ALTERNATIVE ENERGY

ELLIOT ZWIEBACH

NEW YORK - Wild Oats should become more like Whole Foods to survive, while Whole Foods should be concerned about competition from Wegmans and Safeway's lifestyle stores, according to industry analysts who participated in SN's 11th annual Financial Analysts' Roundtable here.

They also differed on the viability of Tesco's pending entry into the U.S. marketplace and suggested that only a handful of regional operators pose a serious threat to the major chains.

SN published Part One of the roundtable discussion in the Sept. 4 issue. One of the topics of conversation in Part Two is the viability of Wild Oats Markets, Boulder, Colo., in competition with Whole Foods Market, Austin, Texas.

Several analysts said they believe Wild Oats can go toe-to-toe with Whole Foods if it's willing to take more chances. "Wild Oats needs to build bigger stores in more urban markets and to focus on the Oats brand and de-emphasize the [smaller] Henry's format," John Heinbockel, vice president of Goldman Sachs here, pointed out. An acquisition of some Albertsons stores could help Wild Oats accelerate that process, he added.

Andrew Wolf, managing director of BB&T Capital Markets, Richmond, Va., offered a similar assessment. "There is a place for Wild Oats if it can execute a bigger box," he said. "The worst thing is to have a kind of look-alike concept [to Whole Foods] that's smaller because even if you're a little more convenient, you're losing on the other attributes.

"[Wild Oats has] got to step up to the plate, build a big store and see what happens because what it's doing now is just running a defensive strategy of going into small markets, [and] eventually Whole Foods is following [them] there too."

Mark Wiltamuth, executive director of Morgan Stanley here, said Wild Oats has "missed the boat by not capturing the mainstream customer - that's where Whole Foods has really excelled."

Meredith Adler, managing director of Lehman Bros. here, said Safeway's lifestyle stores are affecting Whole Foods' sales in some affluent areas. "People are splitting their shopping trips [because] now that they can get more high-quality perishables at Safeway, they've realized it's not just a remodeling there, [and] Whole Foods is losing something like half a trip a week."

Wolf said Wild Oats could be hurt by Safeway's lifestyle stores because they are larger and more differentiated.

For Heinbockel, nothing conventional operators can do in perishables can come close to what Whole Foods does. "There's no question traditional supermarkets have made enormous strides in fresh foods merchandising over the past few years. But then you go to a Whole Foods - and it doesn't even have to be a new one - and you quickly realize this journey is nowhere near over," he explained. "Whole Foods is still, by far, the best in class."

The only conventional retailer that could challenge Whole Foods, Heinbockel said, is Wegmans Food Markets. "You would have a pretty even battle if you put Wegmans and Whole Foods side by side," he pointed out.

As the conversation turned to Tesco, the United Kingdom-based retail giant that plans to enter the Western U.S. next year with a chain of fresh-oriented convenience stores, Adler expressed skepticism about why Tesco thinks that format will work.

"Nobody other than Boston Chicken has really tried to do a dinner-tonight type of business in a big way," she said, "[so] you have to ask the question - because there does seem to be an empty niche that Tesco is going after - why nobody in the U.S. has gone after that niche? While I'm not betting against Tesco, you have to wonder if maybe there's a reason nobody else has tried this."

Heinbockel said Tesco is likely to have to overcome several challenges to make its concept work, including establishing an efficient supply chain and achieving significant store density and an effective commissary. "On the other hand, simultaneously achieving competitive pricing and respectable margins should be less of a challenge, at least in California, where food retailing is dominated by unionized supermarkets with relatively high price structures," he pointed out.

Part Two of SN's 11th annual Financial Analysts' Roundtable follows.

Whole Foods/Wild Oats

SN: Can Whole Foods and Wild Oats co-exist? And how do they stack up against the natural food offerings at conventional chains?

JOHN HEINBOCKEL: I think the real question is, does Wild Oats have to stand apart from Whole Foods? No. For the past five years, Wild Oats has been playing not to lose, trying to get its break-even levels as low as possible in order to minimize the impact of real estate mistakes. So you build a smaller store on a less expensive piece of land - you won't lose big if the store doesn't work but you won't really win either. Wild Oats has to play to win, which means being a lot more like Whole Foods.

Is the market big enough for both of them to do well? Sure. We have argued for a long time that Wild Oats needs to build bigger stores in more urban markets and to focus on the Oats brand and de-emphasize the Henry's format. And very slowly, the company is moving in that direction -Yucaipa has had a little something to do with that.

Will the company move more quickly in that direction? We'll see. Perhaps the possible acquisition of some Albertsons stores will accelerate the process. Without question, however, if the long-term growth opportunity is to be seized, the business model will have to continue to change. Yucaipa will be supportive and content to let this opportunity play out over time. As a result, I'm more encouraged than I was 18 months ago, though Wild Oats still has a lot of work in front of it.

ANDREW WOLF: For an industry like the natural foods business, with so much growth potential, it is interesting that we've seen quite a number of flops among retailers, distributors and producers. Almost without exception, the folks that have succeeded are the ones who are really dedicated to the industry. But when you get folks from outside the industry, particularly, let's say, from conventional grocery, they have not succeeded for two reasons. First, I think, is they're arrogant. They figure these natural food guys are a bunch of ex-hippies and they can just sort of show them how food retailing is really done, whereas it turns out the so-called hippie guys are as tough as nails and they really know what they're doing because they essentially created the industry. So the conventional players have completely missed the boat on who they're competing with. Second, it's the customers who decide the winners and losers, obviously. You need to know this stuff intimately, from procurement through merchandising. Natural and organic products are very differentiated from conventional, and the micro-economics of moving products is similar, but the merchandising and supplier relationships are very different.

As for Wild Oats, it has a couple of stores I've visited that are making some steps in the right direction. The one I've seen most recently is in Superior, Colo., and it's a better box than we've seen out of these guys yet. So it's getting there, and there is a place for Wild Oats if it can execute a bigger box. The worst thing is to have a kind of look-alike concept that's smaller because even if you're a little more convenient, you're losing on the other attributes, particularly assortment. Meanwhile, Wild Oats is competing with Whole Foods, which is a very special company.

On the stock-price side, Wild Oats benefits from the fact that Whole Foods is this incredible company with a good valuation and Wild Oats gets to be associated with it, even though in reality it's not anywhere near Whole Foods. But in the real world - the competitive world - Wild Oats keeps getting pushed to the side where the two companies meet head-on. Wild Oats often relocates a store because it knows a Whole Foods store is opening up nearby. It's got to step up to the plate, build a big store and see what happens because what it's doing now, at best, is just running a defensive strategy of going into small markets, but eventually Whole Foods is following there too.

MARK WILTAMUTH: I think where Wild Oats has failed in the past is in not executing well. Just being in the organic and natural category is not enough for success. You really have to execute on an outstanding level in the perishables area, and I don't think it's done that, and I also think it's missed the boat by not capturing the mainstream customer, and I think going to larger stores is a step in that direction. That's where Whole Foods has really excelled. Not only is it catching the organic devotee, but it's also getting the mainstream customer that just wants high-quality food.

SN: I guess from your answer that you don't feel the emphasis on the fresh boxes from Safeway and A&P and others are going to help them compete much with Whole Foods.

WILTAMUTH: I don't think the organic offerings from the conventional grocers are really going to pressure Whole Foods or Wild Oats. While the whole category is growing by leaps and bounds - with natural foods in general probably growing 7% to 10% and organic vegetables in the 20% area - that's a big wave, and I don't think the efforts by Kroger and Safeway are really going to have any impact on Whole Foods.

WOLF: I have a slightly different take, and it comes from [Whole Foods Chairman] John Mackey. He said the reason Whole Foods is building big stores is to continue to push the differentiation. Because look what Safeway is doing now. It is indexed pretty well in various parts of the store in terms of organics, and so are companies like Kroger and Harris Teeter and others. All of them are moving that way. So if you're a small natural food store, there goes your differentiation.

Strategically, Whole Foods is getting bigger and keeping its assortment differentiated while demand for those products is going to grow and the pie is expanding. I think Wild Oats will suffer because a lot of its stores overlap with Safeway so it is much more vulnerable, and even more so because its stores are less differentiated from Safeway's lifestyle stores due to their small size.

HEINBOCKEL: If you take a Safeway lifestyle store or A&P's Fresh format, there's no question traditional supermarkets have made enormous strides in fresh foods merchandising over the past few years. But then you go to a Whole Foods - and it doesn't even have to be a new one - and you quickly realize this journey is nowhere near over. Whole Foods is still, by far, best in class.

There are, however, some operators that can give Whole Foods a real run for their money. For example, you would have a pretty even battle if you put Weg-mans and Whole Foods side by side. Right now we don't see a lot of this - only at one location, in Princeton [N.J.] - but we will probably see more. If I were Whole Foods, Wegmans is the competitor I would be most concerned about because it operates terrific, large stores, has an array of expertly merchandised fresh departments and possesses a lower pricing structure.

MEREDITH ADLER: I've heard Safeway's lifestyle stores take some share from Whole Foods in affluent markets because of the convenience - people were splitting their shopping trips, but now that they can get more high-quality perishables at Safeway, they've realized it's not just a remodeling there but an upgrading of the perishables, so instead of going to one or the other, they'll still go to Whole Foods if they're having a dinner party or some special occasion and go to Safeway at other times. As a result, Whole Foods is losing something like half a trip a week. Some of that is driven by the economics because you really can't do what Safeway's doing and go upscale with the quality of your offering if the demographics in the local market are very mixed.

In fact, Kroger has mentioned that it's hard to have a really upscale store in a lot of its markets because the trade area draws from lower-middle income and upper income, and if you go too far up-market in a store, you lose that lower-middle income customer. So you really can't even try to be the Whole Foods for the neighborhood without alienating a third or so of your customers. It's just going to be very company-specific.

Alternative Formats

SN: With Tesco planning to launch a fresh food convenience chain called Fresh & Easy in the Western U.S. sometime next year, how do you rate its prospects?

WILTAMUTH: We've heard the Tesco stores will be in a 15,000-square-foot box, which kind of puts it in drug store size. And with that size of a box, you're probably looking at convenience-oriented foods rather than a full assortment. So I think all of us in the industry are kind of waiting to see what Tesco is going to do. The company hasn't been open with its plans, so we're waiting to see what the box is going to look like and how Tesco is going to position it.

WOLF: Well, Whole Foods' first store in Austin was only 10,000 square feet.

SN: It sounds like an experiment.

ADLER: Tesco is signing up for a lot of real estate, starting in Phoenix, I think - 120 or 150 sites - which makes it a little more than a test. But it's hard to imagine it's going to be a traditional beer, cigarettes and magazines kind of convenience store.

WILTAMUTH: Not a 7-Eleven.

ADLER: But why come all the way from Europe to open a traditional convenience store format, with all the logistical challenges about being in prepared foods? You have to find suppliers for every store or build your own commissaries, and what do you do first? Do you find a supplier and then build the stores, or do you build the stores and find a supplier? And how do you manage that process, which I think is going to be very challenging? What's interesting is that there's nobody, other than Boston Chicken, who has really tried in a big way to do a dinner-tonight type of business.

HEINBOCKEL: As good as Tesco is, it will face a few challenges. Establishing an efficient supply chain is probably the biggest one. The company will need significant store density and an effective commissary to make high-quality, competitively priced fresh foods a reality. On the other hand, simultaneously achieving competitive pricing and respectable margins should be less of a challenge, at least in California, where food retailing is dominated by unionized supermarkets with relatively high price structures, thereby providing a good umbrella to start from.

To me, Fresh & Easy sounds like a Harry's-in-a-Hurry on steroids. Harry's-in-a-Hurry was a fresh convenience store of between 5,000 square feet and 9,000 square feet that primarily sold home-meal replacement, and before it closed, I thought the concept was, in several respects, much more interesting than a big box.

SN: There are reports Tesco might be interested in buying other stores in the U.S. Do you think it's ever going to buy a large chain?

ADLER: We hear it wants something with a general merchandise component, and if that's true, it wouldn't want to buy a company that operates a supermarket only. I'm not sure strategically why you would commit yourself to this small-size store format if you really wanted to be in the conventional business. It seems there aren't enough synergies to justify it, so I think the decision it's made says this is the way Tesco wants to penetrate the U.S. market.

WOLF: It's my understanding that Tesco has studied the U.S. food business and rejected supermarkets as the entry. Obviously, it could have been the one to buy Al-bertsons. What intrigues me is to find out whether it is going to go more towards what a Wawa does, which is kind of a better, more innovative model of what a convenience store can be, with fresh produce and other perishables and a fairly developed food-service offering. And I think that ends up becoming a pretty impactful competitor for the incumbent supermarket.

ADLER: But you have to ask the question, because there does seem to be an empty niche that Tesco is going after, why nobody in the U.S. - those retailers that really know the U.S. market - has gone after that niche? While I'm not betting against Tesco, because it's a really great operator, you have to wonder if maybe there's a reason nobody else has tried this except Fresh Market, perhaps. But that's even a slightly bigger box.

WOLF: There's a chain in the Southeast - Fresh Market - that is probably a more developed store than Tesco might have in mind, but nevertheless, it's positioned as a more convenient store with a smaller footprint. It's positioned right between Whole Foods and a Safeway lifestyle store in terms of quality, and it's definitely upscale. The company is based in Greensboro, N.C., and it has about 60 or 70 locations. It's just an interesting store, and it's doing very well against its new-store budgets, and I think there's a big future for that kind of a store.

ADLER: How big is the box?

WOLF: About 20,000 to 30,000 square feet, but I think the first Fresh Market stores were 15,000 to 20,000 square feet, so Tesco is in that ballpark. That's why I'm saying it'll be interesting to see what's on Tesco's mind.

SN: What are your feelings about another new European competitor other than Tesco coming into the U.S.?

ADLER: There's nobody with any strength. Well, wait a second. Perhaps we should be less dismissive of the Albrecht family, which owns stores at two ends of the spectrum, Trader Joe's and Aldi. I've heard it is accelerating the growth of the Aldi stores, and Trader Joe's is of course doing very well.

It's funny, but I personally worry about Trader Joe's as a competitor to Whole Foods - not that they overlap perfectly, but there's a lot of buzz around Trader Joe's. People love it, and there's a cult thing, with people willing to drive for miles to shop there, and the perception of value at Trader Joe's is extremely high.

Another alternative format to watch is Dollar General, which has been testing Dollar General Market, and I think Wall Street investors are nervous because they've seen how much the supermarket industry has struggled with dollar stores.

SN: Another new competitive entry is Amazon.com, which is going into grocery on a very small scale. Any feelings on whether online Internet shopping in the grocery field is going anywhere?

ADLER: The economics are tough. But I think FreshDirect here in New York is doing very well.

Regional Independents

SN: With the restyled Big Three of Kroger, Safeway and Supervalu, will there be opportunities for strong regionals to get stronger by joining forces or simply expanding over a broader area?

HEINBOCKEL: It depends on what you call a regional operator. At this point, H-E-B, Publix and Wegmans really aren't regionals anymore. They are at a different level in terms of size and scale, product and service quality and capability, and I think you will see them expand geographically. But because of their unique cultures, this expansion will be organic rather than via acquisition. And they are pretty much the exception to the rule.

For the other so-called regionals, geographic expansion is very unlikely because the capability, scale and differentiation simply do not exist. Whether or not we see a broad-based renaissance of smaller regionals will depend on how big and unwieldy Kroger, Safeway and Supervalu get. That's always been the name of the game in this industry. Going back to the 1980s, the big national operators stagnated, and companies like Albertsons, Hannaford and Food Lion flourished because the big companies were too centralized.

Today we have a new group of big companies, and it remains to be seen if institutional inertia will set in again. You must be reasonably decentralized to avoid these problems. That's a key reason why I like Supervalu's decentralization. The more decentralized you are, the lower the likelihood of stagnation. For many regionals to compete effectively longer term, they need the big guys to drop the ball, and I just don't think that is going to happen.

ADLER: I second everything John just said. I understand there is already attractive growth coming from very small local companies - chains of five or seven or 10 stores that are innovative in their offerings and that can be much closer to their customers. They're still conventional operators and they're not necessarily running very unusual formats, but they really know what their customers want, and real estate developers are much more open to doing deals with them, whereas in the past they might have been uncomfortable about that.

Now I have a question about Wegmans. Why isn't it growing faster?

HEINBOCKEL: The company has a tremendous quality orientation and wants to avoid opening a bad store, which it's never done. When you think about the complexity of running the kind of store Wegmans does - in terms of sheer size and number of perishables departments - people development is hugely important. It could probably grow faster, but the risk of mis-executing would increase.

As a private company, Wegmans has the ability to grow at any speed it wants, and that's probably a good thing. Because of that, I don't think it's opened a store in the past five or six years that has not succeeded right off the bat.