Gaining Ground

MARK HAMSTRA

The laws of supermarket economics bent under the pressures of 2009.

Some retailers said aggressive pricing is easing.

The formulas that had reliably driven profits for years were tested by the extraordinary environment of deep recession, high unemployment and product-price deflation. Traditional supermarket operators had to rethink their pricing strategies in an effort to hang onto as much market share as they could while still delivering something to the bottom line.

For some operators, it basically took a full year of trial and error, of adjustments and recalculations to get the right balance. Only in recent weeks have some chains indicated that they may have finally figured it out.

In a recent conference call with analysts discussing results for the fiscal first quarter, John Mackey, chief executive officer, Whole Foods Market, said the Austin, Texas-based natural and organic specialist became “more strategic” in its pricing strategies last year, and has begun to see the benefits.

“Early last year, we made the shift from being fairly reactionary on pricing to being much more strategic,” he said. “We have seen this strategy successfully play out over the last several quarters, as we have produced strong year-over-year improvement in gross margin and comps. While many of our competitors have gone back and forth on their pricing strategies, we are sticking with our goal of offering competitive prices on known value items, day in and day out. Our internal benchmarking shows that we maintained our price competitiveness relative to our national competitors during the quarter. We remain focused on continuing to strike the right balance between driving sales, improving our value offerings and maintaining margin.”

In addition, the company also commented that its studies have indicated that other food retailers might have begun to ease off a bit on their aggressive price position on some items. The company surveys 63 competitors on 400 items across the country.

“Right now, we're seeing [that] some of the competitors are actually taking back some gross margin,” said Walter Robb, co-president of the chain. “So the market — except for a couple of isolated metro [areas] — has kind of been easing up a little bit. So that would argue for some stability in gross margins.”

The company is striking a balance using its own formula of price investments and “improved disciplines,” such as inventory control.

“That balance is extraordinary right now,” Robb said.

In the first quarter, Whole Foods said it was able to generate a 116-basis-point improvement in operating margin, to 3.9% of sales, on a 7% increase in revenues, compared with the year-ago period.

The company cautioned that it could be difficult to maintain the level of gross margin improvement that it saw in the most recent quarter for the rest of the year, although it continues to expect margin gains. Some of the profit gains in the most recent quarter came from strong buying opportunities, the company said, and such deals might not be available going forward. In addition, the company has pledged to maintain its relative price positioning in the future, so if competitors reverse course and become more aggressive again, Whole Foods may opt to invest in sharper pricing again as well.

End of the Squeeze

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., predicted that the industry could be nearly at the end of a period of reduced margins.

“Right now, we're entering a phase where we'll see more margin discipline,” he explained. “In the second half of 2009, we essentially saw a price war in food retailing, and when you get to a price war, as with most wars, there's a lot of carnage.”

Wolf said it is difficult to determine whether retailers actually have achieved a reasonable balance between margin and price because as prices spiraled downward, “the whole system was out of balance.”

He cited Issaquah, Wash.-based Costco Wholesale Corp. as among the retailers that fared best under the circumstances because of the nature of its fixed-margin model.

Wal-Mart Stores, Bentonville, Ark., has also stuck to its low-price advantage model but also has become more promotional, “which was disruptive to the market and hurt everyone's margins.”

“But except for Costco, I think everyone went too far,” he said. “Now we're beginning to see a glimmer of change as we begin to see grocers pulling back from the price-war mentality and as customers return to the stores. Some customers, primarily those with higher incomes, are beginning to do some trading up, which is reflected in Whole Foods' results — and while most consumers are still seeking value, some are moving back to more normal patterns.”

In addition, Wolf noted, commodity pricing in dairy, meat and produce is beginning to show some inflation, and those increases are being passed through by retailers.

“So you're seeing the trend to trading down and heavy deflation beginning to bottom out and move the other way toward modest inflation,” he said. “As inflation returns, it becomes a question of whether retailers pass it through and how quickly. Normally, if there's a moderate price increase on the producer side, retailers pass it through quickly — for example, the moderate week-to-week sequential inflation in milk is being passed through.

“Now that business conditions are getting better and there's a glimmer that consumers are feeling better, everyone is throwing in the towel and saying no more margin sacrifice. They want to move back to a more normal environment.”

Steve Burd, chairman, president and CEO of Pleasanton, Calif.-based Safeway, also said in recent conference calls that consumers have begun to show some tentative signs of trading up again. He was asked in a conference call late last month whether that could be good for gross margins.

“As we look at the numbers, increasingly we're seeing other categories that indicate that there is some trading up going on,” Burd replied, noting that volume in the company's floral departments has “picked up dramatically” and that Safeway is also seeing a “continued uptick” in the sales volume at its in-store Starbucks locations and in the wine department as well.

“While premium wines are all lower priced than what they were a year ago, we've seen a step up in that business,” he noted. “So I think that, in combination with some other cues that we have gotten from the marketplace, suggests that there seems to be a gradual improvement here in consumer confidence. And I think that's reflective in the mix of business.”

At the company's investor conference earlier this month, Burd also said he believes competitive pricing activity may have subsided in recent quarters after food retailers overreacted to sales erosion in the early stages of the recession.

“I probably have been asked now 60 times [on each earning call for the last 17 years or so], ‘Hey, what's competitive activity like — any sort of step up in activity?’” Burd quipped. “And I always said some markets are heated up, some are cooling off. And for 58 times that was my answer. And then this last summer I said, ‘There has been a step up in competitive activity.’”

Some of it may have taken place “out of desperation,” he said, as consumers of all income strata clamped down on their spending.

“If you would ask me that question today, I would say that things are now sort of kind of normalized again.”

He went on to explain in detail how the pricing pressures played out in various categories and made their way to Safeway's bottom line last year. (See “Pricing Impacts Safeway's Profits,” Page 21.)

Gaining Share

While Safeway and other retailers have backed away from the price war in favor of beefing up margins, Cincinnati-based Kroger Co. has instead chosen to remain aggressive on price and focus on driving traffic to its stores. The company is leaving the door open for “more measured” price investments going forward, however.

Asking about Kroger's gross margin plans for 2010, an analyst on the company's fourth-quarter conference call last week noted the company “used a lot of gunpowder” in the first half of 2009. (See story on Page 1.)

In response, David Dillon, chairman and CEO, said, “We've attempted to learn the lesson from 2009, and we would apply whatever investments we plan in a more measured way, and we would be cautious and ready to change through the year, and we will leave room in our plans to enable us to do that.

“But we recognize it will be an uncertain year, and it will be a little hard to predict what the back half is going to look like.”

Dillon acknowledged that it's difficult to make changes in some investments in everyday pricing once they are put in place.

“You get customers where they like the everyday prices, and to take that away runs the risk of derailing the very process you got started,” he said. “We drew those conclusions going into the third quarter [of 2009] and recognized that we needed to be careful about making adjustments. We have made some minor adjustments and continue to make some adjustments in our tactics, but the strategy itself is the same we've been describing and we believe it would be a long-term mistake to change course, so we have not pulled back from that.”

Mark Wiltamuth, an analyst with Morgan Stanley, New York, said that, historically speaking, Kroger has done the best job reducing gross margin to keep sales up.

“But in the last two quarters Kroger lost control after it responded aggressively to price reductions by other industry players and ended up with a further gross-margin reduction and some earnings disappointment,” he explained.

“The challenge Kroger faces now is its long-term strategy. The original idea was to reduce prices every year to drive sales and end up with a modest operating margin gain, and that worked for several years. But the industry got into a price war after Kroger had invested in lower prices for several years and got below Kroger, and Kroger was faced with the choice of whether or not to defend its leadership position, and it opted to defend it, which left it with a margin shortfall.”

That situation underscores the problem retailers face when consumers are exceptionally price-focused, Wiltamuth explained.

“If everyone follows a price-reduction strategy, then it stops driving sales, and everyone has to wait for the economy to improve and for consumer demand to pick up to drive sales again,” he said. “Supervalu indicated in its last call it was throwing in the towel and planning not to reduce prices with everyone else but instead planned to protect its margin.

“Kroger is coming off its worst margin performance so it may return to more disciplined pricing. Safeway has already indicated it is done cutting prices now that it's at parity, so it will match prices going forward.”

The return of modest inflation “may help the situation a little,” Wiltamuth explained.

“Inflation doesn't really help the fundamentals for grocers because there are times grocers can't always pass all the inflationary increases through. But inflation would reduce some downward pressure on price and allow some operators to raise prices without raising margins.

“If inflation returns, we could see margins decline further, as we saw in 2004 and 2007. But if the return is gradual, then the increases can be passed through, which would be neutral to gross margin.”

Chuck Cerankosky, an analyst with Northcoast Research, Cleveland, said he believes consumers need to gain more confidence in the economy before some of the margin pressures on traditional supermarket operators will ease.

“I think the biggest challenge — which has dwarfed the role of inflation or lack thereof — has been how shoppers have so readily traded down to save money,” he said. “Every operator I talk to has their favorite example of shoppers trading down. Whether it's someone who used to buy a couple of $30 bottles of wine a week who is now buying one $20 bottle of wine a week, it shows up as trading down. The challenge of that is that it not only affects your sales dollars, but your profit dollars as well.

“If the problem was simply deflation and we only had to wait for product costs to nudge prices upward, retailers would quickly catch on that they don't have to wait for inflation, they could just raise shelf prices. What we are actually seeing, however, is that consumers are looking to buy fewer items or cheaper items. I haven't heard any retailers say, ‘The price of category XYZ has deflated, and consumers are buying more of that category or taking the savings thus generated and spending it in different parts of that store.’

“What I am hearing is that more and more shoppers are sticking to a list, and if they have any money left over, they are saving it, not spending it in the store.”

The frugal disposition of consumers — and their avoidance of discretionary purchases — made it much more difficult for supermarkets to drive bottom-line results during the recession.

“For the past decade or so, retailers have been very good at getting consumers to trade up, whether it be a better piece of fish or an unintended impulse item at the front end of the store,” Cerankosky explained. “Those are the expenditures that round out the ticket for the retailer, and people are skipping those things.”

While some retailers say they see the nascent signs of recovery and shoppers loosening up their purse strings, Cerankosky cautioned that any improvement will likely be gradual.

“I don't think it gets better all of a sudden,” he said. “I think there's a big, big headwind in the form of the jobs market. The economy can be expanding, according to what the statisticians in Washington tell us, but in general at the end of the day there are a couple of big problems, and one is that the jobs market is keeping consumers from jacking up their spending, especially on discretionary items, and the second is that many households still have too much debt relative to their incomes or their income prospects, relative to the headwinds.”

He said one result of the economic downturn that gives him hope for food retailers is an expected reduction in square footage as some more competitors cave in to the pressures and exit locations.

“There's a lot of capacity around that's resting on a much weaker financial base, and as this economy stumbles toward recovery, it may take longer than the balance sheets of those companies allow,” he said. “So capacity rationalization is going to benefit those with the best balance sheets, and they will be able to attract incremental sales from industry consolidation.

“You are not going to get customers to trade up, simply because there are fewer stores to shop at — that's the role of the jobs market — but I do think that on similar items that customers are buying, removing retail capacity from the market will allow them to price a little more generously and allow them to recover some margins.

“I don't think they get back to where they were very quickly, but too many stores selling the same merchandise puts pressure on margins, whether the economy is good or bad.”

He pointed out that Kroger's aggressive pricing stance plays well into its strategy of gaining market share and creating consolidation opportunities.

“From a strategic standpoint, you can hasten rationalization if you are growing market share in a time like this,” Cerankosky explained.

In addition, he pointed out that by proactively grabbing sales and market share with aggressive pricing, Kroger may be protecting its margins in the long term by eliminating the need to recapture lost share as the market improves.

In addition, Cerankosky pointed out that Kroger has been more focused on the actual dollars earned in operating profits as opposed to its margins as a percentage of sales.

“If they see a way to maximize profit dollars with a lower margin because sales are outpacing the industry, that works for them, but it is not a strategy that removes Kroger from the need to deal with a very tough economy,” he noted. “We do like the fact that Kroger was aggressive in going after market share, and we think that will benefit the company.”

Other operators who have invested heavily in margins to retain sales include Ahold's Giant-Carlisle banner, which earlier this month reported margin contraction for the fiscal fourth quarter and year, citing the difficult operating environment and especially strong competition from Wal-Mart. The EDLP-focused banner company was able to drive market share gains for the year, however, Ahold noted.

The chain posted an operating margin of 4.4% of sales for the full year, down from 4.9% a year ago, despite comparable-store sales growth of 2.2%, excluding gasoline.

Ahold's Stop & Shop and Giant-Landover division, meanwhile, was able to maintain a 5.5% underlying margin, the company said, although the banners did experience pressure on margins from a “strong increase in promotional activity” brought on by the competitive environment.

“It was a year of recession in all of our markets, a year when unemployment increased in all of our markets, consumer confidence fell, we saw trading down and, for the first time in years, food deflation,” said John Rishton, Ahold's CEO, in a conference call discussing year-end results. “As a consequence, the intensity of the competitive environment increased substantially.”

He pointed out that through aggressive cost-cutting, the company was able to drive gains in operating margin of 7.9%, however, and an underlying retail operating margin — excluding extraordinary items — of 5.1%.

“Looking ahead to 2010 and beyond, consistent with many CEOs, I don't see any significant improvement in the short-term economic environment,” Rishton said. “I expect unemployment and underemployment will remain relatively high, and consequently, I suspect consumers will remain cautious.”

He said the company also continues to see product-price deflation, although he anticipates that inflation could return during the year.

“At the start of 2009, the environment for our industry was relatively benign. But during the year, we encountered deflation and trading down by consumers,” Rishton explained. “In 2010, I hope we will see the opposite, with the conditions improving through the year. But our visibility, like everyone else's, is limited.”

Jacksonville, Fla.-based Winn-Dixie Stores, meanwhile, after becoming overly promotional earlier last year, settled down and adopted a more “measured” approach to pricing to preserve its profit margins.

“Although consumer food budgets continued to be strained, we are committed to remaining disciplined with our respect to our promotional offerings and maintaining a strategic and measured response to our competition,” said Peter Lynch, chairman, president and CEO, in a conference call last month discussing financial results for the fiscal second quarter. “We will continue to offer products and promotions that are tailored to meet the needs of our customers. We are interested in profitable sales, and will not over-promote in a down market. While we will remain very competitive, we do not want to encourage the sort of unsustainable programs that drive lower margins and do not build our brand or long-term customer loyalty.”

Some sales erosion, he said, is acceptable if the business the company is losing is not profitable.

“What we're seeing is when we lose traffic, it's predominately from cherry pickers,” Lynch said. “And that's not a shopper you want to have for the long term. It's very expensive to maintain, and quite frankly, is not going to help you with your branding efforts going forward.”
Additional reporting by Elliot Zwiebach

TRADE-OFF

Some retailers are sacrificing profits in an effort to build sales; others are seeking to take profit margins at the expense of sales.

* Excluding gasoline

** Supervalu reported net income of $109 million, vs. a loss of $2.9 billion a year ago.

*** Excluding a one-time charge in the most recent quarter.