SN Analysts Roundtable, Part 2: Grocery Competition Increases in a ‘Middling’ Recovery

NEW YORK — The economic recovery is in mid-cycle — a good place for it to be for the conventional supermarket industry — though increasing competition from lower-priced alternatives still presents serious challenges, industry analysts said here during SN’s 18^th annual Financial Analysts Roundtable.

The participants also said Whole Foods Market continues to hold a unique place in consumers’ minds despite its price perception, and Wal-Mart Stores' future may lie in its smaller formats.

Calling the recovery “middling,” Andrew Wolfe, managing director for BB&T Capital Markets, Boston, said, “If people become more secure in their incomes, they’ll continue to gravitate back to the supermarkets, which they know are more expensive but also more convenient than alternative formats.

“But if the economy continues to sort of limp along, the supermarket rally may be short-lived.”

Chuck Cerankosky, managing director, Northcoast Research

Chuck Cerankosky, managing director for Northcoast Research, Cleveland, offered a similar view. “We’re still seeing a lot of competitors opening — whether it’s the dollar stores or Wal-Mart — so until people are feeling a lot better about their personal household financial situations, we’re going to see a certain portion of the consumer base shopping around at a number of retail venues.”

Regarding Whole Foods, Meredith Adler, managing director for Barclays Capital, New York, said she believes the company has to change its approach to appeal to a broader spectrum, while other analysts said that would alter what Whole Foods is.

“One neighborhood-oriented store in Detroit does not mean [Whole Foods] is going to be able to do what discount natural-food chains can do, which is to service a very broad customer base,” Adler explained. “I don’t think Whole Foods has necessarily proven it can do that.”

According to Gary Giblen, managing director of GMG Capital, Darien, Conn., as more competitors arise to challenge Whole Foods in the natural and organic segment, Whole Foods may seek to acquire the more successful ones. “Historically, Whole Foods has bought out any serious competitors, and there is really no reason to think that won’t continue to happen,” he pointed out.

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Discussing Wal-Mart, Scott Mushkin, managing director for Wolfe Research, New York, said the company’s 12,000-square-foot Express store is “the best new format I’ve seen introduced in a long time,” with a full offering of fresh foods, well-priced packaged foods, a decent selection of general merchandise, plus a pharmacy and gas station.

However, with Wal-Mart geared to supplying larger-footprint stores, the company is struggling to find the most efficient distribution methods to supply the smaller boxes, he noted.

Part 1 of the roundtable was published Sept. 16. The full text of the balance of the roundtable follows:

THE ECONOMIC OUTLOOK

SN: Let’s talk about the outlook for the economy as it relates to the supermarket industry.

Gary Giblen: Supermarkets have done well in the current economy, and there’s every indication the economy is going to remain pretty much where it is, which would mean a continued positive environment for supermarkets.

It’s remarkable that gross margins have been so steady-Eddie. There are a million reasons why they shouldn’t be good — a pressured consumer, plus moderate food inflation that has to be passed through, plus high-energy inflation that has to be passed through, plus a near-saturation of private label — which means you don’t have much margin expansion there, at least for the major chains. However, good management and execution, plus a rational competitive environment, should continue. And if any of those various pressures on gross margins lets up, then margins could get even stronger.

Scott Mushkin: I think it’s interesting that margins have held, but sales numbers continue to be a challenge, depending on which company you’re talking about, due in part to the lack of inflation. At the same time, unemployment is better but still elevated, while our pricing surveys remain negative in some areas — generally a sign of a weak consumer and heightened competition. We’ve been calling it the “Dr. Jekyll and Mr. Hyde” economy due to all the crosscurrents we are picking up. Nevertheless, the economy does appear to be mid-cycle, albeit weak — and mid-cycle is generally good for supermarkets.

Supermarkets tend to react in a positive way to a better employment situation, but it’s weak employment that’s throwing us off a little bit and making it harder to understand exactly what’s going on. We’ve been surprised how negative our pricing surveys have been in some places, so competition is there but the backdrop is generally positive, although weak.

Andrew Wolfe, managing director, BB

Riffing on what Scott and Gary said, I think the stocks have outperformed this year because fundamentals have improved — even Supervalu, with a negative-3 comp, is better off than at a negative-5, and Safeway, for the first time in eight years or so, is showing flat to slightly positive volume, and that’s a nice improvement.

I agree wholeheartedly that it’s a middling recovery, and I think the next period for supermarket stocks is going to be tied to the job market. If people become more secure in their incomes, they’ll continue to gravitate back to the supermarkets, which they know are more expensive, but also more convenient, than alternative formats — and perhaps higher quality. But if the economy continues to sort of limp along with a 2% GDP and barely any job growth, the supermarket rally may be short-lived.

Chuck Cerankosky: I think it’s all about employment — specifically, the quality of the employment. We’ve had a prolonged weak jobs market where many people are spending time to save money — at the same time the chains continue to talk about their good stores in higher-end neighborhoods doing a lot better than their lower-end stores. Until that changes meaningfully, they’re going to have to worry less about how rich the product mix is and focus a lot more on pricing.

Gary pointed out that margins have held up, but I think a better way to describe it is that they’ve stopped going down, and we’re not near a peak. We’re still seeing a lot of competitors opening — whether it’s the dollar stores or Wal-Mart — so that has to be considered, and until people are feeling a lot better about their personal household financial situations, we’re going to see a certain portion of the consumer base shopping around at a number of retail venues that exceeds the pre-recession level. 

Meredith Adler: I think the stable margins prove that deflation was actually a very big driver in competitive activity — that supermarkets flipped out when everyone’s comps went consistently negative and they were not conscious of the fact that volumes were actually better. Because we’ve had moderate inflation this past year, it’s just been easier for the environment to be normal.

I agree with all the comments about bifurcation, but I think what is going to be interesting is the changes that are coming to SNAP [Supplemental Nutrition Assistance Program]. We’re going to have the part of SNAP that came from the stimulus going away this fall, and the government is going to have to do something with the entire program because if it expires without being renewed, then the benefits go back to the levels they were at in 1945. The problem is that Republicans and Democrats are continuing to argue with each other. The latest set of data about SNAP indicated that the number of households getting benefits went up 3.4% earlier this year, and it has yet to level off. Although 3.4% is less than it had been going up and certainly much less than during the recession, it is still going up, yet you’ve got people in Congress fighting about whether these people should get benefits.

But the reality is, 20% of U.S. households are getting SNAP benefits, and if those benefits are cut even more deeply, then you’ve got a problem that’s going to impact the supermarkets. Wal-Mart is the biggest redeemer of SNAP benefits, but in the aggregate, the supermarkets are the second biggest, and SNAP accounts for about 5% of revenues for the dollar stores. Because supermarkets serve such a broad audience, I worry that there’s a whole group of people out there that are already hurting — some of them because of higher payroll taxes and some of them because of lower SNAP benefits.

Giblen: Regarding bifurcation, as long as the Fed continues to be extremely accommodative, essentially forcing money into stocks, then the wealth effect will continue to be there, nicely buoying results. And if you have investments and they are going up, then you will be quite comfortable shopping at Whole Foods or Harris Teeter or Fairway or other upscale venues.

Adler: There’s a long lag time for the wealth effect to be visible, but we certainly have had a strong stock market for a while now.

Mushkin: Meredith’s point is interesting because as much as the stocks have worked, it’s been hard to put a bullish spin on everything. Take, for example, industry volume, which went negative a few years back when inflation spiked but which even now has come back down, with volumes near zero. So while some look at the stock market and say the economy must be very good, we believe the data supports a weak mid-cycle rather than a strong mid-cycle view, and we are seeing valuations now that we haven’t seen in a long time.

Read more: CEOs Cautiously Optimistic About Second Half

Wolf: But if everybody is improving, that’s how stocks get valued — they’re dirt-cheap one day and then they’re up the next day.

Adler: The buying of supermarkets came as much as anything because the stocks were relatively cheap and had stayed cheap for a long time. I don’t personally think you can draw a conclusion about the industry from the performance of the stocks. Maybe you can with Kroger, but Kroger as a company has been a good performer for a long time. People’s sentiments change on a dime, but Safeway and Supervalu have created value — or at least the perception of value — in different, non-traditional ways, not just by operating their businesses.

Mushkin: Look at the Southwest, which is booming — in part because of what’s going on in the real-estate market. In San Francisco, for example, the real-estate market went up approximately 25% year-over-year, and there’s been a very sharp turn in real estate in two other Southwestern markets, Phoenix and Las Vegas, and those real-estate improvements look like they’re leaking into the overall economy. We just had an IPO of a company with lots of exposure to these high-flying real-estate areas [Sprouts Farmers Market], and comps have been accelerating, and we do not believe that’s a coincidence. So if you look at Safeway’s footprint, it also has significant exposure to red-hot real-estate markets, and while its comps are better, they are not what I would call robust.

Read more: Sprouts Shares Double During IPO

Wolf: I want to make a point about mix. The only way you’re going to have stable gross margins is to find a better mix if pricing is still competitive in certain markets. The pricing survey I do twice a month in Richmond shows pricing peaked about a year ago, and since then, pricing at Wal-Mart and Kroger is down a little, while the two laggards, Food Lion and Martin’s, have really been playing catch-up, with pricing down a lot. Food Lion in particular has really gotten its pricing better. It’s not quite where Kroger is, but it has tightened the gap a lot. So certain markets are more competitive, and Wal-Mart has been a little more competitive.

Adler: That’s kind of simplistic. You can buy better, your shrink could be better, your transportation and distribution costs could be lower. That’s mix too.

Wolf: I’m talking about the whole industry, the macro environment, so it’s not that simplistic. On the macro level, I think the biggest drivers are pricing and mix. What I’m saying is that mix has no competitive effect, so when the economy improves, mix usually gets better.  But we’re seeing bad pricing — what I call competitive but rational pricing — and other players, particularly the European players, are saying, “Hey, we’ve got to do a little bit of what Kroger did, or actually a little more than a little of what Kroger did.” Safeway is saying it has to do a little bit more as well, and that’s why I agree Safeway is at a point where it has to figure out what it’s going to do with pricing.

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Cerankosky: I don’t deny that mix isn’t getting better — it’s just not uniform. Bifurcation is probably an overused word, but I think when you talk about food deflation occurring and volumes staying down, as they did three or so years ago, it shows how people were acting — they had more money in their pockets and they weren’t spending it.

Mushkin: Companies run into trouble in an environment where you have pricing down and flat volume because margins are not going to hold up. I’m telling you right now, if you get pricing down on ubiquitous items and no volume…

Wolf: I think you get that in grocery.  The other thing going on with mix is in perishables, where produce has been up, and that’s not measured by Nielsen.

Adler: That’s why Safeway’s volume numbers also don’t mean very much — because they only reflect dry grocery, whereas produce and perishables are a reasonably big piece of its business.

WHOLE FOODS

SN: How strong a competitor is Whole Foods to the conventional supermarkets?

Adler: While Kroger has to continue doing what it’s doing to be successful, Whole Foods has to accelerate square-footage growth and go into new markets, and different kinds of markets, to deserve the multiple it has. It has to change who it is.

Wolf: Well, it’s been doing that — opening a lot of stores and accelerating square-footage growth — and it’s been doing it incredibly well, better than I ever thought it would. The ironic thing about Whole Foods is that it was a growth-through-acquisition story until two years ago, and since then it’s been an organic growth company after it bought all its competitors — nothing could be better than that — though when I asked management if we should expect more smaller acquisitions like Johnnie’s Foodmaster, it said yes.

Adler: I hear what you’re saying, but one neighborhood-oriented store in Detroit does not mean it’s going to be able to do what discount natural-food chains can do, which is to service a very broad customer base. I don’t think Whole Foods has necessarily proven it can do that.

Mushkin: I think Whole Foods has to walk a very fine line here because there is nothing like it in the marketplace. Whole Foods is unique in what it brings to the consumer. From its exceptional prepared foods to its quality and animal welfare standards, Whole Foods is special. However, some of its uniqueness naturally leads to higher prices — not necessarily a bad thing, but it may limit how big Whole Foods can become. I thought the Whole Foods that opened recently in Des Moines looked a lot like a discount natural-foods store, and I don’t think that’s good for Whole Foods. I don’t think it wants to look like a farmers' market-style store because that is not why customers shop there, and it is not why customers are loyal.

Meredith Adler, managing director, Barclays Capital

And at some of the smaller Whole Foods stores I’ve visited in Manhattan, the quality and service are not as good as in other cities, and given the pricing, it’s not a positive experience. So I’m not even sure it is maintaining the standards it says it has.

I’m also curious what kind of a message does Whole Foods give to the people in Detroit? Don’t most people still think of it as Whole Paycheck, and if so, how do you change that? Not just by lowering your prices. So how do you communicate it?

Wolf: Well, I think it’s changed — people don’t use that moniker nearly as often as they used to, and that’s a change.

Adler: Who doesn’t use it? I hear it all the time from upper-middle-class people who think the stores are pricey.

Mushkin: We’re a family of seven — two adults and five children — and we go to Whole Foods and The Fresh Market and we’ve tried FreshDirect because we’ve become pickier about what we feed our kids — in fact, I think probably the whole population has — so we try each one out, and by and large, the quality of Whole Foods is excellent. If you’re going to get the dry-aged meat, for example, it’s hard to get that quality from other places.

Adler: But you pay a premium.

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Mushkin: Yes, but you’re paying for Whole Foods’ animal welfare standards, you’re paying for the boats that go out and fish like Whole Foods wants to fish. All of that costs money. There is nothing Whole Foods can do about it, and in my mind changing that approach will diminish its appeal.

Wolf: I’ve talked with conventional operators who have seafood departments like Whole Foods has, and they say they buy tuna from the same docks and charge maybe $3 less a pound. So you’re right when you say customers do pay a premium at Whole Foods. I just think Whole Foods hasn’t made the same investment in price in its fresh departments as it has in the grocery aisles, so yes, from a purely price-position aspect, it has some exposure in its core perishables departments.

Adler: But it’s not all about price either. It’s about price point — and the relationship with the quality of the offering — and I’m not sure it’s changed. And if the price point goes down, do you stay at Whole Foods? I’ll go back to what I said before — that Whole Foods is changing. To grow, it needs to change — and Kroger just needs to do more of the same.

SN: What’s the situation with other natural and organic operators?

Adler: There are two things these companies all have going for them. One is the fact fundamental demand is rising and becoming more mainstream, and the other is that most of these companies are still relatively small in terms of the number of stores they operate, so they have a lot of room to grow off a relatively small base — for example, Whole Foods has 350 stores compared with 3,500 for Kroger.

Cerankosky: So it doesn’t take a lot to move the needle.

Adler: And to a large degree, they are all pretty much different from one another.

Mushkin: I agree they are very different. I would say that Whole Foods is by far the most differentiated, unique format out there, though I think that limits its market-share to a degree.

Adler: Whole Foods has also been around the longest and operates in different markets, whereas a company like Fairway knows only one market [New York].

Mushkin: The strategies of each company are so different from one another. Whole Foods is vastly different from Fairway Foods and also from The Fresh Market. Whole Foods is synonymous with natural and organic foods and incredible quality, while Fairway marries high-quality merchandise with an incredible selection of specialty items along with well-priced traditional grocery items, and The Fresh Market is a small upscale market that emphasizes the customer experience. So the question is, can all these guys co-exist as the industry grows up?

Adler: Their geography doesn’t necessarily overlap that much.

Cerankosky: Whole Foods has an amazing amount of authenticity because John Mackey and Walter Robb [co-chief executive officers] were founding members of the natural and organic food movement back in the late 1970s and early 1980s, and that industry has certainly grown tremendously since then. But The Fresh Market tends to be non-threatening — it does not have a big draw per box, and it picks its real estate very carefully because it is not trying to draw from 10 miles away.

Read more: Whole Foods 'Thrilled' With Detroit Store

Mushkin: The Fresh Market is basically a specialty chain appealing to the Baby Boomer set. Unfortunately if you look at the demographics, by 2020 you’ll have a lot less Baby Boomers than you do today. That group is still very big, but it’s shrinking, albeit slowly. It’s interesting that The Fresh Market is going after a demographic that is not nearly as exciting as what a farmers' market would go after and what Whole Foods would go after.

The other issue affecting the Baby Boomer set is its earnings have peaked. It’s a group that was the best demographic to go after for so, so long, but it’s going to end up being a much tougher demographic over the next 10 years. Boomers want what they have always had, but now they aren’t making as much money, so getting them to pay for what they want will increasingly be a challenge.

Over the years Whole Foods has made a lot of institutional mistakes, which have resulted in a lot of institutional learning, which is good. If you look at lease costs, which are rising very rapidly across retail, including for The Fresh Market, Whole Foods is one of the few companies that has kept the cost well contained.

Adler: That’s because the base is so high that as you layer in more reasonably priced real estate, returns are going up simply because lease-adjusted returns were so bad before.

Mushkin: Whole Foods has done a really good job in the last couple of years embedding those lower costs into what it’s doing.

Cerankosky: A lot of what differentiates Whole Foods is its prepared foods, most of which are very well done.

'BUY THEM OUT'

Giblen: What’s interesting is that, historically, Whole Foods has bought out any serious competitors, and there is really no reason to think that won’t continue to happen. So if a competitor grows and achieves any kind of success, Whole Foods would rather buy them out than compete against them.

Adler: But the company has gotten very good at growing organically, and I’m not sure it would make sense at this point to make a lot of acquisitions.

Giblen: Whole Foods is expanding more into smaller towns and cities, so why not let Fresh Market and other natural and organic chains make a lot of acquisitions and then, if they are successful, Whole Foods can simply buy them and get rid of a bunch of competitors?

Adler: One executive told me he believes that as Whole Foods moves into smaller markets, it is going to crush The Fresh Market.

Wolf: Why wouldn’t Whole Foods crush The Fresh Market? It runs a store that’s twice as productive in sales per square foot, with better pricing, whereas Fresh Market runs stores with more of a defensive strategy in terms of locations.

Scott Mushkin, managing director, Wolfe Research

Mushkin: The thing that’s going on at the higher end is that everyone is doing it differently, so the question is, how much cannibalization is going to come along? The farmers' market-style stores are vastly different from Whole Foods. In fact, if you were to ask operators of farmers' market concepts who they take share from, they would cite the supermarkets, not Whole Foods. With that said, competition is our No. 1 concern when we look at the specialty area.

Wolf: I liken those farmers' market stores to the original Food Lion concept, which was very powerful in its day — more of a neighborhood-oriented, low-investment box that is really convenient for consumers.

Mushkin: Millennials like fresh, healthy, natural and organic foods, but they also like value because of the stage of life they’re in. Timing is everything, and the value-focused wholesome foods provided by the farmers' market concepts look like they will coincide with a generation that desires natural, organic, local and fresh food at reasonable prices.

Adler: Somebody recently asked Kroger if it would start adding square footage to natural and organic products now that the recession is sort of behind us, and Kroger said it never took that merchandise out — in fact, square-footage in natural and organics has been going up for years at Kroger, and it’s been one of the company’s best-performing categories throughout the recession.

Cerankosky: I think one of the underlying trends in natural and organic foods — whether you’re talking high-end meats or more popularly priced produce items — is that there’s a lot more product around and the prices have come down, and the people who didn’t buy it five years ago because of the cost and who are learning about the health benefits are now saying they can afford it.

Wolf: I still think Whole Foods has a huge competitive advantage because it is regarded as the authority on where to go to treat yourself to be healthier. I think the rising costs of health care in America gives Whole Foods this competitive advantage and will keep it growing. People who work in those stores really care about health and the relation of food and health, and I think that gives Whole Foods a real advantage.

Mushkin: The authenticity of Whole Foods is second to none, so it’s not just about natural and organic — it can be gluten free, it can be animal welfare. Whole Foods won’t carry lobsters anymore because it doesn’t like how the lobsters are trapped, and it does a lot of work with small community farmers and with Third World countries on fair trade and fair work standards. Whole Foods goes way beyond food and health — it’s a mission-driven company that appeals to people for reasons beyond just eating natural and organic.

Wolf: I link Whole Foods’ success to the health care crisis — with people getting less of their health care costs paid for and seeing more money coming out of their own pockets, it encourages them to take better care of themselves. Whole Foods has become an authority — a place where you can go for free and say, “Hey, I need to get my blood sugar down — how do I do that through food and nutrition?”

SN Blog: Amazon and Whole Foods in Coming Battle?

Cerankosky: People love eating well, and Whole Foods makes you feel better about doing it. That’s who it appeals to — people who know about and appreciate great-quality food and are willing to pay for it.

Wolf: I think one of John Mackey’s big pluses has been to shift his ideas from the foodie side to the health side. When he went to the foodie side and operated these Nordstrom-style stores, it caused cash-flow issues that necessitated bringing in [investment firm] Leonard Green. Now he’s shifting it back, and I think it’s brilliant. A wise man learns from his mistakes.

Cerankosky: I would say that the costs in the store have been adjusted more so than the mix. Look at the square footage per store among the recent openings. A few years ago Whole Foods was building stores of 50,000 square feet, 60,000, 70,000, and now the average is like 38,000 square feet.

Adler: I think Whole Foods has reduced its offerings of supplements in some stores and has more space dedicated to prepared foods.

Wolf: When I talk to independents who compete with Whole Foods, they say they try to compete on the supplements because Whole Foods definitely has a more edited assortment — even more edited than Wild Oats used to have. Whole Foods is not a pill shop — and yes, it certainly is a take-home food shop. But I still think when someone takes food home from Whole Foods, like barbecue, for example, which has animal cholesterol, at least you know you’re getting naturally raised product that isn’t full of toxins. There’s still that going on.

WAL-MART

SN: What kind of opportunities do you see for Wal-Mart?

Giblen: In terms of execution at the supercenters, Wal-Mart is improving to a level that’s at least acceptable. Out-of-stocks are a bit less of a serious problem, and it’s putting in self-checkouts to relieve ridiculously long checkout lines.

Adler: Wal-Mart is definitely focused on Neighborhood Markets, which is basically a conventional grocery store with great prices. That format has been able to grow on the West Coast but mostly in second-use spaces because the company hasn’t been able to build anything new. And there has supposedly been a lot of pushback from the people at the stores and in the field because they are used to operating in standard boxes — they’re saying it’s much harder to operate with every store having the back door in a different place from what they’re used to, and different store sizes and layouts and altogether different configurations. That’s probably going to slow down the company’s West Coast expansion. However, in my opinion, if you’re Wal-Mart management and you see the lack of discount competition and the size of the population and the density in California and the Pacific Northwest, you should be telling the guys that operate the stores, “Figure it out!” because it’s just such a huge opportunity.

Wolf: I think Neighborhood Markets are great vehicles if Wal-Mart wants to get into urban America, like the single store it operates in Chicago.

Cerankosky: To Wal-Mart’s credit, it opened a full-scale supercenter in Cleveland, in the inner city. It got permission from the city, then the unions got in the way and slowed the project, but Wal-Mart built the store anyway, and it opened with no fanfare.

Gary Giblen, managing director, GMG Capital

Urban is certainly under-penetrated for Wal-Mart, but I still think if I were Wal-Mart, I’d be looking at places where there is limited discount competition, like California.

Mushkin: Wal-Mart would love to go urban, but I’m not sure it likes the returns it’s getting on urban.

Cerankosky: There are some extra costs that go with it.

Mushkin: I think the next big announcement coming out of Wal-Mart will involve the Wal-Mart Express — I think the company is going to move forward with a fuller rollout. It’s got a test going on in North Carolina with a 12,000-square-foot store complete with a gas station, a pharmacy, a full offering of fresh food, well-priced packaged foods, and a decent selection of general merchandise. It’s a phenomenal format — the best new format I’ve seen introduced in a long time. But it will take a lot of those small stores to move the needle. And the question is, can Wal-Mart make the distribution work?

Adler: What’s the distribution issue?

Mushkin: Wal-Mart’s whole distribution system is set up to service supercenters, and it’s not nearly as sophisticated for smaller stores as you would think, given its reputation. It’s all about allocating capital, so most of its supercenters are in rural areas where the cost of land is really cheap. The labor tends to be cheaper too, so Wal-Mart’s distribution is very efficient until orders get picked, and then it’s very old-fashioned in the sense it does not plan out the trucks — they are all stacked by hand, and unfortunately you can’t really distribute well to the small boxes that way.

Adler: Not to mention that if you have a limited assortment in a 12,000-square-foot store, then trying to pick orders out of a supercenter distribution center is terribly inefficient.

Mushkin: What Wal-Mart has with the Express store is a phenomenal format. The question is, can it distribute to those stores? The stores in rural areas are doing double-digit comps in their second year, so as much as you want Wal-Mart to be the urban store, it’s easier for it to go rural.

Read more: Wal-Mart Eyes 'Game-Changer' for Express Stores

Adler: Even if Wal-Mart were able to get more sophisticated, nothing beats Dollar General’s distribution centers in terms of servicing 500 to 600 stores with the same 10,000 SKUs. Is Wal-Mart trying to pick these little stores out of a distribution center that usually services 150,000 SKUs?

Munchkin: Wal-Mart is working to see if it can figure it out — to determine if it can actually get products to a supercenter, where it has the labor, and then move them over to the Express store, using the supercenter as a satellite distribution center. Unfortunately this is Wal-Mart’s story: It discovers this great new format, but because of legacy, it can’t deal with it all that well.

Wolf: It sounds like Wal-Mart is pissed off at the dollar stores and wants to kick their butts.

Adler: But the dollar stores don’t take that much from Wal-Mart.

Wolf: But that’s Wal-Mart’s mentality. If you take anything from them, then the rattlesnake wants to strike, which is actually a healthy, natural competitive action.

DOLLAR STORES

SN: What are the prospects for dollar stores?

Adler: They’re a niche. They do not sell variable-weight perishables, and they are never going to go in that direction.

Cerankosky: But they are going in the direction where they can hit operators like convenience stores with cigarettes and lottery tickets.

Giblen: More cooler and freezer space for food, along with adding cigarettes.

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Wolf: They’re crumb collectors. And there’s a lot of money to be made in collecting crumbs.

Mushkin: Don’t you think Dollar General is just a little bit different — kind of a rural general market?

Wolf: They’re like a fully stocked convenience store, with a lot more emphasis on health and beauty.

SN: Do you get a sense of how the DG Markets are doing?

Adler: The company doesn’t like the returns as much as it likes the returns on a regular Dollar General.

Mushkin: The company seems to be happier with the regular Dollar General stores in California. For some reason, it doesn’t like the DG Pluses out there.

Adler: Maybe because the real estate is so expensive.

Read more: Slowing Dollar Store Growth Sparks Merger Speculation

Mushkin: My question is, is this the right time for the dollar industry, given the macro environment?

Adler: If you look simply at the geography, they still have a lot of white space on the map.

Wolf:  They can go everywhere, and California looks like the biggest red state in the country — if you exclude Los Angeles, San Francisco and the other big cities — because you still have a huge population there of mostly low- and moderate-income people who live in rural environments.

Mushkin: If you look at the dollar-store industry generally, it feeds off of poor economic conditions, and the two biggest concerns are labor and real estate. High unemployment has two benefits: One, more consumers trade into the stores, and two, it lowers the cost of labor and increases the quality of personnel, helping to reduce shrink rates. Poor economic times also hold down the cost of real estate.

Adler: But the industry also has certain advantages. Limited assortment is very efficient.

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