Opportunities for Discounters and for A&P's Rivals

ELLIOT ZWIEBACH and MARK HAMSTRA

The rapid rollout of dollar stores and limited-assortment stores during the last several years could be seen as a vote of “no confidence” in the economy, according to participants in the 16th annual SN Analysts Roundtable.

The analysts also commented on the impact of Target's P-fresh remodels on traditional supermarkets, and on the potential future disposition of A&P.

(This is the third and final installment of the Roundtable — the first two installments, discussing the outlook for the economy and many of the nation's largest supermarket chains — appeared Sept. 12 and Sept. 19 on SN's website.)

“There is going to be a lot more polarization in this country, where there are a few rich people and there are a lot of people who basically can't make ends meet who will increasingly want an option that is extremely inexpensive,” said John Heinbockel, managing director, Guggenheim Partners, in making his case for the rollout of hard-discount food stores like Save-A-Lot and Aldi.

Target's P-fresh format, meanwhile, also is rolling our rapidly and seems to be taking share from a wide variety of competitors, the analysts said.

“[P-fresh] is adding a lift of about 1% to its overall comp, and it's projected to do 1% to 2%, so it's actually moving the comp in this environment,” said Mark Wiltamuth, executive director, Morgan Stanley, who picked up coverage of Target shortly before the Roundtable took place last month.

Andrew Wolf, managing director, BB&T Capital Markets, noted that Target is making a sudden impact with the format by rolling it out on a market-by-market basis.

“You are sitting there in Philly, and all of a sudden you've got a hundred of these,” he said. “Do the math.”

In addition, added Chuck Cerankosky, managing director, Northcoast Research, “They are aimed at the middle of the market, not at the low end like an Aldi.”

P-fresh also “has a pretty good complement of private label on the food side,” added Gary Giblen, managing director, Aegis Capital.

The analysts also discussed whether A&P, which has been in bankruptcy since last December, could continue to be broken apart and sold off piecemeal.

“Who gets the stores?” asked Scott Mushkin, managing director, Jefferies & Co. “The Fresh Market could be interested. Whole Foods has got to be interested in some of those. Those are the most logical players.”

“It's never going to be the whole company [that gets sold],” added Meredith Adler, managing director, Barclays Capital, “but I wouldn't be surprised if you saw interest from some rivals.”

The transcript of the analyst' discussion follows:

SN: Is the hard-discount concept still underdeveloped in the United States?

JOHN HEINBOCKEL: It's vastly underdeveloped. If you were to put all the hard-discount operators together, you'd probably have about 2,400 stores today, and that format should probably have a market share of 5% or higher, which would mean you would probably have two to three times as many units as you have. So I think Save-A-Lot and Aldi will both grow, and I think you will see Dollar General Markets become a much bigger player in that respect. I think hard-discount stores are one of the true growth sub-channels in this business today.

CHUCK CERANKOSKY: I think when you look at Aldi, Save-A-Lot and Grocery Outlet, one thing you want to keep in mind about their numbers is, there are 20,000 more dollar stores out there that are moving closer toward supermarkets in terms of merchandising and refrigeration, so I think the channel is maybe a little more crowded than people realize, and maybe more so than even Supervalu realizes. But it's also a channel that I hope will become a lot less attractive as the economy gets better. I don't think anybody aspires to shop there.

MEREDITH ADLER: I visited some Aldis in Germany this summer, and they look so much better than the U.S. stores. The perishables were just so much better.

CERANKOSKY: Well, they are different stores.

ADLER: It was very frustrating over there because they had very limited assortments, with a lot of merchandise on pallets, and it did not seem like a positive shopping experience for people who aren't that price sensitive. I think for the Aldis in this country, it's a different customer.

SCOTT MUSHKIN: What Chuck is saying is actually really interesting. Median incomes have generally been falling in the United States for over 10 years, which tells us the economy is just not working. If this reverses — if the economy started to work — then there is a lot of square footage that's been added in this format that you would think could become problematic.

MARK WILTAMUTH: Some of these stores are in food deserts where nobody else is servicing the communities.

ADLER: But they don't do a lot of revenues. I was told it takes six Save-A-Lots to equal one good banner store.

ANDREW WOLF: That's the problem — they are hard to execute. That's what Save-A-Lot's got going for it. Aldi, of course, is a world-class operator, but these types of stores are hard to execute. That's why they've got to keep them so simple.

CERANKOSKY: To make a good living as a Save-A-Lot licensee, you've got to have half a dozen or more stores. It's a management nightmare. You are not dealing with highly skilled employees to run these things, and there's a lot of turnover.

HEINBOCKEL: I'm not optimistic that things are going to get better. I think the $40K to $50K customer is going to persistently have less and less to spend, especially if he or she wants to retire before they are 80. There is going to be a lot more polarization in this country, where there are a few rich people and there are a lot of people who basically can't make ends meet who will increasingly want an option that is extremely inexpensive. So I would feel comfortable building a bunch of these on the premise that things are not going to get materially better.

SN: Does this represent an opportunity for any of the traditional grocers beyond Supervalu, which controls Save-A-Lot?

GARY GIBLEN: The unionized chains probably couldn't do it properly.

ADLER: It's such an entirely different format. Kroger has Food 4 Less, which is a bigger box, but it works. Safeway tried a deep-discount warehouse-style format and couldn't run it. Almost all companies have tried it, but when an entire organization is trained to give the customer what they want, it's hard to switch to a price format with only limited service. You have to be very disciplined.

MUSHKIN: But Kroger seems to be able to do it.

ADLER: Kroger hired the management. It was like plug-in-and-play for Food 4 Less using that management team.

MUSHKIN: Food 4 Less is by far what is working best for Kroger in Southern California.

ADLER: That's not surprising. Ralphs has been a challenge for Kroger for a long time, and I'm not exactly sure why. Someone just said people with money were only going to shop in really affluent stores. I'll shop almost anywhere.

CERANKOSKY: I think the clubs disprove that. The clubs attract affluent people, and it's really not an upscale shopping environment.

WILTAMUTH: The average annual income for shoppers at Costco is $96,000.

ADLER: When I talk about upscale, I mean a fancy decor package.

CERANKOSKY: Clubs don't have upscale decor, but they've got upscale merchandise.

Target

SN: What kind of threat is posed by Target's P-fresh?

WILTAMUTH: Target is rolling out P-fresh across the store base, and it's getting some success from it. It's adding a lift of about 1% to its overall comp, and it's projected to do 1% to 2%, so it's actually moving the comp in this environment.

WOLF: What is it doing — about $2 million to $3 million a store in incremental food sales?

WILTAMUTH: If you are a P-fresh shopper, you will have a more favorable view of the whole store, so you will get an afterglow effect from it. That, and the Redcard 5% discount program, are the two initiatives Target is pushing right now, and it's working.

WOLF: How are Target's discretionary sales?

WILTAMUTH: The P-fresh grocery program and the 5% discount initiative are actually fueling positive comps. Comps were only 2% in Target's April quarter, so excluding the Redcard and P-fresh implies that its core comps were negative early in the year. Comps accelerated to 3.9% for its July quarter, so comps clearly picked up. Consumables are only approximately 16% for Target, so much of that is discretionary sales power.

HEINBOCKEL: But Target's discretionary sales are better than Wal-Mart's.

WOLF: But the number is still negative, right?

HEINBOCKEL: No, parts of Target's discretionary sales are still positive — parts of apparel, parts of home. But again, it's a bit of a different demographic.

SN: Does Target pose a threat as a competitor to traditional supermarkets?

HEINBOCKEL: It's a nuisance.

WILTAMUTH: It's another source of pressure.

WOLF: Remember, Target is converting to P-fresh by market. You are sitting there in Philly, and all of a sudden you've got a hundred of these. Do the math.

CERANKOSKY: They are aimed at the middle of the market, not at the low end like an Aldi.

WILTAMUTH: It's probably more of a fill-in trip, but it certainly has increased frequency at the Target stores — that's a key driver of it.

HEINBOCKEL: Let's say Target is pulling $200 million out of a market — that's coming from a lot of different people. It's coming from Wal-Mart, it's coming from traditional supermarkets …

WILTAMUTH: And Target is going with Wal-Mart-level pricing, so it's getting attention.

MUSHKIN: In California, you have big price gaps between the grocers and the mass merchants. That's going to be the big issue when the dollar stores start opening in California — how they price. When Dollar General starts opening there, you'll end up with 25% price gaps between the traditional guys, Target's P-Fresh and Dollar General.

ADLER: Family Dollar is working on price optimization and zone pricing, and I think Dollar General is working on it as well. But they'd be pretty stupid not to, right? Of course prices are going to be higher in California because the rents are going to be higher.

MUSHKIN: But you don't really see higher prices in the Target food offering.

WILTAMUTH: Target is matching the Wal-Mart number.

GIBLEN: Target has a pretty good complement of private label on the food side.

MUSHKIN. That is scary pricing in that market, and Target is going to put tremendous pressure on these grocery chains. It obviously should be charging more in California, but it is not.

WILTAMUTH: That's the funny thing about Southern California — it's always been a Costco pressure zone for Safeway and others.

WOLF: Target bought the old Montgomery Ward stores. That's how it got a bigger presence out there.

ADLER: But when you say Target is matching Wal-Mart, is it matching Wal-Mart's Arkansas prices?

HEINBOCKEL: Wal-Mart is pretty much national with its pricing. We did a study in Tennessee and one in New Jersey and found the same prices, so if anyone could take advantage of price optimization, it is Wal-Mart.

A&P

SN: How do you see the A&P situation playing out?

ADLER: Not well.

MUSHKIN: Who gets the stores? The Fresh Market could be interested. Whole Foods has got to be interested in some of those.

ADLER: A&P has a lot of low-end stores, though.

WOLF: The question for Whole Foods is, could it get the A&P stores free of the union?

ADLER: I think you'd have to break the whole thing apart. That would be amazing — to liquidate the oldest food retailer in the country.

WOLF: You mentioned how onerous A&P's union contracts are. Who would ever want to get tangled in that?

ADLER: I wouldn't be surprised if you saw interest from some rivals.

HEINBOCKEL: Perhaps ShopRite.

WOLF: Do you think ShopRite would take those union contracts?

ADLER: ShopRite has unions too.

HEINBOCKEL: And because A&P is in bankruptcy, a buyer might have a little wiggle room with the unions.

CERANKOSKY: Look at Penn Traffic. When it went through Chapter 11 the last time and sold stores to Tops, Tops got new union contracts. I think the unions would be quite flexible if another union operator stepped in.