PROBLEMS AND POTENTIAL

NEW YORK -- The future of food retailing is filled with an array of marketing and merchandising changes that are likely to keep operators constantly on their toes, according to participants in SN's annual Financial Analysts' Roundtable here.

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To be successful, home-meal replacement products must be made in smaller quantities closer to the point of sale.

The Internet has the capability of revolutionizing food retailing by expanding the kinds of out-of-box programs supermarkets can offer.

Pharmacies are a must for most supermarkets, but whether they are profitable remains a debatable question.

As category management thins out inventories, supermarkets will look more carefully at how they use their cube.

Food safety concerns are likely to help good operators and accelerate the demise of bad ones.

The industry is in a golden era of labor relations.

Participants at this year's roundtable included Meredith Adler, senior vice president of Lehman Bros. here; Ted Bernstein, director of Grantchester Securities, a wholly owned subsidiary of Wasserstein Perella Securities here; Ed Comeau, vice president for equity research at Donaldson Lufkin & Jenrette here; Gary Giblen, locally based managing director of Banc of America Montgomery Securities, San Francisco; Mark Husson, first vice president of Merrill Lynch here; Debra Levin, principal at Morgan Stanley Dean Witter here; and Jonathan Ziegler, San Francisco-based managing director for Deutsche Bank/Alex Brown here. Ziegler was with Salomon Smith Barney at the time of the roundtable.

Part one of the roundtable ran in SN's Sept. 6 issue. Following is part two:

SN: How is private label doing?

COMEAU: I think store brands have had a little bit of a day in the sun and they have not really been exploited to the degree they should have been by companies other than perhaps Safeway and maybe one or two others. So I think there's an awful long way to go for a high-quality store with a store brand.

All these companies are scratching at it a little bit now, though Safeway seems to be the only one that's brought it to a reasonable level, but private label represents probably the greatest merchandising opportunity for these companies. I don't know if U.S. operators can get to where the U.K. is, but there's a lot of road to hoe between where U.S. supermarkets are now and where they could be.

SN: What kind of success could they achieve?

COMEAU: It's hard to know. The numbers are probably about 15% now. The company managements don't give you accurate information when you ask about store brands because they include milk and meat and a lot of other categories that have nothing to do with center grocery. Really, center grocery might be 13%, 14%, 15%, and Safeway might be somewhere over 20%, I would guess, but it should be an awful lot higher than that. HUSSON: I agree with much of what you're saying, but I would ask you to think about store brands in a different way. What is store brand all about? It's about the brand over the door being carried onto the product in the consumer's mind. Sometimes it's got the label on it, and sometimes it hasn't. I think in order to find out what the store brand really is, and to get the retailer to think about it properly, you've got to figure out how much they sell that doesn't have somebody else's name on it. Then what you're left with is 50% of the store, because the fish is a Safeway fish, the apple is a Safeway apple and the store manager and the whole supply chain has to take responsibility for the quality, appearance, merchandising and pricing of that fish and apple in an integrated way.

If you start to think about store brands creatively like that, the numbers are very high, though I realize that's not a traditional measure.

One of the areas of strongest growth in private brand in the last year has been chilled meals. That's something the manufacturers are useless at, nor can they be good. The reason why we've got so many tin packets and pouches in U.S. supermarkets is that manufacturers get economies of scale by manufacturing things in massive volumes in very remote places, which is useless when you're doing home-meal replacement, which needs to be manufactured in relatively small volumes in very local places and is naturally the province of retailers in large-scale markets. That's where the real opportunity is. That's where the likes of Marks & Spencer, Tesco and Sainsbury do a remarkable job in the U.K., and it's a category that is almost non-existent in the U.S.

HOME-MEAL REPLACEMENT

SN: Are you saying that in the U.S., only the large players can make a dent in the home-meal replacement area?

HUSSON: I think so. It depends what you mean by large. Clearly, Ukrop's is not what we would call a large retailer, but it has very large market shares in a very small area, and it makes sense for them to run a manufacturing facility because they've educated their customers over 20 years to expect this stuff -- to turn out teriyaki chicken one day, and coronation chicken the next and chicken vindaloo the day after. LEVIN: I'm sort of skeptical about how much home-meal replacement we'll see. I think it really depends on how you define it, because if you're talking about what's easy for the customer, there's just a huge amount of use of frozen microwaveable foods. That may not be chicken vindaloo -- it may be macaroni and cheese, because that's what Americans eat. I think you're going to see a continued emphasis on perishables by the supermarkets, whether it's deli or bakery or home-meal replacement, but I'm not sure that home-meal replacement really has to be the refrigerated chilled meals that are premade. I don't have a sense from many retailers that chilled meals have been successful or that it's a real huge area of opportunity, but I think, overall, perishables is a real area of opportunity and something they have to focus on because the center of the store does not provide huge opportunities, given the kind of competitive environment we've discussed.

Ziegler: I think another answer to your question is going to depend on how the frequent-shopper programs roll out, and how they tie into the Internet. It's going to be mind-blowing how it's going to expand the capability of the box because they're going to be able to do a lot of out-of-box things. The retailer is going to know everything you buy, and how far you drive to the store -- I think some companies with gas stations are already doing product tie-ins, and they are definitely pricing aggressively by giving incentives to get you into the store.

One thing that strikes me as really kind of exciting is something Costco told me -- that for every dollar of gas it pumps, it does 40 cents inside the club, and I don't think operators like Kroger or Albertson's have lost sight of that. There are going to be opportunities to tie that together and tie it in with the frequent-shopper card and tie it in with Internet capability. Supermarkets will add what it takes to drive same-store sales, whether it's in the box or done electronically.

MERCHANDISING CHANGES

SN: Let's talk about merchandising. Does consolidation distract operators from developing exciting merchandising efforts? Does it give their competitors who aren't consolidating any sort of edge?

BERNSTEIN: I think consolidation actually does the opposite. It supports the development of better merchandising ideas to the acquired company and sometimes to the acquirer.

LEVIN: If you do Best Practices right, then you really have the opportunity to learn a huge amount, and I think the larger companies have just gotten better and better at that.

SN: How about while they're going through the integration process or while they're waiting for an integration to happen, and then it happens and they have to put systems together and do other things. Are they distracted at all?

LEVIN: It depends on the company. It depends on how they're handling the integration and how well it's planned, but there's certainly potential for them not to get the merchandising right, right off the bat.

But at the same time, where there's opportunity, they consolidate private label very quickly. For example, one of the first things Kroger is doing is bringing the upscale private-label program -- Private Selections, which Fred Meyer has -- into Kroger stores. For years Kroger said it was not going to have an upscale private-label program because it really believed in the Kroger brand. But now it's saying, "Oh look, it works. We'll have our Kroger brand and we'll have our Private Selections."

GIBLEN: Safeway says it was learning from Dominick's even before that acquisition was completed. It had its eye on certain innovations and stressed that it was learning more from Dominick's than the other way around, from a merchandising standpoint.

ZIEGLER: And Safeway is saying the same about Randall's as well, saying Randall's is more theater than store. And I think Albertson's is picking up a great ability to improve its home-meal replacement program, which I think needed some improvement, from the properties it picked up. I think Albertson's has the most opportunity, because now it has market share.

GIBLEN: And Food Lion was pretty much behind the curve in terms of perishables and produce merchandising until it picked that up from Kash n' Karry. Now it's using Kash n' Karry as its growth vehicle in Florida.

ADLER: And if you look at the area where the supermarkets are weakest -- nonfood -- one of the things that consolidation gives them is substantially more buying clout on merchandise that doesn't turn that quickly. Kroger has talked about the expertise that Fred Meyer has in nonfood. I think you can probably make the same argument that Albertson's, through its drug stores, has a certain expertise in nonfood that it will be able to share, and, in my view, that's possibly going to be the biggest area of focus, the biggest area of upside, because it's a general nonfood or convenience purchase for the customer in a supermarket, so you don't have the same kind of pressure on margin.

SN: What are some of the promising merchandising growth trends going on right now?

GIBLEN: I think natural foods and organics are really key, and that's both a challenge and an opportunity. I mean right now, Whole Foods and Wild Oats are growing their square footage -- about 15% at Whole Foods and 30% at Wild Oats -- and their comp-store sales are in excess of the supermarket industry's, so obviously they're gaining share. But in a fast-growth category -- and the better supermarket chains are definitely ramping up really big from a small base of natural and organic -- that could be a nice surprise going forward as meaningful business in that area.

Another interesting stealth merchandising trend is pharmacy. Every chain is adding pharmacies in every new store and often retrofitting aggressively, and while it's possible they're not making money in many of those pharmacies, they feel they need to do it from the standpoint of offering a full shopping selection. Whether pharmacies are going to be a driver of the business, we don't know, but the chains must feel as though pharmacies are bringing in traffic, even if they're not a big money maker.

ADLER: There's a lot of evidence that a pharmacy boosts your health and beauty aids and vitamin business, which is where the money is, although it doesn't seem like there are many profitable stand-alone pharmacies in supermarkets. Kroger says they are profitable, Safeway says they're not.

LEVIN: There's a real risk that pharmacy gets less profitable for supermarkets over time if there's a switch to more limited-access networks, as some of the major pharmacy chains have suggested is likely to happen. Supermarkets are likely to be left out in the cold at that point because of not having the same market share when it comes to pharmacy because they don't have the small boxes that are so close together like the drug-store chains.

GIBLEN: Well, then, supermarkets are just going to buy the drug-store chains.

LEVIN: That depends on the opportunity. There aren't that many to buy.

SN: You raise a good point. There are a lot of complications to the pharmacy business. I guess Internet retailers are seeing that it's not just a matter of selling prescriptions on-line. There are doctor confirmations required -- it's just a more complicated business. LEVIN: It's a complicated business, but the Internet retailers are really aiming for the maintenance drugs, and certainly there's a big market for that. And then there's the other side of that, which is the non-pharmacy -- the front end of the drug store, which the Internet retailers are aiming for, and there's a lot of competition in that area, with Drugstore.com and Planet Rx and CVS and with Walgreen's planning to introduce a site, as will Eckerd.

ZIEGLER: And Wal-Mart will have its site.

LEVIN: With Wal-Mart, we don't know exactly how much it's going to do (on the Internet), so there's speculation it could be selling everything in the store. But it's just going to keep testing what's on its site, so we'll see.

USING SPACE EFFICIENTLY

SN: If you can call pharmacy a service for consumers, then which store services are the biggest growth areas that are actually profitable for supermarkets?

ZIEGLER: Photo processing. Perhaps also an automobile service kind of thing. You can blow your mind about what you can do with the convenience of a 55,000-square-foot store when you start going electronic, and the database you can build.

LEVIN: We'll be seeing a lot more banks in supermarkets.

GIBLEN: You're seeing a few kids' playroom areas, but that's limited by the environment, and only some chains will venture into that.

ZIEGLER: Some of these frequent-shopper cards are tying in things for baby boomers -- giveaways or promotions with other retailers in the mall where you accumulate points, so instead of a discount on your food, you get some present from a jewelry store. Fred Meyer (which operates jewelry stores) and Kroger can be hooked into that fairly easily.

HUSSON: One more thing we need to mention is that a lot of things we've talked about here are additions to the box. Where does all this space come from, because box sizes aren't elastic? I think that one of the major trends we're going to see in the next couple of years is that category management as it goes through the second phase is going to result in a "less is more" environment with radically thinned-out SKU counts in some categories that are ridiculously over-wrought. There is a massive amount of variety -- so much that there's almost no choice. A number of studies have shown that you can thin out the variety on the shelf without the consumer even noticing -- you can do a reduction of up to almost 25% of SKU count and the consumer doesn't notice there's reduced variety.

ZIEGLER: What do you think you can do with the boxes, Mark?

HUSSON: Whatever it is that you can put in your playpen. Add more general merchandise, perhaps, or health and beauty aids into a more traditional box. If you look at inventory turns in the U.S., they're pathetic compared to the rest of the world. That's because I think historically space has been so cheap here that U.S. food retailers haven't focused on making the best use of the space that is available. That's no longer the case. A lot of these boxes are very expensive. I think retailers will be looking a lot more critically at the amount of sheer volume in cubes some of their categories actually occupy on the shelf. That's the next move in category management -- to thin those things out.

SN: Maybe packaging, too.

HUSSON: Historically, the manufacturers have sold big boxes and the retailers have picked big boxes, which requires a lot of shelf space. Increasingly, the retailers will end up doing what drug-store retailers are now doing, and that's picking singles to lights and getting stuck in the supply chain. Inventory turns 11 times a year in the U.S., compared with other retailers around the world that do 18 to 30 turns, so there's a huge opportunity there. If you think about it, if the retailer is able to work on turns of higher than 12, there's a massive amount of negative working capital he can generate, which is also what a number of retailers like Carrefour around the world used to actually expand themselves. They used other people's money to build new stores.

ZIEGLER: Around the world, what would you say the average frequency of customer visits is per week vs. the U.S.?

HUSSON: I don't think it's significantly higher.

ZIEGLER: I thought there was more day-to-day shopping, and that's why your turns are better.

HUSSON: In France, there's still the butcher, the baker and the candlestick maker, and consumers don't all go to Carrefour. They do buy a little more often and fresher. But I think the average visit in the U.S. now is three times a week.

ZIEGLER: Not any more. Maybe two. Albert Heijn (chairman of Ahold) said it's a lot more frequent there than it is here.

HUSSON: So they buy less each time they go. It doesn't mean to say your inventory turns should be so much slower.

ADLER: I would question whether the geography means there's going to be an impact because of density of population. I know you can say that in Latin America, where you don't have the same density. But you also don't have big supermarkets in less densely populated areas. There's almost no place in the U.S. where there's any population that doesn't have a decent sized supermarket.

HUSSON: That would argue for higher turns, wouldn't it?

ADLER: No, because you've got big stores with very little population. That's going to slow your turns.

HUSSON: That's what you say is happening in the U.S.?

ADLER: We have that in the U.S., and in Europe you have supermarkets with great density.

COMEAU: In your argument comparing U.S. turns to the rest of the world, you're not implying that the rest of the world is category-managed better, are you, but simply implying that the structure of those markets is different, to some degree?

HUSSON: I'm arguing partly that the reason the turns are faster is they haven't got so many slow items clogging the shelves.

COMEAU: I don't disagree with that. But I would say that a lot of it might have to do with the strength of the big brands here, or the many years buying shelf space and the proliferation of the types of products. A lot of that has lessened in other areas.

HUSSON: I think it was three years ago that Northwestern University did a study on some Kroger stores and found that something like 40% of the range sold less than a case every quarter. You spend more time dusting the product than replenishing it. That's because historically, category management has been done as kind of a one-size-fits-all. The historical approach has been, for this size store, this is the set.

If your head is in the microwave and your feet are in the deep freezer, then on average your body is an average temperature, but you're in big trouble at both ends. Supermarkets have had that problem historically.

Some limited range here is selling very fast in very upscale neighborhoods within a big city, and something else is selling very well in the downscale neighborhoods. But you've got both products in all the stores in the city, which is where category management is beginning to trim that back. If you take category merchandising away from the merchandising center -- if you start looking at the category and looking at the specific market that supermarket sits in and work out whether or not you've done a good category management job in this marketplace rather than for the whole chain -- then there's probably a whole new level of inventory to be added and also to be subtracted as well.

FOOD SAFETY

SN: There's always a potential crisis in the area of food safety. Is there anything operators can do to prepare?

ADLER: It's interesting that Wegmans, which tends to be cutting-edge in terms of things they do, has turned to Hazard Analysis Critical Control Point for assistance. I listened to Danny Wegman talk about home-meal replacement, and all he focused on was the safety of the product and preparing the stores, and this from a company that is a great merchant and already so focused. So I think there is clearly risk, and there needs to be continued focus.

On the other hand, it's amazing to me that we haven't gone the way of Europe regarding genetically modified foods -- it's like an insanity over there, while this country, which I think can be very sensitive on these issues, seems to be totally calm on the subject.

SN: Do you think that's beginning to shift a little bit, that people here are focusing on it a little bit more?

ADLER: Thinking back to the Alar situation with apples, I believe we've actually been through some pretty ugly scares in the past, and I think we've been surprisingly calm lately.

LEVIN: At the same time, we've mentioned that sales of natural foods are very strong and they take market share, so there's definitely a segment of the population that cares about and is certainly interested in organics and more natural type products.

BERNSTEIN: They care, but they're also willing to run the risk of by-products that aren't pasteurized.

GIBLEN: Food safety is another factor that will help the good operators and accelerate the demise of the bad ones. It's just more expensive and more challenging to maintain the public trust on food safety.

ZIEGLER: I think in the home-meal replacement area, the industry will have to pay keen attention to this because of all the various parties involved. It's going to have to come up with some kind of centralized production and safety program for getting product to the stores, as opposed to just dispersing it to the stores, which is one of the other reasons I think the ultimate endgame won't be dispersed production in every single store.

LABOR RELATIONS

SN: Labor relations seem to have been very peaceful for the past few years, although we've had a number of incidents recently where unions have gone almost to the brink and then settled. Given the tight labor situation, are there going to be more strikes, and is wage pressure going to mount up?

LEVIN: I think the wage pressure is already mounting up because, very often, stores are paying entry-level clerks at a scale higher than what's mandated in the contracts. But companies have gotten smarter in terms of how they negotiate, and they've gotten much more adept at convincing the union that it needs to look at the whole playing field, and that includes non-unionized players as well as unionized players.

Safeway has done a stronger job in recent years, and Kroger has also done a stronger job. They've gotten smarter and gone for longer term contracts that reduce their risk.

GIBLEN: It's the golden era for labor relations. We have more moderate wage increases, longer contracts and fewer disturbances than ever before. It's actually a major favorable factor, and the conspicuous absence of labor disturbances is something that's just as important as the things that are happening.

COMEAU: The markets that have historically had difficult labor relations and strikes suffer more from weakness on the part of the local leaderships than anything else that causes problems. These are basically very good, very high-paying jobs, and as you look forward, even though you do have wage pressures at the low end in these markets, these are very high-paying jobs with really good benefits.

GIBLEN: Custer's last stand, from the labor standpoint, was the 1996 Denver go-round, because that was an acrimonious, actually lethal situation, very messy, but it turned out that after getting down to the wire, things worked out very fine, with a moderate cost and a lengthy contract that even switched to a September instead of a May settlement, which gives employers further leverage for the future because they don't have food holidays right in front of negotiations -- and Denver is about as tough as it gets in terms of local union power.

COMEAU: I think the UFCW has shifted all its attention to Wal-Mart and has given up on Food Lion and given up on trying to grow its membership progressively in this channel.

ZIEGLER: Also, I think there's a Greenspan effect here in that companies are negotiating extremely well. Obviously, they've got some problems about labor shortages and opening new stores. I understand there was one operator who couldn't get a store open when he wanted to because there was no labor to staff it.

So you do have those issues, but the industry has negotiated four- and five-year contracts, which should take them over this hurdle that we're in with real tight labor right now.