A 100-YEAR W-A-R

ELLIOT ZWIEBACH

SAN ANTONIO -- As H.E. Butt Grocery here marks its centennial anniversary, it has some big decisions to make that will determine its history for the next couple of decades.

While it fights for a bigger piece of the pie in Houston, it must contemplate whether it wants to expand into Dallas and, if so, through acquisition or new-store growth. It must also decide whether the demands for long-term growth will force it to move beyond the confines of Texas and northern Mexico into new geographies, and whether or not that growth will come through a merger with another operator.

With 296 stores -- including 21 in Mexico -- and a volume estimated at $11.1 billion, H-E-B has earned the respect of most of its industry peers as one of the best operators in the nation when it comes to innovation, competitive zeal and quality of management.

"If I were a retail operator, H-E-B is one of the last companies I would want to face," Andrew Wolf, a securities analyst with BB&T Capital Markets, Richmond, Va., told SN. "They are tough as nails in terms of price and customer service, and a very formidable competitor wherever they go."

Given its very positive reputation -- built as it grew to become the largest supermarket operator in the state of Texas -- H-E-B has never considered resting on past laurels, certainly not under the leadership of Howard E. Butt, son of the chain's founder, nor under his son, Charles C. Butt, who has run the company since 1971.

That sense of restlessness has enabled H-E-B to continue to prosper.

Now, however, it must deal with the specter of Bentonville, Ark.-based Wal-Mart Stores breathing down its neck.

After years of being the market-share leader in Texas, H-E-B fell into a statistical tie in 2003, with a statewide share of 23.4%, compared with Wal-Mart's 23.3%, according to figures published in the San Antonio News-Express. In 2004, H-E-B lost the lead when Wal-Mart supercenters captured 25% of the state's volume, while H-E-B dropped to 23%, the newspaper reported.

H-E-B also lost some ground to Wal-Mart here on its home turf, where its 2004 market share fell 3% to 64%, while Wal-Mart's rose 4.8% to 19%.

Despite Wal-Mart's gains statewide and locally, the battle continues in Houston, where H-E-B is locked in a competitive struggle with Wal-Mart and Kroger that will play out over the next few years.

No one is counting H-E-B out. "As long as H-E-B remains price-competitive in Houston at a reasonable level of profitability and maintains points of differentiation with Wal-Mart, then the likelihood is that the two companies left standing at the top of the heap in Houston will be Wal-Mart and H-E-B," an industry consultant told SN.

H-E-B's strengths will serve it well in Houston, others said.

"H-E-B has always focused on building a low-cost delivery system that's on a par with Wal-Mart's, and it usually comes within 2% to 3% of meeting Wal-Mart price-for-price on the most visible items," one industry observer told SN. "When it comes to cost and price, H-E-B is tough to beat."

Ed Blair, a marketing professor at the University of Houston, said H-E-B does not concede market share easily. "Its key strength is the dominant position it's established in San Antonio and throughout Texas.

"H-E-B is a tough operator that has historically taken a 'scorched earth' policy and not given up any share very easily. In Houston, I believe H-E-B has made a strategic commitment to the market, and it's determined to be a long-term player there as the market shakes out."

With 75 stores in the broad Houston TV marketing area, H-E-B is running a close second to Kroger, with an estimated market share of 21.8%, vs. 23.2% for Kroger's 107 stores, 14.2% for Wal-Mart's 50 supercenters and Neighborhood Markets, and 11.8% for Safeway's 52 Randalls stores.

Within the confines of the city of Houston, however, it's a different story, with Kroger being No. 1 with 26.9%; Wal-Mart within striking distance at 22.3%; and H-E-B back in the pack with 13.8%, just ahead of Randalls' 12.7%.

Noted a real-estate consultant, H-E-B's goal is to achieve a 25% share within the next five years, a goal within more immediate reach, he said, "if H-E-B is able to acquire some key Randalls locations, which could probably get its share up past 20%."

Blair said he sees Randalls as one of the weaker players in Houston, which could work to H-E-B's advantage. "It's hard to see good things happening for Randalls," he said. "Kroger has been eating them up. As H-E-B expands its store base there, it will also take business away from Randalls while making life tough for Kroger."

Albertsons left the Houston market in 2002, in part because of the competitive onslaught being conducted there. There's widespread speculation that Safeway may eventually decide to sell its Randalls stores and exit as well.

Blair said he believes H-E-B has a definite edge over Kroger in Houston. "If you look at their stores, H-E-B and Kroger look a lot alike. But H-E-B comes across as more aggressive on pricing, and it does a better job with ethnic merchandising than Kroger," he explained.

"So I don't see H-E-B fighting Wal-Mart so much as making life miserable for Kroger and Randalls, the same way Wal-Mart makes life miserable for all of them."

Besides a finely tuned ability to price competitively, another weapon in H-E-B's arsenal is its knowledge of serving a Hispanic customer base and a willingness to learn what it doesn't already know, observers told SN.

"Coming out of San Antonio and south Texas gives H-E-B an understanding of the Hispanic market that's better than most operators," Blair said. "Putting H-E-B up against Kroger for the Hispanic shopper is no contest because H-E-B knows how to satisfy the Hispanic consumer better than Kroger does."

The industry consultant told SN he also believes H-E-B has an edge over Wal-Mart in serving the needs of ethnic customers, particularly given the polyglot nature of Houston consumers. "H-E-B is doing a great job appealing to a mix of Anglos, Hispanics and Asians in its stores there, and offering products and signage to meet some of those specific ethnic needs is something that isn't going to happen at Wal-Mart.

"Wal-Mart does a good job with ethnic merchandising, but not in the kind of polyglot situation that it faces in Houston.

"And when you add in the Central Market in Houston that H-E-B operates at the other end of the spectrum, it's clear H-E-B is covering that market completely and effectively."

What H-E-B doesn't already know, it's willing to learn, regardless of the expense, an industry observer pointed out. "If H-E-B wants to know what kinds of products will appeal to a particular segment of the population, it's very willing to send its executives all over the world to learn what they need to know -- whether it's going to France and Italy to find out how to do a better job merchandising cheese, or to Asia to find out what produce items it needs to carry," she explained.

One of H-E-B's biggest assets, she added, is its ability to innovate and to lower its cost structure. "H-E-B is a very efficient company that's been focused on technology for as long as Wal-Mart," she noted, "and that has enabled it to keep prices very competitive with Wal-Mart's."

No one can beat Wal-Mart on price, but H-E-B is doing its best to stay close, an industry consultant pointed out.

"H-E-B is a formidable competitor by virtue of its culture-driven performance and innovation," he told SN, "and it's been able to survive and do fairly well against a lot of supercenter competition because it's done something most other supermarkets have not done: It's worked hard to reinvent its business from the ground up by placing great emphasis on finding ways to run stores profitably while keeping prices competitive with Wal-Mart's.

"Everybody eventually decides to be competitive with Wal-Mart, but not everybody is able to remove costs the way H-E-B has done. H-E-B has thought things through in all areas of the business to take costs out -- in Houston, for example, by moving high-volume product onto the selling floor in pallets that fit into the gondola runs, which is a true labor-saving approach.

"As a result, it's probably ahead of Kroger in the learning curve there."

For H-E-B, the motivation to succeed in Houston, as elsewhere, is a powerful one, the consultant pointed out: corporate survival. "The intensity of its focus comes from the fact its whole business is in Texas," he said, "and I just don't see Kroger being as tough competitively, in part because it doesn't have the same kind of motivation.

"There's also the phenomenon of a public vs. a private company. Kroger needs to get positive financial results, whereas H-E-B, as a privately held company, can take a larger view and make any decisions it wants."

H-E-B's push for market share in Houston could be hastened, observers noted, if Safeway were to put its Texas stores up for sale: the Randalls chain in Houston and the Tom Thumb stores in Dallas.

While H-E-B has always preferred to build its own stores rather than acquiring someone else's, the temptation to get a jump on its Houston expansion while enabling it to move into Dallas might be a circumstance too tempting for H-E-B to pass up, they said.

Whether or not such an opportunity arises in Dallas, some observers said they see H-E-B's eventual expansion there as inevitable, given its historic pattern of moving into ever-larger cities in Texas. H-E-B already operates a single store in Dallas, a Central Market.

According to one trade observer, H-E-B's relatively small size in comparison with national powerhouses like Kroger has always been one of its biggest weaknesses. "Its size has made it tough for H-E-B to grow without moving into new markets. That's why a move into Dallas makes a lot of sense," she said.

The industry consultant said he also thinks Dallas would be a logical expansion market.

"H-E-B has already secured most of the non-metro areas of Texas. With its entry into Houston, it's operating in one of the state's two major metro markets. So Dallas is always a possibility. In fact, it may be impossible as it grows for H-E-B not to expand there."

Trade estimates cited Wal-Mart as the market-share leader in Dallas, with a share of 24%, followed by Tom Thumb at 17.3%; Albertsons at 16.5%; and Kroger at 13.2%.

Chuck Cerankosky, an analyst with Key Banc Capital Markets, Cleveland, said H-E-B would probably do well in the competitive Dallas marketplace "because the company has a good cost structure, and that would help it establish a strong pricing position. And if one or two of the weaker players there decide to sell some of their stores, that would be a way for H-E-B or others to expand quickly in the Dallas-Fort Worth metroplex."

The fact H-E-B has a multitude of formats -- conventional H-E-B stores, upscale Central Markets, limited-assortment Pantry Foods stores and expanded H-E-B-Plus stores -- could also help it in a new market, Cerankosky added. "Having the ability to appeal to different segments in a market with different formats can be a big positive wherever H-E-B goes because it enables it to serve a variety of demographics," he said.

Wolf said he's not sure if H-E-B will opt to move to Dallas. "Dallas is a different story from Houston. That's an Albertsons market, and Albertsons is very strong there."

Whether or not H-E-B moves north into Dallas, the time may come when it decides it has to look outside Texas for new markets to conquer, the consultant pointed out. "There was a time Publix was operating only in Florida. But it wanted to keep growing, so it had to move out of state. H-E-B could come to a similar conclusion," he said.

Cerankosky said he agreed that H-E-B might someday have to look beyond Texas for growth opportunities. "Companies tend to expand in geographies they're familiar with. So I would think H-E-B would probably like to stay within the Sun Belt, which means it could look west and contemplate expansion into New Mexico or Arizona. The company is certainly not shy about taking on established competition, as demonstrated by its efforts in Houston."

H-E-B showed a willingness to explore markets outside Texas when it expanded into northern Mexico in 1997. "That was typical of the kind of cautious, but innovative, approach the company follows," one observer noted.

"H-E-B wanted to grow, but it didn't want to make an acquisition. There was some talk at the time that it might look eastward and perhaps link up with Publix. But it obviously preferred to grow on its own, so it went into Mexico.

"Mexico was an underserved market and one that H-E-B understood, since 70% of San Antonio is Hispanic. H-E-B studied the northern Mexico marketplace carefully, and then moved in by focusing growth in the border towns rather than the interior because many of the shoppers there were crossing the border to shop, and they already knew the H-E-B name."

H-E-B operates 21 stores in Mexico; last year it opened a 300,000-square-foot distribution center there.

Another H-E-B asset, an observer told SN, is the quality of its people, particularly at the management level.

"There's an openness at H-E-B about bringing in outside talent. While many other grocery companies are content to promote from within, H-E-B not only cultivates talent within the organization, but also goes out and recruits people from the top business schools and pays up for them, just as consumer packaged goods companies do."

She said that approach may stem from the fact Charles Butt attended the Wharton School at the University of Pennsylvania, "which enabled him to broaden his horizons and prompt his willingness to look beyond Texas or the food industry for talent."

Some of that attitude may also stem from H-E-B's longstanding sharing arrangements with British powerhouses Tesco and Sainsbury, she added. "Those companies recruit from Cambridge, and it's very prestigious in the United Kingdom for a business school grad to join one of those companies, which is not the case here. But H-E-B has built itself into the kind of a brand that top-flight business school graduates are willing to go to work for."

Birthday Blowout

SAN ANTONIO -- H.E. Butt Grocery here said it plans to spend 2005 marking Celebration 100, a series of Texas-sized special events and promotions for customers and store partners commemorating its centennial year.

Events scheduled include the following:

Four in-store promotions running throughout the year, offering prizes including a new home, $100,000 in cash, Ford trucks, shopping sprees and concert tickets -- made possible through the support of Coca-Cola, ConAgra, Kraft, Procter and Gamble, and H-E-B Own Brands, the company's Celebration 100 sponsors.

Awards of over $500,000 to teachers, principals, and $100,000 to the winning school district in Texas, as part of the chain's annual Excellence in Education Awards.

"The Flight to Fight Hunger," in partnership with Southwest Airlines, in which chain representatives flew to six major Texas cities to donate more than 1.25 million pounds of packaged, nonperishable food products to 18 affiliates of America's Second Harvest, which H-E-B said was the largest single-event contribution to Texas food banks.

"Trees for Texas," in partnership with American Forests, a nonprofit citizens' group, that will enable students at 40 Texas schools to learn about conservation by planting more than 100 saplings from historic trees across the state.

The Celebrate Texas Tour, featuring what the chain is calling the world's largest grill and smoker, will travel to store openings and more than 100 community events and festivals around the state "to bring the party to the people," the company said.

Television ads touting the centennial featuring Houston Astros pitcher Roger Clemens; Tony Parker and Bruce Bowen of the San Antonio Spurs; Ray Benson of Asleep at the Wheel; and Bevo, the University of Texas mascot.

Special commemorative packaging on H-E-B private-label items.

Parties at every store in the United States and Mexico to show the company's appreciation for its store employees, with gifts plus special prizes through an internal company sweepstakes.