A GREATER QUANTITY OF QUALITY

ELLIOT ZWIEBACH

STAMFORD, Conn. -- Quality Food Centers is expanding its reach. Not content to operate solely in the Pacific Northwest, QFC, Bellevue, Wash., has formed a holding company here that is looking across the United States for upscale supermarkets to acquire following the April completion of its purchase of Hughes Family Markets, Irwindale, Calif.

Underscoring its commitment to Hughes, the holding company -- Quality Food Inc. -- said that Dan Kourkoumelis, QFC's president and chief executive officer, will relocate to southern California to become president and CEO of Hughes in order to accelerate planned increases in top-line growth and improve margins.

QFI simultaneously promoted two veteran QFC executives to oversee the company's Pacific Northwest operations: Mike Huse as senior vice president and chief operating officer and Marc Evanger as senior vice president, administration and finance, with both reporting to Chris Sinclair, chairman of QFI.

In an in-depth interview with SN, Sinclair talked about the kinds of acquisitions QFI is looking for. "We're buying good trademarks," he said.

"What we want are good platforms with strong consumer franchises, and a capable management team in areas with attractive macroeconomic trends -- where competition is rational and where there's room for development.

"We want companies with enough scale in a given market to be a significant player with a solid competitive position. And we want concepts that are in the mainstream and are interested in providing total value by offering quality, service and good prices. What we're not interested in is a general merchandise retailer or a discounter, nor are we interested in properties that are in major turnarounds."

He also ruled out price-impact operations. "Price-impact stores would generally not be on our priority list," he said.

According to Sinclair, QFI's priority list consists of "geographies and partners we think would work," and it isn't limiting itself to any particular geographic areas.

"We have a number of conversations in process through our own contacts and through investment banks and it's a matter of building and exploring relationships or pursuing properties where there's some interest in talking," Sinclair told SN.

He said it may be 12 months or more before QFI makes another acquisition -- possibly something in southern California to build on Hughes' base, he said.

Although Sinclair said he has no specific goals for numbers of acquisitions per year, he said one every 12 to 15 months "is a reasonable expectation, though it's not something you can predict.

"But we want to make sure we don't get too far out in front of ourselves in terms of trying to manage our properties."

Under the holding company arrangement, both QFC and Hughes function as operating companies that report to Sinclair.

While keeping its corporate eye open for future acquisitions, Sinclair said QFI intends to concentrate in the near term on developing synergies between its Seattle and southern California operations -- all designed to boost operating margins -- including the following: Considering a possible move toward self distribution, using the expertise Hughes has developed operating its own distribution center to help QFC determine whether it should open its own warehouse in the Pacific Northwest.

Conducting studies to benchmark best practices at both QFC and Hughes, to take full advantage of QFC's superior strength in perimeter departments and home-meal replacement, and Hughes' strength in category management and private label.

Studying the possibility of combining the two chains' buying power and introducing some form of demographically targeted consumer-incentive program.

QFI operates 141 stores -- 84 QFC units in Washington state and 57 Hughes locations in southern California. With the acquisition of Hughes, the company virtually doubled the sales volume of its operating companies to just over $2 billion.

In his new job as president and CEO of Hughes, Kourkoumelis succeeds Fred McLaren, who retired in April, just before QFI completed the Hughes acquisition. Roger Hughes, who had been chairman and CEO of Hughes prior to the acquisition, will retain the title of chairman. Kourkoumelis said his move to southern California, and the appointment of Huse and Evanger to run QFC, should make integration of the two companies run more smoothly. "We will continue to share best practices and strategies between the companies, and this move gives us the opportunity to open up the channels of communication even wider," he said.

According to Sinclair, "Dan is a major architect of the QFC quality model and has led the company's successful growth in the Northwest. [His new appointment] is an excellent fit and the best way to seize the many opportunities we see at Hughes."

Huse was formerly vice president of store operations for QFC, and Evanger was formerly chief financial officer. QFI said the formal title of QFC president and CEO will remain vacant for at least two years.

Added Sinclair, "We're fortunate to have proven leaders in Mike Huse and Marc Evanger, who can continue to build our momentum at QFC and who will also work closely with Dan Kourkoumelis to achieve synergies between the two [operating] units."

The QFC stores have a market share of 20% in the Seattle area, compared with 24.5% for Safeway, Pleasanton, Calif., and 13.5% for Albertson's, Boise, Idaho. In southern California, Hughes controls a 6% market share -- a distant fourth behind Ralphs Grocery Co., Compton, Calif., 21.7%; Vons Cos., Arcadia, Calif., 19.5%; and Lucky Stores, Dublin, Calif., 12.4%.

QFI disclosed plans in May to enter Portland, Ore., early next year by building two QFC stores -- its first QFC's outside the state of Washington. QFC decided to pursue a strategy of multiregional expansion several years ago, hooking up in late 1994 with Zell/Chilmark Fund, a Chicago-based investment partnership, to recapitalize the company and position it for major growth.

Jonathan Ziegler, a San Francisco-based securities analyst for Salomon Bros., New York, said QFC seized upon that growth strategy "when it recognized that remaining a Seattle-only company with a volume of $700 million to $800 million was not an effective long-term survival strategy, and that it needed a larger revenue base spread over a broader geographic area to be a successful player."

Over the last couple of years, QFC has purchased more than 20 stores from a variety of independents in the Seattle area, capped off late last year by the $65 million acquisition of 25 Stock Market stores from Keith Uddenberg Inc., Gig Harbor, Wash. Soon after, QFC disclosed plans to acquire the 56 Hughes Family Markets for $358.8 million.

Sinclair said QFI is taking a two-pronged approach to acquisitions. "We're trying to prioritize properties in attractive geographic locations that fit our concept, and we're trying to be more deliberate in pursuing them.

"Some properties are not available, or their owners are not interested in selling, so we're trying to develop a proactive list, as well as keeping our eyes open for what may come over the transom.

"Besides properties we seek out ourselves, Sam Zell [partner in Zell/Chilmark] and his organization have enormous contacts, and they get a lot of inquiries. And brokers are approaching us constantly."

Among the potential transactions that didn't happen for QFI were both Byerly's in Edina, Minn., and Lunds in Minneapolis before those two companies merged.

"We took a serious look at both companies," Sinclair said. "We think both are attractive properties, and their combination as a scale business is also very attractive. But we're not actively doing anything to pursue the merged company at this time."

Observers said QFI's offer to Byerly's was not rich enough, and there was some reluctance to push the offer too high because of some uncertainty about Minneapolis as a growth market.

With Hughes' distribution center operating at only 50% of capacity, there is sufficient reason to seek additional acquisitions in southern California, Sinclair noted.

QFI would certainly like to expand Hughes, he pointed out -- either through acquisition, "which we would do, absolutely, if we found stores that are attractive fill-ins," or through new-store expansion.

He declined to comment on local speculation that QFI is pursuing Arden Group, Los Angeles, which operates nine Gelson's Markets and three Mayfair Markets in southern California. Officials at Arden Group also declined to comment on the speculation. Acquisitions aside, one of the holding company's goals in the next few years is determining whether or not to go into self distribution in the Pacific Northwest.

According to Sinclair, Hughes' 600,000-square-foot warehouse cannot supply product efficiently to QFC because of the 1,000 miles between the two operations. "But we can learn a lot about best practices in self distribution instead of starting from scratch should we decide to open our own Northwest warehouse," he told SN.

He said QFC has not set any definitive timetable for reaching a decision on self distribution. "We're looking at it right now. And a key part of the assessment is the real estate opportunities we'd need in the Northwest."

Gary Giblen, managing director of Smith Barney, New York, said it is "[nearly] inevitable that QFC will pull the trigger and move to self distribution in the next few years.

"The acquisition of the Keith Uddenberg stores lifted the chain's Seattle-area retail volume to over $1 billion -- the critical mass needed to operate a grocery warehouse with near-optimum efficiency -- and the Hughes acquisition provides QFC with self-distribution expertise," Giblen pointed out.

Sinclair isn't willing to tip his hand on which way QFC is likely to go. "We're assessing a number of opportunities because we know the economics on self buying and distribution are attractive, and we'd certainly like to capture some of those advantages," he said.

"But we have good relationships with our two wholesalers -- Supervalu, [Minneapolis], which supplies about 60% of our needs, and Associated Grocers [of Seattle] -- that we need to sort out.

"We think both are doing a good job, and both are aware that we're trying to figure out how we can capture the most economic benefits, whether through self distribution or through a wholesaler." Also on the holding company's agenda is determining what synergies can be leveraged between QFC and Hughes. QFI said in a prospectus that it believes it can improve results of operations at acquired companies by implementing merchandising and operating practices that have been successful in the Pacific Northwest, including development of higher-margin specialty and convenience departments and expanded private-label programs. "One of our goals is to see what best practices, merchandising procedures and product offerings can be beneficial to Hughes," Sinclair said.

"That's what we're looking at now, and Hughes will try to see what makes sense to them. We think there are a lot of things that can be duplicated at Hughes, based on what QFC has done." Sinclair said QFC and Hughes have formed an executive team "to benchmark best practices, and we'll be testing ideas and concepts at both chains through the balance of the year."

According to Ziegler, QFC's best practices include merchandising fresh products, "and they are [obsessed] about keeping their stores clean. For example, their seafood looks as if it just came off the boat, regardless of the time of day. And they've learned how to operate successfully in smaller stores [in the 30,000- to 35,000-square-foot range]."

Giblen said QFC should be able to enhance the Hughes operation in the areas of systems, perishables, home-meal replacement, price perception and overhead management, while Hughes can help QFC improve in the areas of category management and self distribution. Sinclair said Hughes is ahead of QFC in category management, "and we expect to learn a lot from them. And with both companies in the process of trying to build a private-label business, we will be able to learn from each other."

But QFC surpasses Hughes in its perimeter departments, Sinclair said. "That segment is more highly developed as a percentage of total sales at QFC," he explained, "and we're way out in front on home-meal replacement, prepared meals and full-service delis, and our stores have higher margins in floral and bakery."

The two companies are also looking at the possibility of joint buying, Sinclair said. "We're looking internally at promotions first, to see if there's money to be had with economies of scale."

Another program being studied is a frequent-shopper card, Sinclair said, "though there may be other ways to bring value to customers and to reach the economically sensitive shopper," he said.

"For example, we think demographically targeted consumer incentives offer a big opportunity, and there are other ways to do more by studying consumer research data." With its $2 billion sales base, QFI's goal, Sinclair said, "is to sustain double-digit increases on the bottom line."

At Hughes, the short-term goal is to increase operating margins, he noted.

"We're not looking for any major jumps in financial results at Hughes this year, though we are looking for improvements on the margin side as we sort out best practices at both companies," he explained.

QFC ended 1996 with an operating cash flow margin of 8.6%, and Sinclair said he anticipates some increase in Hughes' margin on earnings before interest, taxes, depreciation and amortization, which he says is running around 5%.

Giblen said QFC should be able to raise Hughes' EBITDA margin to 6.5% within three years. Although QFC has a reputation for high prices, Sinclair said the holding company hopes to build on its image, more than on price, as it markets its operating companies to the public.

"You don't want price getting too far out of line when you're striving for quality and service, and you don't want quality and service getting too far out of line in terms of price. The goal is finding the balance that's exactly right."