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SUPERVALU INC. (NYSE:SVU)

F2Q08 Earnings Call

October 16, 2007 10:00 am ET

Executives

Yolanda Scharton - Vice President, Investor Relations and Corporate Communications

Jeff Noddle - Chairman, Chief Executive Officer

Duncan MacNaughton - Executive Vice President, Merchandising and Marketing

Pam Knous - Corporate Executive Vice President and Chief Financial Officer

Analysts

Charmaine Tang - Citigroup

John Heinbockel - Goldman Sachs

Edward Kelly - Credit Suisse

Steve Chick - J.P. Morgan

Meredith Adler - Lehman Brothers

Perry Ciacco - CIBC World Markets

Robert Summers - Bear Stearns

Mark Husson - HSBC

Operator

Good morning, ladies and gentlemen, and welcome to the Q2 fiscal 2008 earnings conference call. (Operator Instructions) I would now like to turn the call to Ms. Yolanda Scharton. Ms. Scharton, you may begin.

Yolanda Scharton

Thank you. Good morning, everyone. As you know, today’s call is webcast and will be archived for a few weeks and be available on our website for future listening. On today’s call today are: Jeff Noddle, SUPERVALU's Chairman and Chief Executive Officer;

Pam Knous, Corporate Executive Vice President and Chief Financial Officer; as well as Duncan MacNaughton, Corporate Executive Vice President of Merchandising and Marketing.

Today’s information presented and discussed includes forward-looking statements which are made under the Safe Harbor provision of the Private Securities Litigation Reform Act. The risks and uncertainties related to such statements are detailed in our fiscal 2007 10-K.

After today’s call, we will have a Q&A session and if you can, I ask you to limit it to one question so we can accommodate everyone, as we have a very large group on the phone this morning. As always, I will be available after the call for additional questions.

Thank you and now I would like to turn the call to Jeff.

Jeff Noddle

Thanks, Yolanda and welcome to today’s call. As you know, we are on a three-year journey to deliver the full economic benefits as mapped out in 2006 following the acquisition of Albertson’s premier retail property. We have now fully cycled the first full year of the acquisition and we remain on track with virtually every key metric, including the delivery of the fifth straight quarter of double-digit earnings per share improvement.

In the second quarter, we reported diluted earnings per share of $0.69 compared to last year’s reported diluted earnings per share of $0.61, an increase of 13%. When adjusted for last year’s extra week in the acquired property, earnings per share increased by 18% in the first true quarter-over-quarter comparison.

Also in the second quarter, we delivered operating earnings margin improvement on a year-over-year basis. This improvement reflects our ability to generate sales leverage, manage our costs, and deliver the synergy benefits.

One area in the quarter that did not fully meet our expectations was identical store sales. When we provided fiscal 2008 guidance, we estimated ID sales growth of 1% to 2%. As such, our earnings growth plan for fiscal 2008 was not dependent on significant ID sales improvement. That has not changed.

Despite this expectation, we are not pleased with our ID sales performance this quarter. Second quarter ID sales, excluding fuel, for the entire network increased year over year by approximately 50 basis points.

As we commented, sales softened as we finished our first quarter. Deflationary pressures in our pharmacy business from increased sales of generics continued in the second quarter, causing a 30 basis point decrease in ID year over year. In addition to competitive challenges in several markets, we did not adequately plan for and cycle prior year promotional activities.

However, our current run-rate is slightly improved. As such, our ID sales range for the year remains at 1% to 2%, with the expectation that we will be at the low end of the range.

However, I assure you; ID sales improvement is one of our top priorities and I am confident that as we continue to invest in remodels, in implementing our merchandising and marketing program, and execute at the store level, our banners will be well-positioned for success.

It is this confidence that allows us to introduce an identical store sales goal today of 3% or more during fiscal 2010. Our fiscal 2010 year begins in March of calendar 2009, or in about 16 months.

This goal is based on several things. First, where we started from; as you’ll recall, the ID sales of the acquired operations were slightly negative at the time of the acquisition; the success and pace of our remodels over the next few years; and the building of the momentum of our numerous merchandising and marketing activity.

So now let’s turn to the initiative we have underway to deliver the full potential of SUPERVALU. As you’ll recall, in most cases the properties we acquired had excellent market share position, superb real estate locations, and top notch local management. We also knew we needed time to improve several key operations -- several key aspects of our operations to ignite sales.

I would like to quickly cover the key activities we are implementing to build momentum over the next few years and contribute to our long-term sales success.

Achieving the right pace of combination for an acquisition of this magnitude is a very important component to ensuring SUPERVALU's long-term success. Some may say we are moving to slow on certain aspects; some say too fast. From day one, we have said this was a three-year effort and we are holding to this timeline. And remember, we are almost halfway through that timeframe.

What we took on first was in-store customer service, or raising the standards across our store base. It was an area we could quickly implement and have impact. Customer service programs are currently deployed across all of our banners and showing steady progress. These programs also engage all of our associates, building a common culture across the company.

Next, we began to implement a sizable retail capital program of approximately $1 billion. Most of this capital is directed to the biggest area of sales opportunity, our remodel program. It will take a sizable amount of capital and a number of years to achieve a store network that is 80% new or newly remodeled in the past seven years.

Starting with the second quarter of fiscal 2007 through end of the second quarter of fiscal 2008, we have completed 100 major remodels and 35 minor remodels. Each major remodel represents a spend of between $1 million and $4 million.

Our remodel activities are ramping up in the back half of this year and we now expect the completed total of 110 to 120 major remodels, which is up from 100 to 110 given previously. In addition, we expect to complete 25 to 35 minor remodels for the full fiscal year. The increase in our remodel activity is all within our $1.2 billion capital plan.

Since we are at the one year point, I will quickly comment on a couple of the specific remodels we previewed with you as representative last year at this time. As you know, our remodel program is called premium, fresh and healthy, which consists of tailored modules for each demographic and banner proposition. We chose not to take a broad-brush cookie cutter approach to our remodel program, but instead utilize a disciplined, localized approach with built-in flexibility so we can be locally responsive to our customers in their respective community.

For example, in Cambridge, Massachusetts, we remodeled a 56,000 square foot Shaw’s store that was last remodeled in 1991. The $4 million capital project included an enhanced produce, meat, deli and bakery department. In addition, we significantly enhanced and repositioned the entrance in this densely populated neighborhood located only minutes from downtown Boston and very close to Harvard College.

Since the remodel was completed in late August, average weekly sales exceed the prior year by approximately 9%.

Another successful early remodel that we discussed last year is the one in Fullerton, California. This Albertson’s store was opened in 1998 and never remodeled. This store serves a large college population, a significant Hispanic population, and has a considerable high income customer base as well.

With tailored modules, such as wild harvest and shop the world, this remodeled store has seen average weekly sales up nearly 8% compared to the prior year. These remodeled stores are clearly delivering internal rate of returns well in excess of 15%.

Even though it is not our practice to comment on an individual banner, I would like to make a few comments on Shaw’s, as there certainly has been much written of late.

As you may recall, Shaw’s was acquired by Albertson’s, not until 2004 and was never integrated into Albertson’s programs or systems. Therefore, our migration of plans and activities at Shaw’s are different than all other banners. Clearly Shaw’s stores have premium real estate and a well-developed loyalty program, making them prime candidates for a strong remodel program, as well as enhanced merchandising.

In fiscal 2008, we will complete 20 major remodels, representing almost 10% of the chain. To date, half of these remodels have been completed and we are very pleased with the performance we are seeing.

In addition to remodels, we are also building new stores in this market. One new store that we are seeing fantastic results it the East Hampton Connecticut store. The store opened in September of last year and the year-on-year cycle starts this week. The store is averaging in excess of $0.5 million in sales per week and well ahead of expectation.

We also recently made a management change at Shaw’s. When Carl Jablonski announced his retirement as banner president, Larry Wahlstrom, formerly president of our Jewel Osco stores, took the top job at Shaw’s. Larry actually spent 16 years in this market so he understands the competitive New England market very well.

As I have said many times, we see tremendous opportunity at Shaw’s to enhance our brand loyalty through a variety of initiatives that will generate long-term sustainable growth.

Coming behind our important remodel and customer service program is our center led merchandising and marketing organization that will collaborate with our banners and leverage the scale and potential of our coast-to-coast store network, while maintaining local relevance.

This competency will have tremendous potential to drive long-term success across the organization. To date, we are making good progress on this initiative. As you know, moving from a decentralized model to a more centralized one will cause some natural friction with associates, vendors, and service providers. Naturally, our changes impact all of them as well but we firmly believe it is the right decision and we are moving forward at the pace we consider appropriate.

Now I am going to take a moment to make a general comment about pricing surveys. They have been very popular recently and written about as well. As you are well aware, a pricing sample may or may not be a good indicator of the actual price paid by the customer.

For grocery retail, a comprehensive survey would need to take in all pricing variation, including special buys, advertised specials, temporary price reduction, coupon, and loyalty card benefits both at the store and at home, to list a few. These variables make it very difficult for many to get a reliable sample.

We monitor all of our markets across the country consistently and we are well aware of what the actual spreads to our competitors are. It would be great to be in a market that we hold a leading market share position with a large, unfavorable price spread to our primary competitors in the mid-teens, as some have written about in certain markets.

The truth is that would never happen and it doesn’t today. As I have said many times, we’ll be making pricing investments when needed as any retailer would to be competitive. We need to be competitive not only in price but in service, selection and quality to deliver overall value to the consumer.

I hope this gives you an idea where at least I stand on pricing surveys. Now let’s move on.

The foundation is now laid for our national merchandising programs, including acceleration of our owned brands private label, new product introduction, high impact seasonal promotions, and center store initiative.

To hear more about this, I will turn the call over to Duncan MacNaughton, our Executive Vice President of Merchandising and Marketing, who will share with you some of the very exciting merchandising activities underway. Duncan.

Duncan MacNaughton

Thank you, Jeff. I’m thrilled to discuss the progress that we are making on our merchandising and marketing efforts. In the interest of time today, I am going to focus on three key activities that are underway to deliver the tremendous potential of SUPERVALU.

First, leveraging our scale; our migration to a more centralized model that leverages our scale and buying power is essential to our future success. In addition to the cost of good savings, this model also leverages our ability to deliver stronger merchandising programs, category planning, assortment enhancements, advertising and promotional initiatives, and new product introduction, which in turn drive retail sales.

Yet we don’t underestimate the need to be locally relevant. When our SKU commonality across the country exceeds a critical mass threshold, a central procurement model is vital. When SKUs are truly local, the banners manage the deal. We call this go-to-market model corporate led collaboration.

As we finalize SUPERVALU's merchandising and marketing center of excellence, it must be based on a customer-centric, locally relevant philosophy. Without this underpinning, our programs will not resonate with the consumer. We are taking this to the next level by enhancing our already strong research and analytical capabilities to further harness loyalty card data, including using real-time information, target our distinct customer segments by banner and by market, and create new ways to engage, educate and motivate our shoppers.

The next key activity underway is the acceleration of our owned brands program. Clearly this offers a substantial opportunity for SUPERVALU. With SUPERVALU's owned brands, or as some of you might call, private label, at only 15% of total sales today and many competitors well above 25%, we have lots of upside in sales and gross margin opportunity.

Let me give you a quick update on this exciting initiative. We have already begun to reduce our label count from 100 to approximately 20. The rationalization of our label count will result in some savings or synergies.

Our owned brand product strategy is focused on a powerful, three-tier philosophy offering premium private label, a national brand equivalence, and a value label. With a targeted spectrum of quality and value, our products will be attractive options to all of our customers.

Product rollout will be in phases and by category over the next year and beyond. One large launch will occur shortly after the end of the calendar year. Many of our product labels and packaging are currently being updated, or in some cases completely relaunched.

And lastly, strong in-store merchandising programs will support our owned brand efforts.

As you know, private label products deliver higher margins than their national brand counterparts, but equally important is they offer a powerful pricing proposition to our customers looking for value.

As we increased our penetration of owned brand products across the banners, it provides another strong building block for our many other initiatives that are taking root, like customer service and our premium, fresh and healthy remodel program.

The last key activity underway is leveraging our center store. As you heard today, our remodeled stores are showing some very nice results and we will certainly continue to refine and tweak this program with learnings from our banners. But we are already developing the next in-store initiative -- the center store. As you know, our remodel program primarily focuses on the perimeter departments. We need to also drive center store sales and profits.

We have a world class team of center store merchants with deep category knowledge, merchandising expertise, and market experience. This team has been identifying new ways to leverage the scale of our new enterprise to benefit our center store and absolute focus on increasing both sales and margin across all departments, while creating a shopping destination that is customer-centric and easy to shop.

We are still relatively early in our center store process but we’ve had some early wins that show us we are on the right track. Several of these have come through our revamped first to market program. Being first to market has many advantages for center store. It allows us to drive new incremental sales and profits and generates excitement in our stores, helping us to grow market share and win core consumer loyalty.

In recent months, [we have relied on] some important product launches in soda, cereal and soup. Recent examples of this are the launches of Diet Pepsi Max, Kellogg’s Cereal Straws, and Campbell’s Chunky Fully Loaded Soups. Through collaborative efforts across the company and with our vendors, we had 100% of all commodity volume, or ACV, for the first two weeks of each product’s market introduction. The products were very well-received by our customers as well.

These are definitely early wins that support our first-to-market vision in center store.

Additionally, we are working with our vendors on exclusive seasonal merchandising and product introduction. I can’t say too much about these today but they are another indicator that we are leveraging our relationships with our suppliers as we build our center of excellence.

I look forward to sharing our ongoing process in creating a merchandising and marketing competency that is a best-in-class organization that fully supports long-term retail success and delights our customers. I am confident we are on the right path to drive top line sales with compelling, timely and localized offers to our shoppers.

Now I would like to turn the call back to Jeff.

Jeff Noddle

Thanks, Duncan. Now let me turn to our outlook for fiscal 2008. For the full year, we remain on track. We have our fiscal 2008 earnings per share guidance of $2.93 to $3.03 a share, which is before one-time acquisition related costs of approximately $0.20 a share. This range represents an 11% to 15% increase over last year. On a GAAP basis, our range is $2.73 to $2.83, representing an increase of 18% to 22%.

The source of the earnings growth this year will include a combination of the following: a full-year’s impact of the acquisition, as we are comparing to 37 weeks of acquired operations in last year’s results; continued improvements in our operations, ranging from improved store standard to ongoing expense management; the benefit of approximately $40 million to $50 million in pretax net synergy as we overcome the negative synergies from loss of scale, primarily from the sale of the standalone drug business. Net synergies this year will come primarily from cost of goods savings and lower corporate overhead costs; and lastly, earnings will be aided by deleveraging the balance sheet as we march toward the $400 million goal of annual debt reduction.

With that, I would now like to turn the call over to Pam Knous. Pam.

Pam Knous

Thanks, Jeff and good morning, everyone. We are very pleased with our financial performance in the second quarter. With the exception of identical store sales, we delivered on virtually every key metric. Through strong expense management, the elimination of 79 under-performing stores, primarily the acquired properties, benefits of merchandising programs, the emergence of synergies, and interest expense savings coupled with the expected reduction in depreciation expense as a result of the final purchase accounting valuation, we improved margins across the board. This improvement more than offset the previously announced store closure costs in the second quarter.

Our performance this quarter demonstrates SUPERVALU's ability to deliver continued earnings improvement as we have cycled the acquisition and now have meaningful year-over-year comparisons.

My comments this morning will cover three areas; operating results for the quarter, a synergy update, and review of our financial condition.

Total sales for the second quarter were $10.2 billion compared to $10.7 billion last year. The sales decrease is primarily attributable to one less week of acquired operations compared to last year, which approximates $450 million. As a reminder, our third quarter will also have one less week of acquired operations than last year.

For the quarter, increased sales from new stores and positive ID sales were more than offset by the closure of under-performing stores.

Total gross profit as a percent of net sales was 23% for the second quarter of fiscal 2008 compared with 23.1% last year. This change primarily reflects the decrease in net sales for retail food resulting from one less week of acquired operations in the quarter compared to last year.

When adjusted for one less week of acquired operations in the quarter, our gross margin was up approximately 20 basis points, primarily reflecting the benefits of merchandising programs, including certain cost of goods synergies.

SG&A was another area where we saw good progress in the quarter. In the second quarter, SG&A as a percent of sales was 19% compared to 19.4% in last year’s second quarter, or 19.2% when adjusted for the extra week. The reduction in our SG&A rate reflects lower employee related costs, including health and welfare, workers’ comp, and pension, as well as lower depreciation expense, which more than offset store closure costs.

We expect to see favorable comparisons in SG&A as a percent of sales for the remainder of the year, despite the impact of anticipated additional store closure costs for previously announced closures.

Looking at our retail segment, when adjusting last year for the extra week, retail EBIT was up 13% over the prior year, a double-digit increase in our first year-over-year comparison. Retail operating earnings in the second quarter were $385 million, or 4.8% of sales. This compares to $361 million, or 4.2% of sales for the second quarter of last year. This improvement reflects leveraging the scale of our retail operations.

As we have said, our ability to drive results in fiscal ’08 is not dependent on significant ID improvement.

Turning to the supply chain services segment, sales in the quarter were $2.2 billion, up 1.8% over the prior year as strong, new business was more than offset -- I’m sorry, as strong new business more than offset attrition, which included the loss of Clemen in the third quarter last year.

Supply chain operating earnings in the second quarter increased by 12% to $63 million, or 2.9% of sales. This compares to $56 million, or 2.6% of sales for the second quarter of last year.

In regards to other items in the quarter, we incurred approximately $19 million of pretax, one-time acquisition related costs, which included eastern region supply chain consolidation costs, retention expenses, and consultant fees.

I would like to provide a quick recap on our one-time costs since the acquisition. Last year in fiscal 2007, we incurred $65 million. This year, we expect to incur approximately $70 million and in fiscal 2009, we expect to incur the remaining $10 million for a total of $145 million pretax, matching our original estimates from 2006.

In total, the majority of our one-time costs had been necessary to plan and implement key acquisition-related activities, as well as retain necessary resources as we combine our two companies.

Wrapping up the earnings discussion, reported diluted earnings per share in the second quarter increased 13% to $0.69 per share, compared to $0.61 per share last year, and as Jeff said, when adjusted for the extra week, earnings per share increased by 19% in the first true quarter-over-quarter comparison.

Outstanding shares at the end of the quarter were 211 million. Year-to-date, we have repurchased approximately 5 million shares under our stock repurchase program, including 3 million in the second quarter.

I would also like to spend a few minutes updating you on our synergies. Today, we have provided a range of $40 million to $50 million of expected synergies by the end of fiscal 2008. Positive synergies now exceed negative synergies; therefore, synergies are overall benefiting our results in year two.

Our synergies will come from the following three large categories.

Retail leverage and efficiencies, primarily resulting from a reduction in cost of goods sold. We started to see some of these benefits in the first quarter and expect to see them for the remainder of the year.

Corporate synergies come from the elimination of duplicative corporate overhead, as well as systems rationalization. The elimination of corporate overhead for the most part occurred during year one. Until we migrate to common platforms and processes, the majority of the additional corporate synergies will not occur until late in our three-year plans. Supply chain optimization will come primarily from network rationalization, as well as utilization of common warehouse and transportation management systems. At the end of the second quarter, we standardized the Lancaster facility, an important milestone of the East Coast rationalization initiative. This is the first of 10 facilities to be standardized. This important effort will also take three years to complete, so we do not disrupt service to our customers, thus minimizing overall risk.

To wrap up the synergy discussion, our estimate of $150 million to $175 million of synergies is a net figure, which is after absorbing our negative synergies. Going forward, the best way to track our synergy progress is to monitor our EBITDA margins against our original pro forma assumptions, or approximately 30 to 40 basis points on $44 billion of sales. As synergies are realized, you will see EBITDA margin improvement.

As a reminder, pricing investments have never been a component of our synergy expectations. As Jeff has often said, we may choose to invest in some of our markets to enhance our overall brand proposition, not different than what any other retailer would do, and we believe we have the flexibility to do so when necessary and deliver on our earnings guidance.

Turning now to our financial condition, net cash provided year to date by operating activities is approximately $1 billion for fiscal 2008, representing 28 weeks of the combined operations. I know there has been a lot of confusion about cash flow generation and as we have discussed previously, the prior year cash flows were significantly impacted for the three quarters post-acquisition close from payables related to standalone drug, non-core, and acquisition-related payouts.

Therefore, not until these most recent 28 weeks have you been able to simply take the totals and not add back for these non-recurring items.

From a balance sheet perspective, we are on track. Debt to total capital at the end of the quarter was approximately 61% compared to 62% at the end of the first quarter, and 64% at the end of fiscal 2007.

As you are aware, our goal is to reduce debt by at least $400 million annually, starting in the first full year after the acquisition, which is from June 2007 to June 2008. When you look at the balance sheet as of this quarter, you will see debt reduction of approximately $540 million. This is purely a function of timing, other than the $140 million mentioned in quarter one that we are ahead of schedule in the first year.

As we enter our peak borrowing season in the third quarter and accelerate our remodel program in the last two quarters, we are on track with our goal to deliver an additional $400 million of debt reduction by Q1 FY09.

In addition, we expect working capital to favorably impact cash flow at year-end, reflecting continued focus on inventory and other balance sheet metrics after the seasonal peak.

We are in full compliance with our debt covenants. The second quarter reported EBIT of $406 million, depreciation and amortization expense of approximately $228 million, net rent expense of approximately $87 million, and total debt of $8.9 billion. These financial results put us well within our required covenant levels.

Capital spending through the first six months was $511 million. We still expect to be at $1.2 billion for the year. The majority of the remodels in the pipeline were slated to be completed in the third and fourth quarter, and we remain on plan with this important initiative.

For the full year, retail capital spending is estimated at 2.9% of total retail sales, representing a strong commitment to our retail operations.

In summary, we are pleased with these results and remain on track with our three-year plan. We measure our success by sales performance, improvement in operating margins, debt to capital ratio, delivering on our annual EPS guidance, as well as return on invested capital.

In addition, we are generating strong cash flows which will fund our capital plan, allow us to reduce debt, pay dividends and drive returns to our shareholders. We are making progress toward returning to investment grade and we remain focused and committed to our long-term goals of 15% return on invested capital.

Thank you, and now I will turn the call back to Jeff.

Jeff Noddle

Thank you, Pam. In closing, simply stated, our three-year plans are being executed and we are committed to delivering our goal. As Pam indicated and she detailed, we will achieve full delivery of our $150 million to $170 million in net synergies and continue to generate substantial cash flow to reduce debt, putting us in the position to regain investment grade.

We are well on our way and I am confident that we are building a strong enterprise for the long haul that will translate into returns for our shareholders.

Now we’ll be happy to take your questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Deborah Weinswig from Citigroup. Please go ahead.

Charmaine Tang - Citigroup

Good morning. It’s Charmaine Tang for Deb Weinswig. Can you talk a bit about the impact of food inflation, what you saw in the quarter?

Jeff Noddle

As we commented in the first quarter, we said that food inflation was running higher as we enter this new year, between 2% and 3%. I think we said in the first quarter that we were trending toward the high side of that number. That is pretty consistent with what we saw in the second quarter, so I think the trends really are no different than they were in the first quarter. We are still hopeful that we’ll see some abatement but we’ve seen oil prices spike here recently and although some commodity prices have improved somewhat, it is still not enough to say that we see a lower run-rate during the third quarter but we are still hopeful as we move through the year that we’ll see some abatement, particularly in the meat and dairy complex.

Charmaine Tang - Citigroup

And then just one other question; can you share some of your recent observations on your core customer? Specifically, did you see any trading down behavior during the quarter?

Jeff Noddle

Well, we also made the comment in the first quarter -- and let me prepare that comment by saying remember, we look across probably a broader spectrum than most food retailers when we comment on how the consumer is reacting because we are looking through a window that includes the Save-A-Lot customer, which is a lower income demographic, all the way through more traditional to even the high end as well. And we did make a comment that we did see some trading down, particularly looking at our Save-A-Lot, through our Save-A-Lot window.

Those trends were fairly consistent in the second quarter as well, so the trend we saw in that regard I think continues. I think it is not of any great surprise with the pressure from fuel prices, the resets of home mortgages. I think those issues clearly are making people more prudent in their grocery shopping and we think because of our wide spectrum, we have a great window and a good opportunity in that regard.

Charmaine Tang - Citigroup

Great. Thank you.

Operator

Thank you. Our next question comes from John Heinbockel from Goldman Sachs. Please go ahead.

John Heinbockel - Goldman Sachs

If I wanted to drill down on the 2010 comp target, what rough number of remodels do you think you will do in calendar ’09? Slightly up from this year or the same or what?

Jeff Noddle

You know, we haven’t given any numbers yet, John, for that but as you notice, we ramped up another 10 to 20 or so, depending on the range, for this year. I would certainly hope that we could do that or even hopefully more next year. Later in the year we’ll have a more definitive outlook on that but that’s certainly our plan at this point.

John Heinbockel - Goldman Sachs

And you would be disappointed, I guess, if on balance, if the remodels first year didn’t give you a double-digit comp increase? Would that be disappointing or is that too optimistic?

Jeff Noddle

It is very dependent on the exact project. We cited two today that are in very mature markets with not a lot of competitive change and I think we cited one was 9% and one was 8%, and those are certainly adequate to make the returns that we need from remodels.

We will have some that will go significantly above that and there will be some that will have a competitive situation that will produce lower than that. It really is project dependent. And on some cases, we are actually relocating stores, John. We are relocating a store and actually sometimes the rules say you can’t includes those in like stores, which is a vast mystery to me, by the way, but those are accounting procedures.

So those kind of projects, again we would expect even a greater increase.

John Heinbockel - Goldman Sachs

Finally, what that then looks like is to get to three, it is not totally remodel driven. It looks like it’s about half remodel driven and maybe half improvement in non-remodeled stores. Is that pretty fair?

Jeff Noddle

That’s your calculation. My comment would be yes, it is not just remodel dependent. There are a number of initiatives. I think the one comment I would make, we highlighted that early on, the thing that we could do first was improve the service standards in our stores. And if you think about that, we could do that but it’s really out of significance without much of a capital and something we could do early on in the transaction. We highlighted that from day one and I think some of the early progress we have on like store sales that first year were actually from that initiative.

Now, we are investing hard dollars against the consumer in premium, fresh and healthy, in the remodels of the store, and investing significantly in building a marketing competency at the same time.

So I think all those things are essential elements to us producing that kind of number in fiscal 2010 or better.

John Heinbockel - Goldman Sachs

Okay, thanks.

Operator

Thank you. Our next question comes from Edward Kelly from Credit Suisse. Please go ahead.

Edward Kelly - Credit Suisse

Good morning. Nice quarter. Jeff, could you talk specifically about what you think led to an improvement in the sales toward the end of the quarter?

Jeff Noddle

Ed, I would like to have that complete vision but it’s a little hard to do. As we commented when we reported our first quarter, we saw a softening at the end of the quarter and it continued into the beginning. There just seemed to be that period of time had a softening of sales. It’s really hard to arrive at a specific cause or specific metric and, as we commented on the call, we have seen slight improvements in spend.

I noticed some other retailers also reported during that timeframe that -- Costco happens to be one that sticks in my mind that reported a real softening during that same period of time.

I would remind you also, we were beginning at that time to cycle positive year-over-year comps, which we still continue to compare against today. As I mentioned a year ago, I think we got some early wins, particularly out of the service initiative.

I don’t have anything more specific for that short period of time.

Edward Kelly - Credit Suisse

If I read your comments correctly, it kind of sounds like you are confident that you can maintain the profitability of the acquired stores, achieve your $150 million to $175 million synergy estimate, and yet still selectively invest in price. Does that mean that the price investment ultimately comes from other areas, such as potential synergy upside? Is that how we should interpret that?

Jeff Noddle

I think that’s certainly a potential source but you know, there are a lot of good -- we announced this thing a year ago January, so a lot -- the world doesn’t stay static and there are a lot of opportunities for us that are clearer now than they were then, whether they be cost opportunities, whether they be cost of goods magnitude, and certainly some of those, you know, if we exceed our synergy target, we have the option available to us and what do we do with that? Do we invest that against price?

You know, we make those decisions really frankly every single day, even if we weren’t in the midst of a major acquisition. So I think it’s a combination of a lot of factors and I guess at the end of the day, a dollar is a dollar and we try to make a measured decision on how to invest it.

Edward Kelly - Credit Suisse

Okay. And it seems like your free cash flow this quarter must have been very strong. I mean, you had significant debt reduction, you bought back 3 million shares -- how should we think about going forward? You know, anything in excess of that $400 million that you would either spend on share repurchase or debt reduction or remodels?

Pam Knous

Well, as the guidance that we’ve given at this point is for the $400 million for this timeframe, and that is our guidance so we are not changing that guidance.

Edward Kelly - Credit Suisse

Okay.

Jeff Noddle

I have said several times before that if our cash flows are stronger, our first priority is primarily on the $400 million to pay down debt, which we’ve committed to. If the cash flows are stronger, we will consider accelerating remodels. As you’ve seen, we’ve ramped those up a little bit, even though still staying within our capital plan for this year. But that’s also governed by how many you can do at any single time. We certainly, if we think there is available, we can still hit our financial metrics on debt, then we would consider ramping those up faster if we think that’s feasible.

Edward Kelly - Credit Suisse

Last question, I guess a question for Pam, your LIFO charge increased sequentially. It actually looks like it penalized you by about $0.01. How should we look at that in the second half of the year?

Pam Knous

Well, what we see, you know, as Jeff commented on, we are seeing inflation running at the 2% to 3% level and as a result of that, we have incurred a higher LIFO charge in the second quarter and absent some significant change in that trend, you should assume that this higher rate of charge will occur in the third and the fourth quarter.

Jeff Noddle

I would just add that remember that not all those categories that have high inflation at the moment are LIFO categories, such as fresh meat, for example, so just keep in mind. I think what Pam is saying is that is indicative of what the impact might be, but if you get a spike or fall in the non-LIFO category, that still might not change the outcome.

Edward Kelly - Credit Suisse

Okay. Thank you.

Operator

Thank you. Our next question comes from Steve Chick from J.P. Morgan. Please go ahead.

Steve Chick - J.P. Morgan

Thanks. I was wondering I guess first, with the $40 million to $50 million of net synergies that you are targeting for this year, FY08, I’m not sure if for the first half if you’ve told us what the run-rate has been and if that’s a net number that you would expect to garner in the second half here?

Pam Knous

No, what we have said, Steve, is in the first quarter, the synergies had just started to emerge, so really just to make sure this is absolutely clear, that means we really just overcame the negative synergies just slightly in Q1. So at this point, when we talk about synergies, it’s because they are actually having a favorable impact on the bottom line.

And we were actually slightly above that rate in the second quarter. We didn’t give a specific number and we’ll -- we will move to that level kind of pro rata over the remainder of the year. We have given you a range of 40 to 50 because a lot of it is dependent on timing and other things that could possibly shift, but this is where we are at right now.

Steve Chick - J.P. Morgan

Okay. I guess I could understand maybe you don’t want to get too granular with it, but is it -- I mean, is it safe to assume that say $10 million has been achieved in the first half and the remainder is second half related, or we can --

Pam Knous

We’re not going to give the specifics by quarter.

Steve Chick - J.P. Morgan

Okay, but I guess it is safe to assume that the bulk or the chunk of it is second-half related? I guess we’re not going to go there.

Pam Knous

We’re not going to give guidance by quarter.

Jeff Noddle

Well, do remember also, Pam commented on the first quarter, that’s a four period quarter for us also, so you have to kind of do your own analysis and weight those across, but that’s the number we think we will achieve for the year. Clearly -- well, I’ll leave it at that.

Steve Chick - J.P. Morgan

Okay, second question, if I could; the depreciation and amortization expense was a little tough to model I think for the quarter. What is your expectation where depreciation and amortization will be for the year? And of the year-over-year decline this quarter, which I think was about $36 million or so, how much of that decline might have been related to the lack of that extra week from Albertson’s?

Pam Knous

I think that, you know, we haven’t given specific guidance on depreciation expense but you are exactly right, Steve, that clearly a week of depreciation from the acquired properties is a sizable number and actually too if you would look at a new Albertson’s 10-Q, which was filed for this quarter off a couple of weeks but still a quarter of results, you’ll be able to get pretty close to what that incremental week of depreciation was. But that is a sizable number.

And then as I commented in my remarks, we have closed in this timeframe 79 underperforming stores, and so to the extent that those were all under, we had equipment in them. There clearly were fairly significant depreciation charges related to that, as well as then we’ve been on our higher capital spending program, really launching it last year. Our capital spend last year was $1 billion and we are on pace for $1.2 billion this year.

So to -- I would say that this probably is the best you could use as kind of a proxy for the run-rate, but I think that the impact of the store closures and some -- and the ramp up of the capital in the back half of the year will result in there not necessarily being a consistent pattern across the four quarters.

Jeff Noddle

And remember the third quarter still has an extra week in last year and then in the fourth quarter, we are comparable.

Steve Chick - J.P. Morgan

Right, but I guess if I take this quarter’s run-rate and kind of think about it on a per week basis, that’s a good starting point in terms of getting to the rest of the year?

Pam Knous

Definitely.

Steve Chick - J.P. Morgan

Okay, and then sorry, to clarify, the 79 closures, Pam, is that for the -- is that over the last year plus of the deal or is that the last two quarters? How many stores did you close in the quarter?

Pam Knous

Actually, that’s the count from second quarter of last year through second quarter of this year. I don’t have the count for the quarter. Yolanda can get that for you later.

Steve Chick - J.P. Morgan

Okay, great. Thank you.

Operator

Thank you.

Jeff Noddle

By the way, that includes Scott’s, the sale of Scott’s as well. Sorry. Go ahead, Operator.

Operator

Our next question comes from Meredith Adler from Lehman Brothers. Please go ahead.

Meredith Adler - Lehman Brothers

I would really like to talk about a topic that I don’t think has been discussed very much, which is the frequent shopper program. I guess to some extent this question is aimed at Duncan but it is not something that SUPERVALU had before and I don’t actually remember how sophisticated Albertson’s was in using the data they got. Do you see that as an important tool in terms of what you are going to be able to do to drive sales going forward?

Duncan MacNaughton

Meredith, great question. Thanks. The loyalty programs across the Albertson’s legacy markets are a very important and critical part of our growth in the coming years and I would say that a lot of the work that we are doing in the marketing center of excellence is to really hone our skills on how to drive top line sales and grow market basket size to our loyal customers by targeting meaningful and relevant offers to that customer.

As we look across the entire enterprise and look at what the brand means to our customers by market, there could be some natural opportunities. At the same time, the cards to different things for different customers, so we’ve not made a decision whether to roll out that program across the enterprise at this time. We look market by market.

Jeff Noddle

We will, however, Meredith, gather the data we need from other methods and other sources so that we still have good quality marketing information to use in the non-loyalty card markets. But it’s another tool we have available to us in the previously SUPERVALU properties should we choose to do so. We think we have some that are very price oriented and we would make that decision very carefully.

Meredith Adler - Lehman Brothers

Okay, and then just one more question about real estate. I know your focus is on remodels. I’m just wondering, when you look around the markets where you operate, do you also feel that there are competitive pressures on the real estate side to be opening new stores? Is there any risk of losing ground if you are not actively in the real estate market?

Jeff Noddle

I suppose there is always a risk of that but we are going to get 20 plus new stores open this year. What I think is important, Meredith, is that there are certain markets in certain locations that we must build new stores in. By that I mean -- I use Las Vegas as a fast-growing market. You would have to stake your claim as the city pushes out and new areas are developed. You’ve got to get into that prime retail property. And in fact, we just opened a new store in Las Vegas several weeks ago and we will do others.

In the far suburbs of Chicago for Jewel, for example, as the migration of population reaches further out into the further suburbs, again you’ve got to get that primary location. And we’ll continue to do that.

Oftentimes, some of these new stores frankly are open from a land banking program, where we’ll buy land or Albertson’s owned land and we sat on it until such time as we thought the timing was right.

So we are just going to be a little more cautious and careful in doing the new stores. We are going to really hold those to those kinds of situations that I described while we get caught up on the remodels. But if we think the right thing to do -- you know, we are going to look at that every year and we’ll dial that dial back and forth a little bit.

But right now, the best return for our shareholders is to get these stores brought up to date so that we not only have a more modern facility but we also can deliver all the merchandising programs that we think are essential to the future.

Meredith Adler - Lehman Brothers

Okay, great. Thank you very much.

Operator

Thank you. Our next question comes from Perry Ciacco from CIBC World Markets. Please go ahead.

Perry Ciacco - CIBC World Markets

Thanks. Good morning. Jeff, just a little bit more on the synergies, if I could; when I think of the two big chunks, which is negotiating lower cost from vendors and eliminating the duplicated sort of admin infrastructure, I just wonder where you are on those two big chunks. Maybe as a percentage you could express that.

Jeff Noddle

Perry, I appreciate the question. Those are the right issues but again, we’re not going to get that granular in where we stand on any given quarter or any given point in time on all the various metrics.

I will tell you that generally speaking, the overhead issue is a good portion that we were able to get very early on, although now it continues on, dependent on systems and technology as we make those changes across the enterprise. And we have those very definitive and very delineated by department, by area and by when.

The cost of goods is something that continues to get momentum and continues to grow. We started even before the transaction closed by comparing all of the contracts, agreements in pricing and costing between the two organizations. In the first several quarters, we spent time really sitting down with our vendors and saying well, we got this from one and this from another -- how do we make this better off?

Now we are just starting to really, in my mind, leverage really the scale. We are just starting to leverage common promotions across the enterprise. We are using more marketing information, which makes us more intelligent in delivering very specific things into each market.

And though cost of goods savings, you know I -- in my mind, there’s more ahead of us than certainly behind us and that’s the best description I can give you for it.

Perry Ciacco - CIBC World Markets

All right, that’s quite helpful. Just on the premium, fresh and healthy remodels, you’ve given us a little bit on some of the results that you are getting in terms of sales. I’m just wondering what results you are seeing in terms of gross margins. Is there a difference in those stores on margins?

I think you’ve also done those remodels in some different store types, including I think some modules into your price impact. So I am interested in if there are any different results across store types and as I said, the impact on the margins.

Jeff Noddle

There is no question, Perry, we expect and do achieve on balance an improvement in gross margin simply because we are affecting the mix in higher margin departments. As we push harder into fresh, obviously we are expanding in meal solutions in deli, in bakery, in prepared foods. And even though those have higher margins but they also have higher costs also. They have higher labor costs.

So there is no question I think for any retailer moving more fresh, they are going to have to have higher margins, not driven necessarily by higher pricing but a change in mix, and that’s where our investments are going. And then the key is to balance those costs versus those margins to make it a higher return.

Of course, at the same time, until we give them identical store increases, that’s really the fuel that makes the whole thing go.

Perry Ciacco - CIBC World Markets

Right, and then on the different store types, Jeff? Specifically, price impact and some different --

Jeff Noddle

We are taking many of the components and learnings across the enterprise. As we do, for example, cub stores here in the Twin Cities, or shoppers food and drug in the Washington, D.C./Baltimore market, and we’re incorporating certain components. We’d like to call it kind of a plug and play.

Every new store we build or every remodel we do are going to have a significant components that are out of -- but they will vary by market and we think that’s the right way to approach it.

Perry Ciacco - CIBC World Markets

One last question, if I could; we haven’t heard too much about Save-A-Lot over the past year, other than the trading down that you’ve seen, and I guess theoretically, that division should be well-positioned for a weakening economy. Can you tell us what condition Save-A-Lot is in? I know you were working on produce, for instance, and some of the challenges that you’ve been having and how you see that asset going forward?

Jeff Noddle

I think I said in the first quarter and I’ll repeat again; we feel very bullish on Save-A-Lot. We’ve opened some very important markets this year, the Northwest and far south Texas along the U.S./Mexico border, which we think are very important.

We think we should get more Save-A-Lot stores open this year, new stores than we have in the last couple of years. I just think that Save-A-Lot is so well-positioned against the economy and the outlook that we have, we think it’s a very, very important thing for us to enhance.

They have also, if you get into a Save-A-Lot store recently, you’ll see some merchandising changes. They may be subtle to someone who doesn’t shop there. They are more important to those who do. They actually have subtle limited national brand items that are being featured in the stores. They have Pepsi and Coca-Cola type products, Frito Lay, just to mention a few.

So we’ve tested a lot of new merchandising concepts very quietly and we think we are going to have a very good year.

Perry Ciacco - CIBC World Markets

Okay, thanks.

Operator

Thank you. Our next question comes from Robert Summers from Bear Stearns. Please go ahead.

Robert Summers - Bear Stearns

Good morning. Actually, I would like to build on that last question. Your comment on the consumer suggests that the Save-A-Lot business is probably choppy at best. Can you just give us a feel for what the sales trends are like and maybe contrast that performance versus what you are seeing in the acquired stores?

Jeff Noddle

Bob, we really don’t again comment specifically on one format or another, or one area or another. I would just repeat that Save-A-Lot is positioned well against this very difficult -- you know, that Save-A-Lot consumer is a stressed consumer no matter what. Obviously these kinds of things that we’ve seen recently stress them even more.

On the one hand, it makes it more difficult because a lot of these shoppers have only so much money they can spend and they have to spread that as far as they can when they go into the store. But on the other hand, that attracts more of that kind of shopper to the stores.

So I’ll just repeat again; we think Save-A-Lot is a very important part of our portfolio and we think it really gives us a broad, broad spectrum and a very clear window into the entire consumer, at least retail, food and pharmacy kind of look.

Robert Summers - Bear Stearns

Okay. Same question, different approach, without getting specific on the number, was Save-A-Lot additive or dilutive to the reported comp number?

Jeff Noddle

I’m sorry, Bob, we’re just not going to comment by particular unit on what their effect on the --

Robert Summers - Bear Stearns

Okay, thanks.

Yolanda Scharton

We’ll take one more question, please.

Operator

Thank you. Our final question comes from Mark Husson from HSBC. Please go ahead.

Mark Husson - HSBC

Yes, good morning and thanks for what amounts to a giant prozac pill I think for the market. Just looking at the gross margin numbers again, sorry, and the synergy numbers one more time, are we to therefore infer that a year-and-a-half out, that the business will be somewhere between $110 million, $135 million as an annual run-rate, more profitable than we would be running by the end of this year, which is effective for the end of your synergy guidance period?

[Multiple Speakers]

Pam Knous

-- extrapolation of --

Jeff Noddle

Yeah, I guess you extrapolate the number, I hope the rest of the world stays exactly static on us and nothing else changes, but in a perfect world, that would be true, yes.

Mark Husson - HSBC

Okay, well, let’s just have a think about what would go wrong and when you think about gross synergies and net synergies, you clearly gave a number that you thought you would be able to show us at some stage, making some assumptions about the world and the way it looked.

In the event that you talked in the quarter, a couple of your markets have become more competitive than you thought they would have been. Do you still have the flexibility with what you can see out there with the synergy picture to continue to show us somewhere with that range and still invest in those two big markets?

Jeff Noddle

Well, I would comment first, Mark, that I don’t think that markets are more competitive than we would have thought. I would describe it differently. I would describe it -- we always had markets that are becoming more competitive from time to time, so the fact that we have several is not a surprise. You just never know which one, particularly. So I think again, we have that flexibility to respond because we have very much tailored local marketing that allows us to respond.

As I look out, I mentioned earlier on our cost of goods synergies and our marketing synergies that we are going to realize, as I look out, I know we are going to have some flexibility, I hope, beyond those kind of numbers. I know that as we reach out there will be markets we need to respond to as we have to do each and every day and I think we’ve got some financial flexibility to respond. I think if anything today we’re trying to make that point.

It’s not always about price. If in a market, for example, if we’re delivering a significant number of remodels, and we have several markets that are more heavily weighted to remodel than others, at least in the next couple of years, we think that’s an important component and that doesn’t mean we don’t do other things but that might be core to what our expectation of results are.

So that would be my answer, and as far as the prozac comment, probably that stuff will go generic one of these days and we’ll even have a better value for you on that, if that’s what you’re using, Mark.

Mark Husson - HSBC

Yeah, that seems fine to me. Thank you very much. Good quarter.

Yolanda Scharton

Thank you, everyone, and thanks for joining us on today’s call.

Operator

Thank you, ladies and gentlemen. This concludes today’s conference. Thank you for participating. You may all disconnect.

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Source: SUPERVALU F2Q08 (Qtr End 9/8/07) Earnings Call Transcript
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