FOOD RETAILING'S FUTURE 1999-09-06 (1)

Ziegler: We all know these guys are most interested in applied technology -- that's what's driving the high teens earnings growth. It intrigues me that we have a group here that's pretty much going to deliver a high teens earnings growth among the big players, and the drug stores we follow are in that same earnings-per-share growth mode, and yet the drug stores sell at a 10-multiple-point premium except for Rite Aid, and why is that? Because the drug stores have investors convinced there's a whole macro story there of rapid growth, demographics -- they've got everybody convinced that it's the right place to be in the market. The supermarkets don't have that. Home-meal replacement hasn't caught on. The technology thing hasn't caught on, although we all know it's there. The consolidation thing -- people always say every time a deal is done that there's nothing left to do. And so there's not a great demographic story.

pansion? There's obviously going to be a lot happening in Europe now because of Wal-Mart's entry. Will U.S. supermarkets keep out of that business?

Husson: I think they've missed it.

Ziegler: It's going to be a while.

Comeau: I don't know if they've missed it or if it's simply not on their radar screen.

Adler: I think longer-term, you could envision a time when you have big players outside the United States, people like Carrefour who don't have any U.S. presence, asking themselves if they can be truly global without having a U.S. presence. I don't see that happening in three years, five years or even 10 years, but when you look at global consolidation, there are players who don't have much presence in the United States and the question is, is that a longterm strategy?

Husson: Carrefour had a building strategy in the United States several years ago. It wasn't trying to acquire anything. But I think at the time Carrefour had a lot of work to do at home, a lot of upgrading of stores and a lot of systems to introduce at Carrefour France, and I think it realized that a credible U.S. expansion strategy -- doing what Wal-Mart is doing, opening supercenters -- was going to take all the free cash flow of the business for years. So Carrefour looked at it and thought, "are we going to bet the farm on U.S. expansion when there's more work to do at home?," and I think that, sensibly, it withdrew. Levin: But one thing the question implies is that ultimately you'll see the growth rates of domestic companies come down in terms of their earnings because they really do get a benefit from consolidation synergies, the buying power and what they can do with Best Practices and systems and all. And longer term, when earnings growth slows down, the question arises, do they look outside the United States for growth, or do they choose to look inside the United States and go into related areas?

Safeway has certainly indicated it thinks, longer-term, there are areas it is likely to be interested in inside the United States. A lot can happen over the next five years, but those are the types of areas that we'll be discussing.

THE WAL-MART QUESTION

SN: What impact will Wal-Mart have on U.S. supermarket operations?

Ziegler: We really need to wait for Wal-Mart to move ahead on its Neighborhood Market format, which it may do it through an accelerated rollout, but I think it's only talking about increasing the number 80% this year, which sounds like a big percentage, but it has only four stores. If it rolls that out or does make an acquisition, then I think some of the smaller folks will feel the pressure.

Adler: I think Wal-Mart's strategy is to add supercenters to existing stores and replace discount stores with supercenters and expand distribution in a circle around that. Wal-Mart needs to do that because the economics of distribution, market share, all of it, require it to do that all over the country where it's building supercenters.

Bernstein: Isn't one of the interesting aspects of Wal-Mart's neighborhood format that it can be used as a vehicle to penetrate the more suburban types of areas where it hasn't had a presence and where there aren't 15 contiguous acres to plop down a supercenter? To me that seems to be one of the real key strategic advantages of that format for Wal-Mart.

Husson: It's a solution to a problem. Wal-Mart has a problem in that food is an inconvenient offering in what is a convenience industry, and it's struggling with that. A potential solution is to make the food offering more convenient. The trouble, though, is getting the real estate to drive that, which I'm highly dubious it could do in a meaningful way because opening only 20 or 30 stores a year is just a pimple on the backside of a rhinoceros. It's small, and you wouldn't feel it. In order to get the right real estate, Wal-Mart would have to pay top dollar in every single market and come in at the high price in terms of rent and competing with a lot of other people who want similar kinds of real estate at that corner, at major intersections.

Adler: At a recent Ahold meeting, it was surprising to me the extent to which the company talked about small stores as a strategy for its existing divisions. Where I had thought the supermarket industry had sort of abandoned the 40,000-square-foot store, from listening to Ahold, you started to see a lot of reasons why the 40 was the right format for many markets and you'll see Ahold really moving into that space, which means the competition for those good locations just went up, and I would really rather bet on the market leader being able to get those 40,000-square-foot stores than somebody coming in from outside.

Levin: I would not bet against Wal-Mart though. It's obviously still testing the Neighborhood Market, with just a few stores in existence. But it has the capital and the fire-power, and if it decides to really focus on the neighborhood stores, I think that's the topic we'll be talking about several years from now, just like we talk about supercenters today and the kind of pressures they exert on the industry.

It remains to be seen whether Wal-Mart decides to use the Neighborhood Market first to in-fill between supercenters -- which means it really has to get the right location, depending on where the supercenters are located -- or if it's going to use it as a vehicle to approach more urban environments and really have a greater presence in more densely populated areas. It may try a two-pronged approach and do it both ways, but it's really in the early stages since it's only testing a handful of stores now.

Ed Comeau: But Wal-Mart has developed a way to suck up all the incremental business it can around its supercenters and the secondary and smaller markets. If you look at it, Wal-Mart doesn't have large market shares in food in any of the major metro markets it's in, nor can it in a supercenter .

You look at the vehicle it's developed, the Neighborhood Market, which is really inappropriate for a large metro market, and it openly says that itself. I think it designed the Neighborhood Market as a vehicle to pick up a lot of the convenience aspects of what a Food Lion can get in the market or what it leaves on the table by being a large, inconvenient shopping offering to the consumer, as Mark points out.

From my standpoint, Wal-Mart hasn't begun to broach the issue of getting into metro markets, capturing large market shares like the Krogers and Safeways. It's really just taking a step toward picking up a lot of the incremental business along the path of least resistance in the secondary and smaller markets. So until it develops a larger format, which it can easily do but hasn't yet, I wouldn't imagine Wal-Mart is a big metro-market threat with this particular format.

And if you look at that in regard to acquisitions, I wouldn't think that it would be on Wal-Mart's radar screen to make acquisitions in these smaller, secondary markets. I would think it's just going to pursue the path of least resistance as it has with supercenters in secondary markets and do that more effectively with Neighborhood Markets.

Husson: I think there is a market segmentation issue here as well, and that is that the small mart is very much geared to a blue-collar market. If you're getting into suburban markets, Safeway, Kroger, Albertson's or Hannaford Bros. have nothing to worry about from this kind of format because their urban offerings are very fresh. There are surprisingly small amounts of fresh food in these Neighborhood stores -- certainly not something that many higher-income consumers would relish.

Ziegler: I don't think that's what you're going to get. All the operators didn't bother going down to Bentonville to see the Neighborhood Market because they wanted to see something that just makes them relax. When you look at the first supercenter and the latest supercenter, you realize Wal-Mart's learned an awful lot. The company admits it had the thing all wrong.

Adler: Weren't you surprised by how far off the mark Wal-Mart was in that first Neighborhood Market?

Bernstein: It depends what Wal-Mart wanted to do with it. If it wants to do 40 feet of potato chips and Mountain Dew and beef jerky -- if that's what the market consumes in those type of towns -- then that's the right store for that market. The point is that it wasn't a metropolitan-market store -- it was a store for a rural, secondary market.

Ziegler: Wal-Mart may have another option, though, if it wants to get into small stores -- it could supply other products through its Web site, which it's going to develop, and then have it dropped at the small store so the consumer could pick it up on the way home from work. So that's another option of having a plain vanilla Wal-Mart while having some of the more exotic stuff available for order over the Web site.

Giblen: I just think we're not going to reach agreement on Wal-Mart. But whatever the conclusions are, it's probably going to happen a lot more suddenly than anybody here believes because all the rhetoric and commentary was that it would not be pursuing things in the United Kingdom at the same time it got into the Asda deal, which happened quickly and suddenly. It had very fine secrecy attached to that deal. Before we know it, Wal-Mart may decide that neighborhood stores are worth a major rollout and when it does, it will move quickly.

ALTERNATE FORMATS

SN: What do you consider to be the most competitive alternate formats for supermarkets?

Levin: I think we should discuss the obvious first. Wal-Mart supercenters are very real and very significant. There are 600 of them, and they'll keep on going. Wal-Mart will build at least 150 annually, and I think they still hurt independents more than they do the supermarkets, though the supermarkets will still complain. But anytime there's more square footage added to the industry, it hurts cumulatively. If you look at where same-store sales are now, they're weak overall. And you do have some issue of deflation.

Giblen: Warehouse clubs like Costco keep adding food varieties and having great success. And drug stores have pretty much across the board added more than the minimum convenience offering of food. Really, some of them have very extensive food, short of fresh perishables.

Levin: And they're getting better and better at it.

Ziegler: I think somebody like Walgreen's is planning on going into home-meal replacement, and that could be a new threat that's coming. And 7-Eleven is making efforts, although I don't know how rapidly, to be in the home-meal replacement business too. And there are other operations that are all kinds of mixtures. Everybody wants to be in gasoline, and everybody wants to be in home-meal replacement. Convenience is really important to the small store format.

Giblen: And speaking of convenience, convenience stores really have come back from the dead. There's better management in the industry in general, and convenience stores are being consolidated into better managed entities. Basically, the traditional customer was limited to the blue-collar male who wanted a beer at midnight, and that was a very limited segment. But now, they've all figured out that if you have a clean, well-lighted place, you can get a wider variety of customers in.

So while Wal-Mart supercenters are the biggest alternative format threat, when you add up all the others, they do become meaningful too.

SN: What are supermarkets going to do at this point to differentiate themselves in the face of this new competition?

Husson: Just turn this around a little bit and think how many roundtables like this in other areas of retailing are asked where the biggest threat is coming from and the answer would be supermarkets. The restaurant business, particularly the family-owned restaurant business, would certainly say supermarkets. The little hole-in-the-wall video rental guy would probably say supermarkets. Increasingly, the smaller drug stores will say supermarkets. The supermarket is an incredibly resilient format. And now gasoline is beginning to happen in the supermarket industry.

THE INTERNET

Ziegler: Then there's the Internet, with Webvan running full-page newspaper ads every couple of days in the San Francisco Chronicle, telling how they can deliver product to your home for less than you can buy it at Safeway or Lucky, and it's kind of a scary thought. Levin: I don't think we should talk about the Internet because I don't look at that as something that's an immediate threat. I think we're going to hear more and more about it if Webvan really builds its 26 different warehouses around the country and Hannaford finds a joint-venture partner for its home-delivery business, and there are others out there such as Home Grocer and Peapod, which has also reinvented itself, switching from its historical model to a more current model. So we could see all of a sudden a great amount of warehouse space and home-delivery options available to many, many people in this country, but for right now, it's probably happening on a very limited basis.

SN: So supermarkets are in a waiting mode right now to see what models develop and what will happen?

Levin: Hannaford is certainly participating with Home Runs, but the rest seem to be studying it. It wouldn't be impossible for Ahold to jump in because it has a delivery service it's tested in the Netherlands that is now profitable, although it took a very long time to get it profitable.