Analyst says supermarkets face hard quarter but fundamentals will improve next year

NEW YORK — An analyst on Friday forecast a tough upcoming quarter for supermarkets, given food deflation and high competition, but said this is temporary and that fundamentals will improve in the first half of 2010.

Credit Suisse analyst Edward J. Kelly said he expects food price deflation will accelerate to historic highs in coming months. Supermarkets have quickly passed through lower costs in dairy, for example, to boost traffic. They've also cut prices to recover market share.

Meanwhile, competition remains high, especially as consumers curtail spending and trade down to Wal-Mart Stores and Costco, Kelly said.

Overall, however, he remained positive on supermarkets, saying that stocks don't have much further to fall because investors are already aware of these issues.

Kelly said fundamentals will improve in the first half of 2010 when deflation wanes and there are fewer promotions.

"While we admit that timing is an issue given that the upcoming quarter should be challenging, it's only a matter of time before the market begins to price in an improving outlook in 2010," he wrote in a client note.

Kroger Co. is the best company in the sector, given its focus on value, he said.

Kelly has an "Outperform" rating on both Kroger and Safeway Inc., which he said has the right strategy for the long-term and generates cash.

Supervalu Inc., however, is still struggling with its 2006 Albertson's acquisition, but the stock is cheap and new management might be a catalyst for the stock. He rates that stock "Neutral."