SPEAKING VOLUMES
The top line is a top concern in the industry.e in New York City on industry performance produced a less bullish outlook -- at least for the near term -- than a similar gathering a year ago.The upbeat mood last year was driven partly by better sales momentum and expectations of an inflation pickup. But this time, sales momentum is the problem. Same-store sales growth is lagging.The causes aren't hard
September 8, 1997
The top line is a top concern in the industry.
e in New York City on industry performance produced a less bullish outlook -- at least for the near term -- than a similar gathering a year ago.
The upbeat mood last year was driven partly by better sales momentum and expectations of an inflation pickup. But this time, sales momentum is the problem. Same-store sales growth is lagging.
The causes aren't hard to pin down: inflation hasn't materialized and deflation is evident in some sectors. Overcapacity and competition are squeezing operators, who nevertheless continue to spend heavily on capital expenditures.
"The top line is a significant challenge for supermarket operators," said Debra Levin, principal at Morgan Stanley Dean Witter here. "It's going to get more difficult because of the overcapacity issue."
Jonathan Ziegler, vice president for Salomon Bros. here, who is based in the company's San Francisco office, noted that "currently, same-store sales growth is slowing and a little more difficult to come by."
Ed Comeau, vice president at Donaldson, Lufkin & Jenrette here, noted that because factors such as overcapacity and deflation are hurting sales, individual operators are hard pressed to markedly lift volume. "I don't think there's much that these companies can do to drive the top line. There's a lot they can do to lose sales, if they're not priced well or don't provide good service."
Despite the near-term concerns, analysts said retailers continue to do many things right, which may give cause for a more positive long-term outlook. Among the positive developments:
Supermarkets are still successfully gaining efficiencies, which will bring more margin gains.
The industry's consolidation bandwagon continues to roll and create a more rational environment, although there is disagreement over whether it's happening fast enough.
Competition is forcing supermarkets into becoming more expert in marketing, in areas ranging from private label to micromarketing to battling category killers.
Analysts also assessed the field of food retailing competitors -- from supercenters to restaurants -- and even questioned parts of the conventional wisdom about home-meal replacement and restaurant competition.
These are just some of the issues addressed in part one of SN's excerpts from the roundtable, which follows.
Clouds Just Ahead
SN: What is your outlook for the supermarket business, taking into account macroeconomic and industry-specific factors?
ZIEGLER: Looking at the industry in the near term, it appears there is a lack of inflation, or food-price deflation, coupled with a lot of new capacity coming in -- particularly in the Southeast -- and as a consequence it appears that same-store sales growth is slowing and a little bit more difficult to come by.
I do think that while it is a near-term negative to have a lack of inflation, or deflation, a positive spin is that it may accelerate the potential consolidation in the sector. If some of the smaller companies feel that it's too difficult to generate sales, too promotional, it may lubricate the consolidation process, which I think could be really good for the industry.
LEVIN: Overall, I've gotten more cautious so far as the supermarket stocks are concerned. I'm very neutral on the group with respect to how stocks will act. The lack of inflation, coupled with the overcapacity that I think is going to continue to increase, troubles me.
The real positive is that there's still a lot of opportunity for companies to benefit from improvements and efficiencies and from consolidation. You've seen some major consolidation activity. I continue to think that will increase. There's definitely opportunity for the companies to improve their profitability. But it's going to be very tough in terms of their ability to generate sales gains.
GIBLEN: I guess I'm a little more sanguine about the industry. I think there are a lot of positives, and some of the negatives are there -- but there are a lot of offsets to them. I think private label is the greatest thing since sliced bread and continues to increase as a percent of the mix for most companies. That is a very strong profit driver.
While there are certain regions, such as the Southeast, where there are irrational levels of competition, generally, there is a fairly rational level of competition because you have a lot of market share concentration that has occurred in different markets. So we really haven't seen big price wars -- except in isolated cases -- even in the Southeast. The cost structure reduction is very important in the industry. Safeway started it by redefining the rules of the game and pinpointing re-engineering as a key success factor -- and others have ably followed.
So there's a lot of ability to drive down operating costs and make more efficient use of capital. On the inflation front, less food inflation is not a positive, but it doesn't appear to be much of a negative at all because it hasn't affected earnings in the companies and probably is just a temporary, cyclic effect that will be over before the end of the year anyway. So I don't worry too much about that.
COMEAU: The near-term outlook certainly appears to be somewhat spotty with lack of any food inflation out there to help sales. It does remain somewhat competitive in certain areas. I don't think you can ignore the longer-term trend of a much better managed industry emerging from a relatively difficult three-to-four-year period over the last couple of years of low inflation, slow growth and some overstoring.
Companies have made significant improvements in their productivity, as well as profitability. I would expect that would continue for some time. Maybe that won't be the case for every single company. Clearly companies hit walls, like Albertson's has done. But many companies are midway through at best in improving their own efficiencies. So that will continue to be an overriding trend in the long term. The other trend which continues is consolidation.
But I remain fairly positive over the next two to three years that a better managed, more profitable, more efficient industry emerges from what's out there today.
VINEBERG: I think profitability in the industry is already pretty high. A lot of the rationalization of operating margins has already taken place, and sales are sluggish. They're not just sluggish now because of lack of inflation; they're getting increasingly sluggish through the second half of last year. I think the industry is consolidating slowly in a cyclical fashion. In the early 1990s we had 2.5 years of pretty tough times for the industry. It was highly competitive. Then we had about 2.5 good years. Now we seem to be about a year into a slowdown for this sector. I'm afraid things are likely to get worse before they get better.
Long term, I think this industry can go a long way towards consolidation. But what I'd like to see is more merger activity in this business and less capital spending. I'm not convinced that margins should continue to go higher while same-store sales growth is zero or negative. In addition to the internal pressures of excess capital spending, I think that outside channels are very effectively picking away at category business in the supermarket area. I think the clubs are doing a much better job. Drug stores, by adding food to their mix and a lot of convenience items, are effectively picking away at this business. And there's no slowdown in sight with Wal-Mart's supercenter strategy. And I don't see the industry defending itself very effectively. The industry has to defend the top line better. It's not doing that.
Clearly volume growth is not happening and other channels are taking business away from this one. So if we see major merger activity, or some major bankruptcies with a lot of store closings, that would be positive. We're not seeing that yet, so I think things get worse before they get better.
BERNSTEIN: I have a number of concerns going forward, too, over the next 12 months. First and foremost, competitive pressures are a real issue. Given the fact that supermarket retailing continues to be a very mature business and still surprisingly fragmented, competition remains a major concern. As others have mentioned, we're seeing a softening of same-store sales and a real absence of any significant food-price inflation.
Also, I'd note that easy access to capital over the last year or two has contributed to the consolidation trend that's emerging. But the easy availability of capital has facilitated additional overcapacity in the industry, as capital expenditure programs at most companies have been pretty strong in the last couple of years. As far as consolidations go, I think they'll continue to be a key theme in the industry as stronger operators seek to build market share, enter new markets and achieve economies of scale. I think that's true despite the relatively lofty multiples being paid for control of supermarket companies.
On a more positive note, although competition is a constant theme, it's forcing supermarket operators to be better merchandisers and improve operating efficiencies. Examples include micromarketing through frequent-shopper programs, and the effect of the proliferation of information technology throughout supermarkets. As far as the alternative formats, they are worrisome only in that they add square footage in already crowded markets.
A Top Issue
SN: We've heard quite a range of views. Many of you pointed to the top line. Just about everyone had some concerns about it. What is it that the industry is doing now, what can it do better to help the top line? What are the chances for success?
LEVIN: The top line is a significant challenge for supermarket operators. The basic thing they have to do is their blocking and tackling. They have to run a good business. But it's going to get more difficult because of the overcapacity issue. Wal-Mart continues to build supercenters and will step up its supercenter building, and every single major supermarket operator continues to expand at pretty good rates.
Capital expenditures aren't really growing more than they were last year, but they've leveled off at a pretty high level. So with everyone adding more and more footage and having so much overlap with drug store operators or even a Kmart adding more supermarket-type items, it just makes it tougher and tougher. So they just have to do their blocking and tackling better. But I don't see what they can do to change this environment. It takes a very long time for shakeouts to occur, and it's the type of thing that's going to encourage more consolidation because the operating efficiencies are really the keys to generating improvement in earnings -- and you can't get it through the top line.
VINEBERG: I think companies are trying very hard to compete on fronts other than good old-fashioned price competition. People are promoting more creatively. They're using frequent-shopper cards as a promotional vehicle. They're trying to differentiate themselves without resorting to price-war techniques. That's one reason why the earnings have held up better. You may not see it in the high-yield area. They've seen a lot more carnage. But considering that a number of the major chains have been running close to flat same-store sales growth for a year now, we haven't had the price wars you would come to expect.
The industry is trying to get around the primitive impulse to slash prices. By the same token, it's not healthy to have flat same-store sales growth. If you look at other sectors of retail, the discount store business is very competitive and they manage to generate increases. I think the supermarket industry, because it's unionized, is cost-disadvantaged vs. all these other sectors. They shouldn't go after sales for the sake of going after sales.
But I think it reaches a point where a flat top line, or negative same-store sales growth, is just an intolerable situation. Everyone of these companies must face the issue of how long they want to keep pushing margins, and keep rationalizing zero or negative same-store sales growth while they are adding capacity.
ZIEGLER: I agree with Gary [Vineberg]. I think ultimately there can't be a disconnect in sales growth and margin improvement. Admittedly, the industry is much better managed now and technology has come down in cost and up in productivity, so it really works for this sector. But they've got to get sales going again. And I guess there are things out there that these managements are doing to grow the top line. To me, the primary one is to think about consolidation, and I think Safeway is a good example of that, as is Fred Meyer Inc. They both grow the top line by buying existing square footage.
And while some investors may say it's better to have organic growth, and we'll pay a higher multiple for that, I think that's wrong. I think you probably should pay more for a company that's growing through acquisition. So that's one way to grow the top line. The other way is that grocers are trying to take share from other sectors, as other sectors try to take share from them. And we can talk about home-meal replacement. This is an area where they're trying to win share of stomach from the food-service industry. It's still early in the game, but I think there's huge untapped potential there once they get it right.
BERNSTEIN: I think Gary [Vineberg] brings up a very good point with respect to acquisitions. Fred Meyer and Smith's is just one example. Jitney-Jungle is currently trying to do it with its planned acquisition of Delchamps. You saw the same thing with Food Lion's acquisition of Kash n' Karry. Acquisitions are a viable means to grow the top line, and I think organic growth is becoming much more difficult. We see increasing overcapacity and we continue to see fairly significant capital expenditure programs. Often it is very economical for an operator to grow the top line by making acquisitions in the same market or contiguous markets. We're even seeing efforts to grow the top line in noncontiguous markets, with Quality Foods' purchase of Hughes earlier this year. So I think that acquisitions are certainly a means that a lot of operators are employing to grow the top line. I would also say that it's dangerous to discount price as a means of growing the top line. There are very competitive markets out there where shoppers have a lot of alternatives, and at the end of the day, the tiebreaker can often be price. That trend will continue, particularly in the more competitive markets.
SN: But can high-service operators also compete on price?
GIBLEN: Well, there are different ways to do price. If you do a targeted card marketing program, then you can ration the discounts to your best customers. You can come out well on the bottom line, while at the same time being promotional. The classic introduction of frequent shopper was Bi-Lo, a division of Ahold. It was a textbook implementation following the prescription of the former chief financial officer of Food Lion who developed the most advanced thinking on how to do frequent shopper. It works very well.
Also, private label is a way to drive your bottom line very nicely while also providing value to the customer. And you can even create incremental demand for products. You probably give up a little on the top line but you're gaining more on the bottom line. So we have a ways to go before we have considerable earnings pressure related to the soft-sales environment out there. It's different than it was in the early 1990s, when sluggish sales meant increased promotional activity.
There are new ways to drive the top line as well. I think supermarkets are now regaining sales in lost categories, like pet supplies or even prescription drugs. Supermarkets are gaining share in prescription drugs. PetsMart just announced the second in a series of terrible earnings and bad outlook, and one reason was they claimed supermarkets are recapturing some share in the pet supply area. There are a lot of rabbits in the hat in the industry, and the industry is much better managed than it used to be. So I guess that's why I don't think we're at the explosion point on soft sales.
COMEAU: I don't think there's much that these companies can do to drive the top line. There's a lot they can do to lose sales, if they're not priced well or don't provide good service, all the blocking and tackling. But it's very hard for any of these companies, even the best ones, unless they've got a significantly impaired competitor in their market or there's something going on in their marketplace economically that's much different than the rest of the country. It's very hard for them to really drive sales.
All they can do is maintain their market share and possibly grow sales at a modest rate. But I think they're wasting money if they're spending a lot of margin dollars to drive sales. It may not be there. It's a function of the economic environment, in terms of deflation, and also the overcapacity which continues in this industry.
Collecting Loyalties
LEVIN: I have one more comment about price. I think there was some comment about how pricing can be effective. But with the infrastructure and information technology that companies have now, they are surveying constantly and reacting quickly to pricing of competitors. The thing companies are doing right is putting in more and more frequent-shopper programs that eliminate the cherry pickers. So it means that when they are being more effective on price, they're rewarding their better shoppers -- so it's not hurting them as much. And that's a real positive. But I don't think companies can dramatically undercut their competitors on price because you see too much of a reaction by their competitors.
BERNSTEIN: The frequent-shopper card issue is an important one. It's a huge marketing plus for most companies that adapt it and do it well. Still, under 50% of the industry has adopted it in this country. I think you'll see more and more chains start to employ it. Even more importantly, the companies that use the information they garner from it are going to be far ahead in terms of marketing and driving the top line. Several years down the road, we probably will get to a point where everybody has them and you'll see diminishing returns on implementing them.
SN: One of the outstanding chains that doesn't have a frequent-shopper program is Albertson's. Do they know something that the others don't?
ZIEGLER: Albertson's is an interesting company which is, I think, on the right path. But it's wavering a little. Albertson's and Food Lion are EDLP operators. They really want to keep their prices low. I think it's very rational management doing it that way. Their belief is frequent-shopper programs cost money and really mean high-low. I know Gary Michael would be really happy to build a database that frequent-shopper cards enable you to have. I have a feeling he'll come up with another way to do it. But their idea is to keep the prices down and dirty. And they are ranked lower in price and fairly high in quality, so I think they've attained a pretty good balance. But he's just saying there are a lot of costs associated with it. And you can't be an EDLP operator.
LEVIN: Also, there's a discrimination issue because you are not giving the same prices on certain products to everybody who enters your stores. So I think they want to be perceived as a more equal-opportunity retailer.
SN: But isn't Food Lion also EDLP? They have a frequent-shopper card.
ZIEGLER: They are EDLP -- and they're more religiously EDLP than Albertson's today. BERNSTEIN: I think it's a real question whether an EDLP player who has a frequent-shopper card is really an EDLP operator. Almost by definition they aren't.
LEVIN: But there has never been a true EDLP operator because all EDLP operators have some form of temporary price reductions or sales and promotions and it's a matter of degree. And companies are changing their formula over time.
BERNSTEIN: I think that's much truer now than in the mid- to late 1980s or so. But I think you're absolutely right that the lines are blurring tremendously.
Consolidating Views
SN: With all the mergers recently, is consolidation reaching a new level of aggressiveness? Can you predict whether it will pick up over the next year or level off?
COMEAU: I think consolidation is reaching a new level for a lot of reasons. The larger companies are more efficient and realize that a dollar spent on an acquisition is perhaps a better return than a dollar spent on new stores. Also, you have a growing number of financial sponsors who invest in the industry. Ultimately, it'll lead to a sale of the company as a financial sponsor to some strategic buyer. So with both the larger companies with efficient infrastructures with a desire to make more acquisitions coupled with financial sponsors owning companies and buying companies, I would see it continuing and perhaps even accelerating a little bit.
SN: Could each of you mention a likely company that would make a major acquisition?
ZIEGLER: Ahold.
GIBLEN: I think Albertson's might actually step up to the plate in the next year. I think it was important for them to have an orderly disposition of Kathryn Albertson's shares, and now those are controlled in a foundation so they don't have to worry about buying back a huge block of stock to keep control. I think they've looked at a lot of situations over the years and obviously haven't come out with anything. The only major acquisition they made was Jewel Osco in '92. But they'll probably really step up to the plate now. I get the impression they are serious about it.
BERNSTEIN: Among those on the acquirer side are Quality Food Centers, certainly Ahold, probably Food Lion. I think a more interesting topic is probably who the targets are. There are a lot of companies out there that are potential targets for a variety of reasons. Either they're a great operator or in a position between a rock and a hard place. Stater Bros. in southern California, although they just did a high-yield deal, I think is going to be an acquisition target at some point. They are a fantastic EDLP operator. At some point down the road they'll either be acquired or we'll see an IPO there.
Bits and pieces of Eagle Food Centers conceivably could be attractive to someone, although I don't think the chain as a whole would necessarily be that attractive.