KROGER'S NEXT STEPS

ELLIOT ZWIEBACH / JOSEPH A. PICHLER

CINCINNATI -- Kroger Co. here is moving beyond first-stage integration to pursue new growth initiatives, many of which are based on best practices.

Although Kroger declined to be interviewed for this article, the company's public statements and SN interviews with retail observers indicate the company is focusing on a variety of category and format strategies to propel sales, margins and synergies.

Two years past its merger with Fred Meyer Inc., Kroger said it is on target to achieve post-integration synergies of $380 million at the end of the current fiscal year, a year ahead of schedule.

In addition, it said it anticipates that earnings will continue to grow at a rate of 16% to 18% a year for the next two years, with additional synergy savings likely in the second year.

In three years, Kroger said it expects to return to annual earnings growth of 15%, closer to its historical rate prior to the merger.

According to Joseph A. Pichler, chairman and chief executive officer, "We are more confident than ever about the competitive advantages of the merger and the directions Kroger is moving. We've identified 12 additional initiatives that we're pursuing, and we're looking for new opportunities.

"Because of the wide variety of formats we operate and our No. 1 or No. 2 position in 40 of the 46 markets in which we operate, we believe we can meet all our expectations."

Pichler made those comments earlier this month during a conference call reviewing year-end results, which was the source for most of his remarks quoted in this article. Additional comments were made during a public presentation in New York in February.

According to Pichler, Kroger's strategies in the next few months will be heavily focused on sales and margin improvements in five merchandising areas -- private label, pharmacy, general merchandise, natural food and fuel centers -- plus expansion of the Food 4 Less format outside California and the Marketplace format outside Arizona.

Equity analysts told SN most of Kroger's financial and strategic goals are geared to applying best practices culled from the Western operations it acquired in the Fred Meyer transaction.

According to analysts, those practices include the following:

From Fred Meyer Stores, Portland, Ore., expertise in general merchandise, including seasonal buying and overseas sourcing, plus operating insights into pharmacies and natural food sections.

From Ralphs Grocery Co., Compton, Calif., expertise on loyalty card programs, premium private label, working capital management, labor productivity and forward buying.

From Food 4 Less, La Habra, Calif., insights on operating a price-impact warehouse store with a strong emphasis on perishables for a middle- to lower-income demographic.

From Quality Food Centers, Bellevue, Wash., expertise on perishables and store service in upscale locations.

From Smith's Food & Drug Centers, Salt Lake City, data on operating larger combination stores.

Jonathan Ziegler, San Francisco-based managing director for Deutsche Banc Alex. Brown, New York, said these best practices "represent a variety of long-term opportunities Kroger has found while digesting the Fred Meyer merger."

Lisa Cartwright, an analyst with Salomon Smith Barney, New York, told SN the 12 initiatives Kroger is pursuing "are based on studying what each of the acquired chains did well, including category management, private label purchasing and development, and some cost-cutting programs."

According to Meredith Adler, an analyst with Lehman Brothers, New York, "Anyone can let alternative channels take away food sales, but Kroger is fighting back to take share away from others, and the initiatives it is pursuing are very focused on reengineering individual departments -- something Safeway has been doing for several years but that Kroger has been slower to attack."

Gary Giblen, senior vice president and director of research for C L King Associates, New York, expressed a similar viewpoint. "Kroger is taking the same approach in talking about its 12 initiatives as Safeway has taken in talking about its 'breakaway strategies' for more than a year -- an approach that allows the company to execute its initiatives without having to articulate everything to its competitors while still pleasing Wall Street," he told SN.

Kroger is the nation's largest chain of traditional supermarkets, with 2,354 food stores, 789 convenience stores, 398 fine jewelry stores and 77 supermarket fuel centers accounting for sales of $49 billion -- an increase of 8.1% for the year ended Feb. 3, or 6% when adjusted for an extra week in 2000, the company said earlier this month. Merger-related costs were incurred in both the fiscal year that just ended and in the previous fiscal year. Net income for the latest fiscal year rose 19.9% to $1.1 billion, or $1.34 per share, excluding merger-related costs; with those costs included, net income was up 43% to $876.9 million, or $1.04 per share.

Operating cash flow increased 13.3% for the year to $3.5 billion, or 7% of total sales -- a reflection of synergy savings and increased sales of corporate brands, Pichler said.

He said Kroger anticipates additional synergies will come from the 12 initiatives the company is pursuing. However, while he has declined to specify in his public comments what the initiatives are, Pichler did say some of the targets "became apparent during the merger process and others opened up through new technology."

Kroger's approach to executing the initiatives will be based on the methods it used to integrate the Fred Meyer operation, Pichler said.

"We've learned a great deal from the merger process, in which we assembled 16 integration teams that established processes that enabled us to set clear financial targets, develop action plans and measurement systems, and then execute effectively to achieve the synergy goals ahead of our original timetable," he explained.

"Reaching those synergy targets a year early energized the entire organization and freed us up to take the same approach on 12 additional targets that we've identified to achieve sales and margin improvements this year and in fiscal 2002."

Pichler declined to pinpoint the kinds of synergy savings Kroger anticipates beyond the current year, "but the 16% to 18% earnings growth we anticipate in fiscal 2002 -- the year after we achieve the $380 million in savings -- is based on expectations of additional synergies," he said.

Kroger expects earnings to grow at a rate of 15% a year, excluding acquisitions, for the fiscal year that begins in February 2003, he added. "But 15% is not a cap -- it's just our best judgment at this point looking forward."

He said the company sees "tremendous sales opportunities" in five categories, including the following:

Private label. Kroger boosted its corporate brands assortment by 1,100 items in 2000 and in the process converted to a three-tier private label program -- something the chain had resisted for years, analysts said.

"For years the company used the Kroger name on private-label products that didn't have a high volume and the individual chain name -- Fry's, for example -- on higher volume items," Ziegler pointed out.

"When someone would ask why they didn't have a two- or three-tier program," Giblen added, "Kroger executives would say the company didn't need a premium label because Kroger was a high-quality product line. But when they saw the success Ralphs had with the premium Private Selection line and the success Fred Meyer Stores had with the generic FMV [Fred Meyer Value] line, it began thinking about a three-tier approach."

It adopted the FMV (For More Value) line early on in the integration process, and in October Kroger began distributing the Private Selection line companywide, with 300 items introduced last year and 150 more due to become available this year.

The expansion of private label has been a significant factor in Kroger's sales growth, Adler said. "Historically, Kroger didn't have a premium private label line, but when it got a chance to look at the numbers in the Western region, it realized it made sense. As a result, it's adding Private Selection at all Kroger divisions, while simultaneously commonizing products in its core Kroger brands by putting the name of each division -- Smith's, Ralphs, Fred Meyer or whatever -- on the label in its respective geographic area."

According to Pichler, "The rapid increase in corporate store brands has a negative impact on same-store sales, but it builds gross profit dollars, and we're delighted with the speed with which private brands have come on strong in the Western part of the company, with some divisions north of 20%."

He said corporate brands accounted last year for 26% of grocery dollars and 32% of grocery units in the East, "and sales in the West are approaching that level."

Cartwright said the improvements in gross margins from expanding private label "could be pretty significant for Kroger, particularly in terms of manufacturing. Because Kroger manufactures nearly two-thirds of its private label products at its own plants, expanding those lines not only generates better gross margins but it also generates savings on the manufacturing side."

Pharmacy. Kroger, which already operates 1,602 pharmacies, expects pharmacy to be a key driver of identical sales growth, Pichler said, with pharmacy sales expected to reach more than $6 billion by the end of 2002 -- nearly double their total in 1999, he pointed out.

According to Cartwright, pharmacy is a significant business for all food retailers "because it provides one way to help offset lagging comps in the center store. If the pharmacy business is 3% to 6% of total store sales and pharmacy comps are in the mid- to high teens, as it is at drug stores, then pharmacy sales offset negative sales trends in the center of the store."

Kroger is learning a lot about pharmacy from Fred Meyer, which has the largest pharmacy business in the Pacific Northwest, Cartwright noted. She also said Kroger should be able to pick up added benefits from being the first to roll out new pharmacy software that will allow doctors to transmit prescriptions electronically to Kroger pharmacies.

General merchandise. Kroger anticipates additional sales from leveraging Fred Meyer's expertise in general merchandise and seasonal items for sale at Kroger's combination stores, Pichler said.

According to Ziegler, "Kroger management wants to do general merchandise right so it can get the appropriate returns, and while it doesn't yet feel ready to roll out any major programs to its stores, it has made a start with selected general merchandise at some stores -- primarily using seasonal promotions and in-and-out deals, all very exciting stuff that its store base can accommodate."

Natural food. Kroger intends to expand its natural food departments to 550 locations by the end of the year, Pichler said -- triple the number of departments Fred Meyer was operating at the time of the merger. "These departments provide handsome margins and additional sales," he said.

According to Adler, "Emphasizing natural foods will enable Kroger to create demand by making those products more widely available."

Cartwright said Kroger has learned a lot from Fred Meyer about natural food, "and it's using that expertise to develop separate departments to enhance its assortment. Customer feedback indicates consumers like to shop in smaller separate departments for natural food, and that's what Kroger is working to expand."

Supermarket fuel centers. Kroger expects to expand the number of fuel centers this year to between 150 and 170 from the 77 locations it had at the end of 2000, Pichler said. "Gasoline is a natural addition to our one-stop shopping strategy," he noted.

Besides seeking increased sales in those categories, Kroger anticipates additional sales growth from expanding two existing store formats, setting aside $100 million this year to grow Food 4 Less, its California-based price-impact stores, and Marketplace, the scaled-down Arizona version of the Fred Meyer multidepartment stores it operates in the Pacific Northwest.

"But Kroger still has not yet determined if it wants to mix either format with existing stores within a trade area or region," Giblen pointed out.

Kroger operates 88 stores in southern California under the Food 4 Less banner and 11 identical stores in northern California under the FoodsCo name. (Fleming owns the rights to the Food 4 Less name in some parts of the U.S., Kroger in others.)

Kroger said it intends to introduce Food 4 Less into two new California markets this year -- Fresno, in central California, and El Centro, near the California-Mexico border -- with its eye on other potential new markets.

Adler said she believes Food 4 Less is a great expansion vehicle for Kroger "because it caters to an underserved segment. Although on the surface it looks like it's positioned as a supercenter with its emphasis on price, it's really focused on perishables at great prices.

"And where the size of supercenters tends to put those stores at the edge of a market area, Food 4 Less can be positioned closer to where people live."

According to Cartwright, Food 4 Less appears to be successful in markets where there are no alternative price formats to Wal-Mart or warehouse clubs. "The Food 4 Less price format works in a smaller box and in locations that are within reach of urban and suburban marketplaces and that don't require driving as far out as one has to go to get to a Wal-Mart Supercenter," she said.

Ziegler said the Food 4 Less format "gives a traditional operator like Kroger the opportunity to offer a different format for a price-sensitive customer."

Giblen said Food 4 Less would make a good expansion vehicle for Kroger in the central part of the country, "where warehouse stores have been so successful. And there might also be opportunities in the Southeast, where Kroger has built a strong upscale image, leaving room for a downscale operation -- as long as Kroger keeps the two formats completely separate."

The Marketplace format represents a hybrid between a supermarket and Fred Meyer's multidepartment stores, with the same food selection as a combination store but with a vastly expanded general merchandise assortment. Kroger converted all its Arizona stores to the Fry's Marketplace banner late last year.

Pichler said Marketplace is a prototype that can be exported to other geographic areas. "Those stores are meeting our expectations," he noted. "We're delighted with the sales so far, and we anticipate improved opportunities as we make some adjustments to strengthen those stores."

Adler said the Marketplace format gives Kroger the opportunity to penetrate areas that may already be saturated with Kroger-banner stores. "In addition, it enables the chain to add more general merchandise to a store and take sales away from other operators, including mass merchants. But because the stores are not as large as supercenters, they can be situated closer to where people live."

She said she doubts Kroger will begin expanding the Marketplace format to other areas until late 2002 or 2003 "because each store will require a big enough piece of real estate that Kroger won't be able to fill the pipeline overnight."

Kroger is also committed to expanding by acquisitions, analysts said.

Since the Fred Meyer deal, Kroger has completed six smaller acquisitions that have allowed the company to enter six new markets: Richmond and Hampton Roads, Va. (through the acquisition of stores divested by Hannaford Bros. Co.); Sacramento, Calif. (through the acquisition of stores divested by Albertson's); Flint/Saginaw, Mich. (Kessels Food Stores); Seymour, Ind. (Jay C Stores); and Anderson, Ind. (Pay Less Supermarkets).

Kroger anticipates entering a seventh new market -- Omaha, Neb. -- later this year when it completes its acquisition of 16 Baker's Supermarkets, which it is acquiring from Fleming.

According to Adler, Kroger is likely to continue to make as many smaller acquisitions as it can. "But it won't do acquisitions in smaller markets unless the target companies are in the top position there -- it bought Baker's mainly because Baker's was the market leader in Omaha."

She said Kroger is interested in acquisitions that will allow it to fill in gaps in its marketing areas "or to add stores that are not exactly within its markets but on the outskirts where there's already name recognition, the advertising reach is already there and distribution is not a problem."

Besides acquisitions, Kroger said it plans to grow its store base by allocating $2 billion to capital spending this year -- up 17.7% from the $1.7 billion it spent last year -- to open 115 to 120 new stores, of which 20% will be expansions and 20% relocations, and complete 150 to 160 remodelings. During 2000, Kroger opened 87 new, expanded or relocated stores and completed 93 remodels.

Kroger anticipates expanding square footage by 4% to 5% this year, Pichler said, most of it within existing markets "where we can leverage fixed expenses."

He said the company also sees plenty of room for expansion in existing markets. "Our stores are located in 10 of the 15 fastest growing areas of the U.S., and from what we see in the West, the Southwest, the Mid-Atlantic and the central area, growth will continue. And though we have a commanding share in 40 of the 46 markets in which we operate, those shares are at the 25% to 30% level at minimum, so there's a lot of room to grow."

Pichler said Kroger competes with Wal-Mart Supercenters at 403 locations -- 17% of its store base. But Kroger is holding its own, he added, noting that out of the nine marketing areas where the two companies go head-to-head, Kroger's market share rose in five and declined in four during 2000, with an average market-share increase of 0.6% in all nine areas.

Ziegler said Kroger's ability to generate strong operating cash flow makes it possible for the chain to withstand pressure from Wal-Mart on gross margins and pricing. "And with the dominant market share in so many regions, Kroger does well against Wal-Mart Supercenters while the 800-pound giant goes after lesser players."

Pichler said Kroger doesn't have much interest in looking for expansion possibilities outside the food industry.

"We like this business. It's our core business, and there are still plenty of opportunities left," he said. "While we can't predict where opportunities will occur, the industry is continuing to consolidate, and we're sure there will be more opportunities."