A lot of things are going right for the major supermarket operators, and that is likely to continue -- at least for the near term.
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Tracking Progress
These financial experts gathered at SN's New York office to predict which operational strategies will yield big gains and to evaluate challenges ahead
Supermarkets have toiled to re-engineer and build merchandising programs through category management and private label, and those efforts are boosting results. Retailers have also been successful in holding capital-expansion programs up to stricter, wiser measures, analysts said in the wide-ranging roundtable discussion, excerpts from which appear in this issue.
But, analysts noted, luck is also coloring the picture. Higher levels of consumer confidence, fuller employment and the possibility of food inflation are all good news for operators.
For the near term, there is room for continued improvement of financial returns, analysts said. The long-term view, however, rests on how supermarkets handle some major challenges they are now facing.
Even as supermarket executives are feeling more confident about competing with supercenters, they will have to tackle new competitors in home meal replacement without stumbling. Similarly, chains are in many respects only at the beginning stages of building efficiencies, with areas like activity-based costing still waiting to be successfully addressed.
"Overall, it's just very clear sailing," said Gary Giblen, a managing director at Smith Barney, New York. "A good top-line performance in the industry, combined with direct cost controls, and then interaction with the top line helping the bottom line come out strong."
Gary Vineberg, first vice president at Merrill Lynch, New York, cautioned that not all operators are equal when it comes to good results. "I don't know that the industry [overall] is doing all that well, but the major chains are doing very well. And I think a lot of it is consolidation-driven."
Ed Comeau, a vice president at Donaldson, Lufkin & Jenrette, New York, credited much of the success to operator efforts. "The bottom line, as I see it, is that a better-managed industry is emerging from a difficult environment in the last three or four years." Jonathan Ziegler, based at the San Francisco office of Salomon Bros., New York, stressed that operators have become better merchandisers. "In the current environment, managements are very focused on driving their business through merchandising changes, micromarketing and category management as opposed to price, and consequently they're seeing margin improvement. It's become a more rational business. What scares me is things are so good they can only go one way."
Mark Husson, a managing director at J.P. Morgan Securities, New York, pointed to the boost from outside events. "What's exciting for supermarket retailers this year is that they're not doing anything significantly different from last year, and yet consumers seem to be putting an extra item in the basket right now," Husson said. "That's partly consumer confidence and partly full employment."
Debra Levin, a principal at Morgan Stanley, New York, noted that operators continue to face a very competitive environment. "If anything, it's getting a little bit more intense," she said. "That's in part due to the supercenters, but not in total. Every single major company has picked up their square-footage expansion programs."
Here are excerpts from the roundtable:
A GENERALLY UPBEAT OUTLOOK
SN: What is the outlook for supermarket industry performance in the next six months to a year, taking into account factors like inflation and interest rates?
Giblen: I've been bullish on the supermarket industry for a couple of years, and I really see no reason to feel any different looking out at the next six to 12 months.
You have a big private-label trend that really can't be overestimated. It not only gives higher margins, but also the ability to bargain more effectively with suppliers. And it can be add-on sales, too, as in the case of Safeway, which would be a good example.
You have a lot of companies reporting very robust comparable-store sales, and that's very important to see because that not only drives the top line, but also absorbs the operating expenses. It's producing very good earnings at the bottom line.
I would not emphasize food inflation much. I think it might pick up a little bit, but it's not going to be a big deal either way. I don't think you should focus on food inflation as a big positive, but it's not a negative, either. It's a neutral that could turn very slightly positive.
Many companies have done a great job on cost control and re-engineering. It's meant great flexibility in competing with alternative formats.
One important thing in the last year or so has been the industry's almost imperviousness to alternative formats. Those who were worried about supercenters really haven't had anything to worry about. I've yet to see any material impact on any companies from supercenters, and I don't think you will.
So overall, it's very clear sailing: a good top-line performance in the industry combined with direct cost controls and then interaction with the top line helping the bottom line come out strong. So I look for a very good performance overall -- with, of course, a wide variety of performance among individual companies. You could never talk about the industry using a formula because every company is different.
Husson: I agree with most of what Gary [Giblen] said. What's exciting for supermarket retailers this year is that they're not doing anything significantly different from last year, and yet consumers seem to be putting an extra item in the basket right now. That's partly consumer confidence and partly full employment. I think the bigger are becoming better in food retailing. Being bullish on 'the [supermarket] sector' applies to big stocks and not to medium-sized retailers.
I do think there's been a hit from supercenters, and I think it's wrong to minimize the threat from supercenters. They're for real. And they're good news for consumers, in general. If you look at this from the consumer's point of view, you've not only got large supercenters coming on board with very modern facilities and high standards of service, but also people like Kroger and Albertson's rolling out wonderful new stores in huge numbers -- almost unprecedented numbers -- and taking the smaller, less well-capitalized retailers to the cleaners over the medium term. The [return on investment] from those new, larger stores is superior to historical levels.
Category management has more sophisticated tools for micromarketing and [charting] the performance of product on a store-by-store, market-by-market basis -- rather than just assuming that if you're doing what's right on average, then you're doing the right thing for the company. You can have your head in a microwave and your feet in a deep freeze and be average overall, but you'll be in big trouble at both ends. I think retailers are beginning to realize that.
Another point is there is some self-consolidation among the very large chains, and I think that's a prelude to industry consolidation. Vineberg: I don't know that the industry [overall] is doing all that well, but the major chains are doing very well. And I think a lot of it is consolidation-driven.
The industry came out of a very tough period in the early 1990s, probably bottomed out in late 1993, and has been on an up trend ever since. The economy probably has helped the major chains to some degree. But I think these [companies] came out of the early 1990s leaner and meaner. They are effectively consolidating the industry in a way we haven't seen for a long time.
One of the things that characterizes the supermarket industry vs. other retail sectors is that it really is one of the most fragmented retail sectors left. The way we define concentration and saturation is if you look at most sectors of retail, the top three to five operators account for the bulk of the growth of the sector. I think that's not yet true in the supermarket industry; it'll probably be true in five to 10 years. But at this stage, the top 10 operators probably don't even account for all of the growth in the sector, and that allows bigger companies to gain market share and have reasonably good growth without the sector itself growing at a high rate. And it is not growing at a high rate. These [big] companies are smarter. I think this turnaround is good for another couple of years, at most. Food inflation is a positive -- if only in the sense that having some inflation certainly takes some of the impetus toward price competition away. The sector is probably good for the major chains as long as there's a reasonable amount of inflation and as long as the economy holds up. If the economy really starts to weaken, I would start to get concerned, because there's a lot of [retail space] being built into this business that will ultimately lead to another cycle of price competition.
Levin: Overall, I've been basically neutral on the sector, getting increasingly more positive this year because of the outlook for inflation. I disagree with what Gary Giblen said; I don't think you can underestimate what inflation will do.
What happens is company managements are not talking about inflation. They've learned to live with very low levels of inflation, and they budget accordingly. I expect you'll see a pickup in inflation by the end of the year, or maybe the beginning of next year. That should help companies.
It really comes down to an intensely competitive environment. If anything, it's getting a little bit more intense. That's in part due to the supercenters, but not in total. Every single major company has picked up their square-footage expansion programs. There are a lot of new stores out there, and companies are learning how to run the new stores better. It's still a very fragmented market, so there's still some more share to be taken from the independents and small players.
You'll continue to see more consolidation, and I expect that will pick up because a lot of the larger players recognize that it's a major way to drive earnings and catch synergies in distribution, buying, administration and advertising.
Actually, the re-engineering and the efficiencies generated from better systems -- be it distribution, consolidation, category management, better buying or inventory management -- have not been totally accomplished yet. And that should be a real positive for years to come.
Ziegler: A lot of what's been said I agree with. I've looked at the Toys 'R' Us syndrome and the supercenters, and I say that the supercenters are probably the best thing that could have happened to [the supermarket] industry, in a way.
It doesn't mean I dismiss supercenters; anytime you add square footage that is well-managed to a market, it's obviously a negative and is deflationary. Why I liken it to Toys 'R' Us is that Toys 'R' Us had no competition, and got real sloppy in its operation. What the supercenters have done is force these guys to really develop [Efficient Consumer Response], which is driving the business. Coincident with that, because technology seems to have been a magic word in the stock market up until lately, I sell these stocks as being beneficiaries of applied technology. What we have here is slight basis-point improvement in operating margin, and it's really been driving earnings.
In the current environment, managements are very focused on driving their business through merchandising changes, micromarketing and category management as opposed to price. Consequently, they're seeing margin improvement. It's become a more rational business. What scares me is things are so good, they can only go one way.
Comeau: I generally agree with most of what's been said. But the bottom line, as I see it, is that a better-managed industry is emerging from a difficult environment in the last three or four years.
The economics of the business have changed somewhat in the last few years, moving more away from a buying mentality and having inflation as a padding in the business, and more toward running the business where you have a better understanding of your costs and you're making intelligent merchandising and procurement decisions. I don't think the food chains overall had done a good job of understanding their cost of doing business over the last 10 years or so, and [now they] have examined that more closely.
So they're making more intelligent merchandising, procurement and logistical decisions, which is important in wringing out costs and improving efficiency. All of that's been driving pretty good operating performance in a downright difficult environment for last four years. So, by and large, a better-managed industry is emerging.
I'm reluctant to think that the smaller and mid-sized chains, or even a small one-store operator, should be counted out going forward. I don't see the big getting bigger and the small getting smaller. I would continue to see the business being a local business, where a one- or two-store company can excel and succeed against the biggest and the best.
Even though it's clear the larger chains have some logistical and cost advantages, it's still a local business that you have to execute day to day. If a small chain or mid-sized company can do that well, they can succeed against anybody from Wal-Mart to Safeway. So the industry has a constant kind of pruning process where you wash out a lot of inefficient operators or poorly run companies. But as you do that, more and more better, small companies continue to emerge. Just briefly about the supercenters: I think they -- particularly Wal-Mart -- have got their work cut out for them in the metro markets. I don't think it's fair to assume success across the board. The format works well, it's successful, it's profitable and there's nothing wrong with it. But I don't know if they really bring anything to the table that's not already in the metro markets. They have some very clear competitive disadvantages in the metro markets, which they haven't yet begun to test. That said, the outlook [for supermarkets] would be continued fine-tuning of the business and better management among most of the large chains -- and better understanding of costs. But there's still a ways to go in terms of improving financial returns for the industry -- not by a huge amount, but steady improvement each year. I don't see any reason why companies shouldn't continue to leverage upon the skills they have developed.
TUG-OF-WAR WITH SUPERCENTERS
Everybody mentioned supercenters in their outlooks. In talks with supermarket executives over the past few months, SN has found that they generally are less worried about supercenters than they were a year or so ago, when the main supercenter chains announced ambitious growth plans. Do you sense this as well, since supermarket operators now have had a year to gauge the impact of that expansion?
Levin: Supermarket chains have learned to live with the supercenters because Wal-Mart has been experimenting with them since the late 1980s. So [the supermarket industry's] antenna was raised a long time ago, and now they've been competing with them for quite some time, especially some of the more established operators like Kroger, Winn-Dixie and Albertson's. They've seen them in their territories for a long time.
One positive is that there are going to be fewer supercenters built in a lot of these individual companies' territories, as Wal-Mart sort of expands outward in its geography. So that's a relief to them.
I don't think the competitive end of it gets any easier, because there's enough competition from traditional operators. So that's something that you've probably been sensing.
Husson: I think the supercenter issue initially was blown up by Wal-Mart analysts who were desperate to find something positive to say about Wal-Mart. There's not too much you can say, on a large scale, that Wal-Mart does positively. So, for supermarket operators, supercenters were one of those devils you paint on the wall and scare yourself with every now and then.
The scale of the threat is probably overemphasized. If you look at the square-footage expansion for Kroger and Albertson's this year and you add up the square footage they're adding to the market, I think you'll find they're actually adding more square footage than Wal-Mart is. You don't hear people say, 'I'm not buying supermarkets because of the Albertson's threat.' But you do hear them talk about supercenters the whole time. So I think people are realizing the scale isn't as dramatic as we perhaps first thought when the Wal-Mart analysts started saying [supercenters] are 'Retailing 2000.'
Ziegler: I just hope supermarkets don't go to sleep. One of the things you have to keep in mind: Wal-Mart's growth strategy is supercenters, and they have $3 billion to spend on capital expenditures every year, which is a fairly sizable number. That's where it's going to go. The offset, of course, is that there is independent space coming out of the market, a gross addition to square footage of supercenters. There's weaker space coming out, but it's going into stronger hands.
I'm not sure Wal-Mart has really learned the food business completely yet; I think they will. So if anybody is getting lackadaisical, it's almost scary.
Comeau: I don't think anyone's dismissed the supercenter threat, the viability of the format or even its impact on the market. But there have been more and more success stories in terms of chains competing against the supercenters. Also, [supercenters] have yet to be tested in the metro markets in any major way.
Wal-Mart has clearly reined in its capital program for supercenters. If you look back a few years ago, they were talking in terms of $125 million, and allowing projections of $150 million a year to be forecast for the long term. They're sort of in the 100-mode in the number of annual openings. And with the $3 billion in capital, clearly, they have an awful lot of capital to spend on supercenters. But the key issue, as Mark [Husson] pointed out, is they have to get adequate returns on that.
Giblen: To build on what Ed [Comeau] said, let's look at what the companies are actually doing rather than saying. As Mark [Husson] said, Wal-Mart has cut back its capital expenditures on supercenters. Meijer has decided not to go to Cleveland and has greatly curtailed its expansion through the East Central states. They had a devilishly hard time getting set in Indiana and some of the newer Ohio markets. It had to do with unions effectively creating picketing situations that made it even harder than it otherwise would be for a new market entry to be successful.
The actual execution levels in the supercenters -- which I always check when I'm on the road, for different reasons -- are very poor. Wal-Mart may be the worst of them, but I'd take Target and Kmart to task as well. The fact is, Wal-Mart has not sought out an A-team for food. They have not invested the management resources to do a first-class food effort. Sometimes you see a good, new supercenter, but then within six months it's declined to bad standards. That's only logical because they're paying [employees] less than the going rate that supermarkets are paying. So there can be less-qualified workers in general.
The real bottom line here is that you will have supercenters being built, but the format itself doesn't carry any particular strength. Any CEO in the [supermarket] industry will tell you it's just like any other [competing] supermarket opening: It's no better -- and sometimes not as bad -- a threat.
Vineberg: The [supercenter] format itself may not be a supermarket killer. But anybody who has followed the industry for the last 10 years has been through warehouse clubs and deep-discount drugstores. So we were rationally unwilling to panic over supercenters. That was a good thing, because we started to understand the strength of the supermarket industry -- the convenience aspect of it -- and why these other formats aren't necessarily going to destroy the supermarket industry, which was the prevailing wisdom at the time the warehouse clubs were really peaking.
On the other hand, it's wrong to assume necessarily that Wal-Mart is going to assume a totally rational strategy in rolling out these stores. They need a growth vehicle. They're maxed-out domestically in conventional discount stores; international is a much iffier proposition for them. I think they intend to go pretty full bore with [supercenters], which means other discounters are going to have to introduce supercenters of their own.
What it all comes down to is an industry where the format we know is not necessarily all that viable in the more densely populated urban areas. But they're going to build them -- and Albertson's, Kroger and Winn-Dixie are building -- and it all adds up to a lot of capacity coming onstream in this business. Right now, the market share seems to be shifting to these larger operators in a fairly orderly fashion. But chances are that there are going to be some air pockets ahead because there really is a lot of capacity coming onstream.
Levin: And Kmart could start reinvigorating their program, too. They have their challenges, but they are definitely focused on turning around. And they are not ruling out supercenters as a way to achieve that.
Vineberg: Well, they ultimately have to. If your main competitor [Wal-Mart] is operating these stores, can you afford not to operate a competitive format?
Husson: The good point you're making is that if you're not operating that format, then you don't have the traffic for the food shopping -- even if it's only once or twice a month -- going past some of the general merchandise categories. So I think once every [discounter] goes to the [supercenter] format, we are looking at proliferation. It's like a tactical nuclear weapon: Once somebody starts lobbing one, then you get escalation.
That's what happened in France. The casual Carrefours was not a problem until Continente started building huge hypermarkets all over the place and then everyone had to do it to be successful, unless you were just a small local player deeply rooted in your community.
CONSOLIDATION: WEAK OPERATORS BEWARE
Vineberg: If it is correct that the small, local operator and the small or mid-sized chains are not as vulnerable as some of us think, then we are headed for severe overcapacity at some point in the next few years -- and we know what that leads to.
Ziegler: That would be good news, though, for all of our theses. Because that's what will lead to the consolidation the industry really requires.
Levin: Good news -- longer term, yes.
Ziegler: We need some pain to force the consolidation.
Husson: In Europe in the 15th century, there used to be the concept of a 'good' plague. Bubonic plague would sweep across the plains of Europe, and about 20% or 30% of the population would die. A painful experience although it might be, it carried off the weak and the old.
Comeau: If you look back 10 years, the top 10 chains did about a third of the business; you look today, the top 10 chains do about a third of the business. Not a lot has changed in terms of total market share.
I'm not ready to make the assumption that 10 chains are going to have 50% to 60% of the U.S. market in the next several years -- or even close to that.
Husson: You could have said that in France in 1990. There were 12 major operators, then in 1993 there were six and ....
Comeau: [Interjects] You don't have the same opening of markets and regulations there, and this is a much larger free-market economy. You get a smaller chain, like a Genuardi's or someone else, build 10 stores, then build 20, get some financing and buy [other stores]; and the next thing you know, they have 40 stores and are kicking the heck out of somebody else. You have that possibility in every single market.
Stop & Shop, acquired by Ahold, is a very good example. Everybody seemingly looks at that as a consolidation. And look what happens: They kick out 40 or so stores into the market, which makes Shaw's and Star stronger.
My point is that this filtering process kicks out some of the weaker operators, like a plague would, but it doesn't necessarily mean all the big operators will get that big. WHOLESALE ADAPTATION
Levin: The role of the wholesalers can't be overlooked. They obviously have their own challenges -- Fleming and Supervalu -- right now.
Over time, they are improving their systems and making it easier for the independents to have at least some of the advantages of the systems and buying the major operators have. You may see them being able to reinvigorate themselves in terms of sales trends and market shares. That's questionable, but you have to raise the issue because there's some very big investments being made for both of those companies right now.
Giblen: The best wholesalers will do well. Richfood has very vibrant regional chains that work with them. Wakefern [has] ShopRite; ShopRite probably could be considered the best operator in New Jersey -- independents with the help of a strong, cooperative wholesaler.
Ziegler: They also benefit if we get away completely from forward buy, which is not necessarily going to be the case. Husson: Talking about Richfood and some of the better wholesalers, like C&S [Wholesale Grocers] as well: 'wholesaler' is almost the wrong word for them. They're an outsourcing play; they're trucks and warehouses much more than they are, say, 'Let's get around and decide a planogram together and go through promotions for every single SKU you have.' It's much more of a strip-down effort than it has been in the past. I think it's a market opportunity there that has yet to be fully explored.
WRESTLING WITH HOME MEAL REPLACEMENT
We've focused on supercenters, but of course there are other competing retail formats -- ranging from convenience and discount stores to restaurants, home-meal replacement chains and companies like Eatzi's, which are hybrid grocery and food takeout. What are some of the feared competitors in these groups, and how are supermarkets positioned to compete?
Ziegler: Boston Market is obviously a company that has given another wake-up call to the industry, just like Wal-Mart did when they went into food in late 1988 -- and the industry is paying attention.
Eatzi's is an unbelievable concept. I don't think you'd make any money with 40 chefs on staff in an 8,500-square-foot operation, but there's a lot of stuff there that this industry is really in the early stages of exploring. A number of operators have told me, 'Oh, we only have our toe in the water.' But I think it's vast potential to win back share of stomach. I don't even think it's a threat; it's just great potential for this industry, if they do it right. [Supermarket retailers] all have various experiments going on. There's some farther along, like Ukrop's, and I'm not sure they do it completely right. But it makes me excited about this industry.
Levin: In terms of losing share of stomach, it's going to be very difficult for supermarkets to compete effectively with these small, efficient locations like a Boston Market, where people have incredibly easy access and it's fast.
Supermarkets are doing an interesting job right now in terms of all the experiments out there, and they can definitely win back some share of stomach. They have the opportunity, in terms of the vast selection that's available from the supermarket. But it's still going to be tougher to get that easy access because of the size of the parking lot, the number of shoppers and the number of people in the express lanes. Comeau: The problem with that is, to feed a family of four at a Boston Market, you're looking at $40 plus. The average family is not going to spend $40 a night.
If you look at a cold meal that you can take home and cook yourself and feed the family with for $12 or $13, it's a vast difference. That's a competitive disadvantage of the fast-food [operators] -- even
