SN ROUNDTABLE: 1998-09-28 (2)

NEW YORK -- Food wholesalers face a challenging future, securities analysts told SN during a roundtable discussion here. As more independent retailers, who make up the core of wholesalers' volume, go out of business or sell out to larger self-distributing entities in the face of mounting competition, the traditional role of wholesalers may have to change for them to survive, the analysts said.

ions between outlets that sell food blur more and more in consumers' minds.

Shopping via the Internet is likely to be more of a reality as retailers and others strive to work out the economics of computer-generated selling.

Supermarkets must continue to adapt to offset the challenges posed by warehouse clubs. Retailers must make ongoing capital investments to keep their stores fresh. Part one of the roundtable ran in SN Sept. 7.

Participants in the roundtable were Ted Bernstein, director at Grantchester Securities, New York; Chuck Cerankosky, senior vice president of McDonald & Co., Cleveland; Ed Comeau, vice president for equities research at Donaldson, Lufkin & Jenrette, New York; Mark Husson, first vice president of Merrill Lynch, New York; Debra Levin, principal at Morgan Stanley Dean Witter, New York; and Jonathan Ziegler, San Francisco-based director at Salomon Smith Barney, New York.

Consolidation's Effect On Wholesalers

SN: With consolidation comes a threat to the independents, the smaller operators who are supplied by wholesalers. What's going to happen to wholesalers in the next few years? Where are they going? How do they have to change?

CHUCK CERANKOSKY: Despite the consolidation of food retailing, there will still be a lot of independent food retailers left and they will still need a wholesaler. But there will be room for only a few large wholesale companies.

In the past the wholesale industry often made its money on inside margins, which created a credibility problem with its customers and vendors because no one knew how the street money flowed through the wholesaler to the retailer.

Supervalu is now operating like a virtual chain, serving as a conduit for street money by tracking product movement at the independent level and passing on the vendors' promotional dollars to retailers, while its own reward is how efficiently it can distribute product. That's similar to what Kroger does within a chain structure. So the emphasis for wholesalers in the future will be how high a level of efficiency they can attain in distribution.

The smaller wholesalers with good positions will be acquired, while others will fade away if they're not properly investing in systems and facilities because it will become more difficult to compete with the likes of Supervalu. And if wholesalers aren't providing merchandise to customers in a very cost-efficient manner, then independents will find it difficult to compete with regional chains, supercenters and alternate formats. The success of a wholesaler's customer is critical to the existence of the wholesaler.

DEBRA LEVIN: Wholesalers want to become retailers. If you listen to Fleming, Supervalu and Richfood, they continue to say they want to invest more in retail operations because their customer base really is threatened, probably more so than the larger retail companies, by supercenters and other formats.

TED BERNSTEIN: And by self-distribution. As the industry evolves, there's less and less need for wholesalers in general. But I think the big problem faced by the Flemings of the world is that their core customer is going the way of the dinosaur, because they're going bankrupt or they're getting consolidated into larger chains, or what have you, and they have to evolve. And I think the way they're evolving is more and more into retail.

JONATHAN ZIEGLER: Supervalu has an interesting experiment now in Detroit, which involves outsourcing -- using its expertise to run distribution centers for retailers. I don't know what money it makes on that, but I think it might be an interesting way to go in the future.

LEVIN: Supervalu not only wants to be more of a retailer, but it also hopes to recapture retail business, and the big question in my mind is, can it do that effectively?

It's shown some positive signs, it's gotten some new business, but I think by and large the major retailers are running their own distribution facilities and are more likely to continue to do that and get the economies of scale from within.

MARK HUSSON: I think the wholesalers are dealing in a legitimate business segment -- logistics, just running warehouses and trucks -- and they can do that for some of the larger retailers.

I think it's in the interest of some larger retailers to have at least one or two of their distribution centers run by somebody like Tibbett & Britten or Supervalu or Excel Logistics or some outsourcing player, where the wholesaler doesn't try and do all the buying and all the marketing and all the promotions and all the arranged planning and so on, because it's actually not very good at doing that.

The reason why a large retailer might want to do some outsourcing is just to keep tabs on how much it costs to operate a facility, so he can benchmark his own distribution capability and show the unions there is an alternative to running a warehouse with Teamsters, which is tactically useful when it comes to negotiating.

And if you look at Europe, people like Sainsbury may own one or two of its distribution centers, but it certainly doesn't operate them. It gets other people to operate them, and that's because it sees itself not as a food-distribution company but as a food-marketing company, and it is a brand builder rather than a procurement and logistics expert. It believes other people can do that job better.

The question is, can Fleming and Supervalu do that job better than a self-distributing food retailer, and that's still very much a moot point.

ED COMEAU: The problem with wholesalers is they've got this very profitable, independent guy that they serve that still holds a sizable piece of the market, and even though that piece dries up a little bit each year, they can't walk away so they're stuck.

I don't think they can walk away from that business, even though it erodes a little every year, because it's probably tremendously profitable for them. Yet, as they try to build in other areas, being an outsourcer for a distribution center or something else, they're continuing to have difficulties.

ZIEGLER: But isn't it analogous to the supermarket industry dealing with the center of the store, which is basically flat and not growing, so the industry has to build other businesses to grow its comps, such as home-meal replacement and video rentals and produce and all these banks and dry cleaners?

It's very much the same thing. You've got a flat business with wholesaling, and it's probably not very healthy, so you've got to look at new avenues and be aware of who's breathing down your neck and experiment to grow your business through consolidating.

I think Supervalu is certainly keenly aware that its customer base is eroding every year, and therefore it's doing a lot in retailing and outsourcing and technology to grow the business, or to keep it going.

It surely isn't exciting growth at this point. But it seems to me that maybe there are some possibilities there.

HUSSON: Supervalu seems to be the company, along perhaps with Richfood, that stares at itself in the mirror every morning and takes a really hard look at its future business.

BERNSTEIN: Some distributors have a very good attitude, including DiGiorgio, which is constantly reinventing itself and finding value-added services to offer its customers.

On the other hand, when Fleming tried its new pricing program, it shot itself in the foot and caused itself a tremendous amount of difficulty.

So it's certainly something that all distributors are going to have to look at, and they really have to demonstrate to their customers that there is a reason for them to exist and a need to do business with them.

Analyzing Wholesaler Strategies

SN: Is the wholesale business do-able for anybody?

BERNSTEIN: My guess is that you'll see that segment, like others, continue to evolve more toward a food retailer model. It'll always be a mixed model, but I have no doubt they will either grow organically by expanding some of the chains they already own or by purchasing other chains.

SN: And what about the smaller wholesalers, the very regionalized ones who don't want to be retailers? Do they survive long-term?

ZIEGLER: Probably not.

BERNSTEIN: I think the only really good, pure wholesaler out there is probably CNS Wholesale Grocers, a private company. Other than that, you start talking about the co-ops, and the co-ops are having their problems.

SN: And do they have a future?

BERNSTEIN: I think a lot of them clearly don't, because they're going to be put out of business with consolidation.

COMEAU: Somebody should put those five or six wholesale companies -- the two big ones and a couple of smaller ones -- together. Or maybe you just need high-volume warehouses to leverage costs more efficiently and to make their retail customers more competitive, but you've got large companies now with very inefficient, low-volume facilities.

So maybe somebody needs to put Fleming and Supervalu together, or maybe somebody puts three companies together and cuts them in half and ends up with 15 centers doing $1 billion apiece. Something like that has to happen to that industry to keep it floating, because the way it's structured today, they're all paddling around, looking for the next answer, and it's really all short-term fixes. It doesn't solve the decline in productivity of warehouses, given the erosion of their independent operators and the fickleness of all the big chains they're always courting for business, and sometimes they hit and sometimes they don't.

The Retail Channel Blur Challenge

SN: Has there been any shift at all in the balance of outside threats to supermarkets in the last year or so? Certainly the warehouse clubs, as few as they are, have been fairly strong for what they are. Has there been anything else out there that you would point to?

LEVIN: One thing you see in the drug store industry is this move to freestanding locations, which drive convenience, and they really drive front-end traffic.

And if you think about the front end of a drug store, there's total overlap with what's sold in a supermarket. I'm not so much thinking of convenience foods, which are there, but all the health and beauty aids, greeting cards, stationery, sundries and health and beauty care items.

There's a lot of overlap, and those stores are showing very good same-store sales, so there's that channel leakage -- they are taking sales from somebody.

Supermarkets are trying to get back that business, and that's an issue. But there are other kinds of small, deep-discount value operators -- the Dollar Generals of the world, the Family Dollars -- that are increasing their consumable-type items and going after the core supermarket business. It's certainly a very tough market out there. Certainly warehouse clubs and discount stores started it by decreasing the difference in the kind of merchandise they offer and growing at a rapid rate, but everybody has joined the fray.

BERNSTEIN: I think that to a large extent you're seeing a real blurring of the lines in the consumer's mind of who the traditional sellers of those goods are, and consumers are just as willing to walk into a Walgreen's and stock up on Coke as they are on a traditional health and beauty aid type of product, for instance, and that is hurting the supermarket industry across the board. We're seeing a lot of sales going outside the industry.

LEVIN: I don't think consumers are stocking up on Coke, but I think there are a lot of sales that traditionally go through the express lanes at supermarkets, and it is those eight or 10 items that represent the sales supermarkets are losing. And the stock-up tricks used by supermarkets still do a good job fighting it, but the competition is the supercenters and warehouse clubs, and that hasn't changed. It's just part of the industry.

CERANKOSKY: It's clear that Costco and BJ's love selling food, and they remain a big threat. And Wal-Mart, Costco, BJ's and Kmart are not going away.

Therefore, food retailers should rely more on what works best for them -- and that's a combination store. Combos are category killers for frequently purchased goods and services.

And while they might lose some food dollars to Wal-Mart or Walgreen's, they can get their money back through sales of HBC, videos, banking services and gas stations. And down the road I expect to see supermarkets developing other products and services, such as more drive-up pharmacies.

Battling Meal-Solutions Formats

ZIEGLER: Then there are creative outsiders like Foodini, which is owned by Chevron. I don't know whether that's going to roll out. I notice EatZi's is going to open a store in San Francisco in a movie theatre complex. So we're looking at strange traffic draws.

And while some of these outside creative guys are really small now, I think you have to watch them. For example, if Chevron decides that Foodini works, there are big bucks that can go behind that. The Foodini's I've been in looks like it needs a lot of tinkering to make it work, but there's capital there, and there's time.

LEVIN: EatZi's looks great. I saw one in Atlanta, and they have the concept down, and I expect you'll see very rapid growth of that concept.

Another alternative format we haven't mentioned is the health-food retailers, such as Whole Foods and Wild Oats. They are also trying to expand away from their traditional mix of natural and health and organic foods to really attract shoppers with other, more mainstream items in their stores.

Supermarkets themselves have gotten more into natural foods and organics -- not to the extent of a Whole Foods. But again, they're having to deal with somebody else who's just aiming at capturing more supermarket share.

CERANKOSKY: EatZi's and places like that appeal to a clearly upscale audience, and they strike me as very attractive places to buy food with a lot of entertainment value. But to the degree that people go out for food-away-from-home for some kind of entertainment, the provider is at risk when people get bored with that entertainment and begin to go elsewhere.

So it's important for food retailers not to get trapped by providing something trendy one year and then having to remodel soon after.