In Tune

MARK HAMSTRA

Only a handful of companies might have actually seen the current economic downturn coming, and Kroger Co. wasn't one of them.

Its 6-year-old strategy of lowering prices and cutting costs, which has driven an industry-leading stretch of sales growth, might make it seem as though Kroger was prescient, but in fact its efforts simply put it in the right position for the times.

“We are lucky,” said David Dillon, chairman and chief executive officer of Cincinnati-based Kroger, in an interview last month with SN. “We were better-positioned than we had been in a long, long time in customers' minds on price at the very time price became more important to them than it had before.”

However, he was quick to point out, it wasn't all luck that brought the company its success. Its strategy of lowering prices was actually part of an overall effort called “Customer First,” of which price is just one of four areas where the company seeks to continually improve in response to evolving shopper preferences. The other three elements of Customer First are the company's product, its people and the shopping experience it creates in its stores.

The success of the company's strategy, both in the current economic environment and as a foundation for the ongoing health of the business, has prompted SN to name Kroger as the winner of the magazine's 2008 Retail Excellence Award.

Although the economic conditions of the past year, when consumers have been pressured by rising gas prices and other financial hardships, and thus have shifted shopping patterns, Kroger has managed to gain market share and drive sales growth that has been among the best in the industry. (See Page 30 for a comparison of Kroger's performance to that of other companies.)

“What really ultimately matters to us is what affects the customer,” Dillon told SN. “For instance, the debate over whether or not we're in a recession doesn't matter to me. And it doesn't matter a lot to me whether interest rates go up or down. What matters to me a great deal is how the customers behave as a result of that.”

Dillon pointed out that the current strategic effort began when the economy was relatively strong. At the time, most traditional supermarkets seemed to be making an effort to distinguish themselves from nontraditional competitors by emphasizing service, quality and selection. But instead of seeking to differentiate itself from any one competitor or adapting to any specific economic environment, Kroger implemented a strategy that would include lowering its prices, but would also retain the flexibility to adapt to different shopper demands.

“We decided we needed to take some steps to be better connected to our customer than we were,” Dillon explained. “We came to that conclusion for a variety of reasons, and one of those reasons was that the research we did told us that customers thought we were good, but not as good as we thought we were.

“They helped us understand things we needed to address, one of which was our pricing. In the supermarket world, we were actually quite well-priced, but when you looked at where customers buy groceries, which was increasingly not in a supermarket environment, we weren't necessarily so well-priced.”

The company funded its investment in lower prices through a massive cost-cutting initiative and guided it using a disciplined analysis of sales data. The investment in price reductions was systematic, targeting the most price-sensitive products and categories, and it has expanded to include additional items each year for the past several years.

“Customers like that and appreciate that, and they began to give us credit for better price positioning long before the economy actually started changing,” Dillon said.

He stressed the importance of Kroger's leverage of sales data, whether it is used for pricing decisions or in other aspects of its business.

Data Analysis

The retailer began collaborating with Dunnhumby, a British data analytics firm known for working with Tesco, about 10 years ago. After working together on a few projects “to get acquainted with each other,” Dillon said, Kroger and Dunnhumby formed Dunnhumby USA, a 50-50 joint venture, in 2003.

“While Dunnhumby USA has multiple objectives, the primary objective as far as I am concerned is using Kroger loyalty data to help us make better decisions with our customers,” he explained. “The data helps us, for instance, to understand how to segment our stores better, both in deciding which stores ought to be segmented in what categories, and also helping us understand what ought to be different about a store in one segment vs. a store in another segment.”

The sales data analysis helps the company decide which items would benefit from pricing adjustments, either as advertised promotions or in the form of an everyday low price.

It also helped evaluate the effectiveness of its advertising, Dillon explained.

“Now we can tell what households buy what products, and how engaged that household has become because of a particular ad we ran,” he said. “Before [the Dunnhumby collaboration] we were not able to do that.

“One of the themes at Kroger is to add to our intuition as retailers by using data. We use data in merchandising, we use data in pricing, we use data in just about everything now. We try to see if we can improve in an objective way what we are doing.

“There's still lots for us to learn from data,” he added. “I think we are still early in the stage of learning what data can help us understand.”

Neil Stern, senior partner in retail consulting firm McMillan Doolittle, Chicago, said Kroger's success at leveraging data analysis is reflected in its financial performance.

“It's helped them manage assortments, it's helped them manage pricing, and in targeting particular customer groups,” he said. “It's really just applying very intelligent analysis to the business.

“Almost any retailer has the ability to do that, either through loyalty-card data or through data they capture through POS. I just think that Kroger was very early in the United States to start taking it seriously. Instead of just using loyalty cards as a discount mechanism, they really are using it as a strategic tool. They are even using data to help with service levels and how they operate stores.”

Price Perception

Stern agreed that Kroger's effort to lower prices helped position the company perfectly for the current environment.

“This has been part of a long-term strategy to lower costs and lower prices, and it was probably the right strategy for them regardless of what's going on in the economy, “ he said. “But obviously, having that position is a pretty good thing to have right now. I think it's a combination of good long-term planning and the economy sort of heading their way. With more consumers worried about how they are going to put food on the table every week, Kroger is a credible place to get that done right now.”

Kroger's gas promotions have been especially effective this year, Stern pointed out, as it offered aggressive discounts at its 750-plus fuel centers.

“Customers are paying really close attention to that,” he said. “It's one of those lightning-rod issues, when gas is at $4 a gallon, to be able to save 20-30 cents a gallon is something consumers are clearly ready to go out of their way to do, and be loyal to the store that provides it. Maybe it ceases to be quite as effective if gas gets to be $2-$3 a gallon again, but at $4, we sure care.”

He described Kroger's overall grocery strategy as shifting from being a purely high-low promotional retailer, with an emphasis on weekly price specials, to become more of hybrid, offering everyday low prices on key items that are the most important to consumers.

“If managed properly, it's the best of both worlds,” he said. “They offer low prices on the stuff shoppers really notice, plus there's still the excitement of being a promotional retailer in the stores.”

Jon Hauptman, a partner in consulting firm Willard Bishop, Barrington, Ill., agreed that Kroger generally executes well when it comes to creating an atmosphere of value in the stores.

“Kroger's focus on sharpening their prices and narrowing the gap vs. Wal-Mart is a cornerstone of their success today,” he said. “They have done a very good job of sharpening their Center Store prices in general, and their frozen-food prices in particular, which is an area on which Wal-Mart also is aggressively focusing.

“I have been particularly impressed by the clarity of their price-based communication, and their signs throughout the store that show shoppers where the values are and how they can save,” he added, although he pointed out that the company does a better job at this in some regions of the country than others.

He also cited Kroger's extensive, three-tiered private-label program as an important component of the company's value offering.

Kroger offers more than 14,400 private-label items, which comprised a record 26% of grocery sales in the company most recent quarter, and 33% of unit sales. It has a national-brand equivalent Kroger brand, plus a higher-end line called Private Selections that includes some original formulations for which there are no branded alternatives, and a lower-end brand called Kroger Value for even more savings off the mid-range private-label products. The Private Selections line also includes organic products, labeled as Private Selections Organics.

“They've done an outstanding job with their private-label program, providing shoppers with the opportunity to trade from national brands to private-label options, when looking to save a little more money,” Hauptman said, noting that the Kroger Value brand “helps them compete not only against Wal-Mart but also limited-assortment stores and dollar stores as well.”

“They are hitting it on all levels — the upmarket and natural-organics, the national-brand equivalent level, and then also they have not ignored the entry level, and they are doing a good job there as well.”

Dillon noted that the Private Selections line has been leading unit sales growth among the company's private labels, and said the company expected it to be a $1 billion brand this year.

“We described in our conference call for the second quarter that our Kroger-brand performance has been improving even more than it had been for the last several years, and one could conclude from that that it's because of the economy,” he said. “However, over half of the improvement in the units sold vs. the units sold last year has been in Private Selections and Private Selections Organic. That suggests that maybe something more is going on here than just the change in the economy, and I think there's something alive in our corporate-brands program that people like.”

Impact of Inflation

Kroger has reported industry-leading financial results in the first half of 2008, but Dillon still said he is concerned that the rate of the company's sales increase in the second quarter was not as great as the increase the company enjoyed in the first quarter.

“Our rate of inflation has increased, and our sales in the second quarter were down slightly from the increase we had in the first quarter, so obviously, the tonnages we are achieving, while still positive, are not as positive as they were a year ago,” Dillon explained. “That's because inflation eats up some of that gain.

“But I think the fact that we are maintaining our position, and in fact gaining a little bit, is a really positive sign, because most supermarkets in this kind of environment are losing ground,” he said.

Although he pointed out that the whole supermarket industry has benefited from consumers' shift away from casual-dining restaurants toward more eating at home, Dillon noted that Kroger has been more successful than others at capturing that “share of stomach.”

“We are trying to look at this objectively from both directions,” he said. “We are ahead of the game through part luck, part strategy, and we were able to hold our head high even in these tough conditions.”

Analysts agree that Kroger has been a leader among supermarket companies this year.

“Kroger is the best defensive supermarket name, in our view,” said Andrew Wolf, a Richmond, Va.-based analyst with BB&T Capital Markets, in a recent report. “While we remain wary as to the defensive investment merits of most supermarket chains, in our view Kroger is better-positioned to generate decent earnings growth in an economic downturn than at any time since we have known the company.”

He noted that Kroger's strategy of pursuing sales growth through aggressive pricing is a solid one.

“If we are correct that the environment will continue to remain inhospitable, then Kroger's apparent strategy of trading some near-term profit growth for market-share gains is appropriate, in our view,” he said.

Deborah Weinswig, an analyst with New York-based Citigroup Global Markets, said she has been “impressed” by Kroger's ability to drive profits despite inflation.

“We believe Kroger will continue to benefit due to its lower prices vs. supermarket competitors, strong traffic trends, sales-driving initiatives [such as gasoline discounts and free-grocery incentive offers from its Rewards MasterCard], and investments in overall shopping experience,” she said in a recent note.

As an example of how the company is improving its in-store experience, Dillon cited the company's efforts to reduce the amount of time customers have to wait in line to check out, an initiative that involved data analysis to determine optimal use of front-end labor.

“Of course in the supermarket industry, front-end service is very important,” he said. “We have always tried to reinforce it, but in the past we had not actually improved. Now we have actually improved. Now we actually do a better job, and our customers in the research we do tell us we are doing a better job. By making actual real improvements, we are creating a better branding experience for our customer in our store.”

People Power

Kroger is known in the industry for having a strong management team, which is a reflection of Dillon's own management and personality, according to Stern of McMillan Doolittle.

“It's the kind of leader he is, and that kind of leadership is reflected throughout the organization,” he said. “It's very steady, very stable, and there's not a lot of ego there. I think that allows them to focus on the business.”

True to Stern's assessment of Dillon's selflessness, Dillon credited the company's culture and history of strong acquisitions for the development of strong management.

“I have never believed in a one-man show or even a one-team show,” Dillon said. “Our success is going to be the cumulative result of hundreds of thousands of individual associates who are individually committed to the work they do and the role they play.”

He related a story about one of the first jobs he had in the industry, cleaning a store at night when he rotated through a series of jobs as part of his management training program at King Soopers.

“One night one of the guys that had been on the night crew for years said to me, ‘You're not going to be doing this job a long time, but never be too proud to do a little custodial work. It's important to the customer, and it's meaningful.’

“That story illustrates that every associate matters,” Dillon said. “That every person in our organization is the key to our success. Our associates are the ones that really matter, because we would not be successful without each of them individually making a difference. I can't really overstate that point, because it really is important to me.”

He also cited Kroger's success in acquiring companies of a similar cultural orientation.

“Kroger has grown by acquiring some very good regional chains,” he said, citing the 1983 purchase of Dillon Cos. that brought him into the Kroger fold as well as the Fry's, King Soopers and City Market banners, and the 1999 merger with Fred Meyer Inc. that included Ralphs, Food 4 Less and QFC.

“Each one of those divisions has a little bit of culture themselves, and also has a culture that was not dissimilar from Kroger,” Dillon said. “It's one that's dedicated to success, it's one that's dedicated to customers, and it's one that believes in associates being treated fairly. As a result, I think the people who have risen to the tops of those individual divisions for us have held those same qualities for a long time.”

Dillon said the company's culture is based on treating all individuals with the same amount of respect.

“We try to reinforce it by making sure we all know what we are trying to do, and through the clarity of our strategy and the clarity of our objectives, the clarity of our values,” he said. “We talk a lot about the values of the company inside the company, and how important those are to our success. We talk a lot about diversity and how important that is to our success.

“Each of those areas tends to increase an organization's commitment to its values when you probe them,” he added. “Having a more diverse workforce ends up with one that grows in its respect for one another more and more each year, and I just think that's a healthy position to be in.”

Asked about the challenge of maintaining a unified corporate culture across a network of 2,500 supermarkets, Dillon said the company's culture is “the summation of the whole organization.”

“It's not just the leadership. It's not just the management. It's how associates feel every day,” he said. “Individually, our associates are on a mission. They come to this business because they like to serve customers.

“Our associates give us the basis for all of this,” he continued. “Large company or not, if you break it down to its normal unit, which is the individual associate, that isn't any bigger or smaller than anyone else's individual associate.”

Promoting from within is also an important part of Kroger's culture, he explained, although he acknowledged that “occasionally having an infusion of thoughts and views from the outside is helpful. And so occasionally, just to help open our minds and make sure we haven't gotten too narrow in our thinking, we will go and hire somebody from the outside.

“In some of our divisions, we have occasionally hired people who have been with other chains who have had experiences that can help broaden our horizons.”

Kroger has tapped outside expertise in manufacturing, food safety and information technology, for example.

In the area of workplace safety, Dillon said Kroger leveraged management expertise from outside the company to help Kroger reduce accidents and achieve accolades for safety in its manufacturing facilities.

“It enabled us to look at something more objectively than we had been able to do before,” he said. “That's something we didn't at one time pay as much attention to, but we made safety, for us, a value.”

Food safety is another area where the company has tapped outside expertise, in the form of Dr. Payton Pruett, who is vice president of corporate food technology and regulatory compliance. He joined Kroger in 2005 from ConAgra Foods.

Looking Ahead

Analysts see Kroger as being well-positioned no matter which direction the economy trends.

“I think they will be fine,” said Stern of McMillan Doolittle. “I think theirs is a strategy that obviously plays well in an economy that's downturned, but I think it also plays well as the economy recovers — it's not as if you are trading down to go to a Kroger. I think they have the ability to tailor the assortments back up again if that's what the customer calls for. They have the flexibility to be competitive, no matter what the state of the economy is.”

Dillon said Kroger's commitment to its Customer First strategy will enable it to weather whatever the economy brings.

“It's hard for me to forecast — I'm not an economist,” he said. “But I do believe it's going to be harder to predict where the environment is going because it's not just an ordinary downturn, because you have coupled with it a major credit confusion, and a major impact from high fuel prices. I say it is a ‘confusion’ because a lot of our customers don't know what to make of what's going on on Wall Street, and because they don't, it's hard for us to predict how it will affect them and their behavior.

“I'm not going to try to predict where the customer will be going six months or a year from now, but what I am going to try to predict is that as we try to satisfy their needs, we are going to continue to try to change, and by doing that we think we will be well-positioned for any of the outcomes that I can imagine that customers will go through.

“So if things get a little tougher for them, we think we'll be well-positioned on price, and if it goes a different direction where the market recovers, we'll be well-positioned from a service and a people point of view. I don't think you can forecast accurately, and I don't think you can try. Instead, we're going to stay close to the customer and move as the customer moves.”

Kroger at a Glance

HEADQUARTERS: Cincinnati

FOUNDED: 1883

2007 SALES: $66.1 billion

2007 NET INCOME: $1.12 billion

Same-store sales growth, excluding fuel:

Number of employees: 323,000

Number of supermarkets and supercenters (as of Aug. 16): 2,476

Number of convenience stores: 779 (including 91 franchised)

Number of jewelry stores: 393

Number of supermarket fuel centers: 737

Number of manufacturing plants: 42 (18 dairies, 11 deli or bakery plants, five grocery-product plants, three beverage plants, three meat plants and two cheese plants)

Number of corporate-brand items: 14,400

Percent of corporate brands made in-house: 43%