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By Michelle Chang
Although economic conditions improved throughout 2009, domestic grocery store operators have not benefited due to food deflation, a heavy promotional environment, and labor costs. According to U.S. Census data, grocery stores are expected to generate roughly flat growth in 2009 from the prior year, after generating a compound annual growth rate of 4% from 2002 to 2008. The beginning of 2010 appears to be challenging, as consumers are still grappling with a high unemployment rate and tighter credit.

The Fight for Consumers' Dollars Intensified in 2009 and Will Likely Remain Tough in 2010
In food retail, switching costs for consumers are virtually nonexistent. Individuals largely choose locations based on price, and the situation intensified as the downturn progressed. Grocers reacted by lowering prices to retain traffic. For example, Supervalu's (NYSE:SVU) Jewel-Osco chain lowered prices by as much as 20% in certain categories to appeal to price-conscious consumers. Safeway (NYSE:SWY), which had previously spent time investing heavily in its stores, also moved to a low-cost, low-price strategy. Even Kroger (NYSE:KR), which had been the most proactive in repositioning stores to better compete with deep discount formats, lowered prices to maintain market share. We believe competition will remain intense, particularly as Wal-Mart (NYSE:WMT) (the largest food retailer in the U.S. with approximately $130 billion of grocery share, around 20% market share) has renewed its low-price policy with a vengeance, and Target (NYSE:TGT) is testing a new store format that increases its presence in perishables.

While all operators have been negatively affected by the competitive environment, we believe the grocers we cover can withstand these pressures better than smaller independent chains. The grocery industry remains highly fragmented. Kroger is the second-largest food retailer with an approximate 10% share of the market, according to our calculations. The next three largest retailers in terms of sales, Costco (NASDAQ:COST), Safeway and Supervalu, each hold around 5%-6% share by our estimates. We believe that these larger operators are poised to take share from smaller regional chains that have struggled and gone bankrupt amid the economic downturn.

Private-Label Penetration Has Increased, Partially Offsetting Margin Pressure
Because of consumers' increased focus on price, private label brands have grown their share of sales, as these company-owned labels sell at roughly 30% lower prices than their branded counterparts. According to IRI, private label penetration reached 22.8% on a unit basis in 2009, up from 21.6% in 2008. Kroger's own brands accounted for approximately 35% of total units sold in grocery in its fiscal fourth quarter. While a shift to private label generally pressures the top line, the bottom line benefits from increased profitability. Store brands are also a good way to drive traffic, and we believe Kroger has done well to create awareness around its portfolio of brands.

Food Deflation Plagued 2009 but Should Improve as 2010 Progresses
Although price will likely remain the prime vehicle to drive traffic, we believe grocers should see some relief in the form of moderating food deflation. Excess inventory in 2009 drove down prices in key categories such as dairy, meat, and produce. For example, dairy prices reached their lowest levels in recent quarters. Because these categories are essentially commodities, changes in price are passed on to consumers. The recent wave of deflation has placed additional downward pressure on an already weak top line. Delhaize Group reported retail food deflation in its U.S. operations of 2.1% in the fourth quarter of 2009, compared to 6.5% inflation in the same period in 2008, an 860 basis point swing. In addition to negatively affecting identical-store sales, deflation also hurts operators' ability to leverage fixed costs like store overhead and labor. We anticipate that supply will become better matched with demand this year, helping to restore prices. The United States Department of Agriculture expects food inflation of 2.5%-3.5% this year, assuming economic conditions continue to improve. While at first blush this seems high to us, we do believe that inflation will be slightly positive in 2010.

When Will Grocers See Relief?
We expect operators to report tough fourth-quarter results in the upcoming weeks, and largely anticipate that challenging trends, particularly heightened competition, will persist through the first half of 2010. According to W. Rodney McMullen, the COO at Kroger, grocers typically lag an economic recovery by about six months to a year. This is roughly in line with our view that consumer spending (approximately 7% of which is attributable to grocery purchases, according to the U.S. Census) is tied closely to the unemployment rate. At the very least, food retailers should see some relief in the form of moderating deflation as 2010 progresses. Assuming the competitive environment also eases throughout the year, we expect operators to experience less pressure in the back half of the year. However, if retailers maintain their aggressive stance on promotional activity, we believe firms will not begin to see relief until the beginning of 2011.

Our Picks

Kroger
We like Kroger because of its size and scale advantages relative to smaller competitors, allowing it to better withstand the downturn. Kroger is the largest traditional supermarket operator in the United States at approximately $76 billion in total sales, and we believe it is well-positioned to capture share from regional players that have gone bankrupt over the past year.

Safeway
Safeway had been remaking locations to premium positions, but during the downturn the firm has worked to transition to a lower-cost model by reducing prices and cutting back on renovations. Safeway generated $1.5 billion of free cash flow in 2009, which it is using to buy back stock--the board recently approved an additional $1 billion of stock repurchases, with approximately $720 million left in its authorization. We think this is a good use of capital as the stock appears undervalued and financial leverage is manageable.

Supervalu
The company is finishing a three-year restructuring program to integrate the old Albertsons stores, which we believe can help the firm make incremental improvements from its current state. Supervalu has lowered prices and boosted its private-label efforts, moves that we believe should help it keep share. We also have a more favorable view on the hard-discount Save-A-Lot stores relative to the firm's traditional grocery store banners, which stand to benefit more in the weak environment.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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