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The Great Atlantic & Pacific Tea Co. Inc. (GAP)

F2Q07 Earnings Call

October 17, 2007 11:00 am ET

Executives

Bill Moss - Vice President and Treasurer

Christian Haub - Executive Chairman

Brenda Galgano - Chief Financial Officer and Senior Vice President

Eric Claus - Chief Executive Officer and President

Analysts

John Heinbockel - Goldman Sachs

Karen Howland - Lehman Brothers

Perry Caicco - CIBC World Markets

Karen Short - Friedman, Billings, Ramsey & Co.

Carla Casella - J.P. Morgan

Westcott Rochette - Bear Stearns

Phil Fisher - Analyst

Alexandra Jennings - Green Light Capital

Presentation

Operator

Good morning and welcome to the Great Atlantic & Pacific Tea Company’s Conference Call.

For your information, a webcast is available on A&P’s website at www.aptea.com. Chairing today’s call will be Christian Haub, Executive Chairman. Also participating on today’s call will be Eric Claus, President and Chief Executive Officer, and Brenda Galgano, Senior Vice President and Chief Financial Officer.

I would like to introduce Bill Moss, Vice President and Treasurer, who will read A&P’s Safe Harbor Disclaimer. Please go ahead, Mr. Moss.

Bill Moss

Thank you and good morning, everyone. This morning’s presentation may contain forward-looking statements about the future performance of the company and is based on management’s assumptions and beliefs in light of information currently available. The company assumes no obligation to update this information.

These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially from such statements, including but not limited to competitive practices and pricing in the food industry generally and particularly in the company’s principal markets. The company’s relationships with its employees, the terms of future collective bargaining agreements, the costs and other effects of lawsuits and administrative proceedings, the nature and extent of continued consolidation in the food industry, changes in the financial market which may affect the company’s cost of capital, or the ability to access capital, supplier quality control promised with the company’s vendors, and changes in the economic conditions, which may affect the buying patterns of the company’s customers.

I will now turn the call over to our Executive Chairman, Christian Haub.

Christian Haub

Thank you, Bill, and good morning, everyone, and welcome to our Second Quarter Conference Call. As you have heard earlier, as usual, Eric Claus and Brenda Galgano are with me, and after my brief overview remarks, they will review our results in more detail and also discuss the closing integration process of Pathmark.

A&P continued to make progress during the second quarter of fiscal ‘07 as we moved forward with our strategic transformation while at the same time continuing to improve our operating performance in our core Northeast operations.

During the second quarter, we completed the exit of our Midwest operations and announced the sale of our Southern operations. As we approach the completion of our strategic transformation from a geographic perspective, enabling us to focus exclusively on our core Northeast business going forward. We have made steady progress towards the completion of the Pathmark transaction. We are in the final stages of negotiations with the FTC over store divestitures. We are optimistic that this will be resolved soon and that the stores divested will not jeopardize our financial synergy projections or our previously announced transaction timeline.

We will be able to provide more details once we have a final resolution with the FTC.

We have scheduled our shareholder vote for November 8, to receive approval from our stockholders for this transaction. We have committed financing in place and plan to begin the marketing process as soon as we have concluded the regulatory process.

Taking all of this into consideration, we expect to close the transaction before the end of the calendar year. At the same time, our integration planning continues to progress. Brenda and Eric will update you on that process during their part of the presentation.

But let me just say that we have been able to confirm all of our synergy assumptions, and we remain very confident that we will achieve all the benefits of this transaction that we have identified.

I would also note that Pathmark’s operating momentum also continued in their second quarter, with their EBITDA for the last 12 months now at $145 million, this improving trend bodes well for the combined entity going forward.

In announcing the deal last March, we emphasized the excellent strategic fit of the combined companies and our subsequent evaluation since that time not only bears that out, but has increased our excitement over the potential benefits ahead.

In addition to the synergies, we have begun to identify further opportunities to improve the operating performance of the combined company. This optimization potential could be significant, and we will share more details after the transaction is closed, and we begin integrating the businesses.

Operationally, we remain committed to the strategies and practices that helped us achieve improving top and bottom-line trends in our core Northeast operations. And Eric will get into more detail about our operating progress during his remarks.

Let me just say that I am very pleased with the strong identical store sales trend of over 3% despite the more challenging competitive conditions that emerged during the quarter. The benefits of our remodel program, our stronger promotional efforts, and our new pricing strategy are clearly materializing, and we look forward to continued progress as they impact growth.

And finally, I would like to comment on additional accomplishments in our real estate area, where we again achieved significant cash and earnings benefits during the quarter as our asset management capability continues to contribute significantly to our overall results as it has over the past three years.

And we are very confident that we can continue generating meaningful gains in this area; especially in view of the upcoming addition of Pathmark’s assets.

And with that as an overview, I will turn it over to Brenda for more details on our results.

Brenda Galgano

Thank you, Christian, and good morning, everyone. With the announced divestitures of the Farmer Jack and Sav-A-Center businesses and their classification to discontinued operation, our income statements for the second quarter and the year-to-date now reflect our core Northeast operations only.

This morning, we reported second quarter sales of $1.3 billion and a loss from continuing operations of $0.07 per diluted share. Comparable store sales were positive 3.2% in the quarter. Excluding non-operating net gains of approximately $13 million and net losses of approximately $1 million respectively, ongoing EBITDA was $28.3 million this year versus $28.8 million last year.

I refer you to Schedule 4 of our press release for details of the non-operating items for both years. I would also like to point out that both years EBITDA includes income related to the recently expired IT contract with Metro of $1 million and $4.1 million respectively, or about $3 million decrease year-over-year.

For the first five weeks of our third quarter, we continued to see positive sales trends. Second quarter gross margin decreased 30 basis points to 31.28%, driven primarily by the reduced income from Metro, which is worth 25 basis points.

Second quarter ongoing SG&A expenses totaled 31.70% versus 31.99% last year, a decrease of 29 basis points. This decrease is primarily driven by reductions and store labor costs through improvements in store productivity of 20 basis points, store operating expenses as we continued to focus on reducing costs of 19 basis points, and utility cost reductions of 10 basis points, offset by an increase in depreciation of 13 basis points, and advertising expense; mainly radio, of 10 basis points.

I would also note that SG&A for both years includes approximately $2.5 million of expense related to non-cash stock-based compensation. For the second quarter, capital spending totaled $29 million, in line with our full-year estimate of $150 million. Depreciation totaled $34 million. This compares to $50 million of CapEx during last year’s second quarter, with depreciation of $34 million.

During the quarter, we completed one new fresh store and one gourmet store. Overall, the returns on fresh projects continue to exceed our cost of capital. ID sales for capital stores continue to be strong. For the quarter, IDs from all of last year’s capital projects, as well as this year’s completed projects, were in the mid-teens.

For the remainder of fiscal ‘07, we expect to spend approximately $70 million, which includes seven fresh stores, two gourmet stores, and one new liquor store. For fiscal ‘08, we expect capital expenditures to be in the $200 million range. For fiscal ‘09, and assuming the acquisition of Pathmark, we anticipate expenditures in the $250 to $275 million range.

Turning now to our balance sheet, we ended the quarter with net debt of $360 million, including capital leases and real estate liabilities, and net of $2 million in short-term investment and $194 million of restricted cash. The decrease in net debt of about $24 million from the end of the second quarter is primarily due to our adjusted EBITDA of $28 million, proceeds from disposals of properties, including Farmer Jack, as well as our Edison, New Jersey warehouse of $74 million, offset by net interest and taxes of approximately $13 million, CapEx of $29 million, dark store’s occupancy payments of approximately $15 million, and a decrease of $21 million, mainly relating to working capital.

Net debt, excluding restricted cash, was $554 million. Availability under our revolving credit agreement was $219 million at the end of the quarter, with outstanding loans of approximately $7 million. Letters of credit issued under our separate Letter of Credit Agreement totaled approximately $137 million. Including the market value of Metro of $391 million and excluding restricted cash, we ended the quarter with $393 million of net investments or about $9.37 per share.

As of the end of the quarter, we had net operating loss carry forwards of $448 million to offset future tax profits including operating profits and capital gains.

Lastly, with respect to the divestitures, as reported last quarter, we completed the sale of the majority of our stores in the Midwest and ceased operations on July 7. In addition, in the second quarter, we recorded exit costs of $78 million, which were comprised of the following, approximately $60 million for net future vacancy costs related to 33 stores.

I would note that at the end of the second quarter, our total dark store liability was just under $200 million. Net annual payments are expected to be approximately $44 million for fiscal ‘08. We also recorded $14 million related to additional pension withdrawal liability, which will be paid over 20 years.

As a reminder, in the first quarter, we recorded a charge of $43 million. The additional amount recorded in the second quarter is a result of a change in estimate based upon new actuarial valuations.

Lastly, we recorded approximately $4 million in inventory write-downs and other miscellaneous items.

As announced on September 15, we entered into definitive agreements for the sale of the majority of stores in New Orleans market to Rouse’s Supermarket. The remaining stores are being sold to independent buyers. We expect to close on this transaction in the next few months with the expected proceeds in the range of $70 million. We expect that the final transactions to be in by the end of November.

In closing, I am pleased with the continued operating momentum. Our comparable store sales increase in the quarter of 3.2% is the strongest comparable store sales improvement in six years. Excluding the affect of Metro IT, EBITDA increased $2.5 million over the previous year. The sales improvement was accomplished through heightened promotional activity in the Northeast market. I believe this demonstrates that our store execution and strategy is beginning to take hold.

In addition, we remain financially strong and continue to focus on maintaining sufficient liquidity. And as we anticipate the closing of the Pathmark acquisition we are fully prepared for the integration process, and the realization of our synergy targets.

I will now turn it over to Eric.

Eric Claus

Thank you, Brenda. And thank you, Christian. Good morning to you all, and thanks for calling in. I would be remiss to say that the second quarter was really an exciting and a very busy one for us. We had very intensified competitive activity throughout all of our markets, and coupled with that, we have a lot of our initiatives that are in full swing.

I have to say that our team is really energized, and we are all feeling the momentum in our business build, and we feel that from the stores right through into the office. As we are getting closer to closing on the Pathmark transaction, the pre-integration process intensifies. That said, the team is doing, in my opinion, an amazing job of not taking our eye off the ball. We are really making serious progress on improving our store base and our core business every week, and the integration planning is at a very advanced stage, and we are becoming more and more confident every day that we will have a smooth and efficient transition.

The Pathmark team also, and I have to mention this, has been extremely, extremely cooperative, and they are doing the very best that they can under circumstances that I am sure you can understand can be emotional and trying for many of the people in the offices. We are also going through a very intense interviewing process with Pathmark people to ensure that we retain the appropriate talents from the Pathmark Carteret office and also from their field staff.

We have already made many employment offers and received commitments from many of the Pathmark associates including the more senior Pathmark management members that we deem are really integral to that banner’s continued success, and as you recall, I said we want to ensure that we do not have the arrogance that many companies have had in taking over companies that caused them to fail.

So, we really want to make sure that we tie up the talent and that we respect and understand the good things that they do, and we really get the best of both companies.

We have our 12 functional integration team leaders that are ready to engage. And after reviewing all the information provided by the two areas that may have had some uncertainty, which are external experts and logistics and merchandising income synergies, after reviewing their reports, we firmly believe that our stated synergy targets will be achieved and that was big news for us.

So all of that said and done, I would say that we are pretty bullish on this whole transaction, and we are very, very eager and ready to proceed with it.

Somewhat related to that, and I have had a lot of questions on this, so I thought it was worth mentioning. I would give you an update on the CNS logistics contract negotiations.

Although the new contract is not a prerequisite for us to achieve our projected synergy targets, both CNS and A&P recognize the need to create a logistics infrastructure that is really a future model, one that will be low cost and also have sustainability. What we want is a really large company model. And the end objective is for us to have the lowest and most efficient distribution network in the Northeast. To that end, we have made a lot of progress, it is a long road, and one of the toughest things that we did on both companies that we had to break some of our old cultural barriers and I say that on both sides. But I can assure you that the desire to get this new model in place is very, very clearly driving the process.

Both Rebecca and myself, along with the CNS principals continue to meet every second week, always with the objective of concluding a deal in sync with the integration of Pathmark. Again, both companies, like I said are really, very, very committed to making this process work at achieving a long-term sustainable and efficient low-cost model.

Now, let me get back to our actual second quarter results, and as Christian and Brenda have previously mentioned, we announced the divestiture of our Sav-A-Center business in the South. We are very pleased to be able to announce the sale to a local operator. That operator is the Rouse Family of Supermarkets who will virtually take on just about all of our people. And this was a great deal for our people, which really makes us happy. Those people have had some very rough situations after Katrina. We are glad that we rebuilt that business with them and leave it in great condition with a great company, and this is good for both parties.

This last transaction now actually concludes our strategic divestitures that we needed to transform us into a strong and very strategically positioned Northeast company. So, we are in good shape.

In the Northeast, which is now our only market, we continue to make significant progress. And as I mentioned earlier, the marketplace has really heated up. Promotional activity has intensified. However, we are quite pleased with our top-line results, and also with our price positioning. And all of this is really driven by our focus on our game. We are not targeting any one particular group. We simply continue to execute aggressively with our promotions, our new pricing strategy, and our merchandising strategies, and they are paying off for us.

So, as Brenda had mentioned and Christian also mentioned, our comp store sales are really at a record with a 3.2% positive ID sales, and our EBITDA was $28 million, which is about 10% better than ‘06 if you take into account the Metro IT income that ceased in the quarter. And given the market intensity and our strong comps, we are satisfied with the progress that we are making again. And again, it is a long road uphill, but it is quarter-by-quarter, and the last couple of years have borne out that every quarter we continue to improve that a little bit and like I said, we will get to where we need to go.

Our new competitive pricing strategy was also rolled out in the second quarter, which allowed us to grow our merchandising income while at the same time driving our top-line, and our merchants and marketers and operators have done an absolutely outstanding job of executing that at retail. Coupled with our pricing strategy also, our private label development plan and execution have been crucial for us to shield our margin dollars, and I am pleased to report that our private label penetration rate is growing at an incredibly fast rate, and it now stands at 17%, which is up over 200 basis points from the previous year in our fresh stores. And as that stands at about 20% in our Food Basics discount concept, which is also up about 200 basis points from last year.

One question, which I am sure we are going to hear later on is about inflation, as we hear about a lot of inflation throughout the country. I have to tell you that our inflation factor for the quarter is significantly less than that of the market and also significantly less than that of the total industry, and that is primarily because we have executed our new lower pricing strategy in the quarter and to bear that out, our number of items sold, customer count, and basket size were all up in the quarter. All of these are key indicators that the business is building momentum and heading in the right direction.

Let me talk to you a little bit about our store format progress and our capital plan.

When it comes to our capital plan, as in previous quarters, we continue to invest seriously in our capital into our stores and into this market. We now have better than a third of our stores that have been renovated in the past few years, and this is a much healthier state of affairs than that of a few years ago.

Essentially, our bottom third has now become our top third in terms of store condition, and that is exciting. And I recall when I started here two years ago, when we looked at the number of stores that we had to fix, and I am pretty proud of the achievement of having been able to have access, first of all, to the capital and to get those stores done, and to get them well done in that period of time.

In the second quarter, we once again continued to see tremendous progress in our new Food Basics discount format. Again, this quarter, I am very pleased to say that these stores continue to experience very strong year-over-year sales growth. Now, for a second quarter in a row, we can report a much-improved bottom line from stores that were major, major money losers in the previous lives, and those lives were conventional supermarkets, A&P or otherwise.

Our fresh store models also continue to be positive and are gaining momentum every period. We continue to experience solid sales growth, and as Brenda previously noted, the returns are exceeding our cost of capital. And very exciting, this actually had happened after the quarter, but just recently, it is been a year and a half in the making. We are very excited to open our latest fresh store prototype that I had been talking about for the last few quarters. We opened that a couple of weeks ago. That is our Park Ridge, New Jersey facility. That store is clearly now the talk of the town. The early results have exceeded by far all of our expectations, and we have a couple of more like this in the hopper for the fourth quarter, and we have a few more going forward for the first quarter of 2008.

We are very excited about that, and I thank all the people that were involved in that year and a half project. Overall, I would have to say that we continue to be very pleased with our fresh store financials, the mixed shift continues from grocery to fresh. It is on target and it is outpacing Center Store, and driving increased sales and margins. So, once again for the quarter, I really have to say that we are very pleased with our fresh store progress.

When it comes to Manhattan, the team has somewhat corrected our Center Store issues in the Bridge Market store. Early results are showing some improvement, but it is clearly not to the level required to meet the ROI targets in that store. So, again, obviously, we have made corrections based on the errors we made there, and since then we have launched the 49th and 8th, just the upper level of that store in Manhattan.

It is a very contemporary, it is got sort of a grab and go, main-on-main location and a grab-and-go concept with a coffee shop. This store is now outperforming all of our expectations also and it is a very interesting concept that has a lot of room for growth and similar high traffic, higher urban locations in Food Emporium and just in Manhattan in general.

The Trump Palace store, which is 68th and 3rd, that expansion has commenced, as a matter of fact, we will have one portion of it finished this Friday, but the actual opening will be around the third week of November. That is with us taking additional street space there. Again, main on main, this store should be a home run also and we are pretty pleased with the latest developments in the gourmet business.

In the second quarter, we were also very excited and thrilled to announce our association with Starbucks and we will be bringing Starbucks to many of our store locations. This is an absolutely fantastic partnership. It is a great mix in terms of level of quality. If you look at our fresh stores and you look at the reputation and the brand equity that Starbucks have, I think the two of them just fit hand in hand.

We will be launching our first five locations this fall, and we will have an additional 25 stores in 2008. And next quarter we will be able to report some progress on that relationship and how that is moving along. I would be remiss if I did not speak to cost control, because our operators have done such an amazing job, as did our administrators. Our administrative run rate continues to be on track, regardless of all the work that we are doing. 0We have a lot of people doing two jobs during this Pathmark pre-integration process, plus running our business on a day to day. That said, our administrative run rate is still on track. Our marketing costs were slightly higher for the quarter. Although well managed, we certainly did invest in driving our top-line. And we invested in media and that was of course part of our strategy and plan.

In our store operations, our operators continue to do an outstanding job as they focus on cost control, labor productivity and sales per employee hour, once again, better than last year, and they really demonstrated a commitment from our retail teams to getting done what they need to get done. They continue to accomplish all of this without compromising on our store conditions, which we feel improved month after month, getting better and better.

One issue that we do have is our retail shrink has been higher than last year. That is an area that the operators are really trying to focus on now, and that was greatly offset by a much-improved fresh ring, which has now been a company-wide initiative for about three quarters. So, kudos to Paul and the team there.

To conclude, I would have to say that we are very, very focused on our game plan, the strategic direction that we have chosen. As we approach the closing of the Pathmark transaction, things will get even more intense than they already are here. That said, I would have to say that we have a very, very eager team. They are aggressive, and they are willing, and they are able. So, we are looking forward to that.

And we are also determined not to allow the momentum that we are building up slip, and we will not take our eye off the ball and that is one of the key messages in this organization. We have got a lot to do, but we have got a business to run. We have two businesses to run and we will continue running them with a lot of vigor and determination.

We are focused on continuing to deliver that ever-increasing positive results while planning and successfully integrating this Pathmark business. So in closing, my thanks go out again to our Board for their guidance and support and to my executive management team which is a small group of very hard-working and dedicated people, as I say every quarter, and to the whole A&P team that are doing so much to help us deliver on our expectations. With that, I will pass it back to Christian. Thanks very much.

Christian Haub

Thank you, Eric. Just a few final comments before we turn it over to you for questions. I think you have to agree that we continue to make very significant progress in our strategic transformation, and that has continued during the first half of this fiscal year.

Our prospects continue to be very bright and as you can tell, we are very excited about all the opportunities that we have ahead of us. And summarizing, again, for you the key opportunities that include the completion of the Pathmark transaction and the subsequent integration of that business creating a financially and competitively stronger entity with exciting growth potential in the Northeast.

With that, the focus on our core Northeast operations is very important now that we have almost completed the divestiture of our non-core markets. Clearly, the continued successful rollout of our format strategy will continue. We still have two-thirds of our own store base to do and we are looking forward to improving and rolling out new ideas on the Pathmark format as well. Significant additional benefits from our asset management activities and, of course, further cost reduction and optimization potential post-integration.

That is clearly a great deal of work, both underway and ahead of us, but our entire team, as you have heard is energized, excited, and they cannot wait to move forward with this major transformation and advance to its next phase, which is the realization of the tremendous potential of our combination with Pathmark over the next several years. You have heard us talk about the great group of people that we have at A&P and soon we will be joined by the great talent of Pathmark, and together, we will be a truly formidable organization. It will be highly motivated, energized and incentivized to seize all the opportunities to improve and grow our combined company.

That is the conclusion of our comments and we thank you for listening as always, and we will now move forward with your questions.

Questions-and-Answer Session

Operator

(Operator Instructions)

We will go first to John Heinbockel, Goldman Sachs.

John Heinbockel - Goldman Sachs

Hey, guys. A couple of quick things. With regard to the comp progress, which was fairly impressive, was that uniform or did you see a pickup toward the end of the quarter? And it sounds like that was more driven by unit movement than inflation, or was inflation some part of that?

Eric Claus

Inflation was some part of it, but the highest was certainly unit movement and that had to do with our promotional strategy and our pricing strategy. And it actually picked up towards the latter part of the quarter. It was a strong quarter from beginning to finish, but it is like a race, like a marathon, you do 32 miles of running in a 10-kilometer race. We hit it in the last stretch where they took us over the top.

John Heinbockel - Goldman Sachs

So, you would have had to end of the quarter better than the 3, 2, is that continued into the current quarter?

Eric Claus

I will not say what level it is continued, the current quarter is good, it is positive, but I will not comment if it is at the same level or higher.

John Heinbockel - Goldman Sachs

Now, what have you seen competitively here now in the last month since Labor Day hit? Have we seen it step up to yet another level or no?

Eric Claus

It is very hot. It continues to be hot. Our strategy has really been focused on our game, like I said. So, we have tried to do things differently, and we have started about two years ago to focus on our programs. And at the end of the day, remember, we are starting from a much lower base. Our competition has a higher sales per square foot than we do. And obviously, I am sure the people think that while we are off our game doing this Pathmark planning and integration that it is a good time to get us off our game and that gives us even more drive to be on our game.

But we just continue, we are really trying not to focus on specific competitors, specific mediums. We focus on being very innovative in our program, being very creative in our merchandising strategies, the way we merchandise our fliers, the way we have worked on our private label that we can really afford and not to critique the past, but in the past where there have been many attempts at a more aggressive pricing strategy, they brought down the margins to levels that were not sustainable in terms of the business.

So we have done in a fashion I think that is very intelligent, very strategically thought out, that is a mix of new assortments, is a mix of private label, these re-merchandising fliers. Even meat, for example, where drive big promotion in meat, but you cannot commit to only one quarter of the animal, where you have to commit to most of the carcass. So you would make sure that we merchandise the fliers that we utilize the whole, not a pleasant word to use, but utilize the whole carcass in our ads.

So, all of those things coming together, our fresh drive, are drives to increase our fresh. Penetration is really working very well. So all those things came together to allow us strong comps without significantly eroding our margins. And again, as I said, it is not an attack at anyone or anything, it is just this is what we have to do to get our business healthy and it is a good start.

John Heinbockel - Goldman Sachs

All right. Then secondly, what are your priorities here? Let us say Pathmark closes in December, the priorities for the first three months, and in particular how quickly will you make merchandising adjustments both ways to move the top line? Is that not going to happen for a while or will that happen fairly quickly?

Eric Claus

That will happen immediately. It is public knowledge that we have already locked up their top merchants. The very talented guy who has been running the Center store. And as soon as we have the go to be able to get involved in that business, then we will, and it will be quick, and we have got a good team of people there that have agreed to join the company. And also internally, the way we have set up the structure is to make sure that we respect, recognize, and learn from what they do so well.

Because their sales per square foot at Pathmark and Center store is substantially higher than ours. So we have got some things to learn, and we do not want to take something that we are not doing quite as well as them or have not been for a few years, I think we are starting to and try to impose our thoughts on them. But long story short, it will be very, very quick. I mean we are not ones to overanalyze things here. We analyze, but we get things done quickly, and we will do it again here.

John Heinbockel - Goldman Sachs

And the few better changes you make will occur quickly or no?

Eric Claus

Yes, quickly.

John Heinbockel - Goldman Sachs

Okay, thanks.

Operator

We will go next to Karen Howland, Lehman Brothers.

Karen Howland - Lehman Brothers

I was hoping you could clarify something for me. You were mentioning that you were not impacted as much as your large competitors from inflation and part of that was due to your new pricing strategy. I was in the impression that the pricing strategy was to decrease the price of some products that people followed the prices there very closely, increase the prices of other products, whatever, maybe all of these in a jar that people do not follow the prices that they are at so closely and improve your pricing strategy that way. I thought inflation was impacting a lot of the categories that people would be very sensitive to price. So I am not sure how that would make you less susceptible to the inflationary pressures that others have been playing.

Eric Claus

It would, particularly in dairy, but remember, the others have not significantly changed their pricing strategy. We have. We have moved down our prices on literally thousands of items, and also, the way in which we have moved our promotional mix. So it is a very, very complex formula of fresh versus center store, one category versus another category, private label versus, it is like a whole lot of moving parts. But it is very easy to figure out.

If you went to the IRI data, you can look up exactly the same data as us, and you will see that in most of the markets, you will see probably an average of maybe 4% inflation in their prices and you will see substantially less. You will see our prices substantially less than that. So, it is all a mathematical calculation and it is pretty quick to calculate, but it is complex to put together.

Karen Howland - Lehman Brothers

And do you feel like your prices are now, I mean still similarly priced to your competitors in the markets that you are in?

Eric Claus

Absolutely. In every single market, we are well priced, strategically priced against the leader in that market. And we have made a very conscious decision to do that. So whoever is the price leader in the market, that is who we are pricing ourselves too. That was not done like that in the past.

Karen Howland - Lehman Brothers

Okay. And so even though most of the competitors have seen an increase in price, you on a blanket, have not?

Eric Claus

Well, ours have increased also. That is why there is some inflation in our number, but it is less than half of our number. Whereas at the competition, you would find more on an average more than 4% inflation.

Karen Howland - Lehman Brothers

Okay. And then looking at the remodeled stores, I was wondering if you could give an indication of what the comp is. I know you have about 10 to 15 stores that are now cycling through the first year for the fresh stores, if you can give some indication of what those are comping at specifically, rather than the basket of all the stores?

Brenda Galgano

I do not have that right here, Karen, but generally speaking, the second year after we cycle through, the stores will be at about half of what it was the previous year. So if in the first year where we are achieving comps in the mid-teens, generally we are looking at the mid-single digits for the second year.

Karen Howland - Lehman Brothers

Okay, thanks. And then looking at the CNF contract, is there going to be any charge associated with changing the contract?

Eric Claus

No. The biggest thing in this contract is to take a contract, first of all, it was built in different pieces, we have different contracts with CNS, and the biggest change is that the contract is built more on the old wholesale logistics. Sort of that is the premise of the basis of that whole contract, and the change is to really build it to a very efficient logistics infrastructure. So we are paying someone to provide logistics, and not a wholesale procurement type of contract; so it will be built around getting the efficiencies out of logistics that we need to get.

Karen Howland - Lehman Brothers

Great, thanks very much.

Eric Claus

And if I could, John, there was one question I think I misunderstood, and they pointed out to me here, when I said we will make our changes quickly, I was not referring to banner changes to whatever pricing position or aggressive position has to be taken by Pathmark in the marketplace, once we arrive, that will be quickly. Any banner changes we will obviously take some time to think out and really assess and do properly. Next question?

Operator

(Operator Instructions)

We will go next to Perry Caicco, CIBC World Markets.

Perry Caicco - CIBC World Markets

Yes, good morning. Just have a question on the Baltimore and Philadelphia Super Fresh operation, I get the impression that that division has seen some changes in strategy, and I think in the past it is had some consumer image problems, and I guess has had some image or had some issues with positioning in those markets. I wonder if you could tell us what you are doing to address those stores, and how you see the prospects for that group?

Eric Claus

The whole Baltimore and I would even include going up to Philadelphia Super Fresh market is one where we have never had a whole lot of market share. We have not presented ourselves in the past couple of years very well on price. In the last quarter, we have seen the best results in better than 12 months out of that region, it was also admittedly in conjunction with our 25th Anniversary. So we really cranked it up and interestingly, and if you have a chance to go see, we opened a store, this was not in Baltimore, but in Philadelphia recently called Ridge Avenue, where we took the fresh store concept and although we maintained the sort of spectacular great fresh, it was much more positioned on price and abundance. So an abundance of great produce, but at a great price.

And that store out of the gates has done very, very well and is at least, if not better than our expectations, which are already pretty high. So that is the kind of approach that we are taking there. I think going forward, we have got to look at if you combine the Pathmark and A&P as opposed to being a non-factor individually, we become a factor collectively, and I think that we will be able to leverage some of our positions together to make more of a stance in the marketplace that means something there.

Perry Caicco - CIBC World Markets

And wonder if you could also update us a bit on Food Basics, I guess overall the program is I guess kind of stalled while you go back, and I think trying to rethink some of those stores, I guess you have made some adjustments recently to the offering. Could you tell us a bit about that and again kind of in conjunction with where you are going with Pathmark, what role Food Basics might play in the business going forward?

Eric Claus

Food Basics, Perry is definitely a growth vehicle, we are really honestly so thrilled with what has been done there. We finally have the merchandising assortment right. We figured out how to do it in different areas. You can see the results that we have in terms of contribution when I am talking of these sorts of huge money losers for the last two quarters in a row have made such progress. It is really astounding and very pleasing. If we did not have the Pathmark transaction going on, we would probably be much more aggressive in rolling some of these out.

But you can only take on so much at a given point of time that you spread yourself thinly you do not do anything well. So, it is definitely something we want to grow. We do have some stores in the hopper for 2008 to convert to Food Basic, but it is not as aggressive a roll out as it could or should be for that matter. But it is definitely not stalled because we are trying to figure it out. We have gone past that, we have got it figured out and we feel very, very comfortable with the model, how easy it is to roll out and how many we could do. It is just a question of capital, time, and resources.

So, we will continue to grow it, but it is going to take a little longer than we would have liked to get more out of there, because if this transaction was not happening with Pathmark, you probably would see us aggressively rolling it out. As a matter of fact; our recent return on capital model shows the return on capital on these stores now is exceeding the fresh stores. So it is exciting.

Perry Caicco - CIBC World Markets

Okay, thank you.

Operator

We will go next to Karen Short, FBR.

Karen Short - Friedman, Billings, Ramsey & Co.

Hey, everyone, to start, a couple housekeeping questions. Brenda, can you just clarify the northeast EBITDA for the third and fourth quarter of last year. Do we need to bring both quarters down by about $1 million or so and change? Is that about right?

Brenda Galgano

I think that is a fair estimate. You will notice that we did bring this quarter’s EBITDA from last year down by $1 million, and that was due to the move of Sav-A-Center and Farmer Jack into discontinued operations. As part of that we had to go through a number of allocations, and ensure that they were all done on a basis that is acceptable under the accounting rules, and as a result of that we made a net adjustment of $1 million and that is pretty even over each of the quarters.

Karen Short - Friedman Billings, Ramsey & Co.

Okay. And then another housekeeping what was the comp in the northeast last year, was it down 0.5, is that about right?

Christian Haub

In the second quarter of last year?

Karen Short - Friedman Billings, Ramsey & Co.

Yes.

Christian Haub

Let us see. We have to look that up.

Karen Short - Friedman Billings, Ramsey & Co.

Okay.

Brenda Galgano

I do not think it was down. I think it was up slightly.

Eric Claus

While they are looking, Karen, the other thing for Q3 and Q4 will also be the Metro income that we had last year on IT that we do not have this year that we will have to take into consideration.

Karen Short - Friedman Billings, Ramsey & Co.

Right, which is four.

Brenda Galgano

Karen, my notes tell that we were up about 40 basis points second quarter of last year.

Karen Short - Friedman Billings, Ramsey & Co.

Okay. And then, I guess moving to shrink, maybe, Eric, could you just elaborate a little bit on your comments. You made some comments on center store versus periphery shrink. Can you maybe elaborate on what is happening in the center store or what you think is happening?

Eric Claus

We think some of it maybe is there has been changes in procedure and how we deal with defective merchandise that gets returned, whereas before we changed the way it works. And I think there was an assumption by the stores before that they could ship everything back. So they got an automatic credit and we did not get the credit and they came through the office. It is a little bit convoluted, and I do not think it is pure shrink that is gone up in the stores. It is probably more of a paper accounting thing that we are trying to get to the bottom of.

It is not going to help the numbers up or down, because if it is not in the stores, it is somewhere else, but we just have to figure out where it is and the guys are all over that, looking at it.

When it comes to the fresh shrink, we have had a tremendous program that Paul and his team put on with our fresh specialists in the stores to work with the store managers. Every department manager in each one of our stores is on an incentive system now that they can win $1,000.00 a quarter.

If they hit certain numbers, it is a great program to drive them, to drive the sales, and really watch the shrink and bring the shshrink down. So that is really paid off in space, so our fresh shrink is weighed down, although our center shrink is up. But like I have said the net affect on the company is probably negligible. We do not think it is not like stocks went up something. It is just the way in which we account for things or handle certain things.

Karen Short - Friedman Billings, Ramsey & Co.

So would we expect to see some of that in the Center store in the third quarter, or how should we think about that going forward?

Eric Claus

It is not really going to change much, because if you do not see it in the stores, you will see it somewhere in the margin.

Karen Short - Friedman Billings, Ramsey & Co.

Right.

Eric Claus

All right.

Karen Short - Friedman Billings, Ramsey & Co.

Okay. Okay and just I guess turning to the transaction a little bit, Christian, you made comments on once you get FTC approval, there will be some deal related, I guess delay. I just was wondering what your latest thinking was on financing just given the state of the debt market is right now?

Christian Haub

I can also have Brenda talk to that, but obviously we will start the financing process once we have financial regulatory approval, because that all plays into the pro forma and the numbers and at this point, we anticipate that we will go to market and finance this transaction. I think the financing market is based on the input from our lenders are improving, have improved, and as we all see that there is a good chance to raise that financing.

You know we have commitments, so if we believe that we could not raise it in the market then we could go to the committed financing that we have. But we really have to wait for the absolute final conclusion of the regulatory process before we can really do that.

Brenda Galgano

And under the contract, we have up to 20 days to market for the financing after the FTC approval.

Karen Short - Friedman Billings, Ramsey & Co.

After the FTC approval or shareholder approval?

Christian Haub

FTC approval.

Karen Short - Friedman Billings, Ramsey & Co.

Okay. So the longest time lag would be from FTC approval 20 days to closing? Is that fair?

Christian Haub

Yes.

Karen Short - Friedman Billings, Ramsey & Co.

Yes. Because theoretically, you should approve FTC approval before the shareholder vote?

Christian Haub

Not necessarily. That is not linked.

Karen Short - Friedman Billings, Ramsey & Co.

No, well, maybe can you elaborate a little bit on your timing on finalizing the northeast store divestitures? Do you have a sense of where you are with that at on that?

Christian Haub

We are working on it very hard and using our absolute best efforts to conclude this part of the process, but you are dealing with several parties that are bidding on these stores, that are reviewing these stores and it is just taking its time. It is not like we are dragging our feet or anything. You can imagine that we want to get this completed rather yesterday than tomorrow. But it is taking a little bit of its time.

Karen Short - Friedman Billings, Ramsey & Co.

Okay. And then I guess just this last question, Eric, can you maybe elaborate a little bit more on the private label opportunities? Remind me where you are at with the skews and what your plan is going forward and the timing of the rollout?

Eric Claus

Well, we have been aggressively rolling out our private label plan. You know that we have hired this fellow, Doug Palmer, who did the organics line for Safeway. A really talented guy and he hit the ground running. We have completely re-jigged the look, the labeling, the packaging of our America’s Choice. Interestingly enough, the colors blend in with the Pathmark colors also, which are the red, white and blue. There is a good future there to bring the two companies together. We are looking at one of their private label lines, which will be perfect for us. So, we married the two together, reduced the skews tremendously, and Rebecca is really focused on increasing the penetration of private label. We are doing that through promotion, our shelving strategy, and our pricing strategy.

So I think that you will see us, sooner than later, at a private label penetration, which we are always lagging the industry, where I think we will be ahead of most of the industry probably by the end of next year in terms of penetration.

Karen Short - Friedman Billings, Ramsey & Co.

Okay. Great. Thanks a lot.

Operator

We will go next to Carla Casella, J.P. Morgan.

Carla Casella - J.P. Morgan

Hi. I was wondering if you can give your comps excluding the fresh and the new stores, or are they already taken out of comps?

Brenda Galgano

So you are trying to understand comps excluding the stores that have received capital?

Carla Casella - J.P. Morgan

Yes.

Eric Claus

We typically will not break that out, but if you ask about the base business, they are comping positively.

Carla Casella - J.P. Morgan

Okay. And then on the distribution side, are you self-distributing at all or are you 100% third party?

Eric Claus

We are 100% third party.

Carla Casella - J.P. Morgan

And you expect to keep it that way?

Brenda Galgano

Yes.

Eric Claus

Now Pathmark is not 100% third party. They distribute some of their categories internally and through a warehouse that they are operating. It is mostly general merchandise and housing mediates. But that is all part of the discussions and negotiations with CNS.

Carla Casella - J.P. Morgan

Okay. Great, very helpful. Thank you.

Operator

We will go next to Westcott Rochette, Bear Stearns.

Westcott Rochette - Bear Stearns

Thanks a lot guys. Just a couple of quick question. Just to start with the property gain that you guys booked this quarter, where does that show up in the line items. I backed that out of the SG&A, if I were try to normalize.

Brenda Galgano

The gain on the Edison, New Jersey location is, I believe the number is $17 million. So, that is included in SG&A.

Westcott Rochette - Bear Stearns

Okay. So, then, I guess when you broke down your comments of looking at the SG&A and what improved and what did not improve, where would that specifically show up?

Brenda Galgano

That is excluded. So, when I spoke about the SG&A changes, that is on an apples-to-apples basis after excluding the non-operating items, which last year was a loss of $1 million and this year was a net $13 million gain, and included in that was the sale of the warehouse.

Westcott Rochette - Bear Stearns

Okay. And just sticking to utilities or to SG&A, utilities last quarter was a big issue.

Brenda Galgano

Yes.

Westcott Rochette - Bear Stearns

And you had said in your comments that there actually was an improvement over last year. Could you tell that we are on kind of a flatter run rate basis or call it an elevated but on a more comparable basis going forward?

Brenda Galgano

Yes. I mean, in the first quarter, the year-over-year increase was $7 million. This quarter, it was actually a slight decline of, I think the number was $300,000.00 and so going forward, I certainly would not expect the increase that we had in the first quarter. Having said that, can we sustain this marginal decline? That will be difficult.

A lot of it is obviously weather pending, but at the end of the day, I would say that it is probably safe to assume that there is going to be some increase, but not nearly the amount that we saw in the first quarter.

Eric Claus

The other thing I would add in there, Brenda, is that we just concluded a deal with a company that will provide a state-of-the-art software system that manages the electricity in the stores. So, certain things at certain times given certain conditions get turned down or up. And also contemplates deals with the major utilities that at peak times, where they actually pay you to shed electricity at those times. So, our estimation of the payback on that system is less than two years, so that is a good investment. That should help us manage, now, that is not installed immediately, but that will probably take another six months to install. That will help us, I think, also going forward in the next year.

Westcott Rochette - Bear Stearns

And I think you guys had discussed that program in the first quarter.

Christian Haub

Yes, we did.

Westcott Rochette - Bear Stearns

And just looking at another side of the pending merger with Pathmark, you guys have spent a lot of time talking about the synergies and in the 380-page document, going through that, it outlines kind of the cost associated with financing, but I did not really see anything in there, the total cash cost for the integration. Have you guys outlined that or can you give kind of a range there in terms of, between severance, employee retention and the actual integration, like what the cumulative kind of cash outlay to get that ball rolling?

Brenda Galgano

Yes. We had estimated that amount to be approximately $115 million. Of that, about $30 million of it is capital, mainly IT capital. And the remaining $85 million relates to expenses, which includes the severance and contract termination fees and the like.

Westcott Rochette - Bear Stearns

And would that $30 million of capital be included in your $200 million CapEx budget then?

Brenda Galgano

No.

Westcott Rochette - Bear Stearns

So, above and beyond. Okay. And the 115, that does not include all the transaction costs associated between the two parties, correct?

Brenda Galgano

That is correct.

Westcott Rochette - Bear Stearns

Okay. Thanks a lot. Good quarter, guys.

Christian Haub

Thank you.

Operator

We will go next to Phil Fisher.

Phil Fisher - Analyst

Hi. A question about your ‘09 CapEx of $250 million to $275 million, how much of that is maintenance CapEx?

Brenda Galgano

Typically, I would say that approximately $40 million to $50 million would be maintenance CapEx.

Phil Fisher - Analyst

And what is the additional spending on? I mean is it still the upgrades of the stores or is it more integration costs or what is the delta?

Brenda Galgano

It is a mix. Some of it is the upgrading of existing stores. Some of it is new stores, but more of it is the upgrading of existing stores. Of course, as we evaluate optimizing our banners, there may be some costs involved with changing select stores to more optimal banners, so there would be some cost in there as well. We also have costs in there associated with Starbucks, we announced that. And that does not include integration.

Phil Fisher - Analyst

All capital is geared towards improving the business, improving the stores, adding new, improved features to drive customer count or selling more product.

Eric Claus

Our whole philosophy has been to take the lion’s share of our capital and put it back where it belongs, which is in the stores. And I mentioned on the last call also that we will be spending more capital on programs that we developed for our new fresh stores, so we can roll out to all the stores. One example was the over-the-top muffin carts. Those typically have a huge, huge payback because we are almost contains the less of year, typically. So, we want to make sure all of our capital goes to what this business is all about, which is retail.

Brenda Galgano

Yes, and that capital would also be capital put into the Pathmark stores as well.

Eric Claus

Of course, yes.

Phil Fisher - Analyst

Okay. Thank you.

Operator

(Operator Instructions)

We will go next to Alexandra Jennings, Green Light Capital.

Alexandra Jennings - Green Light Capital

On the FTC negotiations, you talked about how some of the stores are being bid on right now. How much EBITDA is associated with the stores you are currently auctioning?

Bill Moss

We are not prepared to disclose any of that information. We will only do that once we have a final resolution completed with the FTC. But as you know, we have under the contract with Pathmark; we have a maximum of $36 million. At this point, I think it is fair to say that we will not exceed that and that that is not going to be an issue for us, but in terms of further details, we are really only prepared to do that once we are done.

Alexandra Jennings - Green Light Capital

All right, thanks.

Operator

And there appear to be no further questions at this time.

Bill Moss

Great. Then we will conclude our call. Thanks again for listening and we will hopefully have lots more information in the upcoming weeks and months. Thank you very much. Bye, bye.

Eric Claus

Cheers. Thank you.

Operator

And once again, this does conclude today’s conference. Thank you for your participation.

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