NEW YORK -- The industry will continue to consolidate, but it may not do so using the growth-by-acquisition strategies the major chains utilized in the late 1990s, supermarket analysts said here.
SN published the first part of the roundtable Aug. 26.
Consolidation is more likely to come about through pursuit of smaller in-market acquisitions, larger investments in existing stores and more aggressive competitive tactics, they said during SN's seventh annual Financial Analysts' Roundtable.
"There are still a few chains that would be strong and attractive [acquisition candidates]," Gary Giblen, director of research for C L King Associates here, said. "But there will be a lot of skepticism [among potential investors] because the recent history of acquisitions has been very disappointing because none of the large acquisitions delivered on their promise."
According to Chuck Cerankosky, managing director for McDonald Investments, Cleveland, industry consolidation can be accomplished through more aggressive competitive tactics. "I think operators like Kroger are very serious about getting more competitive on price, which is going to consolidate the market -- not through acquisition but just by pushing some people out of business."
Neil Currie, locally based executive director for UBS Warburg, Stamford, Conn., said he agreed, suggesting that retailers may want to "use their balance sheets to take their market share."
Financing deals through the high-yield market is another possibility, Ted Bernstein, managing director for Dresdner Kleinwort Wasserstein-Grantchester here, suggested. "The high-yield market has been reasonably receptive to new supermarket deals over the course of the last year," he said -- exemplified by the acquisition of Roundy's, Pewaukee, Wis., by a financial buyer. However, the market has become more selective in the last few months, he added, pointing to unsuccessful efforts by New York-based Gristede's to raise funds for its proposed acquisition of King's Super Markets, Parsippany, N.J., and by Spartan Stores, Grand Rapids, Mich., to raise money in the high-yield market.
Lisa Cartwright, director for Salomon Smith Barney here, said some companies might prefer to seek out in-market acquisitions "to help leverage their fixed costs" -- as Kroger Co., Cincinnati, and Albertsons, Boise, Idaho, have been doing, she pointed out -- "[or] investing in what they already have, or perhaps buying another concept if it's cheap enough or small enough."
Cerankosky suggested that potential acquirers are more likely to look at cash-flow opportunities than store numbers to grow sales, noting that even companies that are losing market share "are still cash-flow positive and profitable."
However, Jack Murphy, vice president of Credit Suisse First Boston here, said that, even if cash flow is positive, "if you talk about ongoing returns that are declining, it's very tough to see what the value of those operations are."
As market capitalization shrinks, yesterday's acquirers could become tomorrow's acquirees, according to Jonathan Ziegler, San Francisco-based managing director for Deutsche Banc Alex. Brown -- "they've become more interesting as acquisition targets rather than acquirers. If you look at where the EBITDA [earnings before interest, taxes, depreciation and amortization] multiples are, these could be great sources of cash flow and capital to potential acquirers."
Cartwright said that cash flow alone should not be the sole criterion for buying a company. "All the time you continue to lose more and more market share, you're basically throwing off cash and giving it back to the investors, and they're investing in a shrinking, value-destroying company, [so] why is that a good investment?"
Turning to the question of whether any European buyers would be interested in acquiring a U.S. company, Currie said he doubted there would be much interest right now. "The investor sentiment within Europe toward owning U.S. supermarkets is very dim right at this moment, so if anybody made a new investment over here, I'm not sure it would go down too well over there," he explained.
The roundtable discussion moved from consolidation to consider the performance of individual chains, the potential for new in-store services and the future of B2B and B2C marketing. The balance of the text follows.
A DIFFERENT PATH TO CONSOLIDATION?
SN: Do you anticipate a new round of industry consolidation?
CHUCK CERANKOSKY: I think what the market needs is a few more acquisitions, not only in retail but in the industry in general. Valuations have come down, and you've got some strong players that could be acquirers. That can inspire investors to recognize there could be some value here that they've missed. That doesn't mean they should be buying sick companies -- either as acquirers or investors -- but it's an interesting thing, because, with [the stock prices of] companies like Costco, BJ's, Kroger and Whole Foods down, a lot of companies have gotten to takeout levels. LISA CARTWRIGHT: I'm not sure if investors would respond positively to that.
CERANKOSKY: I think it's a positive force in the market when people start seeing somebody putting up money for a whole company. We haven't seen that in awhile.
CARTWRIGHT: But throughout this industry, and throughout many industries, I think, people have realized that acquisitions are not always the panacea of value creation that everyone thinks they are. CERANKOSKY: I'm not saying the acquirer hits a home run, but he may simply be recognizing the lower purchase price, which could inspire others.
TED BERNSTEIN: Over the course of the last year, the high-yield market has been reasonably receptive to new supermarket deals. We've seen more new issuants in the last year to 18 months than we saw in the preceding two years, I think. Part of that has to do with interest-rate cuts, with approximately 11 cuts last year. Part of it also has to do with technical factors in the high-yield market, because between 1997 and 1999, 40% of the new issuants in the high-yield market were telecom-related, and there are still a lot of institutional investors who are chanting the mantra "anything but telecom" at this point. And all that, plus the overall cycle of the economy, has given a technical boost to sectors like supermarkets, health care, energy and industrials, so I think the wherewithal for the high-yield market to finance that kind of activity is there.
And we've even seen one recent LBO [leveraged buyout] by a financial sponsor in the high-yield market -- the acquisition of Roundy's. But at the same time, the high-yield market has become more selective than it was maybe six months ago with respect to supermarket issues because of two recent deals that were not consummated and were pulled -- the attempt by Spartan Stores to do a high-yield deal and the attempt by Gristede's to finance the proposed acquisition of King's in the high-yield market. So I think the high-yield market is a source of liquidity for financing these types of transactions, as long as they make some sense.
[Disclosure statement: Three of the companies discussed during the roundtable -- Kmart Corp., Pathmark Stores and Wal-Mart Stores -- are investment banking clients of Dresdner Kleinwort Wasserstein-Grantchester, New York, and/or its affiliated companies.]
SN: So what's the outlook for consolidation?
CERANKOSKY: I think there are some regional chains out there that held out and missed the peak, and they're no longer marketable as a whole, if at all. The chains were perhaps preoccupied absorbing earlier deals, though Kroger seems pretty adept at picking up some of these smaller operators. But now you've got market prices coming down, and the regional operators have to be asking themselves how they can be worth eight or nine times EBITDA when a potential buyer is now selling at six times?
We've also talked about the need to grow sales, and I think operators like Kroger are very serious about getting more competitive on price, which is going to consolidate the market -- not through acquisition but just by pushing some people out of business. So there's going to be consolidation taking place, but a certain aspect of it isn't going to be pretty.
GARY GIBLEN: I think the leading acquisition candidate is Pathmark because it has many unique characteristics. It's a very attractive company because it doesn't really face any Wal-Mart food presence, for the most part, in its market area, and it has expertise in operating urban stores, which is sort of an outside-the-box initiative that many supermarkets are pursuing now. There are still a few chains that would be strong and attractive [acquisition candidates], and the beauty of some of them is they bring expertise as well as a store base as acquisition candidates. So an acquirer could make some pretty exciting deals where he picks up skills as well as a revenue base to work from. But at the same time, there will be a lot of skepticism because the recent history of acquisitions has been very disappointing because none of the large acquisitions delivered on their promise.
JONATHAN ZIEGLER: I'm not sure that's the case. I think Albertsons did an amazing job strengthening its operations after quite some pain.
GIBLEN: It wasn't the acquisition. It was just that American Stores [the company Albertsons acquired in 1999] started doing better on its own, so Albertsons got a better company.
ZIEGLER: Albertsons strengthened its organization amazingly. When you compare where it is today with where it was, it's just starting to show up.
CARTWRIGHT: A little late.
ZIEGLER: Well, yes, the acquisition game was very painful for everybody. Kroger is a stronger company today, but it went through some pain getting to where it is. And if companies stop reporting non-recurring charges, that may interfere with acquisition activity and then they're going to have this volatile earnings stream. But the point is that the market caps of these companies are so shrunken from where they had been at their highs, so perhaps you might look at it as a flip -- they've become more interesting as acquisition targets rather than acquirers.
JACK MURPHY: But who wants to buy them?
ZIEGLER: Well, if you look at where the EBITDA multiples are -- and it's true that we're in a low-interest-rate environment -- these could be great sources of cash flow and capital to potential acquirers.
MURPHY: They're in a terrible competitive position.
CERANKOSKY: I wouldn't describe it as terrible. They've lost share, but they're still cash-flow positive and profitable.
MURPHY: Competitively, they're growing square footage at 4% on average, while Wal-Mart is growing at 20% on average, so I don't think there's a lot of argument there that they're in a bad spot competitively. True, they throw off a lot of cash flow, but if you talk about ongoing returns that are declining, it's very tough to see what the value of those operations are.
ZIEGLER: That's my point -- if your ongoing returns on capital are coming down on new investments, then you just throw off this cash.
CARTWRIGHT: And all the time you're continuing to lose more and more market share, you're basically throwing off cash and giving it back to the investors, and they're investing in a shrinking, value-destroying company. Why is that a good investment? Just because you're paying a dividend for a company that's shrinking and losing competitively to other formats? It doesn't make any sense.
ZIEGLER: Tell me a retailer that would want that in its portfolio of businesses.
BERNSTEIN: Are you talking about financial buyers?
ZIEGLER: I'm talking about buyers from outside the industry, maybe from outside the U.S. These companies might be interesting acquisition opportunities because they're throwing off a lot of cash.
NEIL CURRIE: Right now they are. But the problem is that in three years' time, if margins are hit further and they fall below where they are today, these companies aren't going to be throwing off the same level of cash and they're not going to be able to invest the same level of cap-ex in the stores and they're not going to be able to buy back shares, so it becomes a very vicious cycle.
CARTWRIGHT: And taking that cash right now and cutting cap-ex and giving it back to the shareholder is probably not the answer either, because they're not going to fix the problem.
CURRIE: They're potentially risking their balance sheet.
CARTWRIGHT: Yes, and they're going to create an even worse situation for themselves. But speaking of acquisitions, I can't imagine at this point Albertsons or Kroger making an acquisition in a new market. Safeway maybe, but I think if they do that, the investor community will react negatively because if you can't produce increasing returns in the markets you're already in, with the stores you already have, why would an investor be excited about a company that buys another chain in a new market? Before that, I can see them filling in markets to help leverage their fixed costs, investing in what they already have, or perhaps buying another concept if it's cheap enough or small enough so that even if it's more expensive, based on price-earnings ratios or EBITDA, they can afford it.
CURRIE: I think Albertsons is the candidate for that because it's basically signaled that to the market, and it's hired people to look into acquisitions, so I think they're more likely to make fill-in supermarket acquisitions.
SN: So who's going to buy these retail chains that may be up for sale?
CARTWRIGHT: Frankly, some of them don't even need to be bought. They're doing just fine on their own. I think if you develop a niche and you're close to the customer and you can get close enough on price and you have regional economies of scale, why do you need to be bought out and ruined by a big player?
SN: So you don't see much consolidation coming?
CERANKOSKY: I'm not saying all of them will be acquired. Some will, and some will go bust.
CARTWRIGHT: Some will be sold in in-market deals. But for instance, does H-E-B [H.E. Butt Grocery Co.] need to sell? No. Does Publix need to sell? No. Wegmans? No.
CURRIE: There are pockets of excellence among the independents and the non-grocery companies. I think the way consolidation should happen, although it's unlikely, is this: Rather than simply buying them out, they should use their balance sheets to take their market share. But in order to do that, big changes need to be made in strategies.
CERANKOSKY: I think some of the consolidation can take place among the privately held regionals. They can buy each other or merge and form associations.
OVERSEAS INTEREST IN THE U.S.?
SN: Is there any reason to think Tesco is looking at buying a U.S. operator, perhaps Safeway?
CURRIE: I think Tesco possibly feels the U.S. today looks like the U.K. did 10 years ago, which was extremely competitive, so why invest here now, even though valuations are low? Tesco sees the supercenter as the major growth format globally, and it may eventually determine that it needs to buy a U.S. supermarket operation to gain the scale to develop a multi-format strategy in the U.S., but I don't think the time is right.
ZIEGLER: Do you think Tesco wants to buy a membership wholesale club?
CURRIE: Not necessarily. I think in an ideal world, Tesco might want to do a deal with Target or Meijer, but I don't suppose those two deals are possible right now. So in the absence of being able to get an immediate supercenter presence, how does it get into the U.S.? I think its international people are scratching their heads trying to figure that out. Finding the right entry vehicle might prove very difficult, and I'm not sure the answer involves buying a company like Safeway -- the biggest, most profitable chain but one that potentially is going to see the biggest downside in profitability.
SN: What are Carrefour's intentions in the U.S.?
CURRIE: Carrefour is a multi-format business, with everything from hard discount to supercenters. Maybe because Tesco doesn't have a hard-discount format, there are more options available to Carrefour.
ZIEGLER: At one point Carrefour owned a chunk of Costco, and I think it still has shares in Costco U.K., so there is a relationship there. CURRIE: Right at this moment, the investor sentiment within Europe toward owning U.S. supermarkets is very dim, so if anybody made a new investment over here, I'm not sure it would go down too well over there.
A RETAIL OVERVIEW
ALBERTSONS
SN: Let's discuss a few specific companies, starting with Albertsons.
CURRIE: If you look at what Albertsons has achieved over the last year, it's really executed the strategy that Gary Michaels [former chairman and chief executive officer] had for the business. We're not really seeing anything that's dramatically different from what previous management said two years ago. The company has simply executed that plan. It's pulled out of some markets where it didn't have enough market share, it's cut costs and it's addressed the capital side. The stiffer test comes when we start to cycle through these cost savings and see whether the company experiences any improvement in its profitability, though so far, the signs aren't good. The sales growth, frankly, is very poor, particularly when you strip out the drug side of the business, and that doesn't demonstrate to me that this is a great recovery stock. I think the new CEO [Larry Johnston] missed an opportunity when he took over. He was bringing no baggage to the table, and he could have taken down earnings more significantly and used the excess to get a more positive cycle of sales growth and cost improvement and then reinvested the cost improvement into growing sales much more aggressively.
There seems to be a consensus that nobody wants an extreme price war, and I don't think that's going to happen either. I do think these companies need to be braver about actually trying to take market share from each other, because ultimately that's the only way they can have a sustainable future. They need to be prepared to take down earnings a lot sooner and more proactively rather than what we're seeing currently, where they're reacting to market conditions. Otherwise, they're not going to get a good return on sales.
ZIEGLER: I think there's some rear-view-mirror thinking in there. Sales trends in the industry suck in general, and I don't think Albertsons really ranks worse than anybody else. When Larry Johnston came in April of 2001, he didn't know diddly about food and he had to learn this business, and he's been out in every region working with employees. But quite candidly, he had an asset base that needed rationalization, an employee base that needed rationalization and a store base that just needs to be remodeled, and it's still very early in the game plan. The guy is just getting his feet wet. I think it was strategic to keep Peter Lynch [Albertsons president and chief operating officer] and the team on. He's also brought in new, talented people, and I think he's going to build market share. He's got a huge opportunity with the asset base he has now. But this is still early in the story. However, he's got a bigger challenge than Steve Burd [Safeway chairman and CEO] had when he came to Safeway in 1993 because there are now 800 more supercenters out there.
CARTWRIGHT: I think Johnston had a window of opportunity when he came in. He was taking over from another CEO, and people were very forgiving during that period. He could have come in and said Albertsons was not going to have earnings growth for a couple of years while it cut its cost structure and lowered pricing.
ZIEGLER: But he's done that.
CARTWRIGHT: Yes, but he had the opportunity to do it more dramatically. And basically he didn't say anything for eight or nine months.
GIBLEN: We have no idea how Albertsons is actually doing because its financials so far have been gobbledygook.
CARTWRIGHT: Albertsons has taken more charges than anyone else. I'm not saying Johnston hasn't done good things and he hasn't made progress, but I think the stock, frankly, has been trading up and doing better than the others because of its dividend.
CURRIE: At a conference earlier this year Larry Johnston said, "Do you know that only 30% of our customers are motivated solely by price?" Well, I'm sure he got the 30% right, but rather than say "only," I thought he should have said, "Oh my God -- 30% of our customers are motivated solely by price." To me, 30% is a large chunk of his customers, so for him to think of that as a strength of this business demonstrates to me that these companies just don't understand.
CERANKOSKY: To magnify that, just look at the people shopping at Costco. A lot of them are very affluent, but they want to shop at Costco because they can buy Reidel wine glasses cheaper than they can at Williams-Sonoma. They're motivated by price.
ZIEGLER: But Costco gets it on merchandising, too. That's the whole point about Costco. Not enough supermarket guys go into Costco often enough, or Whole Foods for that matter.
MURPHY: People perceive a value at Costco that they can't get anywhere else, and that's part of what the supermarket formula currently is missing.
SAFEWAY
SN: Where is Safeway heading?
CERANKOSKY: I think the big factor for Safeway is that it's got half its stores in California, Oregon and Washington -- the so-called "tech corridor," which got walloped with a lot of layoffs. But Safeway has segmented the more upscale customer, probably better than any other food chain, and that customer is cutting back. That customer may still be going to restaurants, but he's leaving certain purchases out of his shopping basket, he's suddenly contributing less to comps and he's making less profitable transactions, and that's put a lot of pressure on Safeway to generate sales with stronger, more aggressive promotions that involve reinvesting in margins, and I don't think Safeway has been as quick to do that as, say, Kroger has been.
SN: And are the companies Safeway has acquired doing well?
CERANKOSKY: Well, the company has certainly performed below expectations in that area.
SN: And is its announcement that it plans to use margins to drive sales going to help correct its problems in any way?
CERANKOSKY: We haven't seen a quarter yet that provides any evidence of that, but that's the intention.
GIBLEN: It's also clear that, with Albertsons getting more price aggressive and given the overlap between Safeway and Albertsons, Safeway must have been hurt.
ZIEGLER: It's interesting that Safeway's comps are weak when it doesn't have any Wal-Mart overlap and Pathmark's sales are weak and it doesn't have Wal-Mart overlap either. So there's more out there affecting the industry than just Wal-Mart.
CURRIE: I think Safeway has possibly made every wrong decision it could have made in the last few months. It raised prices and cut back on promotions; it cut costs too much, including service, and it was overly aggressive reducing shrink. But what the customers want, from time to time, is more promotions, especially if it's a high-low operator; they want better service relative to a discounter, and they want to see stock on the shelves -- all the basics. But Safeway got all the basics wrong, and it was very disappointing.
CARTWRIGHT: As I mentioned earlier, Safeway mistook geographical prowess for operational strength.
ZIEGLER: I think Steve Burd was fabulous when he came in and took a company that had great geographical prowess and a great store base but great operational challenges and was able to effect major upgrades. But we're in a new era now of driving sales, and while I think Burd has done a very effective job using cost controls to make Safeway a powerful chain, I believe he now needs to consider bringing in a new chief operating officer who can merchandise the hell out of the property he's got.
GIBLEN: The problem at Safeway is homogenization, which is another aspect of what Lisa is saying. When you look at the existing Safeway stores as well as the acquisitions, decisions were made in favor of cost reductions where the give-up or trade-off was good merchandising, and that was the wrong thing to do.
SN: So customers aren't as interested in Safeway's "culture of thrift" as the investors are?
CERANKOSKY: The culture of thrift applies to the company's P&L [profit-and-loss] statements, but what shoppers want to see is a culture of excitement and merchandising.
CARTWRIGHT: There can only be one low-cost provider. There can only be one no-frills format. And guess what? It's not Safeway. It's not Albertsons. It's not Kroger. It's Wal-Mart. So if you can't be that, you'd better be something else.
KROGER
SN: Does Kroger get the price message?
ZIEGLER: Kroger gets the merchandising message, I think.
CERANKOSKY: I think that Kroger, given its geography, has competed over the years against so many non-union chains, and it's learned that you can't survive just on location and higher prices. You've got to live with somewhat lower margins than competitors to have a more level playing field with union and non-union competition. Kroger has always had to deal with that, so the culture there is to use price a little quicker than some other chains might.
CURRIE: I hear what Kroger has said about price, but I've yet to see evidence that it's significantly cheaper than any other supermarket out there. I think there's been too much lip-service paid to reinvesting margin. Let's see the evidence.
AHOLD
SN: Ahold has been one of the few companies out there buying other properties. Is it going to be able to keep making acquisitions?
CURRIE: The key to Ahold is that it's been such an acquisitive company that it's very difficult to understand what its organic growth has really been. Some of its acquisitions have involved equity, and I think because of problems it's had with its share price and maybe the question marks about the quality of its reporting, its access to more equity is going to be limited. In the absence of acquisitions, it's difficult to try to predict what its long-term growth is going to be like.
A&P
SN: A&P said it plans to invest margin to do whatever it has to do to hold onto market position. Is that a viable strategy?
BERNSTEIN: What else is A&P going to say? It's been undergoing a series of operational and strategic revampings for the last four years, though I'm not sure exactly what it's revamped itself into. It continues to face some pretty significant pressure in a couple of markets, and beyond that, it's had a revolving door in terms of management at a number of divisions over the last six months to a year, so it's hard to see that its whole "turnaround" is anywhere near completion.
MURPHY: Everyone knows that A&P has some troubled assets, and I agree with some of what you're saying. But I think the issue for A&P at this point is one of intrinsic value. With EBITDA over $300 million and a total enterprise value of less than $1.2 billion, the company could be sold at a premium. However, that decision is up to one person, and that's Christian Haub [chairman and CEO].
SN: Would Safeway be a potential buyer if A&P is for sale?
MURPHY: Safeway is a logical geographic fit, but it doesn't have to be Safeway.
GIBLEN: But Safeway absolutely doesn't buy what it calls critical-care patients.
MURPHY: My point is that, geographically, Safeway would make a good fit, and there's a lot more accretion potential for a company that's trading at 3.5 times EBITDA than one that's trading at over 6. But I'm not saying it's a deal that has to happen.
FLEMING
SN: Turning to wholesalers, Fleming has had a tough year, and now it's considering selling its retail stores. Is that a viable move?
ZIEGLER: Fleming decided, under some pressure from Wall Street, that its debt levels are too high, and it's been looking for ways it can defer or reduce capital expenditures and pay down some debt.
CARTWRIGHT: Do you think it's reacting to Wall Street, or is it overreacting to its forward cash-flow projections and the possibility it won't meet its interest payments?
ZIEGLER: It's interesting that Fleming is considering selling its Food4Less stores because Kroger is really excited about that format, so there seems to be some cognitive dissonance about how things are developing because the concept seems OK.
CURRIE: I have some reservations about the Food4Less concept to some extent because to be a discounter, I think you either have to be Wal-Mart, who sells everything under one roof very cheaply, or you really need to follow the Aldi model where you cut your costs to the bone and you sell a small range of products. I think the problem with the Food4Less concept -- the price-impact model -- is that it is neither. With 10,000 or so products, it carries a big range to replenish and service, and when pricing gets tough, you've got to live up to your reputation of being cheaper, even though your cost base is still relatively high. Aldi, with only 500 to 1,000 products, is the classic discount format -- it never veers from that, and every benefit it gets, it reinvests into its prices and into growing sales. Aldi can operate at zero margin and just live off the cash flow if necessary.
SN: Has Fleming overcome the Kmart situation?
BERNSTEIN: I think Fleming has done a surprisingly good job of growing other distribution volume. Even on a net basis, volume is going to be up this year, and Fleming has accounted for a significant portion of the organic growth in wholesale distribution for the entire industry.
CERANKOSKY: I agree. But the thing that intrigues me about the Kmart situation is that Jeff Noddle [Supervalu chairman and CEO] walked away from billions in revenue and you rarely see a company do that. Apparently he saw something there that really bothered him, whereas Fleming took it on, and I guess you really have to have a better feel for what's going on in terms of Kmart's survival to feel good about Fleming.
ZIEGLER: There was a structural thing there that Noddle didn't want to get involved with. My sense of what happened is that when [investor] Ron Burkle was involved with Kmart, he essentially wanted to create a fully integrated supercenter operation and merge Fleming's distribution and Kmart's retail into one company. I don't think Jeff really wanted to do that, whereas Mark Hansen [Fleming chairman and CEO] was more receptive because he was operating a company that was a sicker pup.
CERANKOSKY: Even if that was the case, it was still Noddle stepping back and saying, perhaps, "OK, I can handle the distribution side, but Kmart isn't executing at retail." That's been a chronic problem for Kmart -- getting consumables on the shelf consistently.
SUPERVALU
SN: What's on the horizon for Supervalu?
CERANKOSKY: In terms of its retail segment, I think Supervalu made some re-merchandising decisions and stronger pricing to take out some costs, though it still needs to show positive retail comps. But the bulk of Supervalu's sales still comes from the distribution side, and it has excellent logistics, with a lot of opportunities to expand its distribution role, though up till now that hasn't been enough to offset the attrition among the smaller chains and independents that typically use wholesalers. That's a big challenge because that attrition rate has picked up, and the likelihood of considerable consolidation in the retail food industry makes the need to find additional logistics markets all the more necessary for Supervalu. Where it has a geographic need for distribution space, I think it wants to just broaden what its existing physical plants can handle.
ZIEGLER: I get the impression that Supervalu and Fleming are taking different approaches to the business. Whereas Fleming seems to be going after distribution and not paying a lot of attention to retail, Supervalu seems to be paying more attention to developing its retail business. It's taken a scaled-back distribution business and tried to rationalize it and then start to grow it again off a smaller base because after all, it did lose Kmart. Supervalu has quite a lot of excitement in the Sav-A-Lot concept, which isn't all that dissimilar from Aldi, and it sees a huge potential in terms of licensing the concept to some of its distribution customers who are suffering the loss of price-sensitive consumers. So if Wal-Mart comes to town, Supervalu customers who operate three or four stores and stand to lose those price-sensitive consumers can license the Sav-A-Lot format. And that also serves as a way of rationalizing the business.
CERANKOSKY: Sav-a-Lot identifies a certain market segment, it has its own self-contained distribution and the whole thing is non-union, which really supports the low-cost operation it has achieved.
A NEED TO DEVELOP ALTERNATIVE SERVICES?
SN: Do supermarkets need to invest more in capital spending, or do they need to develop other products and services to protect their sales base?
ZIEGLER: The big companies can afford to do more capital investments based on their cash throw-off, but they simply aren't getting the return on capital because there's too much supply. That's the problem. You can buy Crest toothpaste at probably a dozen places within a short walk of your house, so there's too much supply of consumer product and too much supply of retail space to buy it, and there needs to be a rationalization of the space.
BERNSTEIN: I think an issue we've been missing -- maybe the greatest single issue -- is that all the consumer goods companies seem willing to sell any type of consumable to anybody who will retail it, and a lot of sales are being lost to supercenters or to really good regional competitors, and there is also a huge amount of sales leakage to everybody from the corner gas station to Home Depot to drug stores to retailers that are not traditional sellers of food and other consumables. And I think that's taking
a bigger bite out of supermarket retail growth and profitability than any other single factor we've discussed thus far. So the problem is, the oversupply of supermarket retail space isn't just an oversupply of supermarket retail space -- it's an oversupply of retail space committed to selling consumable items that supermarkets have traditionally sold.
CURRIE: But as supermarket space is rationalized and these other channels continue to grow, the problem may be that the manufacturers allocate more and more money to the alternative channels because that's where the growth is.
GIBLEN: So the answer for supermarkets is to invade the other channels of retail and sell gas, for instance.
ZIEGLER: Or open more pharmacies.
CARTWRIGHT: What they need to do is capitalize on changing consumer behavior. People have less time. They're stopping to do errands at odd points of the day. They need to get in and out quickly, and the supermarket just doesn't provide that convenience.
SN: We've already seen supermarkets starting to go after the products and services being offered in other formats, maybe not as aggressively as they should be, but they have made a start.
ZIEGLER: And that adds a new element of risk to their business. If they think about putting fuel centers in, for example, that's a nice shot in the arm for your same-store sales because they run pretty significant volumes. But I don't know that gasoline trades at a gross margin that supermarkets are used to, and the margin can be volatile. However, operating cost is fairly low. But we're going to go into a very unpredictable earnings stream anyway starting with the third quarter, because once everybody has to start reporting honest earnings, I don't think we're going to necessarily see a steady increase in earnings year-over-year, quarter-over-quarter. We're going to see a lot more volatility, and gas will play into that. And if you go into pharmacy, it's a really nice business because there's nice inflation and good demographics, but how do you make money in pharmacy unless you're Walgreen?
SN: What about in-store banking?
CURRIE: I think banking's all about whether you trust the brand, and I don't think that supermarket brands are developed nearly enough to establish large banking products under their own names that people will accept. Safeway probably more than anybody is moving in the direction of having a trusted brand.
ZIEGLER: That brings up an interesting issue. Why do you think some of the great financial innovations in the grocery space are in the U.K. and maybe in eastern Canada?
CURRIE: I think it's a totally different approach. If you look at supermarket retailing in those countries, it has become very demand-pull. I think retailers in the U.K., particularly Tesco, decided that if customers want cheap prices, they would give it to them rather than allow Aldi to get any part of their market share. And if customers want better quality and better service, they'd give them that as well. But it cost Tesco a lot of money to do that -- its gross margin fell by 200 to 300 basis points. Tesco made it up by increasing comp sales by about 7% to 8%. But supermarket retailing in this country is more about supply-push. It's about trying to get as many products onto the shelves as possible and trying to get as much money out of your suppliers to push margins up.
ZIEGLER: But Tesco really built a brand, didn't it?
CURRIE: It did. Well, first Marks & Spencer, then Sainsbury and then Tesco built their brands. Gasoline was part of the first non-core service where they saw great success. But that was all part of the whole approach to giving consumers an added advantage by using its own brands. And they mostly did it through price in the non-core areas. Once you build up such a strong level of brand trust, you can use your stores to sell anything -- insurance products, banking products, cars, clothes -- you name it, and they're selling it. People trust Wal-Mart to deliver value -- that's why they have come so far so fast so soon in groceries.
CERANKOSKY: If we have to depend on banking for our industry to get sales up, then we better find another industry to cover. It's just an uninteresting segment. It's not merchandising. Most of it is leased. I just think they've got to be involved in products, not services like banking.
BUSINESS-TO-CONSUMER MARKETING
SN: Two years ago, we would have been very interested in talking about B2B and B2C marketing, yet there's been no mention of either topic today
CERANKOSKY: The lack of discussion speaks for itself. Regarding business-to-consumer marketing, we need only look at the example of Webvan, which sought to supply 13 stores out of a massive facility, whereas a Kroger facility of that nature required 400 to 500 stores to be efficient, so it was a ludicrous undertaking from day one.
SN: Is there anyone in the industry doing something with B2C that might pay off in the near term?
ZIEGLER: Albertsons is happy with its B2C business in Southern California. An Albertsons store director whose store happens to be the distribution point for the chain's B2C operation in Orange County said his comps are up double digits because of the addition of that business with its store-pick model, and he said Albertsons regards it as just another service it offers to customers who want it.
CURRIE: I think that's the right answer. It's a service to customers rather than a money-making scheme per se.
BUSINESS-TO-BUSINESS MARKETING
SN: Is B2B closer to yielding the kind of returns that will make anyone happy?
CERANKOSKY: It's real, but everybody has to do it to keep their costs in line.
SN: Are the roadblocks, including lack of standardization, too high at the moment, or is it something that will ultimately help companies on their bottom lines? CURRIE: I think the auction system works well, but that seems to be about it.
ZIEGLER: I think technology is a major factor in this space that we shouldn't ignore, and B2B is one of the technologies that's available. We keep talking about giving gross margin away to bring prices down, but the cost structure still needs to come down as well, and technology, which is also in a deflationary spiral, makes it more affordable.
