deflation

Richard Phegley is keeping his head above water, even if pricing for his company’s products has been underwater for months.

Richard Phegley

While the retail grocery industry has been plagued by deflation all year, Smart & Final Stores, where Phegley is CFO, is on track for flat profits this year and forecasting solid growth for 2017.

To be sure, keeping profits level has been enabled by growing the company, which currently operates 305 stores in seven Western states. Ranked this year at No. 595 in the Fortune 1,000 after taking in about $4 billion in revenue in 2015, Smart & Final has opened 33 new stores in 2016 and relocated six others to larger facilities.

Same-store sales have been off — by 1.2% in the third quarter, for example — because of deflation as well as cannibalization of business from older stores by the new ones. The Consumer Price Index “food at home” segment, in which Smart & Final plays, was down 2.3% for the 12 months ending Oct. 31.

“I sleep well at night,” says Phegley, “but deflation is something I think about before I go to sleep and when I wake up in the morning.”

The publicly held company, which offers both retail and wholesale products and serves both household customers and businesses through a variety of warehouse-style club stores, expects to see double-digit EBITDA growth next year. “We think the deflation is transitory,” Phegley says, although he admits that so far “we’ve not been very good at predicting the end” of the trend.

The company operates Smart & Final stores and larger, Smart & Final Extra! Stores, both of which sell food, food-service supplies, and janitorial products to both household and business customers. It also has Cash & Carry Smart Foodservice stores, which are strictly business-to-business, focused mainly on small food-service operators like hot trucks, caterers, restaurants, bars, clubs, and things like Little League snack stands.

Overall, 70% of the company’s sales are to households and 30% to businesses.

Phegley, who has been with the company for 20 years and its CFO since 2001, recently visited CFO’s offices in New York. An edited transcript of our discussion follows.

What impact is the company experiencing from the deflationary environment?

It’s interesting, because there have been three deflationary periods [for retail grocers] since 1960, but this is the first one that hasn’t coincided with a recession. It’s a nationwide phenomenon. Typically food and food-related products show average annual inflation of about 2% over time.

It makes managing a company very difficult because the top line is shrinking while the economy in general is growing. So the price of a lot of products that we purchase — not purchase for resale, but things like supplies for stores, products for our offices, and labor — are increasing while the price of what we sell is deflating.

What’s causing the deflation?

It’s obviously an imbalance of supply and demand. There’s too much product for the market. But there’s a lot of head scratching about exactly why.

On a product-by-product basis you can look at, for example, eggs, which have been very deflationary. Just a year ago they were inflationary, coming out of a period of avian flu and the culling of flocks of producing chickens. Egg exports from U.S. markets to non-U.S. markets used to be very strong, but now eggs are being overproduced at a time when exports are low because of the strong dollar.

More products are currently deflationary than is historically typical. It seems to be mostly in high-volume categories. Beef is another example. It’s been very deflationary for almost two years, although it’s starting to level out now.

But why are so many types of food products deflationary at the same time? It seems like each should have its own supply-and-demand dynamics.

Yes, and that’s the head scratcher among economists. Is this just a random event, or is it something that’s not random but not yet fully understood?

Is making pricing decisions part of your role?

I’m an input into it. I’m not directly setting the prices. But we are very responsive to prices in the market. As a value retailer, we want to be priced right for consumers.

We are typically 8% to 12% cheaper than Kroger or Albertsons. We have a more edited set of products, and we sell what we sell in great volume at real value. We’re competitively priced, perhaps at a very slight premium, to Costco and Walmart. That price position [reflects] our unique assortment of products and convenient, smaller-format stores that are close to customers.

As lower acquisition costs flow through into all retailers, the typical behavior in the market is to pass that through to consumers. We’re surveying prices in the market every week, and we’ll lower our prices to stay at a competitive gap to the competition.

What is all this doing to your performance?

We measure our economic performance primarily at the EBITDA line, which is flat this year even though our store count is up. Some other retailers have seen year-over-year decreases.

At the retail level, if I’m selling the same number of cases of goods, the price of the case is lower but all of my handling costs are the same. I still have to deliver the cases to the stores, put the product on the shelf, and staff the registers. I’m just paid less for doing that.

We’ve tried to be very judicious about cost, but the flatness is based on having a greater number of stores. Our average store is down a bit in terms of income generation.

Is there an end in sight for the deflation?

We really believe that there are supply-and-demand checks and balances that should presage an end to price deflation, especially in agricultural products. When there’s more of a normal inflationary environment, we should do much better from a financial standpoint.

Have you delayed your schedule for new store openings until the pricing environment improves?

We believe very strongly in store development. In fact, this year we’ve actually opened more stores than in any prior year. We had an opportunity to acquire a group of stores from the bankruptcy of a competitor in the California market.

In early 2015, Albertsons and Safeway group merged, and the Federal Trade Commission required the divestiture of 100 stores in the Pacific Southwest. They went to a buyer that operated them for about six months, and when they failed, we were able to buy 33 of the stores out of the bankruptcy. It was a unique opportunity and one we would do again, although the industry environment was not ideal.

Does Smart & Final anticipate expanding beyond its current markets (Arizona, California, Idaho, Nevada, Oregon, Utah, and Washington)?

Our long-term plan is to grow outside of our seven Western states. The near-term plan, which will cover the next few years, is to continue to saturate the geography that we have.

We like that region a lot. It’s one of the fastest-growth areas of the country. Our seven states have over 60 million people — more than the Northeast or Midwest. Its growth characteristics are much like the Southeast.

In food retailing, the economics of the business depend a lot on distance to distribution centers. So it’s most efficient to have our growth in that seven-state region. Anywhere else we’d have to set up a different supply chain.

Then, is your long-term plan to grow incrementally further eastward?

As you grow east from California and Arizona and Nevada, you run into low-density population areas. We’d need to jump geographies to get to a more dense area like the Midwest, with Chicago, St. Louis, and Kansas City, or Texas, with Dallas, Houston, and Austin.

We are still relatively low penetrated, even with 305 stores. Compared with Safeway or Albertsons or Kroger, we have a much lower density of stores to population than they do.

You’ve been converting many of your Smart & Final stores into larger versions of them called Smart & Final Extra! What’s the strategy behind that?

The “Extra!” stores fulfill more household shopping needs. They have all 10,000 products that are in the legacy Smart & Final stores, plus about 5,000 more products with a strong focus on natural, organic, and perishable products, like produce and fresh meat.

SF Extra Store - RenoAt the end of 2016, about 70% of our Smart & Final banner stores will be Extra! stores. We’re trying to [convert] as many of the legacy stores as possible. We can do that in three ways.

First, if there’s enough space in the store, we can just put the extra products in there. We’ve already done that with most of the ones that are big enough. Second, if there’s an available adjacent shop space, we can expand. We’ve actually had pretty good success doing that. And third, we may need to relocate a store. All of those are very productive places to make capital investments.

But there will always be some of the legacy stores because the real estate is irreplaceable, and we just can’t economically let them go.

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