Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

Executives

William J. Moss - Vice President, Treasurer

Christian W.E. Haub - Executive Chairman:

Eric Claus - President & Chief Executive Officer

Brenda Galgano - Senior Vice President and Chief Financial Officer

Analysts

John Heinbockel - Goldman Sachs

Karen Short - Friedman, Billings, Ramsey & Co.

Perry Caicco - CIBC World Markets

Gary Giblen - Goldsmith and Harris

Karen Howland - Lehman Brothers

Westcott Rochette - Bear Stearns

Eldico Hildress - Waterstone Capital

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

Operator

Good morning and welcome to the Great Atlantic and Pacific Tea Company’s conference call. All lines will bein a listen-only mode until the question and answer session. Today’s teleconference is being recorded. If you object, please disconnect at this time. For your information, a webcast is available at 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 now like to introduce Bill Moss, Vice President and Treasurer, who will read A&P’s Safe Harbor disclaimer. Please go ahead, Mr. Moss.

William J. Moss

Thank you and good morning, everyone. Today’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 inthe food industry generally and particularly inthe company’s principal markets, the company’s relationships with its employees, the terms of future collective bargaining agreements, the cost and other effects of lawsuits and administrative proceedings, the nature and extent of continued consolidation inthe food industry, changes in the financial markets which may affect the company’s cost of capital or the ability to access capital, supplier quality control problems with the company’s vendors, and changes in 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 W.E. Haub

Thank you, Bill. Good morning everyone and welcome to our third quarter conference call. I hope you all had a great holiday season. I wish everyone good health and success inthe New Year. With me today as usual are Eric and Brenda and you’ll hear from them shortly. I’ll begin our presentation by commenting on our results, highlighting some of our important strategic accomplishments in the past quarter, and discussing my outlook for the company.

Of course this is the last time we will discuss the performance of just the old A&P since we closed on the Pathmark acquisition atthe beginning of our fourth quarter. Obviously this was a landmark event for our company, marking both the completion of the strategic transformation we initiated in 2005 and the dawn of an exciting new era for A&P. I’m also very pleased that in addition to that momentous achievement, we continue to make solid progress in our business during the third quarter, highlighted by our strong comparable store sales at over 3% and improved operating earnings.

Our steady focus on key strategic initiatives in operations, merchandising, store format development, and cost management continues to produce traction during this quarter as evidenced by our ongoing strong sales momentum, only slightly lower gross margins despite our aggressive pricing and promotional approach, lower costs through strict internal controls and increasing sales leverage, improved operating income, and finally our tenth consecutive quarter of year over year improved results.

Eric and Brenda will address the key drivers of these ongoing positive trends during their presentations so I’d like to use my portion to very briefly summarize our strategic accomplishments and what’s immediately ahead of us in terms of strategic priorities. First with respect to Pathmark, let me just say that beyond the obvious achievement of completing the deal successfully, we were very pleased with the outcome of the SEC approval process which required us to divest only 6 stores with combined EBITDA only $6 million, effectively preserving over 97% of the combined company’s current profitability.

Overall, the strategic fit of these businesses is optimal since Pathmark’s price impact format adds the final piece we needed to target and serve all major consumer segments in our markets in tandem with our fresh discount and gourmet formats. This is a food marketing portfolio that no single competitor in our market has and Eric will discuss some of its initial enhancements and development plans for all of those formats during his remarks.

Financially, the significant backstage merger synergies we will produce as our integration plan goes forward will put us firmly on the pathway to sustainable profitability, and finally, with all previous non-core operations divested as of the quarter’s end and the Pathmark deal as the capstone, we have successfully accomplished our strategic transformation and I couldn’t be more pleased about our competitive posture and our prospects for future profitable growth inthe northeast.

Turning to my outlook for the new A&P in 2008 and beyond, our outlook is in one respect continuity, as our executive management team remains focused on organic improvement of our business through merchandising and operating best practices. These fundamental elements and the fresh innovative thinking so clearly demonstrated in our merging store format examples have been the catalyst of our improving results over the past 2.5 years and our leadership is fully committed to maintaining and in time accelerating that momentum.

Alongside those ongoing advancements, we are already moving ina careful yet timely fashion to execute the Pathmark 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 a moment.

Once again, I’m very excited about the future prospects of the new A&P and I have great confidence inthe management team under Eric’s leadership and the outstanding talent we have now assembled between both companies.

That’s the end of my introductory remarks and with that I’ll turn it over to Brenda.

Brenda Galgano

Thank you, Christian, and good morning, everyone. This morning we reported second quarter sales of $1.3 billion in income from continuing operations of $1.73 per diluted share. Comparable store sales were positive 3.1% inthe quarter. Excluding non-operating net expenses of approximately $9 million and net gains of approximately $12 million respectively, ongoing EBITDA was $20.5 million this year versus $16.3 million last year. Schedule 4 of our press release details the non-operating items for both years. I’d also like to point out that we excluded $4.1 million of income from last year’s EBITDA related to theIT contract with Metro as it ended in August of this year so will not be recurring.

For the first five weeks of our fourth quarter, we continued to see positive sales trends inthe A&P business. We have also been experiencing overall positive comp store sales growth for the Pathmark stores since we closed on December 3rd. Third quarter ongoing gross margin which excludes the $4.2 million of income related to theIT contract with Metro decreased 12 basis points to 30.51% driven primarily by an increase in special promotions.

Second quarter ongoing SG&A expenses totaled 31.48% this year versus 32.07% last year, a decrease of 59 basis points. This decrease is primarily driven by reductions in store 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 basis points, offset partially by increase in occupancy expense of 12 basis points.

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

During the quarter we completed two fresh stores, one gourmet store, and one new liquor store. Overall returns on projects continue to exceed our cost of capital and ID sales for capital stores continue to be strong. For the quarter, average IDs from all capital projects completed in the last year was inthe high teens. Average IDs from ’06 capital projects completed over a year ago was in the mid single digits.

For the remainder of 2007 we expect to spend approximately $45 million. During the fourth quarter we expect to complete one 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.

Turning now to our balance sheet, we ended the quarter with overall negative net debt or positive net investments of $7 million, including capital leases and real estate liabilities and net of $2 million in short term investments and $542 million of restricted cash. Excluding $348 million in proceeds from the sale of Metro, net debt decreased about $20 million to $340 million from the end of the second quarter. This is primarily due to the adjusted EBITDA of $21 million, proceeds of $60 million from the divestiture of our New Orleans business, offset by net interest expense and taxes of approximately $11 million, CapEx of $19 million, dark store occupancy payments of approximately $14 million, and a decrease of $17 million for net working capital and other which includes the integration and transaction related costs incurred inthe third quarter.

Net debt excluding restricted cash was $536 million. Availability under our revolving credit agreement was $215 million at the end of the quarter with outstanding loans of approximately $11 million. Letters of credit issued under our separate letter of credit agreement totaled approximately $138 million. As of the end of the quarter, we had cash net operating loss carry forwards of $246 million to offset future cash profits including operating profits and capital gains. The decrease in the NOL balance from the second quarter is primarily related to the sale of our Metro holdings.

Lastly I will cover the Pathmark acquisition and the related financing. In connection with the December 3rd acquisition, on November 29th we sold the remaining 11.7 million shares of our holdings in Metro for proceeds of approximately $348 million, resulting ina net gain of $106 million. We closed on the acquisition on December 3rd for total consideration of $1.4 billion. The acquisition was funded by the issuance of equities totaling $393 million, $538 million of restricted cash on hand from the sale of the Metro shares, net bank borrowings under a new revolving credit agreement of $146 million, and a $370 million loan under a temporary bridge credit agreement.

On December 18th we refinanced the bridge credit agreement and issued $165 million of 5.125% convertible senior notes due 2011 and $255 million of 6.75% convertible senior notes due 2012. The principal amount of these notes will be convertible into shares of our stock, cash, or a combination of stock and cash at our option.

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

We also entered into share lending agreements to lend up to 11,278,988 shares of our common stock. Pursuant to these agreements, we loaned 8.1 million shares of our stock to these entities who then sold 6.3 million shares to the public in a public 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 the shares will be returned back to the company under GAAP they are not included inthe EPS calculations.

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

In order to facilitate the syndication of the revolver credit agreement under the current market conditions, we entered into an amended 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 million collateralized 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 capital loans 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, certain accounts receivable, pharmacy scripts, owned real estate, and certain Pathmark leaseholds. Borrowings under the facility bear interest based on LIBOR or prime interest rate pricing plus an applicable margin. For your reference, the agreement has been filed as an exhibit in our third quarter 10-Q.

With respect to the integration, we are right on track. We are inthe process of converting systems with the integration of payroll already completed. We have begun to review all service and professional contracts to reduce operating and admin costs and plan to close Pathmark headquarters within the next five months.

We feel confident in our ability to achieve $150 million in synergies, including $80 million in admin reduction, $40 million incost of goods sold reduction, and $30 million ina combination of supply logistics, marketing and advertising, and other store operating cost reductions. We expect to achieve a run rate of over half of the $150 million by the end of our first quarter in 2008 and expect to fully achieve synergies within 18 to 24 months. We continue to expect total integration costs of $115 million of which approximately $30 million is capital and $85 million will be expense. Of the $85 million in expense, approximately $10 million represents non-cash costs associated with a special stock compensation incentive program. Through the third quarter we have incurred approximately $9 million in integration costs, of which $2 million is capital related to equipment and IT. We expect to incur most of the integration costs within the first six months.

In closing, I am pleased with our continued operating momentum. We had strong comp store sales improvement of 3.1%, excluding the effect of Metro IT. EBITDA increased 4.2% over the previous year. Pathmark’s comparable store sales declined slightly inthe third quarter to negative .4% with EBITDA of $28 million this year versus $30 million last year. The decline in EBITDA was primarily driven by increased shrink. As I previously mentioned, comparable store sales are trending positively to date inthe fourth quarter for Pathmark. We remain financially strong and continue to focus on maintaining sufficient liquidity. With the closing of the Pathmark acquisition, we are fully engaged in the integration process and the realization of our synergy targets.

I will now turn it over to Eric.

Eric Claus

Good morning. 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 say that we’re now officially inthe post-closing process and I’m very pleased to say that all of the hard work and planning for this event at both companies is finally paying off. Integration is progressing very smoothly. At this early stage we have hit every milestone that we set for ourselves and have encountered no major glitches thus far.

We welcome the Pathmark team into our fold and I think that it would be a fair statement for me to say that this has been accomplished ina very positive fashion. We’ve held meetings with all the major Pathmark and A&P teams including all Pathmark store managers and we have a very excited group that feels the momentum building in our business.

Our teams are now very focused and also highly incented to obtain the synergies that this transaction was predicated upon. We are very confident that the $150 million of synergies is well within our grasp and our early assessment of those synergy potentials is consistent with our projections. The actions needed to attain these synergies arein full swing and meetings of our supply partners have begun. This in order to start the all-important merchandising synergy process.

We will report on our progress as it pertains to synergy achievement over the next few quarters and Brenda will speak more to that in the future. We’ve been very quick to integrate retail operations and put the new leadership in place. We are also very quick in putting our new merchandising teams together and are already in the process of strengthening our programs for the next few months. Sales for the Christmas season were positive and continues on a positive track as we speak. We also intend on being very quick to launch our new combined private label programs and plan to have that integrated inthe first part of fiscal 2008. We have started working with our teams to design a store refresh concept for the Pathmark stores that will becost efficient and modernize the look of the stores while enhancing the fresh experience, particularly in areas such as produce, again remembering that this is a price impact that we want to attain and update the fresh store.

The team has really done an outstanding job throughout this whole process of not taking its eye off the ball and we’ve hit the ground running, and I’m very, very pleased with our progress. When it comes to the C&S logistics contract negotiation, we’ve made very significant progress over the last couple of months. As I’ve previously stated though, a new contract is not necessary for us to achieve our projected synergy targets. Both C&S and A&P have recognized, however, the need to create a logistics infrastructure that’s a future model for low costs and sustainability; in other words, a large company model.

Both Rebecca and myself, along with the C&S principals, continue to meet every second week and are getting very, very close to concluding a deal. Again, both companies are really committed to making this process work and we both now believe that we have the end in sight. This will bea very exciting and significant advancement for both companies. More to come on the next call.

Now as for the third quarter, for the first time we’re now truly a northeast company and our progress continues inthe northeast. As mentioned in previous calls, the market is hot and we are abig part of that as we continue to drive to attain our fair market share. That said, we continue to be pleased with our top line results and our price positioning. The gain this quarter of our comp store sales crossed the 3% mark at a positive 3.1% and our EBITDA was $21 million, which is about 25% better than 2006 when taking into account the Metro IT income that was realized in that year. Given the market intensity and our strong comps, we’re very pleased with the quarter. Our new competitive pricing strategy continues to improve our price perception with our customers. Although there is some inflation, it’s less prevalent in our company given the level of competitive activity and our new pricing strategy. Our real gains, however, are evidenced in increased basket sizes, customer accounts, and market share. All of our key market indicators in our businesses are strong and are positive. Private label penetration continues to grow atan aggressive rate and I’ll have more to report on the integration and objectives of this initiative on our next call.

As usual, I’ll update you on our store format progress and capital. When it comes to the capital, we continue to invest although as Brenda mentioned we slowed down a little bit in the third 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 bring Pathmark stores into this initiative, and I will provide more color on that piece of it on our next quarterly call.

In the third quarter we continued to see tremendous progress in our new food basics discount format and I’m pleased again to say that these stores continue to experience very strong year over year sales growth. Now for the third quarter in a row we can report a much improved bottom line from stores that were major money losers in their previous lives as conventional supermarkets.

Our fresh store remodels continue to be positive and continue to gain momentum every period and Brenda alluded to some of those numbers. We continue to experience 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 expectations and we have two more stores like this that are planned to open inthe next couple of months. Overall we continue to be pleased with the fresh store financials as the mixed shift from grocery to fresh continues to be on target, outpacing center store and driving increased sales and margins and we now have the experience of having that two years in a row.

When it comes to our Manhattan Food Emporiums, overall sales inthe Manhattan market are now exceeding company comp so we’re very pleased about that. The 49th and 8th upper level renovation with a very contemporary sort of grab and go concept as well as the one that we did in Trump Towers at 68th and 3rd are really booming and are probably worth a look if any of you have a chance. That’s just the top floors. Both stores basements or the basement levels will be renovated in the first quarter of fiscal ’08 and we’re going to continue on this base with the Food Emporiums.

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

I’d be remiss if I didn’t talk about our emphasis on cost controls. Our administrative run rate continues to be on track. Utility costs again and expectedly were higher for the quarter and we’re aggressively pursuing and implementing systems to mitigate some of the energy price increases. Our store operations teams continue to doa very outstanding job as they focus on cost control. Our labor productivity and sales per employee hour were once again better than last year, again demonstrating the commitment from our teams at retail.

Stock losses and center store are still a problem. They were again higher than last year in that area and our operations is very, very focused on that issue. This, however, fortunately was again offset by much improved fresh shrink which is a company-wide initiative driven by our retain team.

So to conclude, I would say that we continue to stay very focused on our game plan and the strategic direction that we’ve chosen for the company. Our momentum continues and we’re keeping our eye on the retail ball. The Pathmark integration is in full swing and we are very pleased with what we see and our detailed preparation is really paying off. We’re focused on reaching our projected synergy savings and are very confident of obtaining them on time and on the money, so in closing, I’d once again like to send up my thanks to our Board of Directors for their guidance and support, to my executive management team, and to the whole A&P and Pathmark teams who are all doing so much and working so hard in order to deliver on our expectations.

I’ll now pass it back to Christian. Thank you.

Christian W.E. Haub

Great. Thank you, Eric and I think you can hear from all of those statements that we couldn’t have had a better start to the combination of A&P and Pathmark. Certainly summarizing the calendar year of 2007, it’s clearly a year of significant progress across all fronts, strategically and operationally. Our non-core divestitures, merchandising, operating improvements, the new format performances, and the acquisition of Pathmark has positioned our company as a leader in the northeast food retail industry with a decisive number one market position in metro New York and improved presence in Greater Philadelphia. The $150 million of merger synergies that we fully expect to achieve over the next two years ongoing operating improvements across the A&P banners and the continued improvement of Pathmark will at last enable us to establish and sustain overall profitability.

The strict reduction and management of costs ingrained in our corporate culture since 2005 has significantly reduced administrative and other expenses and those efforts will continue unabated, eventually producing the optimal cost structure for our business, and the proactive corporate real estate and tax strategy has again added to our bottom line will continue in the new year and beyond.

While much work remains ahead, all these factors bode exceedingly well for the new A&P and the remainder of this year and through fiscal 2008 and beyond. Our combined team is energized and excited to move forward with the integration and to realize the tremendous potential of our combination with Pathmark over the next several years

This concludes our presentation and we are now pleased to move to the question and answer session part of the meeting today.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from John Heinbockel of Goldman Sachs.

John Heinbockel - Goldman Sachs

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

Christian W.E. Haub

John, we’ve done so much study on all this because of the combination of a lot of factors, a lot of talk about inflation inthe economy. In our case, our customer count is up as well 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 real growth from the business that we’re driving. Obviously our promotionals, our mix has shifted also more to promotional as opposed to regular sales in sort of the aggressive market that we’re operating in.

John Heinbockel - Goldman Sachs

From what you’ve seen so far at Pathmark, and I know it’s early, but would that be driven more by ticket than traffic at this point? Their comp?

Christian W.E. Haub

In Pathmark, yes.

John Heinbockel - Goldman Sachs

You talked about sort of fourth quarter here positive sales trending positively. You didn’t make reference to how that compared to the third quarter. I assume you have not seen much of a drop off from the third quarter given the macro?

Brenda Galgano

That’s correct. In fact, it’s actually a bit stronger than what we saw in the third quarter.

Eric Claus

And we’ve brought the Pathmark team and the merchandising team, they’re working closely with our team, it’s a combined team now, to really draw the promotional part in a more aggressive way than they had been over the last year.

John Heinbockel - Goldman Sachs

How many Pathmark stores do you think will be remodeled inthe next year, the next two years? How many need to be remodeled?

Christian W.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 little plain Jane and they require some facelifting, some paint, some change, and we’re just in the process of evaluating all of that and by the next quarter I think we’ll be able to roll out what our capital plan will be for 2008. What we’re trying to do, and I alluded to it briefly in my comments, is to do something where we can affect a large number of stores by giving ita refresh, a relook, and enhancing in particular a couple of departments like produce and bakery, getting much stronger on the signing, and making ita much more price impact sort of venue when you walk into those locations. Sothe exact number, I think we’ll be able 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 would be that probably over a three year period we could doall of them.

John Heinbockel - Goldman Sachs

And given the capital you’re talking about, would you be happy with a mid single digit sales lift or you’d want something more than that?

Eric Claus

Given that capital, it would 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 already doing.

Eric Claus

Yes. I think what we have to do is... That’s going to bea combination of giving ita new facelift, working on that fresh piece a little bit, and driving the business more aggressively than what ithas been driven in the past, but I think that would be safe to say that would be our objective in those stores.

John Heinbockel - Goldman Sachs

And finally the incremental EBITDA or EBITDA margin on the sales that you get from the Pathmark remodels should be fairly high because they’ll allbe fresh. I assume you’re looking for a double digit incremental EBITDA margin on those sales.

Eric Claus

I would just be safe on 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, then obviously 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 next quarter we’ll have a better handle on it. But to tell you that when we look atit we see a lot of upside to it and we’ve got some great people that joined us that really understand their business and I think it’ll be good.

John Heinbockel - Goldman Sachs

Okay, thanks.

Operator

Our next question comes from Karen Short of Friedman, Billings, Ramsey.

Karen Short - Friedman, Billings, Ramsey & Co.

Hey everyone. Good quarter, congratulations. Just a couple of comments or a couple of questions on your price points. I know you’ve been making a lot of investments on the A&P side. Can you just comment on where you think your price points are now and where you think they need to beat both A&P and Pathmark?

Eric Claus

At the A&P I think we’re pretty well where we have to be. We’re sort of implementing our pricing strategy about six months ago. Do we get credit for it from our customers? No and that’s going to take some time and it’s going to take some marketing but every period we measure this and we see improvement in our customer acceptance or customer... The way they perceive value for the money in our stores but that again is along process that you have to chip away atso I think we’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 to be more aggressively priced than what it is today, and that’s a combination of pricing and also mix.

Karen Short - Friedman, Billings, Ramsey & Co.

Can you comment on the competitive environment? I know you said it was still intensified since the transaction closed or is it just stably intense?

Eric Claus

It’s been pretty hot for the last six months. It’s been pretty hot. And again, we’re a part of that and like I said, we’re focused 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 the market. So we continue doing what we’re doing. I would say that we’re certainly like I said a part of that and we will continue to drive our business until we get to the point at which we feel that we have a fair market share.

Karen Short - Friedman, Billings, Ramsey & Co.

You made comments that shrink was higher inthe center store. Can you give a little color on what you think is driving that and what some of the solutions are?

Eric Claus

The operations team has a whole shrink plan out to control this. There’s a lot 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 accounting and supply that maybe the shrink is up but the margin is also... is compensated in margin, so it may be a little bit artificially higher than what we seeit to be, but suffice it to 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 to drive sales and that’s paid off in spades. That more than offsets it so I think we’ll see that stabilizing over the next couple of periods. I’m not overly, overly concerned. Obviously we’re always concerned 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 how is shrink looking at Pathmark? This is A&P specifically I assume.

Eric Claus

Pathmark’s had some real issues with shrink, especially inthe non-food areas, and I think that maybe there were some of the expenses were cut back in that area. We’ve got the operations teams all over that with loss prevention and some of the tougher markets where they’re really at it. That’s not an area where you can skimp because once it’s known that you’re backing off in terms of security than certainly the not-so-honorable take advantage of that situation, so I can just say that it’s too high. Ithas been high for the last couple of quarters and they’re all over it.

Karen Short - Friedman, Billings, Ramsey & Co.

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

Eric Claus

I don’t know. Brenda?

Brenda Galgano

In the third quarter last year’s EBITDA for Pathmark 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, so that’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 have more questions. I’ll get back in the queue. Thanks.

Operator

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

Perry Caicco - CIBC World Markets

Good morning. Just back onto the same store sales if we could, which was certainly impressive. I guess I’m wondering just how sustainable those kinds of numbers are. You’ve got some inflation in there but I guess if they’re largely driven off promotions, there would be some concern that the foot kind of has to stay on thegas pedal at some expense to sustain that kind of momentum 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 about that.

Eric Claus

It’s Eric. Sothe one question. There’s a few parts to the answer. Yes, there has been significant changes, so by way of example, when we classify our customer base through our card marketing with the platinum, gold, bronze, tin, that whole spectrum of customers and what we would call the better customers, not the cherry pickers, has significantly improved which is good for us because they’re spending more money. Our promotional sales as a proportion of our total sales has increased because we do have our foot on thegas but while we have our foot on the gas, we’ve done a lot of innovative merchandising mixed things to be able to compensate and that’s why you don’t see a significant decline in the gross margin. That’s why we feel that we have the ability to keep the foot on the gas. One of those again that will put more color on next year’s private label where we have an intensive push on private label and we’re growing private label ata rate that certainly outpaces anything you’ll see in the market, but then again we’re coming from further back then most people in the industry. The inflation piece, yeah, we’ve had inflation, we’ve had costs rise strictly on thecost side of things. We’ve been very, very aggressive though in negotiating promotional deals and working on certain promotions that are supplier-funded so I think the long answer is that we have to keep our foot on the pedal. We believe that we can afford to keep our foot on the pedal, not going crazy, but we’ve got to stay aggressive and at the end of the day, if you look at our sales per square foot relative to some of the others 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’s helping.

Another large part of our ID sales increase is also the capital. We now have about a third of our stores that have been renovated. 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 up also. Soall in all it’s a combination of a lot of things.

Perry Caicco - CIBC World Markets

That’s helpful. 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 here with basics? Is basic going to be on hold while you sort of work on the other assets or are there some near term opportunities to add some units?

Eric Claus

I think there’s going to be some near term for a few units but nothing ina major way because we’ve got too much on our plates, although we’re always planning a couple of years out. Soa we go into our strategic planning sessions over the next couple of months, one of our major discussion topics that we have to address with our Board is how do we take this vehicle which we’ve certainly learned how to operate now and how do we grow that 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 a simple cost-effective easy to roll out. Once you’ve got it, you execute it and it can be very, very effective. So we 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 last question if I could. I was just wondering where you are on the process of dealing with the dark stores. I guess there was another sort of hefty expense inthe quarter against those and so I’m just wondering what the timeframe is for bringing that expense down, and is that process somehow linked to the potential reshuffling of banners and assets between your old and new formats?

Brenda Galgano

I can address that, Perry. Atthe end of the third quarter, the liability was approximately $200 million. Of that amount, let me just pull up the details here, part of it relates to vacant stores and there’s another portion that relates to... Of the $200 million approximately $65 million relates to sublease locations and the remaining portion relates to vacant locations which is where we’re really focused on trying to dispose of that. Of that amount, well over half relates to Michigan locations, so there’s a heavy focus on dealing with the vacant properties inMichigan. We’ve added a significant amount to that when we divested of the division this year. With the Pathmark transaction, we have made some changes in real estate personnel such that now we have more resources dedicated to focusing on this and we do expect to significantly reduce the number of vacant locations over the next year.

Perry Caicco - CIBC World Markets

Okay, thank you.

Brenda Galgano

One more point I will make on that is that within the $200 million we do have 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 that doesn’t necessarily mean that they’ll be significant gains coming to the P&L. I just want to make sure that that’s understood. So we do expect that the amount of cash going out the door on a quarterly basis will decline significantly over the next couple of years. This year inthe third quarter we had approximately $14 million of vacant costs and that rate will drop every quarter going forward. In ’08 we expect the payments to be inthe range of $45 million.

Perry Caicco - CIBC World Markets

Okay, thanks.

Operator

Our next question comes from Gary Giblen of Goldsmith and Harris.

Gary Giblen - Goldsmith and Harris

Hi, good quarter, everybody. Did you quantify or can you quantify the inflation component of the 3.1% comp?

Eric Claus

Gary, we’ve spent so much time on this inflation number it can drive you crazy. There’s a lot 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 put in. The best that we can come up with in terms 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 a science to figure it out although some people may think it is. There’s so many variables, but I think we’re probably not far off. Directionally we’re there and putting more energy into understanding it than that is probably not worth the time but that’s about where we end up with our number.

Gary Giblen - Goldsmith and Harris

I’m not sure that’s helpful. So that would imply that you’re fully passing through your wholesale inflation to the customers?

Eric Claus

We are and we’re not because remember there’s the whole red tag savings which is thousands of items that we reduce on a regular basis which is a form of quasi-EDLP within the center store. There’s our whole new pricing strategy which is more aggressive, so on those items it doesn’t matter what thecost is, it matters what your competitors are out. So we target now the most aggressive retailer in each market and that’s where we position ourselves with the most visible items, as well as we’ve increased our promotional activity and quantity of items that we put into our flyers, so the answer’s really a yes and a no. If it’s just a regular item, a blind item where thecost gets passed on, yes. In many of the items it doesn’t because we’re going after it ina promotional way more than we arein a regular way.

Gary Giblen - Goldsmith and Harris

Have there been steps taken recently to relook at some aspects of the C&S agreement? How is that playing into effect?

Eric Claus

I went over that briefly before where we believe that we’re very close to arriving at a deal. It’s taken a long, long time but it’s a very big and it’s a very important contract and we believe that we have the end in sight. When I say the end in sight I’m talking a relatively short period of time where we think we can conclude this contract, bring it to our Board for final approval, and then move forward. It’ll certainly be a benefit, and again it’s a benefit that’s not factored into our numbers, but at this point I don’t count my chickens until they hatch. When it’s done, it’s done. Until it’s done we’re not counting on anything.

Gary Giblen - Goldsmith and Harris

Okay, great, and then finally, Super Value, an hour before you guys mentioned that there seems to be correlation between softness where they had particularly soft sales would bein newer housing markets because the more 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 the more metropolitan area or New York metro, would that general pattern hold?

Eric Claus

I think generally speaking we’re in fairly mature markets for the most part so we don’t feel as much of that as they might in some of the newer areas. I can tell you in areas in such as for example west New York where building development has really slowed down, we can seethe effects of putting a new store in there and now we can probably say that store is probably a year off of our projections just because there’s been a lot of slow down in some of that new building, but other than that, even markets like Hoboken or Jersey City’s on fire, it’s just flying. So we can’t say that we really, really see that. I think some of the areas further south are a little tougher for different reasons. I don’t think that has to do with housing, I think it’s just everyone’s more aggressive and there’s people driving further distances to go shop. But generally speaking, most of our markets are fairly mature and I can’t say... I can understand why they sayit and they’re probably right on the money, but I think they operate ina lot of different markets than we do.

Gary Giblen - Goldsmith and Harris

Okay, thank you very much. Good luck in the fourth quarter.

Operator

Our next question comes from Karen Howland of Lehman Brothers

Karen Howland - Lehman Brothers

Good morning. I was wondering if you could talk at all about your ability to monetize any of Pathmark’s assets. I know they own a handful of stores and you spoke before about there being potentially rights over their stores. Has there been any progress there?

Eric Claus

Nothing that we can specifically talk about but that’s clearly an area that we are focused on and that’s something that we will do probably over the next 12 to 24 months you’ll be hearing and seeing some of those results coming through.

Karen Howland - Lehman Brothers

Okay and no indication of how much or how large of an opportunity that can be?

Eric Claus

No, not at this stage.

Karen Howland - Lehman Brothers

Okay, and then when you talk about the remodels that are hitting in the high teens area, how many stores does that include inthe last 12 months?

Brenda Galgano

Let me see. Sixteen.

Karen Howland - Lehman Brothers

Great, thanks, and Brenda, I was wondering if you could give any guidance, I know you tend not to guide on a quarterly basis or really at all, but as far as interest expenses, upcoming quarter. I know you’ve said $144 million is the transaction for the full year. Is it safe to take 12 weeks of that or?

Brenda Galgano

Yeah, given that the transaction closed atthe start of the quarter and most of the refinancing was done a couple weeks later, I think it’s fair to take the $144 million and then just take 3 13ths of that.

Karen Howland - Lehman Brothers

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

Operator

Our next question comes from Westcott Rochette of Bear Stearns.

Westcott Rochette - Bear Stearns

Thanks a lot guys. So first question, can we just getan update kind of post-merger on the draw down on your revolver?

Brenda Galgano

Post-merger --

Westcott Rochette - Bear Stearns

I’m just trying to... Allthe moving parts because your balance sheet is prior to the merger. There are a lot of moving parts. Roughly what’s the current draw down on the revolver?

Brenda Galgano

Without giving guidance here, I’ll just give you a little bit of direction around cash flow. Use whatever number you want to assume for EBITDA this quarter and going into ’08 and then we have planned CapEx inthe fourth quarter of approximately $45 million. Going into next year the CapEx number is approximately $150 million. We have cash interest expense inthe range of $120 million to $125 million. The $144 of interest expense includes approximately $20 million of non-cash interest.

Westcott Rochette - Bear Stearns

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

Brenda Galgano

In the range of the $200 million. After allthe dust settled from the refinancing and everything else it was in the range of $200 million.

Westcott Rochette - Bear Stearns

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

Brenda Galgano

Yes. The revolving credit agreement?

Westcott Rochette - Bear Stearns

Yes.

Brenda Galgano

Yes.

Westcott Rochette - Bear Stearns

Okay and secondly, a question that also kind of came up on Super Value’s call I will ask you guys. Since you run several different formats, they had talked about consumer trade down that they started to see particularly between their banners. Are you guys in this market seeing any consumer trade down as consumers geta little more anxious? Can you speak to that to any degree?

Eric Claus

Westscott, candidly, none whatsoever. I mean our fresh stores are doing well and that’s a higher ticket than obviously your food basics and Pathmark. If anything, the most momentum... Obviously we’re getting a lot of momentum out of food basics but that’s been that way since we renovated them and changed the concept and our fresh continues trucking along atthe same rate and we’ve seen some improvement in Pathmark also but that’s basically designed that way. We’re not seeing any real trading down or movement that way.

Christian W.E. Haub

Also within the different formats, we always look for trading down from fresh to more packaged or I think our private label penetration increase also is driven much more by our approach to increase it than consumers starting to trade off from national brands to private label. So we look for it because we’ve got that question asked a lot and I think to this date we haven’t seen it. We’ve just went through two major holiday periods, Thanksgiving and Christmas, and they were both excellent.

Brenda Galgano

Can I just clarify, you had asked methe question around the amount of the revolving credit facility. That is the $540 million, $542 million to be specific, but I just want to make sure that everyone catches that in addition to that, we have the term loans which is the total of $133 million, so if you add itall up it’s the $675 million. I just wanted to make sure that’s understood.

Westcott Rochette - Bear Stearns

Okay. That’s a good point of clarification and one last question on, and I don’t know how much you’ve looked atthe Pathmark side on their pharmacy and then your pharmacies are much smaller, what are the plans in terms of integrating those operations and potentially expanding pharmacy within A&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 pharmacies performed?

Eric Claus

Our pharmacies are now integrated together. We have one management 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 pharmacies in was specifically for a reason that there’s already other pharmacies inthe mall or adjacent or the store’s too small. That kind of thing. Pathmark has a very large pharmacy business so we’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 obviously benefits again as a merchandising income synergy there. When it comes to the business, there’s been a change in the pharmacy business because of generics over the last year so although that affects the sales number ina negative way, it affects the profits in a positive way. The whole cough and flu over the last couple of months has been a little bit soft so we haven’t seen a lot of strength either in our 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 a lot guys.

Operator

And we’ll go next to Eldico Hildress of Waterstone Capital.

Eldico Hildress - Waterstone Capital

Hello, just a couple questions. Why the large increase in restricted cash in the quarter?

Brenda Galgano

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

Eldico Hildress - Waterstone Capital

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

Brenda Galgano

In terms of interest rate?

Eldico Hildress - Waterstone Capital

Yes.

Brenda Galgano

Fifty basis points.

Eldico Hildress - Waterstone Capital

Okay and then last question is when was this amendment requirement known?

Brenda Galgano

We amended it on December 27th I believe was the date.

Eldico Hildress - Waterstone Capital

The reason I ask is you didn’t talk about this when you issued the converts.

Brenda Galgano

That’s because that was after when we issued the converts, this was not finalized.

Eldico Hildress - Waterstone Capital

Okay, thank you.

Operator

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

Christian W.E. Haub

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

Operator

Ladies and gentlemen, this does conclude today’s presentation. Thank you for your participation and you may disconnect at this 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!

Source: Great Atlantic & Pacific Tea Company F3Q07 (Qtr End 12/01/07) Earnings Call Transcript
This Transcript
All Transcripts