The Kroger Plan

JON SPRINGER

CINCINNATI — The supermarket industry is under attack. Competition is heavy. Labor and energy costs are skyrocketing. Shopping habits are more unpredictable than ever. The economy and grocery stocks are sluggish at best.

Kroger is upbeat.

"I have no worries about our ability to change, and no concern about our ability to react to changes that the consumer wants," said Don McGeorge, president and chief operating officer of Kroger, in an exclusive interview here with SN. "That has been a great strength of the Kroger Co. through the years, and embracing change is something we look forward to."

A company with the foresight to change for the better even as broad trends turn for the worse, Kroger is the recipient of SN's 2004 Retail Excellence Award. Kroger was chosen by SN's editors, with input from a variety of industry leaders, following a nomination process on the SN Web site, www.supermarketnews.com. The Excellence Award honors a retailer for outstanding performance on a number of criteria. H.E. Butt Grocery, Austin, Texas, won the first Excellence Award last year.

Seldom do accolades come from Kroger itself. Beyond financial reports and community news, Kroger prefers to remain outwardly quiet and safe from the exposure of its strategies that competitors might glean from industry press. It rarely offers comment or consents to an interview. But behind sealed lips and a general lack of sex appeal beats the heart of an innovator and industry leader.

"Kroger represents the realities of this industry better than anyone," said Neil Stern, senior partner of supermarket consultant McMillan Doolittle, Chicago. "They're responding to real-world issues that every supermarket company in America faces every day, and they're trying to be innovative about solving them."

Though Kroger is not without significant challenges, observers say its strategies have helped position it to grow even in the difficult atmosphere of food retailing today. Kroger's strategic plan to invest in lowering prices and cut its own costs is narrowing the pricing gap with low-cost retailers, widening its gap with conventional stores, and winning modest gains in sales and market share in very tough competitive environments. Synergies derived from the 1999 merger with Fred Meyer continue to pay dividends for Kroger in a way that few other companies in the consolidation wave ever realized. Its food-and-general merchandise Marketplace stores, perishables-oriented Fresh Fare format and Food 4 Less value banner have all made significant advances over the last year. Its private-label program, which accounts for 26% of sales and 30% of volume, is considered to be among the industry's best.

Kroger in the meantime has begun to make strides in better understanding its customer, and the implications of that knowledge for its business, through loyalty-card data. Yet despite its considerable size (2,530 stores in 32 states and 2003 sales of $53.8 billion), Kroger remains a resolute believer in local decision-making and local store brands, even as it's gotten better at leveraging its scale toward those functions — distribution and buying — that the customer rarely sees.

McGeorge — who was named president and chief operating officer at Kroger last year when the former COO, David Dillon, was named chairman and chief executive officer — is, like much of Kroger's senior management, a lifer. He joined Kroger's management training program out of college in 1977 and served as a store manager, then in merchandising in the Louisville and Nashville divisions. He became president of Kroger's Detroit region in 1993 and moved to the same role in Columbus, Ohio, in 1997. He was named a senior vice president later that year and was a key figure in integrating Fred Meyer following its 1999 merger with Kroger.

In the interview with SN earlier this month, McGeorge talked about how Kroger is striving to serve a changing customer in a shifting landscape. "I want Kroger to be what the customer wants us to be," he said. "I want us to be the absolute best at meeting the needs of customers."

AN OFFERING FOR EVERY CUSTOMER

While the combination food and drug store has and will continue to be the main vehicle of Kroger sales, as consumer shopping patterns have changed so have Kroger's retail offerings, McGeorge said. In the last year alone, Kroger has made progress in expanding its store formats, with Food 4 Less price-impact stores expanding in new markets such as Chicago, and the Fresh Fare format coming to select locations throughout the country as part of expansions and remodels. Marketplace superstores, which offer groceries and general merchandise in a 100,000-square-foot box based on the Fred Meyer concept, have been introduced in Arizona under the Fry's Marketplace banner, and in Utah under the Smith's Marketplace name. Later this year, the first Kroger Marketplace store will open in Columbus.

"If we're going to be in the retailing business to serve customers, we have to serve them based on their needs," McGeorge said. "And there's not one target consumer. You might have a preference for what you'd like to do, but time demands and hectic lifestyles we all live can often cause you to have other requirements."

McGeorge said Kroger has "an obligation" to serve customers who want meals on the go, as well as those who tend to shop for the basic ingredients to prepare food at home, those who want to experiment with finer foods, and those living on a budget.

While the expansion of the Marketplace concept is viewed as a key defensive weapon against competition from Wal-Mart Stores' supercenters, McGeorge said Kroger still needs to be sure the concept will resonate with shoppers, and that it can keep labor costs associated with operating them in check, before a more aggressive rollout.

"If there's a big urgency, it's not because of Wal-Mart but because the customer wants it," he said. "So our urgency is to first get it right. We're in no hurry to get it out there and get it wrong. So we continue to fine-tune it, and gain comfort that we've got many parts of it right."

Its expansion is tethered to labor costs because "if you're going to compete in the expanded general merchandise business, you have to be cost-competitive with the other players in that business," McGeorge added. "So in Columbus, we worked with union leadership and gained an agreement that will allow us to compete. That's an important element to determining where to put these things."

Co-branding the Marketplace stores with the food stores Kroger operates in the market will be key to the concept's acceptance and help provide its edge against competitors, McGeorge said. "It says to the consumer, 'If you've enjoyed shopping here for all the food-related products you've come to trust us for, here's some more products that we're offering that can fit that need.' There's a certain level of built-in trust there."

The lower cost structure of Food 4 Less, and its proven record of success in Western states, by contrast, has allowed a swifter new-market rollout. "It's offers a great opportunity to move into new markets, and extend our offering in a deeper way to the customer who wants high-quality products, clean, bright and well-lit environments and a good price," McGeorge said of Food 4 Less. "What makes that model work is having the cost structure right, getting the price-value relationship right, and getting the service element right."

LOCAL FLAVOR, NATIONAL POWER

Much of the activity around Kroger today can be traced to the day in 1998 when it announced a $13 billion merger with Portland, Ore.-based Fred Meyer. The deal, which closed in 1999, provided Kroger not only with national scale and geographic reach but provided the beginnings of the Fresh Fare, Food 4 Less and Marketplace concepts it employs today. With the benefit of five years of perspective, McGeorge calls the deal "one of the most successful in food retailing," and one that "continues to benefit us today."

Key to the merger's success was Kroger's integration of the companies. While the late 1990s' spate of retail mergers left behind three supermarket operators with a national reach, Kroger encountered fewer difficulties than competitors Safeway or Albertsons when it came to operating a larger company, observers said. "The size of the merger was not so daunting as the question of how do we integrate these two companies? What can we do to synergize both, rather than just benefit one?" McGeorge recounted.

To Kroger, the answer was to leverage the power of the combined companies while using caution interfering with the local dynamics of its various banners.

"The fundamental principle here is that it's the customer's store, not our store," McGeorge explained. "We operate 24 banners, and we didn't choose to 'Krogerize' them. We realize that each banner has its own equity — a strong identity with their customer — and we didn't want to do anything to destroy that. So we have to make certain we know what it is about that banner that the customer appreciates and expects. Then we can go finding ways to improve it."

At the same time, Kroger works to provide its divisions with cost efficiency through centralized procurement, distribution and, increasingly, certain merchandising functions, McGeorge said.

"We have a large number of centralized functions and a large number of local decisions to be made. The trick is in realizing they have an equal obligation to one another," he explained. "Here, in the centralized organization, we have an obligation to provide service to our divisions and on the flip side, our divisions have an obligation on things we need to be doing to better serve their customers and meet their needs. It's a delicate balance."

Observers say Kroger is getting increasingly better and more efficient in its centralized efforts — which is essential as it battles low-cost operators like Wal-Mart. "Over the last three years Kroger is doing a very good job using its size and gaining economies of scale," Mark Husson, the New York-based managing director HSBC Securities, London, told SN. "And as the third-largest food retailer in the world if you don't count Ahold, it ought to. If you're going to fight against the big retailer from Bentonville, you can't do it with lots of little baby arms. You need one strong arm, preferably with a fist at the end of it."

One area where Kroger appears to combine local and national efforts is in loyalty data. Kroger last year invested in a joint venture with Dunnhumby, the London-based loyalty marketing firm known for its work with the U.K.'s largest food retailer, Tesco. Kroger's early work with Dunnhumby involves analyzing data to develop more customer-specific strategies.

"They're betting a bunch on loyalty data to strengthen their operations," Bill Bishop, president of Willard Bishop Consulting, Barrington, Ill., told SN. "They're the first supermarket chain in the U.S. to make a real commitment that way."

DRIVING DOWN COSTS — AND PRICES

Asked about Kroger's ongoing challenges, McGeorge has a simple answer: It needs to get its costs down.

"We're approaching that in numerous ways," McGeorge said. "I've been extremely pleased with our organization's relentless pursuit of controlling energy costs to the point where we've made enormous progress.

"We're working on shrink — it's a cost with no value to the consumer, and it's a cost we can reinvest to serving our customers better. We're also working on improving productivity — not just the simple reduction of hours but through work process change. It's making us more effective and efficient and it serves our customers better," he added. "We also need to continue to work with contract negotiations that will allow for quality health care and competitive wages. That is vital to serve the need to be able to compete in the retail world we know today."

Along with Safeway and Albertsons, Kroger showed a willingness to endure pain for labor savings with the 141-day strike-lockout in Southern California that ended earlier this year. Executives said recently that deal is already providing Kroger with labor savings, but regaining sales to pre-strike levels will be an effort "that will continue into the foreseeable future," McGeorge said.

Kroger has to this point avoided additional work stoppages, but its union contracts since Southern California have been routinely extended while agreements are forged. "We have to find creative solutions to the cost of service, but it doesn't mean we have to reduce service," McGeorge said.

In California as in some other markets, Kroger is investing in pricing and promotions to win back sales. That's one aspect of a strategic plan announced in late 2001 which also involved further leveraging economies of scale and around 1,500 layoffs of administrative and support personnel.

"Kroger was the first supermarket company to truly realize the competitive environment had changed," McGeorge said. "Economic conditions were such that it called for a change, and we announced a strategic plan to remove costs and invest in growing top-line sales. That was real leadership in this industry. And it's the path we continue today from executive management right down to the store level."

The plan has met mixed results so far. Kroger's sales have rebounded since flat results in 2002, and its most recent quarterly results, reported last month, showed identical-store sales excluding Southern California and fuel sales, to have risen by 1.1%. But Kroger added its fiscal year goal of 1.3% comp growth, excluding fuel and Southern California stores, will be "challenging." Also, certain top-line sales gains have come at the cost of margins and as a result, earnings. Wall Street and investors have been lukewarm, though many say economic conditions, rather than a flawed strategy, is to blame.

"What Kroger hasn't done are dumb things just to prop up earnings," Gary Giblen, director of research for C L King, New York, told SN.

The focus on increased sales will help Kroger better leverage its expenses, which in turn will improve earnings, executives say. (Similarly, Kroger has been focused on making fill-in, in-market acquisitions rather than breaking into new ground since market share also correlates with Kroger's return on expenses, McGeorge explained.) "We are not just trying to be a pricing story," Dillon said last month in a conference call.

"We're not fighting Wal-Mart, we're fighting for a customer," McGeorge added. "And a customer has choices. We have to provide the best customer service, quality, variety, pricing and atmosphere that allows that customer to choose Kroger."