Great Atlantic & Pacific Tea Company F3Q07 (Qtr End 12/01/07) Earnings Call Transcript

| About: The Great (GAP)

The Great Atlantic & Pacific Tea Company, Inc. (GAP) F3Q07 Earnings Call January 8, 2008 11:00 AM ET

Executives

William J. Moss - Vice President, Treasurer

Christian W.E. Haub - Executive Chairman:

Eric Claus - President &Chief Executive Officer

Brenda Galgano - Senior Vice President andChief Financial Officer

Analysts

JohnHeinbockel - Goldman Sachs

KarenShort - Friedman, Billings, Ramsey & Co.

PerryCaicco - CIBC World Markets

GaryGiblen - Goldsmith and Harris

KarenHowland - Lehman Brothers

WestcottRochette - Bear Stearns

EldicoHildress - Waterstone Capital

Operator

Goodmorning and welcome to theGreat Atlantic and Pacific Tea Company’s conference call. Alllines will bein a listen-only mode until the question and answer session. Today’s teleconference is beingrecorded. If you object, pleasedisconnect atthis time. For your information, a webcast is available at A&P’s website at www.aptea.com. Chairingtoday’s call will beChristian Haub, Executive Chairman. Also participating on today’s call will be EricClaus, President and Chief Executive Officer, and Brenda Galgano, Senior VicePresident and Chief Financial Officer. Iwould now like to introduce Bill Moss, Vice President and Treasurer, who willread A&P’s Safe Harbor disclaimer. Please go ahead, Mr. Moss.

WilliamJ. Moss

Thank you and good morning, everyone. Today’s presentation may containforward-looking statements about thefuture performance of thecompany and is based on management’s assumptions and beliefs in light of information currentlyavailable. The company assumes no obligation toupdate this information. Theseforward-looking statements aresubject to uncertainties and other factors that could cause actual results todiffer materially from such statements, including but not limited tocompetitive practices and pricing inthe foodindustry generally and particularly inthecompany’s principal markets, thecompany’s relationships with its employees, theterms of future collective bargaining agreements, the costand other effects of lawsuits and administrative proceedings, the nature and extent of continuedconsolidation inthe foodindustry, changesin the financial markets which may affect the company’s cost of capital or the ability to access capital, supplierquality control problems with thecompany’s vendors, and changesin economicconditions which may affect thebuying patterns of thecompany’s customers. I will now turn the call over to our Executive Chairman, Christian Haub.

Christian W.E. Haub

Thankyou, Bill. Good morning everyone andwelcome to our third quarter conference call. I hope you allhad a greatholiday season. I wish everyone goodhealth and success inthe NewYear. With me today as usual are Ericand Brenda and you’ll hear from them shortly. I’ll begin our presentation by commenting on our results, highlightingsome of our important strategic accomplishments in thepast quarter, and discussing my outlook for thecompany.

Of coursethis is thelast time we will discuss theperformance of just theold A&P since we closed on thePathmark acquisition atthebeginning of our fourth quarter. Obviously this was alandmark event for our company, marking both thecompletion of thestrategic transformation we initiated in2005 and thedawn of anexciting new era for A&P. I’m alsovery pleased that inaddition to that momentous achievement, we continue to make solid progress in our business during the third quarter, highlighted by ourstrong comparable store sales atover 3% and improved operating earnings.

Oursteady focus on keystrategic initiatives inoperations, merchandising, store format development, and cost management continues to producetraction during this quarter as evidenced by our ongoing strong sales momentum,only slightly lower gross margins despite our aggressive pricing andpromotional approach, lower costs through strict internal controls andincreasing sales leverage, improved operating income, and finally our tenthconsecutive quarter of year over year improved results.

Eric and Brenda will address the keydrivers of these ongoing positive trends during their presentations so I’d like to use my portion to verybriefly summarize our strategic accomplishments and what’s immediately ahead ofus in termsof strategic priorities. First withrespect to Pathmark, let mejust saythat beyond theobvious achievement of completing thedeal successfully, we were very pleased with theoutcome of theSEC approval process which required us to divest only 6 stores with combinedEBITDA only $6 million, effectively preserving over 97% of the combined company’s currentprofitability.

Overall, the strategic fit of these businesses isoptimal since Pathmark’s price impact format adds the final piece we needed to target andserve allmajor consumer segments inour markets intandem with our fresh discount and gourmet formats. This is afood marketing portfolio that no single competitor in our market has and Eric will discuss some of its initialenhancements and development plans for allof those formats during his remarks.

Financially,thesignificant backstage merger synergies we will produce as our integration plangoes forward will put us firmly on thepathway to sustainable profitability, and finally, with all previous non-core operationsdivested as of thequarter’s end and thePathmark deal as thecapstone, we have successfully accomplished our strategic transformation and Icouldn’t bemore pleased about our competitive posture and our prospects for futureprofitable growth inthenortheast.

Turningto my outlook for thenew A&P in2008 and beyond, our outlook is inone respect continuity, as our executive management team remains focused onorganic improvement of our business through merchandising and operating bestpractices. These fundamental elementsand thefresh innovative thinking soclearly demonstrated inour merging store format examples have been thecatalyst of our improving results over thepast 2.5 years and our leadership is fully committed to maintaining and in time accelerating that momentum.

Alongsidethose ongoing advancements, we arealready moving ina carefulyet timely fashion to execute thePathmark integration plan assembled under Brenda’s executive oversight over the past several months. Again, both Brenda and Eric will provide additional details on all these activities in amoment.

Onceagain, I’m very excited about thefuture prospects of thenew A&P and I have great confidence inthemanagement team under Eric’s leadership and theoutstanding talent we have now assembled between both companies.

That’s the end of my introductory remarks andwith that I’ll turn itover to Brenda.

BrendaGalgano

Thankyou, Christian, and good morning, everyone. This morning we reported second quarter sales of $1.3 billion in income from continuing operations of$1.73 perdiluted share. Comparable store saleswere positive 3.1% inthequarter. Excluding non-operating netexpenses of approximately $9 million and net gains of approximately $12 millionrespectively, ongoing EBITDA was $20.5 million this year versus $16.3 millionlast year. Schedule 4 of our pressrelease details thenon-operating items for both years. I’dalso like to point out that we excluded $4.1 million of income from last year’sEBITDA related to theIT contractwith Metro as itended inAugust of this year sowill not berecurring.

For the first five weeks of our fourthquarter, we continued to seepositive sales trends inthe A&Pbusiness. We have also been experiencingoverall positive comp store sales growth for thePathmark stores since we closed on December 3rd. Third quarter ongoing gross margin whichexcludes the$4.2 million of income related to theIT contractwith Metro decreased 12 basis points to 30.51% driven primarily by an increase in special promotions.

Secondquarter ongoing SG&A expenses totaled 31.48% this year versus 32.07% lastyear, adecrease of 59 basis points. Thisdecrease is primarily driven by reductions instore labor and benefit costs of 27 basis points, a reduction in admin costs of 23 basis points, and a reduction in store operating expenses of 14 basispoints, offset partially by increase inoccupancy expense of 12 basis points.

I wouldalso note that SG&A for both years includes expense related tonon-cash-based compensation of $2 million for this year and $800,000 lastyear. For the third quarter, capital spendingtotaled $19 million with depreciation of $33 million. This compares to $64 million of capitalexpenditure during last year’s third quarter with depreciation of $41 million.

During the quarter we completed two freshstores, one gourmet store, and one new liquor store. Overall returns on projects continue toexceed our costof capital and IDsales for capital stores continue to bestrong. For the quarter, average IDs from all capital projects completed in thelast year was inthe highteens. Average IDs from ’06 capital projects completed over a year ago was in themid single digits.

For the remainder of 2007 we expect to spendapproximately $45 million. During the fourth quarter we expect to completeone fresh store enlargement, one Pathmark remodel, and three fresh remodels. We also plan on starting a number of projects that will be completed in early 2008.

Turningnow to our balance sheet, we ended thequarter with overall negative net debt or positive net investments of $7million, including capital leases and real estate liabilities and net of $2million inshort term investments and $542 million of restricted cash. Excluding $348 million in proceeds from the sale of Metro, net debt decreasedabout $20 million to $340 million from theend of thesecond quarter. This is primarily due tothe adjustedEBITDA of $21 million, proceeds of $60 million from the divestiture of our New Orleansbusiness, offset by net interest expense and taxes of approximately $11million, CapEx of $19 million, dark store occupancy payments of approximately$14 million, and adecrease of $17 million for net working capital and other which includes the integration and transaction relatedcosts incurred inthe thirdquarter.

Net debtexcluding restricted cash was $536 million. Availability under our revolving credit agreement was $215 million at theend of thequarter with outstanding loans of approximately $11 million. Letters of credit issued under our separateletter of credit agreement totaled approximately $138 million. As of theend of thequarter, we had cash net operating loss carry forwards of $246 million tooffset future cash profits including operating profits and capital gains. Thedecrease in the NOL balance from the second quarter is primarily relatedto the saleof our Metro holdings.

Lastly Iwill cover thePathmark acquisition and therelated financing. In connection with the December 3rd acquisition,on November 29th we sold theremaining 11.7 million shares of our holdings in Metro for proceeds of approximately$348 million, resulting ina net gainof $106 million. We closed on the acquisition on December 3rdfor total consideration of $1.4 billion. Theacquisition was funded by theissuance of equities totaling $393 million, $538 million of restricted cash onhand from thesale of theMetro shares, net bank borrowings under anew revolving credit agreement of $146 million, and a $370 million loan under a temporary bridge credit agreement.

OnDecember 18th we refinanced thebridge credit agreement and issued $165 million of 5.125% convertible seniornotes due 2011 and $255 million of 6.75% convertible senior notes due2012. Theprincipal amount of these notes will beconvertible into shares of our stock, cash, or a combination of stock and cash at our option.

In connection with this offering, weentered into convertible note hedge and warrant transactions to increase the effective conversion price of the notes which minimizes dilution forexisting shareholders. The conversion amount is $36.40 for the $165 million note and $37.80 for the $255 million note. With thehedge and warrant transactions, we effectively increased the conversion amounts to $46.20 and$49.00 respectively. For EPS purposes,once theconvertible notes arein the money, the shares will be included in theEPS calculation using thetreasury stock method similar to thetreatment of employee stock options.

We alsoentered into share lending agreements to lendup to 11,278,988 shares of our common stock. Pursuant to these agreements, we loaned 8.1 million shares of our stockto these entities who then sold 6.3 million shares to the public in apublic offering which was consummated on December 18th. We did not receive any proceeds from the sale of these shares other than a nominal lending fee. Because theshares will bereturned back to thecompany under GAAP they arenot included inthe EPScalculations.

The net proceeds from the convertible offerings were used torepay the$370 million senior secure bridge credit agreement. Details of theacquisition and financing transactions including pro forma financial statements can be found in theprospective supplement filed with theSEC on December 14th.

In order to facilitate the syndication of the revolver credit agreement under the current market conditions, weentered into anamended and restated credit agreement on December 27th. The$675 million amended credit agreement provides for a 5 year term loan of $83 million, a 5 year term loan of $50 millioncollateralized by certain real estate assets, and a 5 year revolving credit facility of$542 million, and enables us to borrow funds on a revolving basis for working capitalloans and letters of credit. The agreement includes an accordion feature which gives us the ability to increase commitments by$100 million. The facility is secured by all assets of the company including inventory, certainaccounts receivable, pharmacy scripts, owned real estate, and certain Pathmarkleaseholds. Borrowings under the facility bear interest based onLIBOR or prime interest ratepricing plus anapplicable margin. For your reference, the agreement has been filed as an exhibit in our third quarter 10-Q.

Withrespect to theintegration, we areright on track. We are inthe processof converting systems with theintegration of payroll already completed. We have begun to review allservice and professional contracts to reduce operating and admin costs and planto close Pathmark headquarters within thenext five months.

We feelconfident inour ability to achieve $150 million insynergies, including $80 million inadmin reduction, $40 million incost ofgoods sold reduction, and $30 million inacombination of supply logistics, marketing and advertising, and other storeoperating costreductions. We expect to achieve a run rateof over half of the$150 million by theend of our first quarter in2008 and expect to fully achieve synergies within 18 to 24 months. We continue to expect total integration costsof $115 million of which approximately $30 million is capital and $85 millionwill beexpense. Of the $85 million in expense, approximately $10 millionrepresents non-cash costs associated with aspecial stock compensation incentive program. Through thethird quarter we have incurred approximately $9 million in integration costs, of which $2million is capital related to equipment and IT. We expect to incur most of theintegration costs within thefirst sixmonths.

In closing, I am pleased with our continued operatingmomentum. We had strong comp store salesimprovement of 3.1%, excluding theeffect of Metro IT. EBITDA increased4.2% over theprevious year. Pathmark’s comparablestore sales declined slightly inthe thirdquarter to negative .4% with EBITDA of $28 million this year versus $30 millionlast year. The decline in EBITDA was primarily driven byincreased shrink. As I previouslymentioned, comparable store sales aretrending positively to date inthe fourthquarter for Pathmark. We remainfinancially strong and continue to focus on maintaining sufficientliquidity. With the closing of the Pathmark acquisition, we are fully engaged in theintegration process and therealization of our synergy targets.

I willnow turn itover to Eric.

Eric Claus

Goodmorning. Thank you, Brenda. As Christian mentioned, only days after the close of the third quarter, we obtained a very major milestone in our history as we closed on the Pathmark transaction. We can saythat we’re now officially inthepost-closing process and I’m very pleased to saythat all of the hard work and planning for thisevent atboth companies is finally paying off. Integration is progressing very smoothly. Atthis early stage we have hit every milestone that we set for ourselves and haveencountered no major glitches thus far.

Wewelcome thePathmark team into our fold and I think that itwould be a fair statement for me to saythat this hasbeen accomplished ina verypositive fashion. We’ve held meetingswith all the major Pathmark and A&P teamsincluding allPathmark store managers and we have avery excited group that feels themomentum building inour business.

Our teamsare now veryfocused and also highly incented to obtain thesynergies that this transaction was predicated upon. We arevery confident that the$150 million of synergies is well within our grasp and our early assessment ofthose synergy potentials is consistent with our projections. Theactions needed to attain these synergies arein fullswing and meetings of our supply partners have begun. This inorder to start theall-important merchandising synergy process.

We willreport on our progress as itpertains to synergy achievement over thenext few quarters and Brenda will speak more to that in thefuture. We’ve been very quick tointegrate retail operations and put thenew leadership inplace. We are also very quick in putting our new merchandising teamstogether and arealready in the process of strengthening ourprograms for thenext few months. Sales for the Christmas season were positive andcontinues on apositive track as we speak. We alsointend on being very quick to launch our new combined private label programsand plan to have that integrated inthe firstpart of fiscal 2008. We have startedworking with our teams to design astore refresh concept for thePathmark stores that will becostefficient and modernize thelook of thestores while enhancing thefresh experience, particularly inareas such as produce, again remembering that this is a price impact that we want to attainand update thefresh store.

The team has really done an outstanding job throughout this wholeprocess of not taking its eyeoff the balland we’ve hit theground running, and I’m very, very pleased with our progress. When itcomes to theC&S logistics contract negotiation, we’ve made very significant progressover thelast couple of months. As I’vepreviously stated though, anew contract is not necessary for us to achieve our projected synergytargets. Both C&S and A&P haverecognized, however, theneed to create alogistics infrastructure that’s afuture model for lowcosts and sustainability; inother words, alarge company model.

BothRebecca and myself, along with theC&S principals, continue to meet every second week and are getting very, very close toconcluding adeal. Again, both companies are really committed to making thisprocess work and we both now believe that we have the end in sight. This will bea veryexciting and significant advancement for both companies. More to come on the next call.

Now asfor thethird quarter, for thefirst time we’re now truly anortheast company and our progress continues inthenortheast. As mentioned in previous calls, the market is hot and we are abig part ofthat as we continue to drive to attain our fair market share. That said, we continue to be pleased with our top line results andour price positioning. The gain this quarter of our comp storesales crossed the3% mark at a positive 3.1% and our EBITDA was $21million, which is about 25% better than 2006 when taking into account the Metro IT income that was realized in that year. Given themarket intensity and our strong comps, we’re very pleased with the quarter. Our new competitive pricing strategycontinues to improve our price perception with our customers. Although there is some inflation, it’s lessprevalent inour company given thelevel of competitive activity and our new pricing strategy. Our real gains, however, are evidenced in increased basket sizes, customeraccounts, and market share. All of our key market indicators in our businesses are strong and are positive. Private label penetration continues to grow atanaggressive rateand I’ll have more to report on theintegration and objectives of this initiative on our next call.

As usual,I’ll update you on our store format progress and capital. When itcomes to thecapital, we continue to invest although as Brenda mentioned we slowed down a little bit in thethird quarter and that was very specifically around the acquisition of the Pathmark stores, so we continue to invest capital in our stores. We will now bringPathmark stores into this initiative, and I will provide more color on thatpiece of iton our next quarterly call.

In the third quarter we continued to see tremendous progress in our new food basics discount formatand I’m pleased again to saythat these stores continue to experience very strong year over year salesgrowth. Now for the third quarter in arow we can report amuch improved bottom line from stores that were major money losers in their previous lives as conventionalsupermarkets.

Our freshstore remodels continue to bepositive and continue to gain momentum every period and Brenda alluded to someof those numbers. We continue toexperience solid sales growth and as previously noted, returns are exceeding our cost of capital. Our new fresh prototype in Park Ridge continues to outperform our sales expectationsand we have two more stores like this that areplanned to open inthe nextcouple of months. Overall we continue tobe pleasedwith thefresh store financials as themixed shift from grocery to fresh continues to be on target, outpacing center store anddriving increased sales and margins and we now have the experience of having that two years in arow.

When it comes to our Manhattan FoodEmporiums, overall sales inthe Manhattan market are now exceeding company comp so we’re very pleased about that. The49th and 8th upper level renovation with a very contemporary sort of grab and goconcept as well as theone that we did inTrump Towers at68th and 3rd arereally booming and areprobably worth alook if any of you have achance. That’s just the top floors. Both stores basements or the basement levels will be renovated in thefirst quarter of fiscal ’08 and we’re going to continue on this base with the Food Emporiums.

Lastquarter’s call we mentioned that we had entered into an arrangement with Starbucks. We have opened our first four locations. They’re alldoing quite well and we’re really excited about the projected rollout of the next 25 locations in fiscal 2008 and again we’ll reportmore as we getmore experience with this going forward.

I’d be remiss if I didn’t talk about ouremphasis on costcontrols. Our administrative run rate continues to be on track. Utility costs again and expectedly werehigher for thequarter and we’re aggressively pursuing and implementing systems to mitigatesome of theenergy price increases. Our storeoperations teams continue to doa veryoutstanding job as they focus on costcontrol. Our labor productivity andsales peremployee hour were once again better than last year, again demonstrating the commitment from our teams at retail.

Stocklosses and center store arestill aproblem. They were again higher thanlast year inthat area and our operations is very, very focused on that issue. This, however, fortunately was again offsetby much improved fresh shrink which is acompany-wide initiative driven by our retain team.

So to conclude, I would say that we continue to stay veryfocused on our game plan and thestrategic direction that we’ve chosen for thecompany. Our momentum continues andwe’re keeping our eyeon theretail ball. The Pathmark integration is in full swing and we are very pleased with what we see and our detailed preparation isreally paying off. We’re focused onreaching our projected synergy savings and arevery confident of obtaining them on time and on the money, so inclosing, I’d once again like to send up my thanks to our Board of Directors fortheir guidance and support, to my executive management team, and to the whole A&P and Pathmark teams whoare all doing so much and working so hard in order to deliver on ourexpectations.

I’ll nowpass it backto Christian. Thank you.

ChristianW.E. Haub

Great. Thank you, Ericand I think you can hear from allof those statements that we couldn’t have had a better start to the combination of A&P andPathmark. Certainly summarizing the calendar year of 2007, it’s clearly a year of significant progress across all fronts, strategically andoperationally. Our non-coredivestitures, merchandising, operating improvements, the new format performances, and the acquisition of Pathmark has positioned our company as a leader in thenortheast food retail industry with adecisive number one market position inmetro New York and improved presence inGreater Philadelphia. The $150 million of merger synergiesthat we fully expect to achieve over thenext two years ongoing operating improvements across the A&P banners and the continued improvement of Pathmarkwill at lastenable us to establish and sustain overall profitability.

The strict reduction and managementof costs ingrained inour corporate culture since 2005 hassignificantly reduced administrative and other expenses and those efforts willcontinue unabated, eventually producing theoptimal coststructure for our business, and theproactive corporate real estate and tax strategy has again added to our bottom line willcontinue in the new year and beyond.

Whilemuch work remains ahead, allthese factors bode exceedingly well for thenew A&P and theremainder of this year and through fiscal 2008 and beyond. Our combined team is energized and excited tomove forwardwith theintegration and to realize thetremendous potential of our combination with Pathmark over the next several years

Thisconcludes our presentation and we arenow pleased to moveto thequestion and answer session part of themeeting today.

Question-and-AnswerSession

Operator

(Operator Instructions) Our first questioncomes from John Heinbockel of GoldmanSachs.

John Heinbockel - Goldman Sachs

A couple of things. When you look at thecomp, is that being driven more by ticket or traffic at this point?

ChristianW.E. Haub

John,we’ve done somuch study on allthis because of thecombination of alot of factors, alot of talk about inflation intheeconomy. In our case, our customer count is up aswell as our basket size is up and inflation does play a part of it also, but we would estimate that to be less than half of our [inaudible]sales. Most of it’s coming from realgrowth from thebusiness that we’re driving. Obviouslyour promotionals, our mix hasshifted also more to promotional as opposed to regular sales in sort of the aggressive market that we’reoperating in.

John Heinbockel - Goldman Sachs

From whatyou’ve seen sofar atPathmark, and I know it’s early, but would that be driven more by ticket than traffic at this point? Their comp?

ChristianW.E. Haub

In Pathmark, yes.

John Heinbockel - Goldman Sachs

Youtalked about sort of fourth quarter here positive sales trendingpositively. You didn’t make reference tohow that compared to thethird quarter. I assume you have notseen much of adrop off from thethird quarter given themacro?

BrendaGalgano

That’scorrect. In fact, it’s actually a bit stronger than what we saw in thethird quarter.

Eric Claus

And we’vebrought thePathmark team and themerchandising team, they’re working closely with our team, it’s a combined team now, to really draw the promotional part in amore aggressive way than they had been over thelast year.

John Heinbockel - Goldman Sachs

How manyPathmark stores doyou think will beremodeled inthe nextyear, thenext two years? How many need to be remodeled?

ChristianW.E. Haub

John, the overall state of affairs in those stores was not as bad as the A&P Portfolio stores a couple of years ago. They area littleplain Jane and they require some facelifting, some paint, some change, and we’re just in theprocess of evaluating allof that and by thenext quarter I think we’ll beable to rollout what our capital plan will befor 2008. What we’re trying to do, and Ialluded to itbriefly inmy comments, is to dosomething where we can affect alarge number of stores by giving ita refresh, a relook, and enhancing in particular a couple of departments like produce andbakery, getting much stronger on thesigning, and making ita much moreprice impact sort of venue when you walk into those locations. Sothe exactnumber, I think we’ll beable to tell you by our next quarter call, but is definitely a remake program that we want to do that’s inexpensive per store and can hit a lot of stores that our objective wouldbe thatprobably over athree year period we could doall ofthem.

John Heinbockel - Goldman Sachs

And giventhe capitalyou’re talking about, would you behappy with amid single digit sales lift or you’d want something more than that?

Eric Claus

Giventhat capital, itwould have to bein the mid single digits.

John Heinbockel - Goldman Sachs

But it would be hard to get double digit, I assume, given the sales volume it’s alreadydoing.

Eric Claus

Yes. I think what we have to do is... That’s going to beacombination of giving ita newfacelift, working on that fresh piece alittle bit, and driving thebusiness more aggressively than what ithas beendriven in the past, but I think that would be safe to say that would be our objective in those stores.

John Heinbockel - Goldman Sachs

Andfinally theincremental EBITDA or EBITDA margin on thesales that you getfrom thePathmark remodels should befairly high because they’ll allbefresh. I assume you’re looking for a double digit incremental EBITDA marginon those sales.

Eric Claus

I wouldjust be safeon that if I was forecasting anything because I don’t know what the effect of the whole market is going to be. As you try to increase market share, thenobviously you can have some erosion of margin, so I don’t think I’d be ready to give you a number on that yet but I think by nextquarter we’ll have abetter handle on it. But to tell youthat when we look atit we see alot of upside to itand we’ve got some great people that joined us that really understand theirbusiness and I think it’ll begood.

John Heinbockel - Goldman Sachs

Okay,thanks.

Operator

Our nextquestion comes from Karen Short of Friedman, Billings, Ramsey.

Karen Short - Friedman, Billings, Ramsey& Co.

Heyeveryone. Good quarter,congratulations. Just a couple of comments or a couple of questions on your pricepoints. I know you’ve been making a lot of investments on the A&P side. Can you just comment on where you think yourprice points arenow and where you think they need to beat bothA&P and Pathmark?

Eric Claus

At the A&P I think we’re pretty wellwhere we have to be. We’re sort ofimplementing our pricing strategy about sixmonths ago. Do we getcredit for itfrom our customers? No and that’s goingto take some time and it’s going to take some marketing but every period wemeasure this and we seeimprovement inour customer acceptance or customer... Theway they perceive value for themoney in ourstores but that again is along processthat you have to chip away atso I thinkwe’re there. We believe that at Pathmark there’s some correction to be made, that Pathmark over time has allowed itself to creep up a little bit whereas being a price impact banner for us it’s got tobe moreaggressively priced than what itis today, and that’s acombination of pricing and also mix.

Karen Short - Friedman, Billings, Ramsey& Co.

Can youcomment on thecompetitive environment? I know you saidit was stillintensified since thetransaction closed or is itjust stably intense?

Eric Claus

It’s beenpretty hotfor the lastsixmonths. It’s been pretty hot. And again, we’re a part of that and like I said, we’refocused on our game and we’re focused on trying to get to a fair market share given the real estate that we have and the square footage that we have in themarket. So we continue doing what we’redoing. I would say that we’re certainly like I said a part of that and we will continue todrive our business until we getto the pointat which wefeel that we have afair market share.

Karen Short - Friedman, Billings, Ramsey& Co.

You madecomments that shrink was higher inthe centerstore. Can you give a little color on what you think isdriving that and what some of thesolutions are?

Eric Claus

The operations team has awhole shrink plan out to control this. There’s alot of tightening of controls and whether they’re back door, front door, to get on this. I think we also had... We changed some of the processes with regard to accountingand supply that maybe theshrink is up but themargin is also... is compensated inmargin, so it may be alittle bit artificially higher than what we seeit to be,but suffice itto say that the teams are really focused on that. They’ve put a real focus on the fresh shrink which actually the solution on fresh shrink was todrive sales and that’s paid off inspades. That more than offsets it soI think we’ll seethat stabilizing over thenext couple of periods. I’m not overly,overly concerned. Obviously we’re alwaysconcerned if shrink is up but I think that we should be back on track within the next few periods.

Karen Short - Friedman, Billings, Ramsey& Co.

And howis shrink looking atPathmark? This is A&P specifically Iassume.

Eric Claus

Pathmark’shad some real issues with shrink, especially inthe non-foodareas, and I think that maybe there were some of the expenses were cut back in that area. We’ve got theoperations teams allover that with loss prevention and some of thetougher markets where they’re really atit. That’s not an area where you can skimp because onceit’s known that you’re backing off interms of security than certainly thenot-so-honorable take advantage of that situation, so I can just say that it’s too high. Ithas beenhigh for thelast couple of quarters and they’re allover it.

Karen Short - Friedman, Billings, Ramsey& Co.

Can yougive some direction on how much above industry it would be?

Eric Claus

I don’tknow. Brenda?

BrendaGalgano

In the third quarter last year’s EBITDA forPathmark was $30 million. This year it was $28 million. That decline is fully due to an increase in shrink in the$2 million to $3 million I would say, sothat’s something that we believe we can correct.

Eric Claus

It’s certainly higher than where it should be.

Karen Short - Friedman, Billings, Ramsey& Co.

I havemore questions. I’ll get back in thequeue. Thanks.

Operator

We’ll go next to Perry Caicco of CIBC World Markets.

PerryCaicco - CIBC World Markets

Goodmorning. Just back onto the same store sales if we could, whichwas certainly impressive. I guess I’mwondering just how sustainable those kinds of numbers are. You’ve got some inflation in there but I guess if they’re largelydriven off promotions, there would besome concern that thefoot kind of hasto stay on thegas pedal at some expense to sustain that kind ofmomentum or arethe changes more fundamental? Is there some profound difference n the overall customer proposition? I’m particularly interested in center store when you talk aboutthat.

Eric Claus

It’sEric. Sothe onequestion. There’s a few parts to the answer. Yes, there hasbeen significant changes,so by way ofexample, when we classify our customer base through our card marketing with the platinum, gold, bronze, tin, thatwhole spectrum of customers and what we would call the better customers, not the cherry pickers, has significantly improved which is goodfor us because they’re spending more money. Our promotional sales as aproportion of our total sales hasincreased because we dohave our foot on thegas butwhile we have our foot on thegas, we’ve done alot of innovative merchandising mixed things to be able to compensate and that’s why youdon’t see a significant decline in thegross margin. That’s why we feel that wehave theability to keep thefoot on thegas. One of those again that will putmore color on next year’s private label where we have an intensive push on private label andwe’re growing private label ata rate that certainly outpaces anythingyou’ll see in themarket, but then again we’re coming from further back then most people in theindustry. The inflation piece, yeah, we’ve hadinflation, we’ve had costs rise strictly on thecost side ofthings. We’ve been very, very aggressivethough innegotiating promotional deals and working on certain promotions that are supplier-funded so I think the longanswer is that we have to keep our foot on thepedal. We believe that we can afford tokeep our foot on thepedal, not going crazy, but we’ve got to stay aggressive and at theend of theday, if you look atour sales persquare foot relative to some of theothers in the market, we’ve still got a ways to go and I think that once the customers start seeing that the quality is there, the prices are there, the conditions of the store improving, that’shelping.

Anotherlarge part of our IDsales increase is also thecapital. We now have about a third of our stores that have beenrenovated. I think it’s 28% - 29% to be exact. That certainly helps push the total number up although I’ll say our base stores are up not nearly as much as the renovated stores but they’re upalso. Soall in allit’s acombination of alot of things.

Perry Caicco - CIBC World Markets

That’shelpful. I’m assuming that part of the stronger EBITDA, part of the contribution has been the improvements in food basics. I’m just wondering where you go from herewith basics? Is basic going to be on hold while you sort of work on the other assets or are there some near term opportunitiesto add some units?

Eric Claus

I thinkthere’s going to besome near term for afew units but nothing ina major waybecause we’ve got too much on our plates, although we’re always planning a couple of years out. Soa we go intoour strategic planning sessions over thenext couple of months, one of our major discussion topics that we have toaddress with our Board is how dowe take this vehicle which we’ve certainly learned how to operate now and how do we growthat vehicle and just give us more room for growth again in this and other markets because it’s a very simple... You know the model from Canada, Perry,it’s asimple cost-effective easy to rollout. Once you’ve got it, you execute it and it can be very, very effective. Sowe certainly don’t want to let that just die on the burners, although I would say you’re not going to see significant development in 2008.

Perry Caicco - CIBC World Markets

One lastquestion if I could. I was justwondering where you areon theprocess of dealing with thedark stores. I guess there was anothersort of hefty expense inthe quarteragainst those and soI’m just wondering what thetimeframe is for bringing that expense down, and is that process somehow linkedto thepotential reshuffling of banners and assets between your old and new formats?

BrendaGalgano

I can address that, Perry. Atthe end of the third quarter, the liability was approximately $200million. Of that amount, let me just pull up the details here, part of it relates to vacant stores and there’sanother portion that relates to... Of the$200 million approximately $65 million relates to sublease locations and the remaining portion relates to vacantlocations which is where we’re really focused on trying to dispose ofthat. Of that amount, well over halfrelates to Michiganlocations, sothere’s aheavy focus on dealing with thevacant properties inMichigan. We’ve added a significant amount to that when wedivested of thedivision this year. With the Pathmark transaction, we have madesome changesin realestate personnel such that now we have more resources dedicated to focusing onthis and we doexpect to significantly reduce thenumber of vacant locations over thenext year.

Perry Caicco - CIBC World Markets

Okay,thank you.

BrendaGalgano

One morepoint I will make on that is that within the$200 million we dohave assumed... We’ve assumed certain locations would be early terminated so we expected to be on track with that and reduce the number of vacant locations but thatdoesn’t necessarily mean that they’ll besignificant gains coming to theP&L. I just want to make sure thatthat’s understood. So we doexpect that theamount of cash going out thedoor on aquarterly basis will decline significantly over the next couple of years. This year inthe thirdquarter we had approximately $14 million of vacant costs and that rate will drop every quarter goingforward. In ’08 we expect the payments to be inthe range of$45 million.

Perry Caicco - CIBC World Markets

Okay,thanks.

Operator

Our nextquestion comes from GaryGiblen of Goldsmith and Harris.

GaryGiblen - Goldsmith and Harris

Hi, goodquarter, everybody. Did you quantify orcan you quantify theinflation component of the3.1% comp?

Eric Claus

Gary, we’ve spent so much time on this inflation number it can drive you crazy. There’s alot of components. You’d think it’s an easy calculation to make but there’s so much... The merchandise mix, the promotional mix that you putin. Thebest that we can come up with interms of really trying to understand our inflation is that it’s a little less than half of what our ID growth would be. It’s not ascience to figure itout although some people may think itis. There’s so many variables, but I think we’reprobably not far off. Directionallywe’re there and putting more energy into understanding it than that is probably not worth the time but that’s about where we endup with our number.

Gary Giblen - Goldsmith and Harris

I’m notsure that’s helpful. So that would imply that you’re fullypassing through your wholesale inflation to thecustomers?

Eric Claus

We are and we’re not because rememberthere’s thewhole red tag savings which is thousands of items that we reduce on a regular basis which is a formof quasi-EDLP within thecenter store. There’s our whole newpricing strategy which is more aggressive, soon those items itdoesn’t matter what thecost is, it matters what your competitors are out. So wetarget now themost aggressive retailer ineach market and that’s where we position ourselves with the most visible items, as well as we’veincreased our promotional activity and quantity of items that we put into ourflyers, so the answer’s really a yes and a no. If it’s just aregular item, ablind item where thecost getspassed on, yes. In many of the items it doesn’t because we’re going after it inapromotional way more than we arein a regular way.

Gary Giblen - Goldsmith and Harris

Havethere been steps taken recently to relook atsome aspects of theC&S agreement? How is that playinginto effect?

Eric Claus

I wentover that briefly before where we believe that we’re very close to arriving at adeal. It’s taken a long, long time but it’s a very big and it’s a very important contract and we believethat we have theend insight. When I say theend in sightI’m talking arelatively short period of time where we think we can conclude this contract,bring it toour Board for final approval, and then moveforward. It’ll certainly be abenefit, and again it’s abenefit that’s not factored into our numbers, but at this point I don’t count my chickensuntil they hatch. When it’s done, it’sdone. Until it’s done we’re notcounting on anything.

GaryGiblen - Goldsmith and Harris

Okay,great, and then finally, Super Value, anhour before you guys mentioned that there seems to be correlation between softness wherethey had particularly soft sales would bein newerhousing markets because themore pressure on housing prices and newer and less stable housing markets. If you looked at your market area, let’s say I don’t know, South Jersey versus themore metropolitan area or New Yorkmetro, would that general pattern hold?

Eric Claus

I thinkgenerally speaking we’re infairly mature markets for themost part sowe don’t feel as much of that as they might insome of thenewer areas. I can tell you in areas in such as for example west New Yorkwhere building development hasreally slowed down, we can seethe effectsof putting anew store inthere and now we can probably saythat store is probably ayear off of our projections just because there’s been a lot of slow down in some of that new building, but otherthan that, even markets like Hoboken or Jersey City’s on fire, it’s justflying. So we can’t say that we really, really see that. I think some of the areas further south are alittle tougher for different reasons. Idon’t think that hasto do withhousing, I think it’s just everyone’s more aggressive and there’s peopledriving further distances to go shop. But generally speaking, most of our markets are fairly mature and I can’t say... Ican understand why they sayit andthey’re probably right on themoney, but I think they operate ina lot ofdifferent markets than we do.

Gary Giblen - Goldsmith and Harris

Okay,thank you very much. Good luck in thefourth quarter.

Operator

Our nextquestion comes from Karen Howland of Lehman Brothers

Karen Howland - Lehman Brothers

Goodmorning. I was wondering if you couldtalk at all about your ability to monetize anyof Pathmark’s assets. I know they own ahandful of stores and you spoke before about there being potentially rightsover their stores. Has there been any progress there?

Eric Claus

Nothing that we can specifically talk aboutbut that’s clearly anarea that we arefocused on and that’s something that we will doprobably over thenext 12 to 24 months you’ll behearing and seeing some of those results coming through.

KarenHowland - Lehman Brothers

Okay andno indication of how much or how large of anopportunity that can be?

Eric Claus

No, not at this stage.

Karen Howland - Lehman Brothers

Okay, andthen when you talk about theremodels that arehitting in the high teens area, how many storesdoes that include inthe last 12months?

BrendaGalgano

Let mesee. Sixteen.

KarenHowland - Lehman Brothers

Great,thanks, and Brenda, I was wondering if you could give any guidance, I know youtend not to guide on aquarterly basis or really atall, but as far as interest expenses, upcoming quarter. I know you’ve said $144million is thetransaction for thefull year. Is it safe to take 12 weeks of that or?

BrendaGalgano

Yeah,given that thetransaction closed atthe start ofthe quarterand most of therefinancing was done acouple weeks later, I think it’s fair to take the $144 million and then just take 313ths of that.

Karen Howland - Lehman Brothers

Okay,great. Thanks so much and congrats on a good quarter.

Operator

Our nextquestion comes from Westcott Rochette of Bear Stearns.

Westcott Rochette - Bear Stearns

Thanks a lot guys. Sofirst question, can we just getan updatekind of post-merger on thedraw down on your revolver?

BrendaGalgano

Post-merger--

Westcott Rochette - Bear Stearns

I’m justtrying to... Allthe movingparts because your balance sheet is prior to themerger. There are alot of moving parts. Roughly what’s the current draw down on the revolver?

BrendaGalgano

Withoutgiving guidance here, I’ll just give you alittle bit of direction around cash flow. Use whatever number you want to assume for EBITDA this quarter and goinginto ’08 and then we have planned CapEx inthe fourthquarter of approximately $45 million. Going into next year theCapEx number is approximately $150 million. We have cash interest expense inthe range of$120 million to $125 million. The $144 of interest expense includesapproximately $20 million of non-cash interest.

Westcott Rochette - Bear Stearns

I guessI’m not looking forward, just kind of immediately, before you started all your capital plans into this currentquarter, kind of once allthe monies changed hands and the convert. What was thedraw down on your revolver?

BrendaGalgano

In the range of the $200 million. After allthe dustsettled from therefinancing and everything else itwas in the range of $200 million.

Westcott Rochette - Bear Stearns

And did Ihear correctly that your current credit agreement is $540 million in your prepared remarks?

BrendaGalgano

Yes. Therevolving credit agreement?

Westcott Rochette - Bear Stearns

Yes.

BrendaGalgano

Yes.

Westcott Rochette - Bear Stearns

Okay andsecondly, aquestion that also kind of came up on Super Value’s call I will ask youguys. Since you run several differentformats, they had talked about consumer trade down that they started to see particularly between theirbanners. Are you guys in this market seeing any consumer tradedown as consumers geta littlemore anxious? Can you speak to that toany degree?

Eric Claus

Westscott,candidly, none whatsoever. I mean ourfresh stores aredoing well and that’s ahigher ticket than obviously your food basics and Pathmark. If anything, the most momentum... Obviously we’regetting alot of momentum out of food basics but that’s been that way since we renovatedthem and changedthe conceptand our fresh continues trucking along atthe same rate and we’ve seen some improvement in Pathmark also but that’s basicallydesigned that way. We’re not seeing anyreal trading down or movement that way.

ChristianW.E. Haub

Alsowithin thedifferent formats, we always look for trading down from fresh to more packagedor I think our private label penetration increase also is driven much more byour approach to increase itthan consumers starting to trade off from national brands to privatelabel. So we look for it because we’ve got that question askeda lot and Ithink to this date we haven’t seen it. We’ve just went through two major holiday periods, Thanksgiving andChristmas, and they were both excellent.

BrendaGalgano

Can Ijust clarify, you had asked methe questionaround theamount of therevolving credit facility. That is the $540 million, $542 million to be specific, but I just want to makesure that everyone catches that inaddition to that, we have theterm loans which is thetotal of $133 million, soif you add itall up it’s the $675 million. I just wanted to make sure that’sunderstood.

Westcott Rochette - Bear Stearns

Okay. That’s agood point of clarification and one last question on, and I don’t know how muchyou’ve looked atthe Pathmarkside on their pharmacy and then your pharmacies are much smaller, what are theplans interms of integrating those operations and potentially expanding pharmacy withinA&P and just more recently would have been your experiences in terms of cough, cold, and flu? Have those trended kind of in line with where there’s a drag to sales or margins that some of the other drug retailers have had a little weaker performance through the recent period? I’m just wondering how your pharmaciesperformed?

Eric Claus

Ourpharmacies arenow integrated together. We have onemanagement team headed up by Carol. The expansion potential in A&P is not that great because the areas of the stores that we don’t have pharmaciesin wasspecifically for areason that there’s already other pharmacies inthe mall oradjacent or thestore’s too small. That kind ofthing. Pathmark has avery large pharmacy business sowe’re pretty excited by it. One of the first things we did was negotiate the supply contract coming right out of the gate to make that contract a joint contract which obviouslybenefits again as amerchandising income synergy there. Whenit comes to the business, there’s been a changein the pharmacy business because ofgenerics over thelast year soalthough that affects thesales number ina negativeway, itaffects theprofits in a positive way. Thewhole cough and flu over thelast couple of months hasbeen alittle bit soft sowe haven’t seen alot of strength either inour business there, but it’s nothing that’s of major concern to us because the earnings certainly seem to be there.

Westcott Rochette - Bear Stearns

Okay. Thanks alot guys.

Operator

And we’llgo next to Eldico Hildress of Waterstone Capital.

EldicoHildress - Waterstone Capital

Hello,just acouple questions. Why the large increase in restricted cash in thequarter?

BrendaGalgano

At the end of the third quarter, the cash was restricted for the use of the acquisition which closed two dayslater.

Eldico Hildress - Waterstone Capital

Okay, andthen just because I haven’t had time to go through all thedetails of your past and your amended credit agreement, what was the increase in cost?

BrendaGalgano

In terms of interest rate?

Eldico Hildress - Waterstone Capital

Yes.

BrendaGalgano

Fiftybasis points.

EldicoHildress - Waterstone Capital

Okay andthen last question is when was this amendment requirement known?

BrendaGalgano

Weamended iton December 27th I believe was thedate.

Eldico Hildress - Waterstone Capital

The reason I ask is you didn’t talkabout this when you issued theconverts.

BrendaGalgano

That’sbecause that was after when we issued theconverts, this was not finalized.

Eldico Hildress - Waterstone Capital

Okay,thank you.

Operator

And it appears we have no further questions at this time.

ChristianW.E. Haub

Okay, I think then we’ll conclude ourconference call and we will thank you very much for your participation and welook forward to talk to you again atthe end ofour fiscal year. thank you.

Operator

Ladies and gentlemen, this does concludetoday’s presentation. Thank you for yourparticipation and you may disconnect atthis time.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!