The industry could be in for a new round of consolidation activity next year in which some major national chains go after some of the larger regional operators, according to participants in SN's 16th annual Analysts Roundtable.
“Like sharks that die if they stop moving forward, these chains are going to grab growth one way or another,” Gary Giblen, managing director of Aegis Capital, New York, said. “[Kroger and Safeway] will justify acquired growth with the rationale of transforming the industry and their company and righting the downward direction.”
The catalyst for consolidation, Giblen said, could be a renewal of price war activity resulting from the difficult consumer environment and the industry's need to resolve volume problems.
That catalyst could actually occur, Andrew Wolf, managing director for BB&T Capital Markets, Richmond, Va., noted. “I think the industry will continue to muddle along with results that are kind of flattish, and inflation will matter a lot. In that scenario, rapid hyper-inflation could put consumers back in play,” he said.
Meredith Adler, managing director for Barclays Capital, New York, offered a similar outlook. “There's a real risk of increased competitive activity that won't be good for profitability,” she said.
John Heinbockel, managing director for Guggenheim Partners, New York, also said he's worried about the operating environment in the first half of 2012, which he said could be weaker than it is today.
It's that possibility that raises the specter of a new round of merger activity, Giblen said. “There is an argument to be made that you are going to see more merger-and-acquisition activity from Safeway and Kroger just to get growth to overcome the macro challenges. Major price wars [could] create a tinderbox, where all it takes is a little bit of flame to light the conflagration, and that will lead to significant M&A activity.”
Wolf said he believes Kroger “is much more receptive on that front.”
Mark Wiltamuth, executive director for Morgan Stanley, New York, said the last round of major industry mergers left investors will little patience for acquisitions in the grocery space. “If you look back to the 1990's, it's just littered with value-destroying deals, accretion that was promised but never delivered and big acquisition premiums paid,” he noted.
Chuck Cerankosky, managing director for Northcoast Research, Cleveland, said he sees a different series of developments — some de-consolidation among the larger companies, “which will result in the formation of some new super regionals.”
Scott Mushkin, managing director for Jefferies & Co., New York, said the outlook for food stocks is not good. “At this juncture I would say bet on the winners — bet on Kroger, bet on Whole Foods, bet on special situations like Winn-Dixie, but stay the heck away from everything else.”
Touching on other topic during their discussions, the analysts made these comments:
On Whole Foods Market, Austin, Texas: “Whole Foods can sustain its momentum because it had a very differentiated store base going into the [economic] downturn,” Cerankosky said. “Now it's getting a higher return on investment, being more cost-conscious and opening somewhat smaller boxes, so it still has a lot of sales momentum ahead of it.”
On Winn-Dixie, Jacksonville, Fla.: “It has to take a very tarnished brand name and polish it, and it's going to be a long, slow slog,” Adler pointed out. “But management is very excited about some of the transformational remodels the company is doing. Now that it has remodeled half its store base, the question is, how easy is it to take an already remodeled store and give it the panache you've got in the transformational stores?”
On Fresh & Easy Neighborhood Market: “Tesco was overly ambitious — it tried to do too many things at once,” Wiltamuth said. “The general idea was to offer something that was fresh and easy, and it didn't really live up to its name.”
The first part of the roundtable ran in the Sept. 12 issue of SN. Part two of the discussion follows, beginning with the analysts' predictions for the year ahead:
MARK WILTAMUTH: I would say food inflation will get worse in the second half and volumes will decline for the Big Three. Kroger might escape it, but at Safeway and Supervalu, I think you are definitely going to see some ongoing volume problems.
JOHN HEINBOCKEL: My prediction is, competition will stay rational until early 2012 and then the consumer will weaken — and I think the operating environment will be tougher in the first half of 2012. I'm more worried about 2012 than this year.
MEREDITH ADLER: Either the market stays rational or it doesn't. Maybe nothing changes until 2012. But I think there's a real risk of increased competitive activity that won't be good for profitability.
ANDREW WOLF: Like the economy, I think supermarkets are in a period of stagflation, so if inflation gets to a cumulative 10%, that would change behavior negatively; and if inflation doesn't somehow settle down, then consumers could be in play. At this point I don't see the kind of massive channel shift you often see in a deep recession. When we were in the recent recession, it caused everybody — even the Whole Foods shopper — to go on strike.
So my prediction is that we are not going to enter into a deep recession in the back half of this year and probably not even in 2012, although we have an increased risk of it, and I think the industry will continue to muddle along with results that are kind of flattish, and inflation will matter a lot. In that scenario, moderate inflation would be okay, but rapid hyper-inflation would be tough, and that could put consumers back in play.
SCOTT MUSHKIN: I think the problem right now is employment, employment, employment and what's going on with the macro economy. The fact is, this industry is under an enormous amount of stress, and it appears to be getting worse, and that's the problem.
But the retailers are running their businesses better, and that combination makes the crystal ball extraordinarily cloudy.
WILTAMUTH: That doesn't sound good for stocks.
MUSHKIN: I agree, it doesn't sound good for stocks. So at this juncture I would say, bet on the winners — bet on Kroger, bet on Whole Foods, bet on special situations like Winn-Dixie, but stay the heck away from everything else.
ADLER: Or just avoid supermarkets altogether.
MUSHKIN: Right. Stay with the winners and say prayers for the losers, even though they are trying to run their businesses better.
CHUCK CERANKOSKY: My prediction is, industry consolidation over the next couple of years is going to include some de-consolidation among some of the bigger players, which will result in the formation of some new super-regionals.
GARY GIBLEN: Actually I think there is an argument to be made that you are going to see more merger-and-acquisition activity from Safeway and Kroger just to get growth to overcome the macro challenges.
The way I see it, major price wars will manifest themselves by the first half of 2012 — because of all these factors that create a tinderbox, where all it takes is a little bit of flame to light the conflagration, and that will lead to significant M&A activity by Kroger and Safeway. It may not be logical or add value in a business school net-present-value sense, but it is going to happen anyway. Like sharks that die if they stop moving forward, these chains are going to grab growth one way or another. They will justify acquired growth with the rationale of transforming the industry and their company and righting the downward direction. A multiple of problematic risk/reward actions get taken in corporate America in the name of “transformational transactions.” I'm not saying it's the rational thing for Safeway to do, but I think the realpolitik is, Safeway has to do it.
WOLF: Don't you think those ideas are a little at odds with each other — the industry blowing up in a price war at the same time companies want to do deals? Not a great idea.
GIBLEN: I think the valuations of the target companies would be lower too, so the actions would be justified.
WOLF: And what would happen after the dust settles?
GIBLEN: If price wars begin and pressures increase, the theory is that the industry should consolidate further, and while we don't have the best currency now, we do have debt capacity, low interest rates and two-way synergies and learnings, so now is the time to proactively change the course of the industry. There are only a few great private supermarket companies out there, so there will be a “gold rush” for the Publix, H-E-Bs and Wegmans of the world.
WOLF: After spending time with Kroger recently, I got the feeling it is much more receptive on that front.
HEINBOCKEL: Safeway's track record on acquisitions isn't great. At this point it wants to hoard cash or at least generate cash. I think it's a fair point that when you see which companies out there you might want to own, there are fewer of them than you would have seen five or 10 years ago.
GIBLEN: I don't think Safeway would be interested in buying a turnaround company, because it has failed to turn around those kinds of companies.
ADLER: It has destroyed some good companies.
GIBLEN: But if it could manage it financially if it could accept dilution for a couple of years and look at it as a transformative acquisition — saying, we're not in the Southeast — boom, we're going with Publix, and we're going to have two-way learnings.
WILTAMUTH: I don't think investors have any patience for acquisitions in the grocery space. If you look back to the 1990s, it's just littered with value-destroying deals, accretion that was promised but never delivered, and big acquisition premiums paid.
WOLF: You are probably right because the industry is not well-regarded, but I think Kroger could pull it off.
GIBLEN: You could justify a year of dilution, and maybe more, if you said a particular acquisition would change the course of U.S. food retailing history and be transformative for Safeway, Kroger or whoever the acquirer is.
SN: Can Whole Foods maintain its forward momentum?
WOLF: Whole Foods doesn't have a national competitor. It acquired all its competition — Bread & Circus, Fresh Fields, Mrs. Gooch's, Wild Oats. It was brilliant, and Whole Foods learned from each one.
There are some potential competitors in the Pacific Northwest and other Western regions, but there is nobody nationally to threaten Whole Foods right now. Two years ago you could have said perhaps Trader Joe's was enough of a threat in dry grocery. But Whole Foods has chosen to selectively match Trader Joe's on price in categories where Trader Joe's has maybe two items and Whole Foods has 10. It will match them on the two that Trader Joe's carries but be at a higher market price on the other eight that Trader Joe's doesn't stock, thereby taking away some of Trader Joe's value advantage through category management.
Whole Foods has been an acquisition story more than a new-store growth story. Over the last five years it's grown the store base by an average of 25 units a year, but it bought Wild Oats in the middle so it has actually averaged out to 13 stores a year through acquisition and 12 net new stores. Its peak years were last year and five years ago, when it opened approximately 16 net stores. But I think the next phase will all be new-store growth.
WILTAMUTH: I think the key for Whole Foods is that it learns from its mistakes. During the downturns, it backed off its indulgent capital spending; the box size has come down; it's gotten out of some of its more aggressive larger leases; and it's really started to focus on cost control. This is a company that for years thought that if you focused on cost control you'd kill the golden goose. Now it seems to be willing to work on margins and sales. It is not just a sales story any more — that's the beauty of it. There is nothing to complain about on its fundamentals. Whole Foods is back, and it is riding the upper-income consumer recovery. It's fixed its price image.
ADLER: Whole Foods talks all the time about how its own initiatives have helped it recover. Perhaps it's simply that the high-end consumer has recovered. So how much of it do you think is really due to steps the company has taken?
WOLF: I think Whole Foods is a very successful, aggressive company that is really doing much better. Just compare it with Wild Oats. Wild Oats couldn't comp, whereas Whole Foods has doubled the sales per square foot Wild Oats was doing. And that should tell you enough. Just think about those two companies — one was crummy and one is excellent. I think Whole Foods is one of the best companies in America. One thing about [co-CEO] John Mackey — he can be a little erratic and people always focus on the negatives, but this guy is about as competitively tough as they come, and the company is therefore very adaptive.
CERANKOSKY: I believe Whole Foods can sustain its momentum because it had a very differentiated store base going into the downturn. It's made a few mistakes, and it's learned from them — for example, in the area of capital allocation. Now it's getting a higher return on investment, being more cost-conscious and opening somewhat smaller boxes that are highly differentiated, so it still has a lot of sales momentum ahead of it, and I think it can keep it going. It doesn't look like anybody is as differentiated. You hear about Safeway's lifestyle stores being differentiated, but no one is as differentiated as Whole Foods.
ADLER: I do think Whole Foods stuck with premium for too long without having a mid-level price point.
WOLF: John Mackey recently suggested the chain could go too far with cost containment. For example, the chain's approach to perishables shrink — it realized it should be using more refrigeration for items like grapes. That's brilliant — keep it fresh. But for other types of perishables, do you keep something overnight that you might have thrown out before? Maybe the grocery store down the street keeps it two nights. That's where it gets tricky. So there is a limit to how much margin you are going to get out of more efficient operations in areas like shrink control.
But what do you think of its growth plans? Is it going to be able to double the number of stores it opens? Execute it and really be a growth story?
GIBLEN: The exciting thing is, it is embracing a smaller store concept.
WOLF: … because right now it is a 5% square-footage-growth company.
HEINBOCKEL: I don't think it is going to be a 15% or 20% store-growth company. I don't know about reaching 1,000 stores either, which is what it's talking about. Our saturation analysis, which focuses on households with annual incomes of $75,000 and above, would suggest only 700 to 750 stores. To get to 1,000 would mean Whole Foods would have to appeal to a broader customer base, which is possible, given its smaller boxes and lower prices, but it's certainly not a slam dunk.
WOLF: How many do you think it can do a year?
HEINBOCKEL: It can do as many as it wants to do because there are few real bottlenecks. There's probably no bottleneck in capital because it is building smaller stores, nor is the bottleneck in real estate. The bottleneck will be people and building stores the right way. At the end of the day, it will be opening no more than 30 or 35 stores a year three or four years down the road, and if it is smart, it will limit it to that and still grow at 8% or 9%, and that is fine. That is not super-charged growth, but it's good enough to grow the top line at 12% to 14%.
MUSHKIN: We're dealing with a very bifurcated economy where the upper 25% doesn't want to shop at the same places as the bottom 75%. The top 25% seems to want to completely segregate itself from the rest of America. That goes for food-away-from-home and food-at-home. That's the Whole Foods customer.
If you look at all the companies — Fresh Direct, Fresh Market, Earth Fare in the Southeast, Sprouts on the West Coast — this upper-end income area is a huge growth opportunity because if you look at how much money these people are spending on food-at-home, they have a fairly sizable runway to spend more for food if they choose to allocate their discretionary dollars in that direction instead of for Gucci bags. They have discretionary dollars. So the growth opportunity is there for Whole Foods in spades. There is no one else doing it like Whole Foods does because it's not just about high-end. It's also a lifestyle choice. People we call “YEMmies” — young, educated mothers — want to shop Whole Foods because the company stands for what they want to stand for — things like humane treatment of animals, local sourcing. It is really a belief system. So we feel the growth opportunities are there.
Will Whole Foods be able to execute? Having Walter Robb as co-CEO is clearly improving execution. One thing about John Mackey, though, is that he learns his lessons really well. He doesn't like to admit a mistake, but once he's admitted it, he becomes almost like an evangelist. Given that, it's hard to imagine the company will repeat the mistakes it made with new-store development in 2007 and 2008.
ADLER: Based on what Mackey said, I don't think Whole Foods is going to grow at a rate of 10% or higher, though to get to 1,000 stores, you do have to believe it can find a way to appeal to more people in places like Omaha. Whole Foods has already put one store there, but it said it put it in the wrong location. But can it find a way to add another two or three stores in second-tier markets like Omaha? Maybe it will have to go to third-tier markets.
WILTAMUTH: Let's not forget it has one toe in London.
WOLF: Many years ago I was able to see a schedule of Whole Foods' sales per week by store, so I did some demographic studies to figure out how sales varied by customers' income and education levels, and it turns out there was no correlation — perhaps because people drive long distances to shop its stores. That sits very well for its saturation because stores in a lot of different places still attracted plenty of business. What's going to be interesting is when it starts putting second stores in Omaha or Richmond or wherever.
HEINBOCKEL: It may accept a lesser return, but does it allow the return-on-investment to go down materially while growth is accelerating? It shouldn't do that.
MUSHKIN: It may depend on the values and lifestyles of the residents in each area. A Fresh Market in Omaha may prove better than a Whole Foods there because the natural and organic lifestyle may not be as important. I was recently down in Naples, Fla., comparing the Fresh Market to the Whole Foods. It's not a really great Whole Foods, but it did seem that the general population has not fully embraced the Whole Foods “lifestyle” — at least not yet.
WILTAMUTH: Whole Foods may be the only brand among all the companies we follow that really is a brand, and it is really a draw for people. People go there, and they like to be affiliated with it. I don't think people have that feeling about a Safeway or Albertsons.
SN: What's the outlook for Winn-Dixie?
MUSHKIN: Winn-Dixie's problems are still significant, given its sales per square foot and regional market share. But having cycled through the oil spill last year and with a new guy running the stores — Larry Appel — who is making good progress, it still seems like its market-share growth has settled down in a lot of areas.
ADLER: The Florida economy is one of the few that is really starting to improve, especially because of tourism.
MUSHKIN: We looked at all the employment markets in Florida, and we were surprised. We thought Winn-Dixie was getting more of a push from the economy and from improvements along the Gulf Coast, but it isn't as much as we would have thought. So we'll see if it can last. But Winn-Dixie still has some big problems that it will take awhile to resolve.
ADLER: It has to take a very tarnished brand name and polish it, and it's going to be a long, slow slog. But management there is very excited about some of the transformational remodels the company is doing. So far it has at least three to point to that are doing well, though two are actually new stores rather than remodels.
Winn-Dixie is a company with no debt that's sitting on cash, so it's got borrowing capacity. But the transformational remodels it is doing now are expensive. That means every time it does one, it is placing a much bigger bet than it would have otherwise. Management believes these stores are going to be very important sales drivers. I've wondered whether there is a halo effect — whether successful remodels at six out of 12 stores in a market will help its image more broadly — but that's still to be proven. You have to give it credit, though, for absolutely remarkable management of cash flow.
Now that it has remodeled half its store base, the question is, how easy is it to take an already remodeled store and give it the panache you've got in the transformational stores? I don't have any answers to that question, and I don't think Winn-Dixie does either.
CERANKOSKY: The intriguing think about Winn-Dixie, I think, is you've got a very good management team. But the company needs both price investment and capital investment, so it really puts a premium on the economy getting better in Florida.
ADLER: Besides significant price investments, what do you think it needs to do?
CERANKOSKY: I think it needs to get customer volumes up. Looking at sales per store, it's got to do more than remodel because it has already remodeled quite a few stores.
ADLER: It's not about remodeling for Winn-Dixie — it's about customer service, perishables, cleanliness. Price is certainly a piece of it, but I think it is trying very hard to be known for something besides price. I don't think price is what holds it back — I think it is reputation.
CERANKOSKY: Its reputation is hurt from some very high prices in the past. Look at the history of management there, which raised prices to improve comps, which resulted in a negative spiral.
SN: Let's talk about Fresh & Easy. It contends its timing was bad, given that it entered the U.S. just as the recession began.
MUSHKIN: I actually object to the timing issue as an excuse. Coming into a bad economy with a discount concept, it should have been a great time. After all, dollar stores have been doing really well.
CERANKOSKY: The amazing thing about Fresh & Easy is, at that level of sales, it should be making some money by now.
GIBLEN: It sure isn't.
ADLER: Fresh & Easy has this enormous infrastructure, though — it built this commissary and distribution center.
CERANKOSKY: Fresh & Easy built it, and the customer didn't show up.
GIBLEN: It's literally a case study at Harvard Business School on how not to enter a new market. Tesco has rectified some of the strategic errors, but some of them are not easily correctible, like store locations on the wrong side of the traffic patterns — where people are driving to work on the side of the street where the store is located, instead of on the side where they're driving back home from work.
WILTAMUTH: I think it's invested so much capital in infrastructure, it will have to keep tweaking it. I don't think Fresh & Easy will exit.
ADLER: It is still opening stores.
GIBLEN: It is going to keep on coming, but I don't think it is ever going to be very successful. At this point it was supposed to be profitable, yet it lost $300 million in its last fiscal year.
WILTAMUTH: I think Tesco was overly ambitious — it tried to do too many things at once. It was trying to train the customer into private label shopping by offering 50% private label and 50% brands, and the feedback from consumers was there were not enough brands. It also tried to train the customer into everyday low prices, and the customer said he wanted more high-low and more drama. The stores themselves are very Spartan, with concrete floors — uninspiring. They don't make you feel like you want to cook a dinner you bought there. And it was doing things like pre-selecting your vegetables for you, so you could only pick the three apples in a particular bag.
ADLER: Does that matter, though?
WILTAMUTH: Well, it's just too many things layered on top of each other. I think the general idea was to offer something that was fresh and easy, and it didn't really live up to its name.
ADLER: I think the product assortment, at least in the very beginning, was totally out of whack with what the stores looked like. The product assortment was actually oriented toward upper-middle-class customers, and the stores looked very downscale. I don't know that Fresh & Easy made a mistake with the offering — I think that's what it wanted — but I don't think it understood that in the United States anything that plain vanilla isn't going to appeal to an upscale shopper.
WILTAMUTH: I thought some of the products — like the prepared dinners that are ready to take home and cook — looked great. But there were too many misses on a lot of the other big things.
SN: Do you think Tesco could try opening bigger stores?
HEINBOCKEL: I think that would compound the problem.
WILTAMUTH: I think it will stay with smaller stores.
GIBLEN: It will keep on building the smaller stores and will maintain an active pipeline — it is “swinging open doors” as we speak. It's also been selectively closing stores in Arizona and Nevada, where the store base has really suffered from the economy and bad locations. But Tesco is committed to these stores, for better or worse. I think it's a pet project of the former CEO [Terry Leahy], who is no longer there in good part because Fresh & Easy proved rotten and hard, though he still plays a major role at Tesco.
WILTAMUTH: I think the interesting thing is that the conventionals going head-to-head with Fresh & Easy say they have not felt the impact of those openings at all. That really tells the story. If you talk to Kroger and the other conventional operators in the Phoenix market, for example, they say they simply match Fresh & Easy on price on a couple of items where they need to match them — and that effectively neutralizes the threat.
MUSHKIN: But the bigger problem is, while they say they haven't felt the openings, if a Fresh & Easy store is doing $100,000 a week, that volume is not coming from the sky — it is pulling that $100,000 in from someone, someplace. And California is ground zero. Now Tesco is going into Northern California, and each store represents $100,000 or $150,000 out of someone's hide.
WILTAMUTH: That's one of our concerns about Safeway, which will be going up against new competition from Tesco's Fresh & Easy, Target's P-fresh and dollar stores.
MUSHKIN: You also have Fresh Market there …
ADLER: … And Grocery Outlet is going to continue to expand.
WOLF: if you think about it, what Tesco was offering was a new product, and it didn't beta-test it. It went out and did focus groups — Tesco executives lived with American families, and they did all this brilliant research, and they put all this money in. If you cover any new-product companies, as I do, you know there are all kinds of reasons consumer research just doesn't pan out in the marketplace. Tesco made a huge, multi-billion-dollar bet without a beta test! You really have to wonder about its corporate governance or lack thereof.
ADLER: Except that it's been chump change for them. But when Tesco announced it was coming here, I said its only competitive advantage was a willingness to lose a lot of money — and that has turned out to be true. People were so terrified of what Tesco was going to do here.
WOLF: It is a great concept, but it doesn't resonate with anybody.