The Battle for Canada

BRIAN DUNN

Discount supermarkets in Ontario are going toe-to-toe with Wal-Mart in a pricing battle likely to leave multiple parties bruised.

Newly arrived but heretofore underperforming Wal-Mart Supercenters, combined with Loblaw's determination to hold onto its leading market share and reignite its retail engine, are said to be the major contributors to the price war. At stake is prosperity in Canada's most populous market, though it's only a matter of time before Wal-Mart's influence reaches Alberta, where analysts say the price-war scenario is likely to repeat.

According to one industry analyst, four of the seven supercenters Wal-Mart opened in Ontario within the last year are not doing as well as expected. An eighth supercenter opened in late August. Wal-Mart Canada opened its first supercenters in Ontario less than a year ago.

“The stores were priced about 2% below the discounters in the area, which are essentially [Loblaw's] No Frills and [Metro's] Food Basics, but they didn't get the traffic, so they dropped them by about another 9% or 10% in June, which the discounters followed, which created a big gap with Loblaw's Real Canadian Superstores,” said the analyst, who requested anonymity. “That in turn forced the superstores to drop their prices to the same level.”

Wal-Mart Canada, based in Mississauga, Ontario, denied some of its supercenters were not doing as well as expected and were forced to drop prices.

“The stores are exceeding our expectations and customers have reacted positively to our selection, pricing and quality,” said Christy Gallagher, a Wal-Mart Canada spokeswoman. “Our pricing strategy at our supercenters has been the same for years, which is to be the price leader.”

Gallagher admitted prices have been “rolled back” across the board on about 20% more items this year than in 2006, due primarily to a stronger Canadian dollar.

With 13 more Wal-Mart supercenters opening this fall in Ontario and six or seven set to open in Alberta, it's going to be “horrendously expensive for Canadian supermarkets, with another downward adjustment in prices, and it's not going to end soon with Wal-Mart opening 20-25 supercenters a year,” said the analyst.

Bottom-Line Impacts

The impact was reflected in the most recent quarterly results from Loblaw, Metro and Sobeys, which were all below expectations in Ontario, according to the analyst, who said margins will be impacted further when Canadian food prices go up at the end of the summer as more produce has to be imported, mainly from the U.S. and South America.

“As we move into the fourth quarter this year and first quarter next year, you'll see the same scenario repeated in Western Canada.”

Wal-Mart has its own challenges. It's dealing with union drives by its workers, especially in Quebec. Analysts note Wal-Mart has benefited from having a more flexible and cheaper workforce than its rivals, but that could soon change.

The United Food and Commercial Workers union is seeking accreditation in two locations each in Quebec, British Columbia and Saskatchewan. And a Quebec arbitrator is currently hearing arguments over a first collective agreement at another Wal-Mart store in the province.

The analyst said 75% of the price war is reactive on the part of Loblaw in response to Wal-Mart Supercenters and 25% is proactive by Loblaw, which needs to make its Real Canadian Superstores more price competitive.

“The good news for Metro is that its Dominion stores are not affected as much as its Food Basics and A&P banners, because most Dominion stores are in urban areas, whereas the price war is mainly in suburban and outlying areas.

“Sobeys is more of a conventional supermarket, so it's not being hit too badly, while its Price Chopper isn't a strong banner.”

The chains are trying to hold onto their market share and battle back using promotional prices, but the fundamental change is in the structure of regular prices, the analyst said. He said the price cuts affect about 300-400 items per store, or approximately 15%-20% of total volume.

“Loblaw has been fairly aggressive with its No Frills pricing in response to the Wal-Mart Supercenters,” said another analyst, “whereas the Metro guys claim they're prepared to give up a certain amount of market share to Wal-Mart, because they don't want a price war. If a 3-liter bag of milk at Wal-Mart is $3.96, they're prepared to set their price at $3.98 and take what they can get rather than going to $3.94.”

Loblaw's aggressive pricing is not all related to Wal-Mart, said the analyst. It's also related to Loblaw “screwing up its business model and trying to gain back some traffic and curb some of the square footage growth by its competitors,” the analyst said.

“And from a financial performance standpoint, we're also seeing some choppy waters for both Sobeys and Metro who are investing margin in response.”

Metro is holding its own, according to Alain Brisbois, head of Metro's Ontario division, who added that Ontario is probably the most competitive market in North America with excess square footage that doesn't allow Wal-Mart much room to lower prices further.

“In the last five years, square footage has been growing between 5% and 10% annually while disposable income and population growth has not kept pace, which puts pressure on the industry to capture and maintain new business.”

Brisbois called the Ontario situation a “moving target,” which Metro can fight with its Food Basics stores by increasing its flier distribution with weekly high-low pricing where prices are lower for a week on certain items to attract customers and the rest of the items are everyday low prices.

To protect margins, Metro is merchandising its stores better with greater execution at the store level, said Brisbois.

“We also make sure we have the right products, which is not always easy, but it's not much different than what we do on a weekly basis. It's not just prices that attract customers, it's also freshness, assortment and service, which we're very good at.”

Rebuilding the Superstore

Wal-Mart is not entirely to blame for the price war. According to one analyst, its eight supercenters impact about 30 Loblaw stores. Loblaw, on the other hand, is the province's largest player and in the throes of an aggressive program to reinvent itself through lower prices and revamped superstores. Loblaw is lowering prices across its entire network on price-sensitive items to gain lost traffic.

“Loblaw is trying to get its act together on a number of fronts, and most of the longer-term changes won't kick in until next year, such as more advertising for private label and more new-product activity, especially on the food side as they haven't been all that aggressive since they launched Blue Menu [a new line of healthy foods] about three years ago.”

On the store side, Loblaw opened a new pilot prototype, Real Canadian Superstore, in Milton, Ontario, on Aug. 29, renaming it Loblaw Superstore with more emphasis on fresh foods and groceries, and a scaling back of electronics and furniture.

“The store is a little smaller, at about 120,000 square feet, than a traditional superstore and they've culled about 30%-40% of general merchandise to make more room for stuff that remains, so it will actually sell better,” said the analyst. “They've also tried to simplify their approach to merchandising to reduce the cost of operating the store.”

The store features a wide aisle in the center of the grocery section to push special deals similar to a Wal-Mart store and improved back-room operations to get merchandise onto shelves more quickly, a problem Loblaw is still tinkering with.

Loblaw is also getting rid of inventory that isn't selling, particularly nonfood items, said analyst Anil Passi of Dominion Bond Rating Service, Toronto.

Irene Nattel, an analyst for RBC Capital Markets, Toronto, in a research note praised the store for improving upon the selection and “shopability” of previous models. “It's a big step forward, but no guarantees of success,” she said.

“One of the biggest surprises of the new Loblaw management team was its decision not to abandon the Superstore format but rather to fix it in the belief that a well-operated, successfully merchandised food/general merchandise box could be an important weapon in the war for share of the consumer wallet in Ontario,” Nattel wrote.

Health and beauty products have been given more prominence at the center of the store to create the environment of a drug store, albeit one with 20% lower prices, reports said.

The take-out food area is reduced by 10% in favor of healthier food such as salads, while freezer space has been boosted 30% to take advantage of consumers picking up frozen meals.

Grocery aisles are shorter and wider to make shopping and replenishing easier. The checkout area has been increased by 166% to improve labor efficiency by 10%, said Loblaw.

The Milton Experiment

At Milton, Loblaw also claims to be Canada's first bagless supermarket, encouraging shoppers to use “green alternatives,” such as reusable cloth bags and proprietary totes that fit into the store's shopping carts.

The new superstore's pricing is up to 15% lower than traditional Loblaw supermarkets, according to another analyst. Loblaw said it will test the Milton store over the next three months and, if successful, will redesign other superstores next year.

Although the Milton store featured several improvements in efficiency and productivity, the food offering, a key to all Loblaw stores, is “disappointing,” analyst Perry Caicco of CIBC World Markets, Toronto, remarked in a report after touring the store.

“Unfortunately, the food offering is weak. Perishables are limited and undermerchandised, natural and organic have been minimized, and pricing, although lower, is still not close to Wal-Mart.”

In addition, the store's marketing theme appears to be centered on the environment and health issues that might be inconsistent with generating the widest customer appeal, Caicco added.

“By not offering even biodegradable plastic bags, restricting parking unless a customer is pregnant or drives a hybrid car, removing fried food from the take-out counter and eliminating trashy magazines and unhealthy candy from the check-out counter, may limit choices that could alienate as many customers as it inspires.”

Although generally well received in Western Canada, Loblaw superstores have faced numerous problems since they were launched in Ontario in 2003. According to Caicco, they tend to lack identity with shoppers who aren't sure if they are a discount store, a big Loblaw grocery store or a department store. A similar lack of distinction as to their positioning also limited their appeal, the analyst added.

Superstores are critical to Loblaw as they represent about 22% of the retailer's overall sales. The company expects to generate 9%-10% more sales at Milton than a typical superstore, with 13%-14% less inventory.

“We feel it can reduce inventory but not confident it can increase sales,” Caicco concluded. “The store may not reach its potential because of a diminished food offering.”

Neither Loblaw nor Sobeys could be reached for comment.

Tumultuous Year in Canada

Though no one event is entirely to blame, the Canadian grocery market has been in upheaval ever since Wal-Mart began expanding its discount stores to supercenters a year ago. Among the changes are tightening prices, especially among discount banners in Ontario, although strategic acquisitions, management reshufflings and conceptual changes are also affecting the country's largest food retailers.

Following are some highlights and recent financial performance illustrating a tumultuous year in the Canadian grocery industry:

Analysts predicted difficult times for Sobeys in Ontario when it lost out to rival Metro Inc. in the A&P portfolio sale of 2005. But the 100-year-old company has soldiered on. In May, Sobeys announced it would be purchased by its largest shareholder, Empire Cos., which officially completed the going-private deal in June. Last month, Sobeys said it will buy one of Western Canada's strongest independents, Thrifty Foods of Vancouver Island.

The winner of the A&P Canada sale has realized millions in synergies since acquiring the assets — marked by strong locations in populous Ontario — but sales have been largely flat. Phase two of the integration, realignment of store banners, has been put off until next year while Metro fights pricing battles in Ontario. “We want our people to be focused on their job,” Eric LaFleche, chief operating officer, said in a conference call last month.

Canada's largest food retailer has also experienced a rocky ride as a new management team, led by Galen Weston, scion of the company's longtime controlling family, launched a comprehensive restructuring program this spring. The plan in many ways resembles the one Kroger accomplished in the U.S.: Lowering prices to be more competitive with supercenters, while expanding and refining its food/general merchandise format. Loblaw last week announced intentions to outsource its warehousing and distribution operations in Ontario.