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Industry Analysis: Grocery
Grocery stores are the traditional destination for consumers looking to stock up on many of the items they use on a day-to-day basis. The need for shoppers to replenish their pantries and refrigerators typically results in frequent trips to the supermarket. For this reason, industry sales tend to be noncyclical. Competition for these dollars, though, can be intense, which helps to explain the unimpressive profit margins. Consumers typically have a variety of options to choose from when deciding where to purchase items. Not only do they often have a choice between competing neighborhood supermarkets, but they can also shop at alternative retailers, such as large national discount chains and warehouse stores.
From an operating perspective, supermarkets are a homogenous group. Factors that may cause results to vary, aside from a company's ability to execute its business plan, include geography and store formats. Generally, though, investors can use common analytical benchmarks to evaluate the performance of these retailers.
Growth across the industry is rather subdued. At times, expansion through store development and/or acquisitions will gain in priority. During periods of economic strain, though, managements might curtail expansion. Readers can get a sense of how the food retailers are faring in this regard by looking at the data for "Number of Stores" found on each Value Line company page.
Although dynamic top-line growth is not typical of the industry, investors should keep a close eye on same-store sales (or "comps"). The way in which this number is calculated can vary from retailer to retailer, but it provides a useful indication of sales trends at stores open for a year or longer. This figure can provide a gauge of a company's ability to improve the productivity of existing assets. Few retailers will be able to sustain earnings growth without increasing same-store sales.
In this mature industry, even low- to mid-single-digit comp growth can be a respectable achievement. Food retailers usually get a boost from inflation, since added costs are relatively easy to pass along to shoppers. Inflation in the food aisles, combined with a lackluster economy, will work to the advantage of those retailers with a strong reputation for economical pricing, rather than service or selection. Regarding those companies with fuel centers at their locations, in most cases, the volatility in gasoline prices requires investors to evaluate comps excluding fuel sales.
Grocery store chains operate with slim margins, compared to the typical industrial company. Operating margins are usually in the mid-single digits. Moreover, margins are now generally narrower than was the case at the start of this decade. The influx of competition from other retail formats, including supercenters and warehouse stores, is a key factor in this trend. Among supermarket operators' efforts to maintain good margins are increasing the mix of private label items, which generate bigger profits than their branded counterparts, and managing labor costs, which can necessitate taking a firm stand in union contract negotiations.
One difference investors will note between a grocery store Value Line page and the typical industrial company page is the inclusion of data for gross margins. Gross margin (gross income divided by sales) includes the cost of goods sold, but not operating expense. A comparison of gross and operating ratios can reveal the relationship between what a company pays for its inventory and how much of a mark-up is charged. For example, gross margin will typically suffer if a company adopts an aggressive pricing strategy, perhaps to increase or defend market share. A company can, however, mitigate the negative impact of such a strategy on the operating margin to the extent that it is able to increase sales (allowing for better fixed-cost absorption) and control overhead expense.
Even though Grocery companies grow slowly, they produce ample cash flow to cover annual capital spending. When managements are not pursuing acquisitions, investors can expect food retailers to return a decent amount of cash to stockholders. Indeed, several companies have aggressive share repurchase programs, and the majority pay a regular cash dividend. Typically, yields are under the Value Line median, but with the average payout ratio usually well below 50%, dividend growth normally keeps pace with earnings advances.
Solid cash flow lends greater flexibility in financing daily operations and expansion efforts. It's true that when broader stock markets are in rally mode, or a new company has a unique business model (e.g., organic foods), common stock issues will provide low-cost funding, but managements more often rely on debt. The noncyclical nature of the industry allows companies to comfortably use debt leverage to boost shareholder returns. Still, sufficient cash flow is crucial to manage debt, especially a heavy burden (as much as 60% of total capital for some companies).
Grocery store stocks have attributes that appeal to conservative investors. Usually, few of these issues have Safety ranks above 3 (Average), but they do often carry relatively high marks for Earnings Predictability and Stock Price Stability. Again, a steady, largely predictable business cyclical helps here.
Historically, Grocery equities have traded at price/earnings multiples below the market average, reflecting the companies' relatively subdued growth prospects. Betas are commonly below 1.00, indicating modest share-price volatility.