading our real estate team and he and his crew are going through and doing a market by market granular review of all of the markets we are in and so I don’t want to take a particular market but we can and we are getting very granular in our look much like we did with Salt Lake City. We can look at both owned, affiliated, licensed and independent retail and think about the best way to maximize our opportunity within a given sub market. I think you are absolutely right. We are trying to get away from looking at it just while it is all Southern California or all Intermountain West or name your market that we might have referred to in the past. But how do we get more granular in our look.

We are doing so as we speak, we would have completed about half the country at this point but we are real detailed in our analysis at this point.

Meredith Adler - Barclays Capital

My question really is there a way to reduce the fixed costs, the market wide fixed costs to be able to make a change in a particular subsector or eliminate a subsector in some markets?

Craig Herkert

I think it ties back to Super Fusion quite frankly. So I do think yes. I think if we were to approach it this way and we divested some assets I think clearly we think there is an opportunity for us to make sure we continue to leverage the fixed costs of the company. But that is part of what this company has been working on for the last 3.5 years with Super Fusion and becoming one.

Meredith Adler - Barclays Capital

My final question is I believe [All Holdings] acquired one of your larger wholesale customers in the Southeast, [You Prop]. Does that have a meaningful impact on the efficiency at the distribution center? I know everything is being centralized in Lancaster. Are the benefits of that and the new technology offset the impact of losing those [You Prop] stores?

Craig Herkert

I don’t think really we have anything to comment on that particular acquisition at this point in time.

Operator

The next question comes from the line of Edward Kelly - Credit Suisse.

Edward Kelly - Credit Suisse

To me it is encouraging that it seems to be you are looking to get smarter about your promotional strategy and you seem to get that this hyper promotional stance is just a race to the bottom for the industry. It sounds like maybe there are some other players out there that are starting to take that view but I wouldn’t say it is the majority. Are you seeing from a ground up market perspective others beginning to acknowledge the same thing yet or are we not even close to that?

Craig Herkert

I don’t know I would say we are close to that. We saw some of the most aggressive promotional spending I think we have ever seen over the last holiday season. That is not market specific. It was just all over the place and it was all kinds of competitors. So no I don’t know I am seeing that yet.

Edward Kelly - Credit Suisse

As we think about this past holiday season and for instance Thanksgiving a number of retailers have talked about how it was such a tough holiday. Did you not experience that because you got smarter about how you promoted? Was Thanksgiving actually okay for you?

Craig Herkert

I don’t want to talk about a particular week. I will talk about the quarter and I would characterize it this way. I am pleased with the decisions we made. It is tough to look at a negative 6.5 ID and say you are pleased but we did so with thought and with intent. So yes I am pleased with the way the quarter came out given the environment we are in and I am pleased with the actions this team took and I think you apply that across the weeks within that quarter.

Edward Kelly - Credit Suisse

I think I heard you say in the past, and these are not your words they are my words, but you are pretty much committed to not blowing up the P&L through pricing to improve your competitive position. This is something that would take place over time. This quarter would seem to be an affirmation of that. My question to you is you talked about this 6.5 down ID that is clearly market share you don’t want to lose. How long can you continue with this strategy if you don’t drive better IDs?

Craig Herkert

We will continue to fight that balance but market share that is unprofitable is not a good thing for SUPERVALU or its shareholders. So we are focused on market share as a piece of what we do clearly but we want it to be profitable, sustainable market share gains not market share gains that we bought with money we don’t have. So I kind of reiterate what I said in the past quarter. We want to be thoughtful about our spend. I think you are right. Your words are fine to me with regard to how we are approaching this.

This team is doing so much good work right now on finding ways to take costs out of our business or to be more efficient or to leverage better costs from suppliers and how we pass that along in the form of better pricing particularly everyday shelf pricing is exactly what we are working on. You are right, it is not a magic bullet but it is something that over time will be effective and sustainable which is important to us here. What we want to do are things that are sustainable.

Edward Kelly - Credit Suisse

Can you discuss the trend in vendor allowances? Has that increased this quarter and is that part of the reason the gross margin sequentially was a little bit better?

Craig Herkert

No. I don’t think we saw any changes in allowances this quarter. No trend change there.

Operator

The next question comes from the line of Scott Mushkin - Jefferies & Co.

Scott Mushkin - Jefferies & Co.

My first question is I think you commented your prices are actually in line, your internal surveying shows they are in line with your traditional competition less one market. My question is that is amazing considering your comps are down 6.5%. So what do you think is driving that? It is not price. What is driving customers away from the store at this stage?

Craig Herkert

I think we talked about certainly deflation is part of it and that is endemic to the market but I think the other part is as Pam mentioned we made a strategic decision to not buy customer count. So we had a 2% drop in customer count which is trending I think 70 basis points worse than where we were a quarter ago. That was a conscious decision we made not to go out and purchase customer count or purchase ID sales that we didn’t think were sustainable and frankly we couldn’t afford. I’m not sure if that answered the question but that is sort of where we are.

Scott Mushkin - Jefferies & Co.

Our survey is actually showing in certain markets not priced with guys at all anymore. In certain markets, not everywhere. I guess I am having a little trouble reconciling you don’t want to buy the stuff but where prices are and why. I don’t know how to reconcile this but maybe I will move forward.

I didn’t hear anyone talk about the current trends. The quarter I think closed December 5th. Has anything materially changed? Are you still running about negative 6.5? Where are things trending since the close?

Pamela Knous

What I said in my prepared remarks is the trend from Q3 is continuing into Q4.

Scott Mushkin - Jefferies & Co.

So there is no improvement. Nothing. Just the same. Are inflation trends the same too? You are not seeing anything different there as well?

Pamela Knous

Didn’t see anything different but we did say we will start to cycle some deflation in produce in the fourth quarter.

Craig Herkert

We do continue to see fairly significant deflation in some key produce categories. We measured some of this pretty heavily and it is shocking some of the deflationary numbers in some of the larger produce categories that we continue to see. So deflation is a continued issue.

Scott Mushkin - Jefferies & Co.

I know on the last conference call you talked about how you were going to try and consolidate Sav-A-Lot into your traditional distribution business. I was wondering is that something that can really be done? Can Sav-A-Lot distribution go through your traditional distribution business? Is that still in the cards here or maybe not?

Craig Herkert

Frankly I don’t recall we said that. What I would say is our President of Supply Chain, Janelle [Hogart] has done a great job of looking at all of our supply chain opportunities across our network and continues to look at how to best service all of our stores. I don’t think we have ever spoken specifically about any particular distribution methodology but we did say Janelle is the executive in charge of all of the above and she and her team are looking at how we best serve our customer’s needs.

Scott Mushkin - Jefferies & Co.

I guess the idea I am trying to understand at least from a cost perspective how the holistic approach including Sav-A-Lot helps you from a cost perspective as you move to market.

Craig Herkert

I would say as we move down the road we will continue to look at how we best serve our customers most efficiently and how we best grow market share in the different formats we have. So we will continue to work through that process as we go down the road.

Scott Mushkin - Jefferies & Co.

I think Southern California went over to the centralized procurement and purchasing and I wanted get an update how that went. Is that the last major market to go over?

Craig Herkert

I think that happened awhile ago. That happened before Q3.

Pamela Knous

We are 80% done at this point so you should just presume that we are substantially the big banners are taken care of. So at this point we are not differentiating between who is on and who is off. We have pretty much accomplished that this year.

Operator

The next question comes from the line of Neil Currie – UBS.

Neil Currie - UBS

I just wanted to ask about CapEx for next year. It looks as though you are going to retain this current level of CapEx. When I compare you against other supermarket competitors your CapEx depreciation is pretty low at 0.7 times. Kroger is 1.5 times and Safeway when they were at the peak of the lifestyle remodels they were at 1.6 times. Is it just a function of your balance sheet restricting you from what you want to do or are you happy you don’t need to do that much to the store base in order to resurrect the sales performance?

Craig Herkert

Can I say yes to all of the above? I actually think we are being prudent with our spending. The fact that our balance sheet causes us to be thoughtful I think that is a good thing. I think our shareholders ought to be pleased that we are being thoughtful and incredibly prudent with our capital. I actually have seen in great detail the plans that Pam spoke about earlier about how we could touch hundreds of stores and do so very efficiently and very effectively I think is really exciting. The fact we can open stores particularly Sav-A-Lot stores through our licensee program is very, very capital efficient as you know. So I think we accomplished both opening stores that we think matter in this environment and going forward and we have spoken about that. I think we can continue to update our traditional retail stores with appropriate customer facing initiatives that I think will matter to our customers and that is important to us.

As Pam said I think we have a robust program to ensure our physical plants are up to date. Finally even as Scott alluded to just a moment ago, I think we have a built in capacity with our supply chain that allows us to grow our business without necessarily having to invest in new physical assets in the near-term and still allow us to grow as we get more efficient and split those assets even further.

Neil Currie - UBS

I wanted to ask again about this balance you are trying to strike between gross margin and sales because clearly you have backed off a lot of the heavy promotional activity but the downside was that your comp deteriorated. I am trying to back out deflation and think about underlying volumes which clearly may be somewhat negative. What is your confidence in the next 12 months you could see volumes move to flat to positive? If you don’t see that in the next 12 months do you feel you may have to revert to a more aggressive pricing stance to kick start them into life?

Craig Herkert

First of all we are not going to talk about the next 12 months until April so let me dodge that question. Let me say the initiatives that this team are working on today are each and every one of them…the purpose of each of those initiatives is to in fact achieve a better shopping experience and make us more competitive for our customers. As we roll these initiatives out quarter by quarter it is our plan these things do have merit to our consumers.

So let me be blunt in saying everything we do is focused on making sure we are doing things that are relevant to our consumers. As I said earlier we think this is a 12-18 month process as we roll these things out. Let me not talk about fiscal guidance until we get there in April.

Neil Currie - UBS

But maybe conceptually you think the key to the customer experience is the key to improving sales and that customer experience is more about merchandising choices than it is throwing capital at the stores?

Craig Herkert

Yes. That said, you will see us talk more in the early part of next year about some of these customer facing things Pam alluded to earlier when we talked about touching 300 stores. Once we get going on that I would like to be transparent with you and tell you what we are doing. So I don’t want you to think we are not going to spend money in stores on things we think will matter to our customers. We do intend to do that. But absolutely we think the primary focus is on merchandising, pricing and continued experience. The fact we want our customers to be happy when they are in our stores both at the butcher block, the meat counter, the seafood counter, the deli and certainly on their way out the door. So we are focused. Our operations team is focused on making sure the experience she has when she is in our store is a positive one.

Operator

The next question comes from the line of Mark Wiltamuth - Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

A question on your SKU rationalization. Do you think there is going to be a gross margin impact from that or is that just mostly going to drive sales when you get the stores reset?

Craig Herkert

I don’t know there is a gross margin impact so much as our expectation would be it helps drive sales for all of the reasons I mentioned earlier and clearly an expectation would be that it causes us to be more efficient both from our supply chain and particularly in each of our stores. So we would hope to see positive financial indicators on those two areas.

Mark Wiltamuth - Morgan Stanley

In terms of signaling here, if you look at this quarter this is a quarter where all the competitors seemed to get more aggressive on gross margin investment. We have seen some of your competitors with gross margins down 100 basis points or more. With your comments here with your analytics is this just a signal to us that the days of 40, 60 and 100 basis point gross margin sacrifice are over and you are just going to be more disciplined here on out?

Craig Herkert

I think what we have said is we intend to be more disciplined. We intend to be more thoughtful and to spend our money in ways we think drive long-term customer loyalty as opposed to buying short-term gains. So I think that is right.

Mark Wiltamuth - Morgan Stanley

To check up a little more on your efforts to centralize merchandising, how much of that is really being done centrally now and how much is being done locally to kind of balance the need for local taste?

Craig Herkert

We probably have about 80% of it done centrally. I will tell you getting Steve onboard early next month is going to be very exciting for us as we look to add some executive talent to continue to look at how we strengthen and simplify the central merchandising program. But it is probably about 80% today.

In closing, I would like to wrap up today’s call with a final thought. That is since my arrival in May we have been pushing hard for SUPERVALU to embrace speed and simplicity in everything we do, especially important in the current environment with consumers focused on value. We need to execute on the simple blocking and tackling, offering the right merchandise relative to neighborhoods we serve at a fair price.

As I have said many times, grocery retail is ultimately a simple business and SUPERVALU is repositioning itself to meet the consumer needs in this challenging environment driving operational efficiencies and producing results that resonate with our shareholders. I look forward to visiting with many of you in the months ahead and thank you for your continued interest in SUPERVALU.

Operator

This does conclude today’s call. You may now disconnect.

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Source: SUPERVALU Inc. F3Q10 (Qtr End 12/05/09) Earnings Call Transcript
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