Change for the Better

MARK HAMSTRA

For even longer than Kroger has employed its “customer first” strategy, it has printed the following sentence on each of its employee paychecks: “A satisfied customer made this paycheck possible.”

After a century and a quarter of building itself up and tearing itself down, of rethinking its tactics again and again, Kroger has arguably reached a point where it is satisfying customers better than it ever has. Its estimated $69 billion in 2007 sales leads all conventional supermarket companies, and its sharp pricing and highly customized merchandising strategy are propelling those sales at a rapid pace.

Achieving this position in the market has required a series of transformations over the generations that Kroger has been in existence, said David Dillon, chairman and chief executive officer, in an interview with SN.

“The importance of 125 years isn't so much the longevity, but the fact that nothing can exist unchanged for 125 years, and Kroger has gone through a metamorphosis several times in its history,” he said.

He considers Kroger to have undergone two major metamorphoses in his 25 years with the company. The first was in 1988, when the company undertook a leveraged recapitalization, and the second began about five years ago when the company launched “customer first,” the strategy that has helped drive same-store sales through a customer-oriented approach to what the company sees as four key areas: product, price, people and the store experience.

The current effort is no less transformative than the changes the company has undertaken in the past, including the strategic overhaul in the post-World War II era when it went from operating about 5,000 relatively small corner grocery stores around the country to its current network of 2,500 mostly traditional supermarkets from California to Virginia, with a strong stable of alternative formats supplementing its bread-and-butter food-and-drug combo stores.

“Somebody decided that we needed larger stores, the population became more mobile, and in responding to the customers we had a make a rather radical change,” Dillon explained of the shift in the middle of the last century. “Kroger as an organization rose to meet that challenge and made that change, just as we did in 1988, and just as we are doing now.

“It is that willingness to change that has given us our 125th birthday,” he said. “Without a willingness to be a very different company every 10 to 20 years, we would not still be here, in my opinion.”

The current transformation to “customer first,” which Dillon describes as being in its early stages, has been driven by two major forces in the marketplace overall, which he described as the fragmentation of food retailing and the changing ethnicity of America.

“It's no longer just the supermarket selling food,” he said. “It's now the discount stores, the dollar stores, the drug stores. In fact, if you go in a drug store today, what distinguishes them now from 10 years ago is more groceries, and if you go into a discount merchant, what distinguishes them now from 10 years ago is more groceries. Plus, there are lots more restaurants out there today, and people are not only going there to eat but bringing things home as well.

“This fragmentation of where people buy their food in effect has supermarkets playing in a bigger market.”

The other major trend Dillon sees as shaping Kroger's current strategic direction is the evolution of the nation's demographic makeup. This goes beyond the actual ethnicity of the population, he explained, and includes changes in the flavor preferences of Americans and their affinity for foods from other cultures.

As an example, he cited the mainstream popularity of Mexican and Tex-Mex cuisines, requiring product assortments that in many cases are different from what the growing population of Mexican-Americans themselves are seeking.

“You've got these widely varying taste buds, which means that as a business, we've had to address customers in entirely different ways,” he explained. “That's essentially how we came down to the idea that we needed to be more focused on the customers than we were, and that's why we refer to our strategy as ‘customer first.’ The decisions we're making are from the point of view of the customer — it's why we segment our stores, to address that increasing desire for variety, and it's why we offer different kinds of stores and different formats.”

Data-Driven

It's also what drove the company to establish Dunnhumby USA, a joint venture Kroger operates with British customer analytics firm Dunnhumby that assists Kroger in customizing its assortments, its marketing and even its decisions about where to build alternative store formats, such as the massive Marketplace locations and the more upscale Fresh Fare banner.

Although the current strategy was not known as “customer first” when the transformation first began, the crux of the strategy began to manifest itself soon after the 1999 acquisition of Fred Meyer Inc.

“We didn't use the words ‘customer first,’ but we began responding with some lower prices,” Dillon explained. “At that time, we knew internally that it's not all about price — price was an inhibitor at the time — but it was actually more about getting better as a retailer and connecting better with the customer. Price was just the outward manifestation of that, which people saw publicly.

“A lot of forces came together to make this ‘customer first’ focus. Part of it was our work with Dunnhumby; part of it was the realization that what we needed to do to be successful in today's environment was the need to recognize these trend changes and the fragmentation of where people shop. All of those things came together to say to us, ‘We've got to have a different strategy from what we had before, and we have to have a little different vision of the company from what we've had before.’

“The leadership of the organization developed a picture — it wasn't something that I came up with or even something that a small group of individuals came up with, and over the course of a year, it came to be ‘customer first.’”

The strategy has worked, analysts said, because it drives top-line sales, which, combined with a focus on small, in-market acquisitions, has allowed the company to grow market share.

“They have re-engineered the company to be competitive and profitable at a much lower cost structure,” said Neil Stern, senior partner, McMillan Doolittle, Chicago. “They have driven down gross margin significantly, and have driven down the cost of their operations significantly, and have now put themselves in a position where they can compete effectively against Wal-Mart. That certainly wasn't an easy task.

“It's not just cutting costs and reducing prices — they have done it with a lot of insight and intelligence behind it,” he said, citing the company's leverage of its Dunnhumby investment “to use their data to sort and price more intelligently.”

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., said Kroger was the first of the major supermarket chains to recognize that a major strategic shift was needed to compete with the rise of Wal-Mart supercenters, and was smart to realize that it could in fact also still compete effectively on price, despite Wal-Mart's rapidly growing presence.

“In the late '90s through the early 2000s, Wal-Mart was able to become No. 1 in grocery market share, all on price,” Wolf said, and proved that it was possible to thrive as a national, low-price operator.

“Kroger publicly recognized it first, and really changed their go-to-market strategy in what I believe was a very effective way,” he said. “They were there early with the most price investment.

“The other thing they did was to really bring more value per dollar to customers,” he said. “They didn't take anything away from their merchandising — and in fact they've improved it.”

The change required a “culture shift” at the company, Wolf said. “It was very slow, gradual change, but they have a culture now that is really focused on moving volume through the stores to give shareholders financial results.”

He cited as an example of Kroger's dedication to the “customer first” strategy its recent decision to roll out Safeway's Blackhawk gift-card displays. Although Safeway is a competitor, clearly Kroger got the message that its customers preferred that offering. Another example Wolf has seen is Kroger's decision to place some service deli and dairy offerings near the front of some of its stores — a move that runs counter to traditional supermarket layout strategy but offers convenience for the customer.

Private Label

Kroger's extensive private-label program, which includes low-, middle- and high-range offerings, has been an important component of the company's recent transformation, analysts said.

Jon Hauptman, a partner at Willard Bishop, Barrington, Ill., noted that Kroger has done an especially good job of offering “strong per-unit values” in product categories throughout the store, in large part through the use of private labels.

“In virtually every category, there is a low-priced private-label option for those customers looking to make a trade-off,” he said. “Having strong per-unit values on items throughout the store encourages shoppers to shop the store more intensively because there are great values available wherever they might be looking for them.”

By as early as the 1920s, Kroger had begun realizing the value of making its own products — and that expertise pays off today, as the chain has one of the most highly regarded private-label programs in the country. From a single facility on State Street in Cincinnati that produced a wide variety of products for the fledgling chain, Kroger's manufacturing operations have grown to 42 different plants producing thousands of products. A typical Kroger store carries about 11,000 private-label items, more than half of which are made by the company itself, according to a recent report by Karen Short, an analyst at Friedman, Billings, Ramsey & Co., New York.

That vertical integration allows Kroger to achieve better margins on its private-label brands than many chains that source their store brands from other manufacturers, according to Jim Hertel, senior partner, Willard Bishop.

Another area where Kroger has excelled, Hauptman said, is in communicating the low-price message to customers.

“They get full credit for having low prices and strong values through effective signage and with their store brands,” he said. “You find price communication in the center of the store, in the perishable departments, even in HBC and pharmacy. They send a consistent price- and value-oriented message wherever you look.

“A lot of people do the basics right, but they don't get credit,” he said. “Kroger is getting credit.”

Key to the company's pricing has been its ability to get within about 8% of Wal-Mart's supercenter pricing, said Hertel. Most shoppers are willing to ignore price differences of up to about 4%, he explained, but are willing to pay up to 8% or 9% more if the retailer “offers a strong enough value proposition.”

“Committing to hit that 8% number is the fine balance point between making sure you've got enough gross margin that you can run a traditional full-service supermarket, and being able to compete with Wal-Mart from a price-image standpoint,” he said.

Key Acquisitions

Acquisitions have been a part of Kroger's history for almost as long as the company has been in existence, but two key deals — the purchase of Dillon Cos. in 1983 and of Fred Meyer Inc. in 1999 — have been especially transformative.

Some analysts view the company's purchase of Dillon Cos. — which at the time was a large publicly owned supermarket operator with operations in the Midwest and Southwest — as a defining move for the company, giving it the leadership that took it through a leveraged buyout in 1988 and then guided it to its current course.

“The industry has been consolidating for a number of years, and my opinion is that it will continue to consolidate for a number of more years,” Dillon said. “What that's saying is that there is benefit to size. Big players have gotten better and smarter, and as a result it is beneficial for smaller operators, both for their employees and for their own leadership, to join a bigger company, because it gives them, then, additional opportunities for personal growth and it gives them the opportunity for growth of their stores.”

Just last year, Kroger made two such deals, buying 20 Farmer Jack supermarkets in the Detroit area from A&P and 18 Scott's supermarkets in Indiana from Supervalu. It has made similar purchases throughout the decade, including 15 Harris Teeter stores in Georgia in 2001, 17 Albertsons in Houston in 2002, 18 Raley's in Las Vegas in 2002, and 13 Food Town stores in Ohio in 2003. Along the way, it picked up scattered handfuls of Albertsons, Winn-Dixie, Cub Foods and other locations.

Chuck Cerankosky, an analyst with FTM Midwest Securities, Cleveland, said Kroger's strategy is a cost-effective way of building market share.

“They have a strategy that looks like it should work for a while, and that is to pick off small store groups or even individual stores in some cases at far less than replacement costs in markets where Kroger already operates,” he said.

Dillon said Kroger's approach has varied in how it has approached each acquisition.

“Some are extensions of existing markets, and often in those cases, the store will just reopen as a Kroger store or a Ralphs store or a Fred Meyer store, or whatever the brand is in that particular market,” he said. “Other acquisitions that we've had, like Fred Meyer, did a couple of things for us — one was that it took us into some new geography, which is always a helpful thing, but second is that it did it with some companies that were some really great franchises. They had great connections with their local customers, and they had a lot to offer the company as a whole.

“We have learned just as much from the Fred Meyer division in making Kroger better as the Fred Meyer divisions have learned from Kroger to make them better, and maybe even more.”

One of the keys to the success of such deals is to make the employees of the acquired company feel valuable to the organization as a whole, Dillon said.

“When it is really a two-way street in that way, people have the opportunity to grow, people have the opportunity to contribute and people feel valued, and it really makes the merger quite successful. We're interested in a wide range of those where we think it's a winning combination for us, and for the people and the assets that would be acquired in that kind of merger.”

It was a lesson he learned about Kroger back in 1983, when both he and his predecessor as Kroger's CEO, Joseph Pichler, joined Kroger with the Dillon Cos. acquisition.

“Both of us thought that with an acquisition like that, we might not have a place with Kroger — especially me, because I was with the family, and Dillons had been a family company,” he explained. “I figured that a big company like that would not have any use for me, but the fact that Kroger was receptive to having two executives come out of a company that was acquired, and to have both rise to the level of CEO, is a testimonial to Kroger's whole culture and their whole view about valuing people broadly.”

Stern of McMillan Doolittle said Kroger's approach to acquisitions has been one of “blend and learn.”

“Everybody has struggled with acquisitions in the short term, including Kroger, but in the long run all you have to do is look at who's running the show over there — that's David Dillon, and he came from an acquired company,” he said.

“There's two ways to do an acquisition,” Stern explained. “One way is the ‘my way or the highway’ approach, in which you are buying companies to incorporate your program. Or you can take the approach that Kroger's undertaken and sort of blend and learn, and not destroy what's been built locally, and I think they've done a pretty good job of balancing that.”

In addition to Dillon being the byproduct of an acquisition, Stern cited other examples in which the company has adopted components of its acquisitions for more widespread use in the company, including the Private Selection upscale store brand, which came from Ralphs via the Fred Meyer Inc. deal, and the Fred Meyer Inc. general merchandise expertise.

Kroger's Marketplace stores, the mammoth supercenters that feature extensive offerings in both food and nonfood, are a direct result of the acquisition of Fred Meyer, which was one of the pioneers in supercenter operations. Kroger now has about 30 of those locations under various Kroger banners in Arizona, Utah, Kansas and Ohio, and the company recently was reported to be planning to open the concept in Texas.

“The characteristics that those stores have, particularly in nonfood, but in other ways too, all came from our learnings from Fred Meyer,” Dillon explained. “And in fact their performance today is a direct result of the partnership between the merchandising staff of the corporation and the merchandising staff of the Fred Meyer division. Those two have worked together to create the mix of products and the marketing focus and the merchandising skills needed to develop and expand and renew and grow the Marketplace store.”

Wolf of BB&T Capital Markets noted that he believes Kroger could also have benefited if it had elected to buy certain parts of Albertsons when that company put itself on the block two years ago. Although Kroger was reported to be one of the interested parties, Albertsons instead was divided between Supervalu and a private-equity consortium led by Cerberus Capital Management.

He suggested Kroger would have benefited from picking up certain components of Albertsons, including its Jewel chain in Chicago, Acme in Pennsylvania and New Jersey, and Shaw's in New England, all regions where Kroger has little or no presence.

“I felt it would have been very beneficial to them long-term,” Wolf said. “But Supervalu needed to transform its business, and Kroger did not.”

Other analysts pointed out that Kroger might not have been able to structure a deal the way it wanted so that it could pick up only the desired locations while avoiding antitrust issues in other markets.

“They probably realized it would have been a very difficult transaction in the way it was being offered,” said Cerankosky. “But I am sure they are very aware of individual Albertsons store locations that fit in with their individual strengths, such as in Denver [where Albertsons LLC still has stores].”

Most analysts seemed to think Kroger would shy away from investing in “turnaround” opportunities in the form of struggling regional chains.

“If they didn't buy Marsh [which was for sale in 2006 in Indianapolis, one of Kroger's strongest markets], why are they going to buy these other things?” Wolf said. “They have a very disciplined acquisition model: Unless something strikes them as compelling, they are not going to do a deal.”

The company's emphasis for now is on “small in-market acquisitions, or opportunist acquisitions,” said Stern. “But not a large one, and I think it makes sense given their need for financial stability.”

However, one analyst pointed out that now that the company has in the last few years improved its debt ratios — an obstacle that may have prevented it from making acquisitions in the past — it could be more receptive to large acquisitions.

“While the company's acquisition strategy has historically focused on making in-market acquisitions, we believe Kroger may finally be at a point where it would look to expand beyond current geographies, assuming the right opportunity presented itself,” said Short of Friedman, Billings, Ramsey in her report. “We believe the company is fairly agnostic on criteria, meaning that it would consider acquiring a nonunion operator, in a new or existing market, or entertain the idea of acquiring an operator with outsourced distribution.”

She listed several possible scenarios for deals that Kroger could make in the coming years, including buying the recently combined A&P-Pathmark Stores or Ahold's U.S. business to gain a foothold in the Northeast; buying Winn-Dixie's or Albertsons' Florida operations to enter the Southeast; buying Harris Teeter in the Mid-Atlantic; and buying Roundy's Supermarkets in the Upper Midwest. She also said the Marsh stores could eventually become available again, and Kroger could be interested as part of a consolidation of the fragmented Midwest market.

Varied Formats

Despite the success of the Marketplace concept, which measures about 100,000 to 120,000 square feet, Kroger's core vehicle remains its traditional food-and-drug combo outlets operating under 14 different banners in various markets.

“Our traditional combo store is still our bread and butter,” Dillon said, “and I think it has very long legs. It's a terrific store, because it's small enough that it can actually serve a neighborhood kind of market, but it's big enough that it can have everything that the neighborhood needs. It still works really, really well.”

He describes the stores as offering “everything you can get at a drug store and everything you can get at a supermarket under one roof,” adding that Kroger is “very happy with the pharmacy business included in those stores.”

Analysts have pointed out that Kroger is one of the premier pharmacy operators in many of its markets.

The company's price-impact format, Food 4 Less, operates primarily in California and the Las Vegas area, although in recent years the company has expanded the banner into the Chicago market with about a dozen locations.

These stores, which feature a warehouse-style layout, “are clearly focused on the value segment of marketing,” Dillon said. “To a certain extent, in some markets, they are also focused on Hispanic marketing. That calls for a little special expertise in what we carry in those stores.”

The company's Fresh Fare stores, which target the other end of the income spectrum, tend to be a little smaller than traditional combo stores and have an emphasis on the food component of the offering. They also have a higher level of service “for people who are looking for a different eating experience than what a combo store might provide,” Dillon said.

“Customers, we find, have widely varying needs, and have varying needs at different times — different times of the day, different times of the week and different times of their lives,” he said. “So our small stores, our medium stores and our big stores all have a role to play.”

Another division at Kroger that is often overlooked is its convenience store operation, which also was a byproduct of the Dillon Cos. acquisition. The company now has about 800 stores in this division, including two acquisitions made after the Dillon Cos. deal.

“We're finding that a wider range of customers are interested in the store, and a wider range of assortment is called for, and it's been a fun format for us,” Dillon said, adding that having the c-store expertise within the company has also given Kroger “a leg up on gasoline.”

Short estimated that Kroger generates about $4.45 billion in sales from its 631 supermarket fuel centers.

Kroger also obtains cross-banner synergies from its Fred Meyer Jewelry stores, Dillon said. Many of the stores operate inside Fred Meyer locations, but Kroger has begun testing the outlets inside its other banners.

“We've opened a few inside our Marketplace stores, and that's been a fun thing to have,” he said.

Local Know-How

Analysts said Kroger stands to continue to improve its position with customers through its ownership stake in Dunnhumby. While pricing was the first area of focus in the “company first” strategy, the other areas — people, product and the in-store experience — will continue to improve as a result of Dunnhumby's analytical expertise.

“A lot of people have talked about targeting and segmentation, but what I see from Kroger is a commitment to actually execute against that,” said Hertel. “The potential exists for them to get merchandising right store by store, to get assortments right store by store, and to get offers targeted household by household.

“With a centralized approach to merchandising and decision-making, but then a shopper-by-shopper approach to synchronizing that — that's the kind of approach that I think bodes well for them in the future,” he said. “While I think there may have been some solid results on a test basis or a limited-execution basis, my guess is that a lot of that is still in front of them.”

Dillon said the company's work with Dunnhumby has enabled Kroger to interpret the sales data it has accumulated through its loyalty card programs in more depth than it otherwise would have been able to. Dunnhumby's strength, he said, is its ability “to take large piles of data and make sense of it.”

“We see it as a key competitive advantage, and part of Kroger's long-term strategy to continually improve that overall shopping experience for our customers,” he said. “It allows us to look at actual shopping behaviors and interpret them in ways that we were previously unable to interpret them.”

He credited Dunnhumby with giving Kroger “one of the more robust loyalty programs in the country.”

“There are a lot of smaller grocery retailers in the U.S. that have done a really nice job with loyalty, but on a really large scale, like ours, it's considerably harder to do, and Dunnhumby has assisted us in doing that,” he said.

Kroger used the analysis to create seven main categories of customers, and within each of those seven there are variations based on specific preferences and tendencies.

“Almost every store has some of those seven shoppers, but they occur in widely varying proportions,” Dillon explained, although he declined to list all seven categories. “Our stores would carry products that would be more focused on the categories they carry in high numbers, and less on the ones that they don't have in high numbers.”

The data helps Kroger maintain a local feel in its stores despite its near-national reach.

“We've found that some things can be centralized, either because you are trying to provide significant intelligence on an issue — and it's easier to do that one time than 18 times — or because you get some cost efficiencies by doing it in one location,” he said.

“But similarly, we see many reasons to keep many things local, and in particular things that are highly affected by feedback from customers. You can't really engage people across too broad a territory,” he added. “To engage people in the stores, which is the thrust of what we want to do, you really need people on the ground who work with them every day.”

That flexibility — the company's willingness to adapt to market conditions across geographies and across time — is at the heart of its success.

“Any time you stop growing and stop changing — because, really, they are synonymous — you really are not capable of going into the next world where the customer wants you to be a little different,” Dillon said. “So really, as a company we try to push ourselves, and as individuals we try to push ourselves to always grow — we try to grow every year. Our own resistance to change needs to be fought, and we need to find a way to change.”