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SuperValu, Inc. (NYSE:SVU)

F2Q09 Earnings Call

October 14, 2008 10:00 am ET

Executives

David Oliver - Investor Relations

Jeffrey Noddle - Chairman of the Board, Chief Executive Officer

Pamela K. Knous - Chief Financial Officer, Executive Vice President

Analysts

Deborah Weinswig - Citigroup

Edward Kelly - Credit Suisse

Scott Mushkin - Jefferies & Co.

Meredith Adler - Barclays

Analyst for [Karen Short - SDR]

John Heinbockel – Goldman Sachs

Charles Cerankosky – FTN Midwest Securities Corp.

Mark Wiltamuth – Morgan Stanley

[Bob Sumers – Kelly Capital]

Operator

Welcome to the Q2 fiscal 2009 earnings conference call. (Operator Instructions) Mr. Oliver, you may begin your conference.

David Oliver

SuperValu’s call today is webcast and will be available for replay on our website. Today on the call are Jeff Noddle, SuperValu’s Chairman and CEO, and Pam Knous, Executive Vice President and CFO.

As you know, the information presented and discussed today includes forward-looking statements which are made under the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. The risks and uncertainties related to such statements are detailed in our fiscal 2008 10K. After today’s prepared remarks, we will have a question and answer session. As always, I will be available after the call for additional questions.

I will now turn the call over to Jeff.

Jeffrey Noddle

First and foremost I would like to address our second quarter results. No doubt we all know it is a difficult environment and one of the most challenging operating climates we have seen in a long time. But we cannot blame the external forces alone for our results. We did not execute well on several fronts and that contributed to our delivering results below the low-end of the first call analyst range of $0.61 to $0.72 as well as below our own expectations.

Of course weaker than expected same-store sales performance is a contributor to our retail performance. The 40 basis point ID sales decline from the quarter one run rate is substantially tied to a soft Labor Day holiday materializing late in the quarter. That aside, we still should have performed better. I will address this further in a moment.

As for the quarter retail operating earnings were $284 million or 3.6% of sales, down from $385 million or 4.8% of sales in the prior year. The second quarter was impacted by higher fuel, utility and LIFO costs and the duplication of merchandising costs that we had projected in our updated guidance at the end of the first quarter, as well as the poor cycling of the Labor Day holiday week.

Besides these factors, the quarter-over-quarter shortfall was affected by price investments and promotional offerings in certain markets that in retrospect did not produce the sales and margin expected and failure to achieve sales leverage on occupancy costs and to downwardly adjust certain selling and administrative expenses especially labor and related costs to reflect the weaker-than-planned sales environment.

Both of these issues however are within our control. First, we have taken action to improve sales in the back half of the year. In fact through five weeks of the third quarter ID sales have improved approximately 80 basis points compared to quarter two ID sales as our marketing and merchandising initiatives begin to gain traction.

We have also taken action to reduce selling and administrative expenses through company-wide cost reduction initiatives which will produce notable benefits in the fourth quarter. These initiatives are wide ranging reaching from shrink to infrastructure costs and touch many lines on our P&L. Accordingly you shouldn’t just extrapolate our second quarter results to arrive at our full-year performance.

We have updated our full-year guidance to reflect this current performance adjusting our raise to $2.86 per share to $2.96 per share which is within the first call range of $2.67 per share to $3.08. Again to reiterate, this revision in our guidance reflects the performance in the second quarter and our belief that the steps we have taken will have a positive impact on our second half results. Yet even in these difficult times delivering within our updated guidance range for the year will enable us to report fiscal 2009 diluted earnings per share ahead of last year.

Our negative ID sales of 130 basis points in quarter two compares to -90 basis points in quarter one. The majority of the decline from the first quarter occurred late in the second quarter, specifically Labor Day. Soft sales over the Labor Day week accounted for approximately 30 basis points of the 40 basis point ID sales decline. Looking at our Labor Day sales, it appears as if strapped consumers opted for school supplies and fuel rather than on spending on a traditional last-of-the-summer holiday barbeque. Needless to say, economic headwinds are disconcerting and have resulted in consumer confidence being at historic lows.

As such we are revising full-year ID sales guidance to flat to -50 basis points and we anticipate flat to +50 basis point ID sales for the balance of the year. On a year-over-year basis we continue to see the benefits of our remodels with offensive remodels delivering a 6% lift in the quarter.

Overall ID sales performance reflect the lift for remodels and other banner initiatives which are fully being offset by trading down, which we still estimate at approximately 100 basis points from competitor activities and approximately 20 to 30 basis points from growth in owned brand sales and in pharmacy generics. In total we are experiencing slight declines in customer counts although this is partially offset by higher average tickets, which reflects both food inflation and a consolidation of supermarket trips.

We have not seen a major change in overall price positions in our major markets nor a change in overall market share that cannot be substantially tied to our owned store closing activity. Today we have stores with positive ID sales performance in all of our markets. Those markets hardest hit by the mortgage debacle and higher levels of unemployment tend to be weaker.

It is worth noting however markets with price impact banners, shoppers, Cub, Shop ‘n Save and Save-A-Lot tend to be well positioned in the current economy. In fact our Save-A-Lot banners bring perhaps one of the best positions of any food retailer to serve economically distressed consumers.

Considering our second quarter ID sales, you might ask why we are optimistic relating to our ID sales expectation in the second half.

First, as we have said throughout the year we are cycling easier ID sales comparables in the back half of the year.

Second, as I previously stated retail ID sales through the first five weeks of quarter three have improved over quarter two.

Third, I’m pleased to report that in quarter two approximately one-third of our traditional supermarkets had ID sales of 2% or better, an improving trend over quarter one which I believe represents early evidence that our merchandising and marketing initiatives are gaining traction.

Last and more importantly, we will have the added benefit of many strategic and tactical initiatives not previously in place.

Up until the beginning of the third quarter we were in the development phase of our customer focused marketing initiatives. We have now moved to the execution phase with data and analytics in place to help us better understand an individual consumer’s shopping habits including what they are buying and what they are not. Our new programs create individualized incentives for customers to shop our stores more often and increase the dollar amounts spent on those trips.

In September we launched our first direct marketing program that uses this individual customer specific data. Marketing, merchandising and vendor teams all partnered to create offerings that combine products and trip driving incentives based on their historical purchases. These customer-specific offers were mailed out to more than 2 million households featuring more than 23 million relevant offers to customers shopping our Acme, Albertsons and Jewel-Osco banners. This is a key step in providing locally relevant personalized marketing to our customers. We are very pleased with the response that our stores have seen so far.

Our owned brands program is also gaining traction. In the second quarter our private label sales penetration reached the mid-16% range improving more than 110 basis points since quarter two last year. With this year’s highly successful launch of Wild Harvest and more recently Culinary Circle, we now expect to reach 17% penetration by the end of fiscal 2009, four months ahead of our original expectation on this metric.

I am very pleased with the progress our team has made and will continue to make with the goal of reaching 20%+ penetration within the next three years. As we move toward this goal, it is important to keep in mind that although increased owned brand sales may result in reduced ID sales in the short term it is by increasing penetration that we will improve customer loyalty and gross margin rate over the longer term.

This year we have seen increases in fuel prices hit consumers extremely hard. To provide consumers relief at the pump and drive store traffic we are enhancing our ability to deliver cross-marketing fuel promotions. With our new gas rewards program in the months ahead customers in a number of our markets will receive savings at the pump based entirely on purchases made in our stores.

Today we have approximately 130 fuel centers so in many of the markets where we don’t have fuel centers, we’ve established successful cross-marketing alliances with retail fuel partners such as Holiday here in Minneapolis, Irving Gas in New England and Exxon in Philadelphia.

To complement our merchandising programs we have introduced our first national branding campaign. If you are in any one of the major markets you may already know about our Good Things Are Just Around the Corner branding campaign such as at Cub, Tasty Prices Are Just Around the Corner, Holiday Traditions Are Just Around the Corner at Jewell, and Food Lovers Food is Just Around the Corner at Albertsons. As these taglines demonstrate, good things becomes the proof points that reflect our local knowledge of the customers we serve ranging from good value to good produce to good service.

With this national campaign we are highlighting that our products and services are readily available and easy to get to. We know that in food retailing it’s often hard to differentiate one banner from another. Thus in our branding campaign we want consumers to know that we are their neighborhood store and we know them better than anyone else. In today’s economic environment it is important to reach out and bond with customers. It’s not only good business, it is smart business and we are seeing favorable customer responses from this approach.

These programs I’ve highlighted today demonstrate our commitment to driving sales and creating value for our customers. We are excited to finally be in the execution stage, implementing and seeing traction on many of the initiatives that we have discussed over many quarters with you.

Before Pam’s comments and my concluding remarks, I’d like to make a few comments regarding Jewel-Osco one of our premier banners. Yes, we certainly are cycling Wal-Mart’s entry into the greater Chicago market. But more importantly, capital in this market is still performing above the company average and remains priority one.

Earlier this month our Board of Directors had an opportunity to visit three of our newest offerings in the Chicago market: A remodel, a new urban grounds up location and a small format store. I must say they were excited from what they saw.

The remodeled Ashland and Wellington location is the highest volume store in the Jewel-Osco banner while our new [Kinsey] and Desplaines location just outside the Loop just opened to rave reviews. Both stores feature the latest innovative thinking from our merchandising team and design department. We are pleased with the early results for both of these locations and will provide you an opportunity to experience these stores and our new format Urban Fresh by Jewel store in the Lincoln Park area next spring at our Investor Day conference in Chicago.

Our 16,000 square foot Urban Fresh by Jewel location caters to the needs of busy on-the-go professionals and time-sensitive commuters. The format features a variety of ready-to-go meal solutions, produce and organic offerings, and a selection of fresh meats and seafood as well as the basics that any shopper looks for. We think a smaller format has significant potential particularly in an urban market like Chicago where real estate is difficult to come by. We will take learnings from this site and leverage them into our plans in the future.

I courage you to visit and hopefully shop at our Jewel-Osco stores. We’d be grateful for your feedback and certainly for your dollars.

I will now turn the call over to Pam and then I’ll come back with a few closing comments.

Pamela K. Knous

Today my comments will focus on our second quarter operating results, financial condition and updated fiscal 2009 outlook.

As Jeff previously outlined, our second quarter earnings for the retail segment declined approximately $100 million or 120 basis points as a percent of sales to 3.6% for which I will now provide additional explanation in detail. Of the 120 basis point decline in retail operating earnings as a percent of sales, approximately 50 basis points relates to gross margin and 70 basis points relates to selling and administrative expenses.

As a point of comparison, in the first quarter of fiscal 2009 retail gross margin declined 20 basis points in contrast to the prior year. The further decline in retail gross margin rate from the first quarter primarily reflects additional investment in price and promotional offerings as our customers search for values and ways to maximize their grocery budget.

As Jeff just mentioned, in certain markets these activities did not produce the sales and/or margin expected. As a result the benefit of acquisition-related synergies obtained in the quarter was fully muted.

The 50 basis point decline in gross margin rate from the prior year whilst partially funded by other components of the income statement. First, as we disclosed in April the quarter did benefit from interest rate reductions that occurred subsequent to our March guidance. Second, the quarter did benefit from non-taxable life insurance proceeds on executives of the former Albertsons organization, which is a component of retail selling and administrative expenses.

The 70 basis point increase in the quarter in selling and administrative expenses reflects both the higher level of costs we discussed in the prior quarters be it energy, duplicative merchandise staff, and a concentration of operating expenses associated with warehouse standardization, automation activities and systems integration, all of which will continue to pressure selling and administrative expenses as well as the fact that we did not sufficiently adjust our variable occupancy and employee-related costs in response to the weaker sales environment.

We can categorize this 70 basis point decline compared to the prior year in two buckets. Occupancy costs including utilities, depreciation and other facility-related costs increased approximately 35 basis points, and higher employee-related costs including the acquisition-related integration activities increased approximately 35 basis points despite lower overall incentive compensation as well as the benefit of synergies.

While we are disappointed in our retail performance in quarter two, the 3.6% EBIT to sales contribution is in line with what our major competitors reported in their most recent quarter and does indicate that our overall profitability in this difficult environment is comparable to our peers.

Moving to supply chain, we continue to see strong performance with a 50 basis point improvement in operating earnings as a percent of sales in the quarter for a record 3.4% of sales compared to 2.9% last year.

This strong performance reflected improved sales leverage as well as the pass-through food inflation, new business growth, lower customer attrition and effective expense control. Many initiatives have been taken throughout supply chain to increase efficiency and reduce costs yielding outstanding results in the quarter. Our low attrition results can be attributed to our supply chain expertise, high levels of service and strong relationships with many of the premier independent operators in the country.

Many of you have asked about the impact of Target’s migration to self distribution. By the end of the second quarter Target transitioned as scheduled volume in our Southeast region to a SuperValu managed third party logistics operation. This followed the initial conversion of a Texas facility in early April. Through the second quarter this financial impact has been largely mitigated by new business and benefits achieved from supply chain initiatives.

Although no assurance can be given that we will successfully mitigate the impact of future transitions, we are aggressively seeking replacement business and will continue to implement cost reduction initiatives.

Over the past several weeks significant focus has been placed on liquidity in the credit markets. I would like to take a moment and review with you SuperValu’s near-term debt maturities and credit facilities.

In the second quarter current debt maturities increased to $531 million from $446 million at the end of quarter one. Significant components of current maturities include $200 million in bonds with a May 2009 put option and $124 million of scheduled payments on our term loans. We have included $700 million in notes due next August in our long-term debt consistent with the company’s accounting policy. These maturities have been classified as long term due to the company’s intent to refinance these borrowings long term and our ability to do so under the revolving credit facility if the public debt markets remain unattractive.

Today we have $1.3 billion in available capacity under our existing five-year $2 billion revolving credit facility which is sufficient to meet our financing needs through fiscal 2010. Of course we will review all financing options available including the public debt markets to ensure we maintain optimal borrowing flexibility and costs.

Our revolver is part of the $4 billion senior credit facility maturing June 2011 which has two financial covenants: An interest expense coverage ratio and a debt leverage ratio. At the end of the quarter we are easily in compliance with both covenants with trailing 12-month EBIT adjusted for one-time acquisition-related costs of $1.7 billion, depreciation and amortization expense of $1 billion, net rent expense of $0.3 billion, and total debt including capital leases of $8.8 billion. Borrowings under the senior credit facility are tied to LIBOR or the prime rate with recess based on time intervals we select with most borrowings today resetting monthly.

I want to assure you that debt reduction continues to be a priority and we remain committed to reducing borrowings by at least $400 million this fiscal year. Our current debt-to-capital ratio is 59% nearly 600 basis points lower than the acquisition date just over two years ago.

We hope you noticed this quarter we have provided in our release for the first time a condensed statement of cash flow which is much easier to do now that we are on one common general ledger, another acquisition synergy we can scratch off the list.

Through 28 weeks of fiscal 2009 our net cash flows provided by operating activities were approximately $700 million compared to [inaudible] payment of income taxes of $266 million and profit sharing contributions of $44 million. Both of these items are components of changes in operating condensed statements of cash flow.

Year-to-date net cash flows used by investing activities were approximately $600 million compared to approximately $400 million last year primarily reflecting higher capital spending in the first half of this year compared to the prior year. Our capital spending plan for fiscal 2009 is $1.2 billion to $1.3 billion reflecting an estimated 155 major remodels and 14 new traditional supermarkets.

Regarding synergies, I want to once again affirm that we remain on track for choosing synergies of $40 million to $50 million in fiscal 2009 which places us on target for $150 million to $175 million in total acquisition-related synergies by quarter four of fiscal 2010. However synergies realized in the second quarter were fully offset by shortfalls in gross margin and selling and administrative expenses.

Development of our merchandising system is on track. In fact in September we implemented our new forecasting module which is now in use by the merchandising team. This tool greatly enhances our understanding of retail performance at the category and item levels enabling us to make better business decisions and represents the major step in achieving a best-in-class merchandising organization.

As noted in our release we have updated fiscal 2009 guidance to a range of $2.86 per share to $2.96 per diluted share on a GAAP basis.

Although our practice is not to give quarterly guidance, we did want to provide additional context on the remaining quarters’ results. As I just discussed we expect retail gross margin to remain under pressure as consumers continue to be challenged by economic headwinds and we strive to deliver value to them as well as increased LIFO expense. As well the impact of higher selling and administrative expenses will continue to pressure results in the back half of the year.

Mitigating activities include the company-wide cost reduction effort that will benefit late in the third and more notably the fourth quarter. These activities which include labor productivity, shrink reduction, overhead cost elimination, SKU rationalization, and controls over maintenance and even utility usage to name a few are in addition to our strategic growth and synergy initiatives.

As a result our fiscal 2009 guidance anticipates third quarter earnings per share to be slightly below the prior year and fourth quarter earnings per share to finish strong as the merchandising initiatives and the full effects of cost reduction activities take hold. The fourth quarter will also benefit from the 53rd week.

In closing, despite the challenges facing us today high levels of food inflation, a pressured consumer and higher operating costs, our financial condition remains strong and we are well positioned for the back half of the year.

I’ll now turn it back to Jeff.

Jeffrey Noddle

Despite weaker-than-planned operating results in quarter two we still expect another record earnings year. As we have told you, we have taken action to improve our sales performance while creating value for our customers and reducing costs in the back half of this year.

Reflecting on our balance sheet and cash flows that Pam discussed, we are pleased to affirm our cash flows will provide for more than $1 billion in capital spending and debt reductions of at least $400 million this year.

I want to assure you we are doing the right things today for success tomorrow. We are not sitting and waiting for the economy to improve. We know the importance of being agile in our operations and responding to changing customer behavior. We are adjusting the dials, eliminating costs, capturing synergies and executing on our strategic initiatives: The remodeling, merchandising, marketing, customer service and our owned brands. All of these are essential to creating long-term sustainable success for our company.

I will now turn it back for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Deborah Weinswig - Citigroup.

Deborah Weinswig - Citigroup

Pam, you stated that part of the issue as regards the SG&A side of things is the fact that SuperValu did not appropriately cut back labor hours. Is there a new labor scheduling software that you’re going to be using or are new disciplines going to be put in place? How are you going to be achieving lower hours in light of the sales performance?

Pamela K. Knous

I think it was really just a question of adjusting to the new sales levels. Clearly there is an inflation component of those sales in relationship to units, and I think it really was just a question of forecasting. We would not say that a new tool is necessary but that just greater focus on sales performance, [inaudible], so that is something that we’re on top of and we’ve really got rectified already as we move into the third quarter.

Jeffrey Noddle

I’ll comment on that further too. We really have a state-of-the-art labor scheduling system and software. That really isn’t the issue. As we commented, the disappointment we had in sales was really at the end of the quarter and I don’t think we had fully adjusted to the effective inflation and that we’re handling less tonnage of goods on our front ends for example. We adjusted that opportunity and most of that correction is already in place and we should see some in the third and certainly a lot more in the fourth.

Deborah Weinswig - Citigroup

On the urban fresh format, and obviously it’s still early days, but can you talk about the strategy and how you’re thinking about this format going forward?

Jeffrey Noddle

We’re very excited. We took a location that we had in the Lincoln Park area of Chicago, which if you’re familiar with it is on the near North side and very much surrounded by young professionals and very urban commuters as we talked about, and we wanted to experiment. We had really planned this for quite some time though I know a lot of people are trying smaller format stores, we just thought this was the location that lent itself to that.

We took our [Jewel-Osco] team which is very creative and innovative in this regard and we said, “Let’s create something together,” and we put in a lot of ideas, a lot of food-to-go, a lot of meal solutions, very limited, I wouldn’t call it completely limited dry grocery and staple items but a good enough selection of the important items. But we really emphasized something that I think is attractive to the foodies, a lot of organic and certainly a lot of prepared meals, different entrees and things during the lunch hour that varies by day of the week and the same for dinner.

We really took a lot of things where we think the consumer’s going. Although the consumer may be pausing for more value today, they still are time-starved and are looking for solutions. It’s hard to describe but we really encourage you to go see it and if not, next spring we will have an Investor Day in Chicago.

Operator

Our next question comes from Edward Kelly - Credit Suisse.

Edward Kelly - Credit Suisse

Jeff, could you provide some color on the promotions that you talked about this quarter specifically what went wrong? And then the 60 basis point decline in the gross margin to me seems to contradict some of your earlier comments about how your price investments are going to be more selective than broader-based. Is this a change in strategy in terms of how you’re thinking about price and how should we think about the gross margin in the back half?

Jeffrey Noddle

I don’t think it’s a major change in strategy. We are still selecting certain categories across the entire traditional supermarket enterprise to go to a more every day low price approach. We had started that earlier this year. We continue that throughout.

We’ve invested more broadly as we talked about before in New England and in Acme specifically, but we also ran some promotions that we would have expected a better return in the near term.

However as we commented earlier, the five weeks in the third quarter we have seen a pretty substantial 80 basis point improvement in our ID sales from that trend. I think as always you get some delayed impact from some of those investments and I’m very hopeful that’s what we are seeing now.

That number that you’re talking about is a 50 basis point impact which I think was about 20 basis points in the prior quarter. I do think that it’s not a substantial change of strategy. We just think we can take some of the money that we are investing and invest it wiser with a really more specific marketing capability that we now have. So rather than shotgun everything we can take some of that money and really target it to a more immediate return, and I think you’re starting to see a little of that in our results.

Edward Kelly - Credit Suisse

When you talk about that you didn’t necessarily get right away the sales lift that you were hoping for in promotions, you’re not trying to say that the promotions didn’t work and you’re not going to continue them. Is that right?

Jeffrey Noddle

That’s correct.

Edward Kelly - Credit Suisse

As we look at the gross margin in the back half, we probably should make some similar type assumptions as to what we saw this quarter?

Jeffrey Noddle

I think we made comment that we continue to see margins under pressure and we’re just assuming that it’s a tough competitive environment and the trading down impact continues 100 basis points or more. I don’t see that changing in the back half of the year. We’re certainly not going to look to improve margins to make our performance come out for the year but we’re certainly going to attack the cost side. I think we’ve got opportunity to get a little better lift in sales the way we had planned and if that should happen, then we will have better results.

Edward Kelly - Credit Suisse

Related to the improvement you’ve seen so far this quarter, Safeway when they reported indicated something similar. How much of this do you think is related to both you companies getting sharper on price relative to some changes we’ve seen in consumer behavior just over the last few weeks? I think we’ve obviously seen some noticeable change in trend. Are we seeing a greater trade-down out of restaurants? Is that part of what’s benefiting you now?

Jeffrey Noddle

I think we are. When I look at the broader retail sales results for September that were reported, you saw general merchandise, clothing retailers just with terrible, terrible results. I think that just reflects that there’s cut back in those areas and that maybe supermarkets are even better positioned against restaurants and other choices. I think consumers are a little more conservative, they’re staying home more, they’re certainly being more careful where they spend their dollars, and hopefully some of these investments we have made now are showing up as well. But I think it’s a combination of both of those things.

Edward Kelly - Credit Suisse

Pam, what are you assuming for LIBOR now as you’re looking at this current guidance? I don’t think you mentioned it on the call but it’s obviously up a lot from earlier in the year. It seems to be coming down a touch but I don’t know how you look at that.

Pamela K. Knous

We’re using the current 4.5 LIBOR.

Operator

Our next question comes from Scott Mushkin - Jefferies & Co.

Scott Mushkin - Jefferies & Co.

I’ll start off with the comments you made with traffic being down and tonnage being down as well. I’m just trying to get a feel for (a) what you think is driving that. If you go back to the Albertsons assets and you look back to when it was part of Albertsons and you bring these forward, it seems like these assets have been losing tonnage and traffic for an awful long time. How do you stop that?

And then the second question I would have and maybe it’s part of the first one is the individualized incentives. You said 2 million in households. How big is that in relation to those market places to get kind of a size and scope there?

Then the final thing I have is, is it time to consider some alternatives here to get the balance sheet in better shape?

Jeffrey Noddle

There’s a lot to work with here. As far as traffic or tonnage, we’re seeing a reflection of what’s going on in the industry. The whole industry if you add it all up together is not equaling the inflation rate, so there is some tonnage impact across the industry. And I know that there are some who are doing better than others certainly but if you take it across the whole business, people are trading down. People are being more cautious in their shopping.

As far as the Albertsons’ properties, much was written by you and others about what the conditions were of the Albertsons properties when we acquired them. I remind people it’s only been eight quarters or nine quarters since we’ve been on this journey and one could say for the first year you’re spending a lot of time organizing and establishing a foundation and a culture. We’re now really executing the things that will make a difference in the significant position we have in many, many urban markets.

You have to look at these same-store sales trends over a broader really three-year trend. If you do that, really only the Shaw and Acme chains really are negative over that three-year trend. Now I realize we’ve had some inflation during that but we have said continuously from the beginning we are going to invest in these markets, we’re going to bring these stores up to standard, we’re going to execute up to standard. We had lots of opportunity and as I said, much was written about the condition of those properties. We shouldn’t expect us to solve all those within eight or nine quarters.

I’m disappointed that we had a bump in the road here although I’m not completely surprised that would occur along this journey. What it does, it gives us more incentive on near term to finish things quicker and make a difference. I’m beginning to see from where we sit things that are going to make a difference and will impact our results.

You asked about the 2 million households. That’s one example that started. That’s about 10% or so of the households that we serve but it’s going to our best customers which are our top tier, our platinum and gold customers. We think we can move that group quicker than most but that doesn’t mean we won’t go attacking those that we’re not getting today.

There are just lots of activities that I could detail here but I just think if you look back at some history in this industry, and we had others that have gone through similar journeys as we have, with the major acquisition and then bringing companies together. It’s still a very short period of time relative to that and if you look at their trend over those times as they put a number of resources and things together, they went through some difficult blips in the road as well.

Lastly in terms of alternatives for the balance sheet, I think Pam gave a good report on the condition of our balance sheet and I certainly will leave it there. But I’ll always repeat that our Board continually considers all options that are best for our shareholders and will continue to do so.

Operator

Our next question comes from Meredith Adler - Barclays.

Meredith Adler - Barclays

I’ll start with a simple question about Target. You did not mention what is planned in terms of more migrations to self distribution. Have they laid out for you what will be happening in the second half of this year and next year?

Jeffrey Noddle

The migration that is going to occur this year has occurred. There will be no really further substantial impact of that until later on next year. They have a facility in Iowa that is under construction. That’ll open in the second half sometime next year. I’m not sure of the exact date. Beyond that we’re not aware of any further new construction although we have meetings over the next month or two with Target that’ll give us more color to that. But really for the next year or so now or almost a year, we should have no additional impact.

Meredith Adler - Barclays

I would like to go back to the topic of the promotions that you guys did. First, distinguish between promotions and price investments but also whether there was anything that you looked at and said, “Gee, we shouldn’t have done this at all,” and that you’re going to change completely? Or is it just a tough environment and takes time to get people to respond?

Jeffrey Noddle

Yes, yes and yes. As I said earlier, I think we’re getting smarter about how we spend our money on promotion. We just know more now. I talked from the beginning as you well remember that we needed to build a marketing competency because neither company in my view had a marketing competency that fits today’s retailing, and we have invested heavily in that. We have well over 100 people now in that effort. We’re now just executing real-time real things that we have laid out and planned for this particularly over the last year. So we’re just able now to be a lot smarter about how we invest our money, where we invest our money and to get a better return.

As far as price investments, I think I spoke of that earlier. We’re continuing to take certain categories, we’re going to migrate that across the enterprise, there are certain markets where we’ve done broader things, we may consider other markets to do that, but we’ve incorporated that into our guidance and thinking for the year.

At the same time we’ve got tremendous headwinds in the consumers’ conservatism and certainly their reluctance and they’re very cautious in how they spend and the trading down phenomenon that we talked about. Having said that though, I think supermarkets are a real good place to be in this environment and we intend to enhance that opportunity in the back half of the year and particularly going into fiscal 2010.

Meredith Adler - Barclays

You had once said that if you had an opportunity to lead with capital, which obviously with 155 remodels you are leading with capital in some places, that you didn’t feel as much need to lead with price. Is that still something for specific markets, maybe Southern California, where you’re thinking about emphasizing capital more than price or do you need to do both simultaneously?

Jeffrey Noddle

I think we need to do some of both Meredith. In my view, no matter what environment we’re in we have to have up-to-date stores, we have to have up-to-date merchandising in the stores, we have to deliver new concepts. Much was written again about the condition of some of the Albertsons properties prior, but keep in mind something that I said earlier that I’m not sure everyone noted as much as I would like, over a third of our stores have 2% or better ID sales. That obviously is across all of our enterprise.

The notion that pricing is the only issue that customers relate to today, if that was the case in some of those markets, we have certain markets that we’re Every Day Low Price, that’s our price perception. We have certain markets that we’re very promotional. What is written a lot is that our price perception in the more promotional markets isn’t as good. Well, if we’ve got a third of our stores that are 2% or better in ID, clearly we’re satisfying customers on a full value proposition. And full value means you’ve got to deliver lots of things to customers; not just the single every day price.

It’s a balancing of those styles and we’re trying to take real-time information and relate that today. I think we have a much better capacity to do that.

Meredith Adler - Barclays

You had mentioned more than once that the legacy banners Cub, Shop ‘N Save, Shoppers Food all have strong price positions and they’re well positioned in this market. Are they actually showing better sales on average versus the acquired banners?

Jeffrey Noddle

I’m going to stop short of answering that because that gets into more market specific information, which we don’t really like to do.

But I think one of the things I wanted to emphasize is I’ve seen much written about what our price positions are and the accuracy of some of that isn’t always accurate in terms of we’re looking at pricing over a broad range of products over a broad period of time. It was interesting to me that of all these reports that have been written recently, not one of them mentioned Save-A-Lot, and Save-A-Lot is as well positioned in this market place in a stressed consumer environment than any chain in the country. And we have 1,200 of those.

So we have to keep in mind that SuperValu, I’m trying to emphasize that we have a portfolio here and some are very well positioned to take even further advantage of this condition and circumstance.

One thing I want to correct that I did forget in the Target answer, there will be one smaller dedicated facility that transitions early in fiscal 2010. I said we had over the next year not much impact. We do have a smaller impact from Phoenix and then a larger one when we get to the Iowa location later in the year.

Operator

Our next question comes from Analyst for [Karen Short - SDR].

Analyst for [Karen Short - SDR]

I was wondering if you could provide some more details on the sequential decline in offensive remodel returns in the quarter from 8% last quarter to 6%?

Jeffrey Noddle

I just think the best information that we can give on that is that we have the trading down activity, the tough consumer environment, general dampening of the retail market place has just made it a little bit tougher for the remodels. We’re not overly concerned by that because we think that the more that we can deliver that type store, it really plays into the people migrating away from restaurants and those kinds of activities.

But I remind you once again that we said the biggest impact that we had was our disappointment around the Labor Day holiday and certainly that impacted the new remodels as well. I think we should take a look at that number again at the end of the third quarter. As I said our quarter has begun on a stronger sales trend and we’ll be interested to see what that looks like at the end of this quarter.

Analyst for [Karen Short - SDR]

I was wondering if you could provide an update on your inflation outlook for the year?

Jeffrey Noddle

We would say it’s running between 5% and 6% at current, and that’s of course compared to the same time a year ago. So you do have a very solid inflation running year-over-year.

I will tell you though that we are sensing now that we should begin to see some decline in the rate of inflation hopefully later in the year. Commodity prices have come off some, some of the proteins are softening a little bit, certainly demand is affecting that, and the outlook for demand. So I’m hopeful we’ll get some reduction in that rate later in the year. The pipeline for increases now is not as strong as it was at the beginning of the second quarter.

I just think the overall economy is going to dampen the appetite for vendors and manufacturers to push more increases through. We still have some of the pipeline but I wouldn’t be surprised in the fourth quarter if that would come off rather substantially hopefully.

Operator

Your next question comes from John Heinbockel – Goldman Sachs.

John Heinbockel – Goldman Sachs

Jeff, a couple of things, as branded volumes have come under pressure here have you guys seen any change in the magnitude of trade allowances, trade money from the vendors? And, if you haven’t, do you think that likelihood that that picks up over the next couple of months or quarters?

Jeffrey Noddle

I don’t think we’ve seen a big change in terms of the rate or levels of funding from the vendors and manufactures. Though John, I do think they’re getting better and better all the time of targeting towards certain events and certain locations. I just think they’ve gotten smarter at using information like we do on how to put money in to the marketplace that will get a return and an impact on sales.

I do think though your point over time, as the economy winds get tougher, as owned brands continued to pick up steam I wouldn’t be surprised to see some increased promotional activity coming out of the branded sectors. Certainly, I expect the increases, the price increases to stop or to at least soften as I mentioned a moment ago. But, I don’t think we’ve seen a large change in that regard.

I think in some instances when you get in to a meat related and protein related, they’re really a little unsure frankly, what to do at this point. The whole business model of the meat department has to be somewhat rethought I think today and we’re working hard on that as well.

John Heinbockel – Goldman Sachs

In terms of your leaning towards shelf price investments or promotions, I know where you get the quicker bang for the buck but where do you think you’re better off targeting? Do you need to be more promotional? Say, with a negative comp, you’ve got to get positive to get some leverage on expenses. When you get positive you can retool that a bit.

Jeffrey Noddle

Well, as you know John, all of that to us is very banner specific and it really varies greatly. We have said that for a long time that we’re going to be very locally relevant and some of those issues very much are in the style of the market, our go to market strategy, the history in those markets. But, I would just make a broad statement John to say that I do think that overtime we want to position ourselves to be better priced in certain categories that people buy every day.

Yes, you can drive short term results with promotional activity, I don’t know if that builds the strength of long term loyalty that we intend to build. That’s why we’re working really hard on the marketing area. We’re really trying to do the things that are going to bring long term loyalty not just one quarter’s worth of results. When we say we want to reposition, we want to rethink some of the investments that we’ve made, we’re just going to be smarter about what we do today.

That marketing is going to bring in loyalty. You made a comment but I would differ a little bit. I think when you change shelf pricing, that just takes longer to produce results. But, it does build loyalty. People realize you don’t have to run to as many locations as maybe they thought before. Certainly, we see a higher percentage of our sales today in promotional versus every day and that’s no surprise. Customers have to do that today.

But, we’re going to build loyalty, we’re going to be smarter about how we do it and we’re going to target those very carefully. I would say overtime we want to be better priced in the categories that people look to buy every day.

John Heinbockel – Goldman Sachs

Finally, if you look at that third of the stores, and I know it’s not volume, but a third of the stores 2% or better, that sort of means the other two thirds are somewhere between -1% and 2%, if my math is right. What’s the commonality if there is any between the plus 2% and the ones that are -1% or more? Is it geographic, competitive overlap, quality of store base? Is there any commonality?

Jeffrey Noddle

That’s a real hard question. I think if there’s any commonality really it is driven as much by anything by what competitors are doing. Is there a new competitor down the street? Is there new square footage in the trade area? That’s probably the biggest factor John that affects that. And, certainly our remodels where we’re remodel recently impacts us on the positive side. But, it really is the near term competitive activity and not so much by an irrational move by competitors as it is new square footage, or new remodel, new investment in the area.

That’s why we categorize differently our offensive remodels from defensive remodels. Whereas offense are two thirds or more of our remodels are offensive but in defensive sometimes the right decision is to just hold ground and then build from there and in fact we’ve done that in many locations. But, I really think it is competitive more than any other common trait that I can look at across the banners.

Operator

Your next question comes from Charles Cerankosky – FTN Midwest Securities Corp.

Charles Cerankosky – FTN Midwest Securities Corp.

If we could look at a format you mentioned but I want to give you a chance to brag a little Jeff, can you compare how Save-A-Lot has done system wide versus a year ago or the rest of the chain in terms of sales growth and profitability improvement?

Jeffrey Noddle

Well, as you know Chuck and it’s frustrated you over the years that we never gave out specific Save-A-Lot information and I won’t other than again to make some general color comments. This environment is perfect for Save-A-Lot. But, I also want to credit Save-A-Lot, not only is this a great environment for them, they have made a number of changes to their go to market, to their marketing, to their product selection over their last year. We talked about this a couple of quarters ago I believe more specifically.

We are seeing the benefits of those and they happen to be very timely. There isn’t question that Save-A-Lot is going to have a strong year and that Save-A-Lot in this environment is going to produce relatively better results than most traditional retailers, not just ourselves. It’s a strong component and as I look forward right now I don’t see anything that says we shouldn’t have a great few years ahead of us in Save-A-Lot.

Charles Cerankosky – FTN Midwest Securities Corp.

Noticing Aldi recently, they probably the last couple three quarters they have been featuring a lot more general merchandise. Any thoughts about that as part of Save-A-Lot’s go to market strategy?

Jeffrey Noddle

Well, if you remember some years ago we did an acquisition of Deals which is a dollar store business and although we didn’t completely turn the store in to small combination stores, we did get some residual benefits out of the Deals operation. We just know more what kind of general merchandise to put in these stores today and they are very targeted.

But, I would venture a little bit to say I think Save-A-Lot more than their competitors in that space have really emphasized value priced food for people. We’ve improved the produce operations and the perishables operation. We have more nutritional approach and trying to help in some of these inner city markets and things. So, as much as the general merchandise is better, I will tell you that I think the food emphasis sets us apart a little there and we’re going to continue to emphasis that.

Operator

Your next question comes from Mark Wiltamuth – Morgan Stanley.

Mark Wiltamuth – Morgan Stanley

I wanted to ask a little bit about your merchandising efforts. I know you’ve gone through a lot of effort to bring all the merchandising under one roof in Minneapolis and I was curious if you could give us an update on some of the functional wins you’ve had so far? And, when does the duplicative marketing spending really end?

Jeffrey Noddle

We have migrated most of the merchandising group together now here in Eden Prairie. We announced recently that we are going to do things on a banner approach rather than initially we thought we would do it on a category approach. That begins shortly in Acme and as that goes we’ll begin to bring them in one at a time and it will run through next year.

I’m very hopeful as we get started that we’ll be able to accelerate the timing on that and those duplicate costs then should run off over these next few quarters and get relatively less as we get through fiscal 2010. So, they should begin to trail off from really what is a high point during this quarter.

Mark Wiltamuth – Morgan Stanley

Any guess on how much of an SG&A savings that is as you get off of those? And, in general, can you quantify some of your SG&A cuts that you think you can achieve over the next year?

Pamela K. Knous

Mark, we have not quantified the impact of the duplicative staff nor have we specifically quantified any of the cost reduction activities. We have fully built it in to our guidance and so that’s kind of where we are at.

Mark Wiltamuth – Morgan Stanley

Just to switch topics and ask a little bit about private label, are you finding that the lift is coming out of the lower price point private label or is the more upscale Wild Harvest and some of the other upper scale private label items moving better?

Jeffrey Noddle

Well, the fact that we introduced a significant amount of product on the top end has driven the absolute numbers on the top end but, we’re getting a lift on a relative comparative basis through all three levels. But, the Culinary Circle was introduced in August so that obviously has a big lift. Wild Harvest was just a couple of quarters before that so that has really lifted the top end. But, we see, as you look at each layer, we see improvements and no surprise people are turning to our own brands to save money.

Operator

Your final question comes from [Bob Sumers – Kelly Capital].

[Bob Sumers – Kelly Capital]

I just wanted to circle back to the inflation discussion real quick and see if you had an estimate on what realized inflation was? And then also, just given the framework that we’re in how that impacted the P&L acknowledging that when you’re making price investments it’s a little tough to figure that out.

Jeffrey Noddle

Well, I think I commented earlier that we think the current run rate on inflation is 5% to 6% currently. As I said earlier, I’m hopeful that we’ll start to see some decline in the rate of inflation but it’s pretty hard to predict. I mean, oil prices certainly should help, commodity prices have weakened some.

As far as the impact on the P&L I mean I just think this has made for a tough operating environment. We have inflation that is occurring, yet consumers are trading down and pulling back so that changes mixes, it affects our operating expenses rather directly. We’ve commented several times about utilities are certainly rising faster than any inflation factor we’ve seen. Those are double digit kind of increase on energy cost.

Yes, oil helps certainly in fueling of the trucks but the bigger cost to us is refrigeration and stores. That continues to raise double digits. Pam also commented on the LIPO impact, all indicators we’re seeing is certainly the non-cash impact but it’s probably double the rate that we’ve had previously. It just makes Bob, for a tougher operating environment but I also think as I’ve said many times, I think our industry is well positioned as people get more conservative and move away from restaurants we have a wonderful opportunity.

I’m glad that we have remodeled a number of stores now that can make a difference and we’re delivering some of the merchandising innovation in the fresh area in to more stores than just those up for the major remodel. I think those things over the next year are going to make quite a bit of difference and I’m just happy to have some of the things behind us that we have talked about although they impacted us to have a weak quarter. But, I’m glad that they are behind us because I think the opportunities are clearly in front of us.

[Bob Sumers – Kelly Capital]

Then with respect to trading down which I think you framed at 100 basis points. Could you give us texture around the behavior that you are seeing that’s behind that? And, maybe the sense of whether that’s a number that could actually get worse before it starts to get better?

Jeffrey Noddle

Well, the kind of activities we talked about last quarter that I would repeat, we see people trading down in the meat area particularly, going in to more ground meats, more poultry, not as much beef tenderloin over the summer to throw on the grill. We’ve seen categories, pastas are up, baking is up. The intuitive things you would think people would do they are doing. Again, you’ve got the impact of our own brands as well.

Is that going to get worse rather than better? Boy, that’s a tough call. The mindset of the consumer right now isn’t very good. We’ve anticipated that environment to continue through the rest of the year.

[Bob Sumers – Kelly Capital]

Then last question sort of bigger picture, over this earnings cycle we’ve seen the major operators step up pricing investments, gross margin investment, any broader thoughts on directionally where we’re reshaping industry margins?

Jeffrey Noddle

Well Bob, I don’t think that we’re talking about a landscape change of margin in the industry because we’re all investing more in fresh and perishables and meal solutions and those require a certain margin, they have a higher labor component, higher occupancy cost component. So, I think although there is going to be areas of the store that are going to be more competitive, I think pharmaceuticals is certainly one that is more competitive than it was in the past but, I think there are other offsets to that as we move more in to value added products for consumers.

I don’t see a sea change here of margin in the industry. But again, it can vary by markets as well.

David Oliver

Again, I will be available after the call today for additional questions and thank you for the call.

Operator

Thank you for participating in today’s conference.

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Source: SuperValu, Inc. F2Q09 (Qtr End 09/06/08) Earnings Call Transcript
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