(MONEY Magazine) – Quick--pick a growth stock. What comes to mind? Tech? Pharmaceuticals? How about supermarkets? No, we're not kidding. Rampant consolidation has created gargantuan grocers whose ability to cut costs and squeeze suppliers has produced amazing earnings growth. In an industry notorious for thin margins, Kroger, the largest chain with 2,400 stores and $49 billion in sales, increased earnings per share 21% in 2000. Albertson's, second largest with revenues of $36.8 billion, swelled to 2,549 stores in 36 states, up from just $13 billion and 826 stores in 1996. Safeway, third with 1,759 stores, boosted earnings 13% in the first nine months of 2001.

After the market crash of early 2000, growth managers turned to supermarkets--a group they typically ignored--as if they were comfort food. Kroger and Safeway started showing up among the top holdings of go-go funds like Janus Olympus. Grocery buyers have been rewarded with a 67% return for Kroger since February 2000, a 36% gain for Albertson's and 16% for Safeway--while Standard & Poor's 500-stock index sank 15%. Is it too late to join the party?

Probably not. But supermarkets do face some serious challenges. First, the acquisition pace has slowed--and that had been supermarkets' main source of sales and earnings growth. Second, the rapid expansion of warehouse stores, plus Wal-Mart and Target supercenters, portends cutthroat price competition and the profit drain that goes with it. Third, once the economy moves toward a recovery, institutional investors may replace supermarket shares with stocks more likely to sizzle in an upturn. Such a rotation could limit supermarkets' gains, regardless of their earnings.

At the same time, supermarkets are quintessential growth-at-a-reasonable-price stocks; their average P/E is 35% lower than that of the S&P 500, while their expected 2002 growth is the same or higher. They're still well priced. And they're staving off rival supercenters by adding pharmacies and gas stations to keep customers coming.

Kroger: The market leader

Kroger is the Big Kahuna in the supermarketplace; we recommended it in November as a safe haven and continue to find it attractive. The company's P/E of 14 times estimated 2002 earnings is a discount to its expected 16% earnings growth rate, making it the cheapest of the major chains.

In part that's because Kroger, headed by chairman and CEO Joseph Pichler, doesn't produce the glowing numbers of rival Safeway; operating margins in the most recent quarter, for example, are 5%, compared with Safeway's 7.5%. Also, a full quarter of Kroger's stores compete head-on with supercenters. A recent Bear Stearns report showed that in those areas where Kroger faced a supercenter, 2000 sales growth and market share gains were below average.

The chain is responding aggressively to the threat. Kroger is pushing its widely admired private-label food business, now 21% of sales. Profit margins for house-brand items run about 10% higher than on goods purchased from wholesalers. Also, like other chains, Kroger has ventured beyond groceries. In fact, it is the seventh largest pharmacy operator in the U.S., and a third of its stores don't dole out drugs yet.

Analysts believe Kroger is on track to boost margins to Safeway-like levels. If the company succeeds, the stock should merit a P/E ratio closer to 19, figures Rich Eisinger, co-manager of Mosaic Mid-Cap Growth, which owns shares of both Kroger and Safeway. That would add up to a 33% increase over Kroger's recent price of $25.23.

Safeway: The up-and-comer

Safeway, which expects to rake in $34.3 billion in 2001, boasts a reputation as the industry's best-run chain. It's also the least vulnerable to supercenters. Chief executive Steven Burd says that 70% of Safeway's stores are in urban areas, where megastores are less of a threat. "When a supercenter does come in," Burd says, "it kills off the undercapitalized, small, independent regional supermarket company." Whatever business Safeway loses to supercenters, he adds, it regains from smaller grocers.

Burd has ambitious plans to cut $1.6 billion from Safeway's costs over the next five years and invest those savings in promotion, new product lines such as natural foods and other sales boosters. He's also thinking about acquiring companies outside the grocery business.

But these kinds of growth can hurt the bottom line. After Safeway warned in July of lower than expected earnings for the rest of 2001, investors punished the stock. The company recently cut its annual earnings-growth targets for the next five years to 13% to 15%. At a recent $44.55 a share, or 15 times estimated 2002 earnings, Safeway trades near the bottom of its 10-year range. As of late November, it was 30% off its 52-week high. We think that's an overreaction. "Given their track record," says Stein Roe Focus manager David Brady, "the valuation is very attractive."

Albertson's: The turnaround play

Albertson's is the high-risk play with the most potential gain. It's still recovering from the botched $12 billion purchase of American Stores in 1999, which cost it more than half its market value--and some credibility with investors. However, many longtime stockholders believe that the April appointment of former General Electric executive Larry Johnston as CEO signaled the beginning of significant improvements.

Johnston has already announced the closing of 165 unprofitable stores in weak markets. That's a sign that Albertson's is becoming leaner and more disciplined, says Alison Kerivan, who follows supermarkets for Babson Funds. Johnston is positioning the company to pursue growth measures like prvate-label products and grocery store-pharmacy combos, she says.

The company's 2002 P/E of 15, with expected earnings growth of 13%, puts it in the same price range as Safeway and Kroger, which are in much better shape. But Albertson's has more room to grow than its peers, Kerivan says. She cautions, however, that the turnaround is no sure thing, making the stock, recently trading at $33.30, a buy only for long-term investors willing to accept some risk.

--LISA GIBBS