Unifying Force

MARK HAMSTRA

Craig Herkert wants to make Supervalu add up to more than the sum of its parts.

Craig Herkert

More than ever before, the company's chief executive officer, on the job for about a year now, is looking for synergies that help unite Supervalu's various divisions and banners.

Although the company has long been a hybrid of wholesaler, traditional supermarket operator, and limited-assortment-store operator and licensor, the 2006 acquisition of Albertsons skewed the balance decidedly toward traditional retail.

In theory, that should have been good for the bottom line as the company reaps the higher margins associated with supermarket retailing, as compared to wholesaling. The complications of integrating the various regional retail components of the company, combined with the economic slowdown of the past two years, have made that theory difficult to realize, although in recent quarters the company has shown the ability to boost the bottom line, albeit at the expense of volume.

Comparable-store sales fell 6.8% in the most recent quarter, and 6.5% in the quarter before that, creating a situation analysts said is not sustainable, even if it helped deliver strong margins as a percentage of revenues.

What Herkert has done, however, in his short time as CEO, is attempt to unite the company under a more unified corporate culture.

“He's definitely made progress on the way the company thinks of their businesses,” said Karen Short, a New York-based analyst with BMO Capital Markets. “Instead of being two separate businesses — retail and distribution — both operating autonomously, he is trying to bring them under one roof. He seems to be making an effort to think of the business more holistically.”

That was an initiative Herkert made clear early in his tenure when he explained that the company was going to pursue strategies based on geographic market rather than by the traditional divisions of the company along business lines.

In a conference call with analysts discussing the company's second-quarter results last fall, Herkert said his goal would be to “grow market share by emphasizing geography over banner and ownership, which will enable us to choose the format that best serves a given neighborhood.”

Thus Save-A-Lot stores, or perhaps an independent operator supplied by Supervalu, could be expanded in a market where the company had historically focused on one of its own traditional banners.

“For the first time, we are looking at all that we offer in a market and how that totals up to market share and gives us leverage,” Herkert said at the time. “This integrated point of view will dramatically change how we grow.”

Since then, Herkert has repeatedly invoked the company's leverage as a network — including wholesale customers and the entire Save-A-Lot business, in addition to traditional supermarkets — of 4,300 stores.

Short described this change in perspective as “part of a cultural transformation.”

As the Albertsons acquisition had consumed much of the company's attention during the last few years, the distribution business became subordinated at the company, despite its strong performance, analysts said. The new, geographically based model would seek to tie the wholesaling operations serving independents more closely with the company-owned banners.

The wholesale business and supply-chain-services operations together account for a little more than 21% of the company's volume now, but in the last quarter accounted for nearly a third of operating income. Supervalu is the primary supplier for 1,940 stores operated by independents and regional chains, and is the secondary supplier to another 550 stores.

Centralized Merchandising

The holistic approach to thinking about the business might also be reflected in the company's focus on centralizing merchandising and marketing. The company is lining up more companywide promotions in which it would run a simultaneous promotion with a single vendor across the entire Supervalu network.

“National promotions are an effective initiative because they enable the company to get optimal value on vendor discounts by including all stores under all banners in the negotiations,” said Gary Giblen, executive vice president, Quint-Miller & Co., New York. “And if Supervalu can get those kinds of deals together, it's a powerful tool that makes a lot of sense.”

Although Supervalu has been talking about the centralization of merchandising ever since the Albertsons acquisition, Herkert has realigned the reporting within the company's various divisions to make this more effective.

Speaking at a recent investor conference, Herkert explained that the company has truly centralized merchandising by having local merchants in each of the company's divisions report directly to Steve Jungmann, executive vice president, merchandising, who joined Supervalu earlier this year.

The new alignment involved a change in mindset — from one in which individual regions acted autonomously under the assumption that consumers in distinct markets were overwhelmingly different.

“We now start with the supposition that we are mostly the same, that we are mostly buying the same products for our families — whether that be the same brands of macaroni and cheese or the same brands of toilet issue, detergent, toothpaste, face cream or analgesics,” Herkert explained. “We are buying the same products in most of our stores across this country. So we start with that, and then we say, ‘Well, how do we deal with the things on the fringes, that are in fact unique and local?’”

The area where the company had a “disconnect” under the old model was not in the buying, but in the setting of pricing and promotions.

“We've been doing the buying for some time in the Twin Cities for all of our traditional banners,” Herkert explained. “However, we were doing the pricing and some of the selection — certainly the ad selection — within the banner. So you had one group of people determining the cost and what we are going to carry, and another group of people who are determining the retail [price], and if it was on promotion, where in the store it would go on promotion. That was obviously causing us a lot of internal conflict.”

To resolve this, the company about three months ago decided to have all the merchandising leaders in each of the divisions report to Jungmann.

“That doesn't mean they are moving to the Twin Cities,” Herkert explained. “We will in fact keep very talented people in all of our regions because we want to make sure that we take care of the regional differences and understand what's going on locally.”

All merchandising decisions, however, including product placement, shelf alignment, and both everyday and promotional pricing, are now made centrally by Jungmann and his team.

“Already we are getting some nice leverage as we talk to our vendor partners with one voice — something quite frankly our vendor partners have been asking for for some time,” Herkert said.

Likewise, the company is moving in that direction with the marketing function, with all divisional marketing leaders in the field reporting in to Julie Dexter Berg, who was named chief marketing officer earlier this year.

Optimizing SKUs

At the same time the company is centralizing its marketing and merchandising functions, it also is rationalizing its assortment of SKUs — or as Herkert said he prefers to call it — “optimizing” the assortment.

The SKU rationalization effort began in earnest last fall as one of the key initiatives Herkert launched — part of an effort to make the stores easier to shop that also has the benefit of reducing costs and freeing up warehouse space. Some 26 general merchandise categories — including automotive, electronics and fragrances — have been eliminated. The supermarket, Herkert explained, is not where Americans go to buy their small appliances any more.

In 10 grocery categories that had been rationalized by late April, SKUs have been reduced by an average of 20%, the company said.

Although Bentonville, Ark.-based Wal-Mart Stores reversed course on its SKU-reduction program and brought back many of the products it had previously eliminated, Herkert said Supervalu has seen benefits from its own efforts in this area.

“The 20% of the SKUs that we've taken out in some of these categories still allows us to be an assortment leader,” he said in response to an analyst's question during the company's recent fourth-quarter conference call. “There may have been a handful of items that we've had to respond to consumer requests for, but it's been very, very small.”

Chuck Cerankosky, an analyst with Northcoast Research, Cleveland, said the weak economy has also contributed to the need for SKU reductions.

“I think SKU cuts reflect some of the observations Craig Herkert made when he got to the chain, and the fact that people don't need as many SKUs when the economy is rough,” he said. “They have to look at the SKUs they have collected over their banners over the years and see which ones are moving. That is something previously management perhaps fell behind on, and of course reducing SKUs can cut costs, not only at the store level but in the supply-chain operation, because slow-moving SKUs take up space in the warehouse and crowd out sales of faster-moving products.”

Giblen of Quint-Miller agreed that trimming SKU count is “the correct move” because reducing clutter increases customer satisfaction. “Plus it reduces the cost of doing business,” he said.

In addition, Herkert explained, the improved in-stock positions on more popular items are helping drive more sales of those products and, in some cases, freeing up more space for private label.

“We're able to position our private brands much better than we were before,” Herkert continued. “We have a great private-brand program. We've got a team here that has delivered beautiful products, but we were hiding them, quite frankly, because we were over-assorted.”

Earlier this year, the company took on a direct relationship with its private-label vendors as part of an effort to help grow that aspect of the business, and is also seeking to reduce costs and boost sales in store brands.

“We have aggressively negotiated new companywide sourcing agreements to achieve cost reductions,” Herkert said, citing savings “in the mid-single-digit millions” in one beverage category alone. “Already in the first quarter, we're aggressively promoting the marketing and value of our private brands to shoppers.”

In addition, this spring the company embedded private-brand personnel within product-category teams to increase emphasis on those products. Herkert said he set a goal of increasing private-label sales penetration by more than 200 points in the current fiscal year, to just over 20% of sales.

Project SHE

The SKU reductions dovetail with what could be described as Supervalu's “remodeling light” effort, dubbed Project SHE, for “simplify her experience.”

The project, which is expected to be rolled out to 300-plus stores this fiscal year, involves minor adjustments, such as a storewide effort to reduce shelf heights. It also involves, in some cases, reorganizing the stores somewhat to take better advantage of space that has been freed up by SKU reductions.

Herkert said the company is in the “first stages of the multi-year initiative.” Supervalu is also continuing its schedule of full-scale remodels.

Project SHE, Herkert explained, is “focused on dramatically enhancing the shopability of our stores — not only making them more customer friendly, but also simplifying the retail experience.”

In addition to the benefits from SKU rationalization and reduced shelf heights, the initiative also involves upgraded displays, better product adjacencies and clearer signage.

The company's efforts to improve the in-store experience have been reflected in shopper-survey scores, the company said. Scores for price competitiveness, checker courtesy and friendliness, the likelihood of customers' willingness to return or recommend the store to others, and the quality and freshness of perishables all increased by approximately 100 to 400 basis points in the most recent quarter, said Pamela Knous, executive vice president and chief financial officer.

“Since Craig's arrival last spring and our company's renewed focus on the customer, shoppers' responses on all four items have improved at least 400 basis points,” she said. “Our perishable scores, which have been a real focus, are up nearly 900 basis points. Clearly, we are moving in the right direction and making meaningful progress toward meeting customer expectations and improving the overall shopping experience.”

Asset Sales

One question that has hung over Supervalu for the past three years is which assets might be for sale. In the year since Herkert came on board, the company has sold three blocks of stores: a group of 46 Albertsons in Utah — a divestiture that had been initiated prior to Herkert's arrival — the Bigg's chain in Cincinnati, and the company's Shaw's locations in Connecticut.

Analysts have long speculated that other divisions might be for sale, including the rest of Shaw's, Acme in the Philadelphia market, the upscale Bristol Farms chain, the Save-A-Lot banner and the wholesale distribution business.

Herkert said at a recent investor conference that the company had completed its analysis of its markets and determined which “sub-markets” were worth keeping and investing in.

“We've completed the sub-market reviews for the entire country,” he told investors. “That does not mean necessarily that we are done announcing where we are going to stay, or where we are going to invest. It demonstrates in these last two markets [Cincinnati and Connecticut] that we were serious about monetizing things where we didn't think that there was an appropriate future for us, and that we would have a better return for our shareholders by monetizing.”

Cerankosky said more asset sales are “inevitable” at Supervalu.

“Management will do what they have been doing, which is look at all divisions, and sell underperforming parts of those divisions, like they did with the Connecticut Shaw's,” he said. “Then they also have the lonely outposts like the Bigg's in the Cincinnati area.”

Short of BMO Capital Markets also said she believes the company will have to divest some more operations.

“He has made some small decisions about exiting some markets, but I think much bigger decisions need to be made,” she said, noting that the economic environment might not have been conducive to asset sales recently.

If assets were for sale, she said, “I don't know if there have been any buyers — it may be that he has tried to sell underperforming stores, but no one has bought them, so he has no choice but to try to fix them.”

Giblen suggested Supervalu should consider the sale of markets where the company has a strong presence.

“If Supervalu plans to exit some markets, it could have moved much more vigorously than it has,” he said. “When your business is characterized by total malaise in some regions, you have to do things to simplify the business. To do that, Supervalu needs to sell regions that have good market shares but that lack momentum or have lost their luster.

“The company already sold the Shaw's stores in Connecticut, and it should sell all of Shaw's. And the Albertsons in Southern California would be an obvious addition to the list of regions to sell, though if Supervalu got creative and converted some of those stores to Save-A-Lot and then leased out space to other operators, that could make better use of the Southern California properties. Or else Supervalu could put another name on the Albertsons — perhaps by expanding its use of the Lucky name to more Hispanic neighborhoods.”

Another idea that has been discussed is the possible sale of the whole company to private equity — a scenario that could either allow the company to be spun off into its various parts, or could also allow the company more freedom to invest in the initiatives that it needs to undertake to improve the business.

“What should really happen is it should be LBO'd,” said one analyst, who asked not to be identified, referring to a leveraged buyout. “The equity is small enough, so it would be possible from a deal side. It is also the business that could be most easily broken up.

“He could at least have a little bit of leeway as a private company.”

With its stock trading near 52-week lows — and off more than 60% from its value just two years ago — the company does appear to be valued at a price that could attract a buyer.

Earlier this year, the stock had moved up on industry reports that a buyer was interested, but such talk quickly faded.

The stock last week was trading a weaker multiple than its rivals Safeway and Kroger — and it has a market capitalization much less than that of Whole Foods.

Protecting Margins

Mark Wiltamuth, an analyst with Morgan Stanley, New York, recently upgraded his position on Supervalu, as the company's stock price had fallen to about $13 per share.

He cited the company's shift toward protecting margins, while eschewing price competition, which he said reduced the risk of a shortfall in cash flow.

“While protecting margins and regularly losing market share is not a winning proposition over the long term, it does preserve cash flow for debt reduction and makes the company less prone to earnings misses, in our view,” he wrote in the report.

He noted that the company's strategy to preserve margins at the expense of market share is illustrated in Morgan Stanley's own recent pricing surveys, which found Supervalu expanding the price differential between itself and its closest peers in several markets.

At Shaw's in the Boston market, for example, a price differential of about 11% last summer has since been expanded to about 16%, according to the Morgan Stanley research.

Similarly, the premium for shopping at Albertsons in Las Vegas has increased to more than 5%, a reversal of the 5% lower pricing that Albertsons shoppers would have enjoyed a year ago.

Even in Chicago, where Morgan Stanley found that Supervalu's Jewel-Osco had a slight price advantage, that lead had been reduced under the company's strategy to preserve margin at the expense of sales.

Analysts noted that eventually the company will need to address its pricing position to become more competitive again.

“Supervalu stores have had uncompetitive pricing for years, and the company hasn't been aggressive enough to change that,” said Giblen. “But despite corporate inertia, Herkert could have been more creative in addressing that issue. For example, Whole Foods had a high-price image but it turned that around within six to nine months, and if Whole Foods can do it, then Supervalu should have been able to do it.”

Herkert outlined the company's pricing vs. margin strategy in January, during the third-quarter conference call.

“Clearly, our promotional activities during the first half of the year were costly and did not produce the sales and margin results that we had hoped for,” he said. “In contrast to the first two quarters [when retail gross margins were off by 60-80 basis points compared with year-ago levels], our third-quarter retail gross margins were off by only 10 basis points relative to the prior year.”

He said Supervalu “remains a promotional retailer at its very core.”

“However, we will not sacrifice margins for promotional activities that we do not believe will influence long-term customer loyalty,” he said. “Rather, our goal is to offer everyday pricing that customers believe to be fair and merchandise that is relevant to the local markets where we serve.”

In addition, Supervalu has been making progress in narrowing the gap between everyday shelf prices and promotional prices, he explained.

Although in the third quarter the company's promotional mix increased by 350 basis points, unit sales of products with everyday pricing increased as a percentage of the overall mix in the fourth quarter, with a corresponding decline in promotional units, Knous said during the fourth-quarter conference call in April.

“It is great to see our progress in fixing these pricing imbalances, where we had high shelf prices on some great everyday items and therefore sold the vast majority of units on promotion,” she said.

The company is paying for its retention of margins in the form of declining market share in many markets, however.

Knous said that as of February, on a year-over-year basis, the company lost market share in 60% of the 90 markets in which it operates 10 or more stores (including Save-A Lot and independent customers in the market-share mix). For the top 20 markets, which account for two-thirds of sales volume, the cumulative share loss was 60 basis points, she said.

The market-share losses reflect both declining comps and a 6.2% reduction in square footage for planned store closures, she noted.

Expanding Save-A-Lot

While Supervalu doesn't appear poised to grow its traditional store base any time soon, Herkert has repeatedly emphasized the prospects for growing Save-A-Lot, the limited-assortment banner that runs largely independently from its headquarters in St. Louis.

In one of his first initiatives as CEO, Herkert unveiled a plan to double the size of the 1,200-store Save-A-Lot banner during the next five years. He also realigned the reporting structure so that Bill Shaner, the head of the Save-A-Lot division, would report directly to him.

In the company's fourth-quarter earnings call, Herkert said the expansion of the chain is “well on track, with 100 stores in this year's pipeline.”

“We are developing the internal expertise and skills to ramp up to a pace that will allow us to more than double in five years,” he said.

He said the newest stores in the chain are “doing quite well,” with sales averaging 10% above internal projections and with initial capital costs 10% below former spend rates.

“The Save-A-Lot team has had good success controlling capital by utilizing existing store interiors, aggressively negotiating construction bids and leveraging internal architectural and engineering expertise,” he said.

The cost of opening a Save-A-Lot store has been reduced to about $1 million, Herkert said in response to an analyst's question.

Although he declined to say what proportion of the 100 Save-A-Lots planned for this year would be corporate vs. licensed, he did say at an investor conference last month that the company was prepared to expand the format with more aggressive corporate development going forward. Currently, the company's licensed Save-A-Lots outnumber corporate locations by about 2 to 1.

While independent licensees are enthusiastic about Supervalu's push to expand the format, it has been difficult for many small businesses to obtain loan financing, Herkert pointed out.

“Expanding that banner is logical and a move in the right direction,” said Giblen of Quint-Miller. “It's the most differentiated format in the company, and it offers just what today's parsimonious customers want. And even in a booming economy, there are price-sensitive people.”

Cerankosky of Northcoast Research said it's too soon to thoroughly evaluate the job Herkert has done with Supervalu in the past year, but he is encouraged by the expansion of the Save-A-Lot banner.

“It's good to see the focus on what the company is good at, such as Save-A-Lot,” he said. “The biggest challenge is accelerating sales growth on the conventional supermarket side of the business, which was enlarged when the company acquired Albertsons. The challenge of doing- that is going to ultimately determine the success of the Albertsons acquisition.”

The decline in comp-store sales “has to be addressed,” he said, “whether that means pricing or merchandising or going with your best stores.”

Giblen of Quint-Miller said he would give Herkert a grade of “B-minus” for his first year as CEO.

“Supervalu is doing the right things, but it's doing them slower than most analysts would have hoped,” he said. “It's not so much because of the economy — the economy has been better for some companies the last quarter or two — but more because the rate of change at Supervalu is glacial. That's not one person's fault. It's pretty hard to turn a battleship around, and Wall Street tends to get over-excited about the potential for change, though it doesn't always happen quickly.”

Additional reporting by Elliot Zwiebach

AT A GLANCE

SUPERVALU

Headquarters: Minneapolis

Fiscal 2010 Sales: $40.6 billion

Fiscal 2010 Net Income: $393 million

Retail Division:

1,161 traditional supermarkets under the Acme, Albertsons, Bristol Farms, Cub Foods, Farm Fresh, Hornbacher's, Jewel-Osco, Lucky, Shaw's, Shop 'n Save, Shoppers Food & Pharmacy and Star Market banners (ranging from about 40,000 to 60,000 square feet). This division also includes 23 dedicated distribution centers.

Save-A-Lot Division:

855 licensed and 333 company-owned Save-A-Lot limited-assortment stores (averaging about 15,000 square feet).

Supply Chain Services Division:

Includes 21 distribution facilities, nine of which supply the company's own stores in addition to independent customers, servicing stores in 49 states. Serves as a primary supplier to 1,940 stores owned by independent customers and as a secondary supplier to 550 additional stores. This division also offers third-party logistics services through Supervalu subsidiary Total Logistics and its Advantage Logistics operations.

SOURCE: Supervalu 10-K annual report