STRENGTH IN TRADITION

Elliot Zwiebach

NEW YORK -- Conventional supermarkets are likely to sustain themselves as the dominant shopping format, despite losses in share-of-stomach to supercenters and other alternative formats, analysts said here at SN's 10th annual Financial Analysts' Roundtable.

The analysts said convenience and execution will be the keys to the supermarkets' long-term viability.

"Examine consumer behavior, and the statistics speak for themselves -- supermarkets are losing market share," Bryan Hunt, director of high-yield research for Wachovia Securities, Charlotte, N.C., said. "So is the traditional supermarket moving toward extinction? No, [because] consumers will always pay a premium for convenience, service or some other differentiating factor. But other channels will continue to evolve."

According to Chuck Cerankosky, managing director for KeyBanc Capital Markets, Cleveland, "Consumers have continually shown they are willing to pay a bit of a premium for convenience. People don't want to drive around, particularly with the high cost of fuel these days. The key, though, is making sure you execute well, have the right cost structure, be well-located, have clean stores and preferably be non-union."

Gary Giblen, senior vice president and director of research for Brean Murray & Co. here, offered a similar opinion. "Executional excellence is going to be key," he said.

It's the strong operators who will survive, Mark Wiltamuth, executive director of Morgan Stanley here, added. "We've seen some of the weaker players fall by the wayside, and we may see more events like that, where shares get reassigned or shifted. But there will always be a grocery industry of some sort. These [major grocery] companies are all covering their interest costs, and they're not in dire straits by any stretch of the imagination."

Consumers will always come back to the conventional supermarket, particularly as Wal-Mart Stores' supercenters age, said Carla Casella, vice president of high-yield research for JP Morgan Securities here. "People test out concepts like Wal-Mart, warehouse clubs or organics markets all the time, but they still get the best convenience and selection in supermarkets, and they always end up going back. They may bounce down and up a little bit until Wal-Mart's been there for five years, but then they seem to hold relatively steady, which shows that people do favor the convenience of the supermarket."

Supermarkets' fortunes are improving, according to Mark Husson, New York-based managing director and global head of consumer research for HSBC Securities, London. "Even with more supercenters, discount stores, clubs, wholesalers and hard discount stores than there have ever been on the face of the planet, comparable-store sales [at supermarkets] are moving upward at precisely the moment when mathematically the structural argument would tell you they should be moving down continuously" -- an anomaly he attributed to declines in Wal-Mart's comps as its stores age.

The analysts also discussed several specific supermarket operators, including the following:

- Pathmark Stores, Carteret, N.J., which they said they believe may have a tough time regaining its financial footing, particularly if there's a price war in the metropolitan New York market.

John Heinbockel, vice president of Goldman Sachs here, said Pathmark needs to establish "a more consumer-centric culture and a truly differentiated shopping experience. And despite terrific sales productivity, [Pathmark] is underachieving in perishables." He suggested the chain might opt to introduce a fresh store and possibly a price-impact warehouse format.

According to Hunt, with only two major wholesalers in Pathmark's operating area -- Wakefern, which supplies ShopRite, and C&S Wholesale Grocers, which supplies A&P and Pathmark -- "it's going to be extremely difficult for anyone to differentiate its product cost from a supply chain perspective, [and] with relative costs across the market on a similar footing, Pathmark must execute a strong merchandising strategy to gain market share."

"I think the competitive environment is going to give Pathmark a run for its money," Casella said.

- A&P, Montvale, N.J., whose history on store execution prompted analysts to question its prospects for success as it moves forward.

Even with capital from the sale of its Canadian operations and the potential sale of its Farmer Jack stores in the Midwest, "just having more capital to spend isn't necessarily a great thing," Heinbockel said. "It had a fairly aggressive capital program about three years ago when it built quite a few new stores and then ended up closing some of them. We will need to see much more executional consistency before we can buy into a [sustainable] turnaround."

Husson was also skeptical. "A&P has bought itself some survival time, but nothing it has done in store format development in America for the last 15 years appears to have worked."

With both A&P and Pathmark having greater financial flexibility, "everybody's got deep pockets right now," Hunt said. "[But] there's not enough pie to go around, and there is inevitably going to be significant investment in price."

- Winn-Dixie Stores, Jacksonville, Fla., which analysts said may not be able to recover from past operating mistakes and its Chapter 11 filing earlier this year.

"Winn-Dixie is a good example of how consolidation to kill excess capacity proceeds," Cerankosky pointed out.

"The company has failed to define a strategy or reinvest in its stores at this point," Hunt said, "and it's continuing to lose market share in its core markets. It has a weak value image and may require a significant amount of advertising and capital to even maintain its current market position against deep-pocketed competitors like Delhaize America, Publix and Wal-Mart."

- Ahold USA, Chantilly, Va., whose inconsistency troubled some analysts while others said the company may be poised for an upswing.

On the plus side, Giblen said he hopes Ahold doesn't lose its regional merchandising abilities as it seeks to cut costs by combining divisions. But with its financial crisis behind it, "there is now the ability and appetite to invest in price, remodels and other basics and to stop cutting back labor, so I would think Ahold will get a bit of a bounce."

Cerankosky was more pessimistic. "Ahold seems to have a rotating attention span with its various divisions, letting them fall into disrepair and then resurrecting them with a new strategy, but we don't see the long-term corporate-wide execution a better-managed company would show."

In other roundtable topics:

- Analysts said regional chains have an edge over larger operators -- "because they are so good at knowing their regional market," Casella said, and because "they are nimble and creative," Hunt pointed out.

Size determines what a company can do, said Andrew Wolf, managing director for BB&T Capital Markets, Richmond, Va. "Good small companies generally win on merchandising, while big companies are able to garner economies of scale."

- Reflecting on alternative formats, analysts said membership clubs will continue to grow their food sales and convenience stores will continue to take share from supermarkets in some categories, while dollar stores will lose some of their momentum unless they decide to get into food in a bigger way.

- Wal-Mart Stores remains a major competitive challenge, analysts said, particularly in the Sun Belt states where it is already strong. But with its supercenters aging and comparable-store sales gains weakening and moving closer to those of Kroger and Safeway, "the perception of the threat is going to diminish," Husson said. Casella said Wal-Mart is also facing more internal challenges to keep its employees focused, "and that's sapping some of its energy."

The first part of the roundtable ran in the Sept. 5 issue of SN. The text of the balance follows.

The Future of Supermarkets

SN: Let's talk about the long-term outlook for supermarkets. Statistics indicate the supermarkets' share of all retail sales continues to decline and shopper trips to supermarkets are down. So are we approaching a time when supermarkets will no longer be the dominant format in U.S. food shopping?

CHUCK CERANKOSKY: I think supermarkets are going to be around, but it's a matter of who's got the best strategy. Consumers have continually shown they are willing to pay a bit of a premium for convenience. People don't want to drive around, particularly with the high cost of fuel these days. The warehouse clubs have shown that being closer to more affluent markets means they can build more stores and increase average spend and frequency. So I think convenience has a role, and quality certainly has a role. Wal-Mart sells a lot of clothes and sporting goods and food, but people aren't writing off other retail sources of all those merchandise categories. The key, though, is making sure you execute well, have the right cost structure, be well-located, have clean stores and preferably be non-union. Winn-Dixie showed what happens when the physical plant is allowed to deteriorate.

MARK WILTAMUTH: I think capital spending has been strong enough for the grocery majors to hold their shares, but we have seen some of the weaker players fall by the wayside. Winn-Dixie is a signpost for what happens to those that are not competing effectively, and we may see more smaller events like that, where shares get reassigned or shifted. But there will always be a grocery industry of some sort. These companies are all covering their interest costs, and they're not in dire straits by any stretch of the imagination.

CARLA CASELLA: We've conducted studies the last few years of the markets where Wal-Mart has been competing the longest, and what we see is the really weak falling by the wayside while the major players are holding their share. They may bounce down and up a little bit until Wal-Mart's been there for five years, but then they seem to hold relatively steady, which shows that people do favor the convenience of the supermarket and there is some loyalty there as well -- provided operators have the right strategy and the right pricing in that market.

Last year was the first time since we've been doing the study that we saw a few markets where Wal-Mart actually lost share, which shows there is a saturation point. Very often we hear people say they are "guilted" into going to Wal-Mart when they really have to fill up on everything, though they say they really don't like it. People test out concepts like Wal-Mart, warehouse clubs or organic markets all the time, but they still get the best convenience and selection in supermarkets, and they always end up going back.

GARY GIBLEN: On the other hand, some chains are retreating upscale. Safeway is basically pursuing a "Whole Foods-ization" of the chain as a long-term strategy. That means executional excellence is going to be key. A&P has put the same strategy in place, but A&P is starting from a point where it hasn't been able to make the stores actually work well day-to-day. So that's going to be the ultimate test for A&P, and indeed for Safeway because the challenge is that pressures from alternative formats on the low end mean you have to cut your costs and control labor more than ever before at the same time you're trying to provide a value-added experience a la Whole Foods or others who are non-union, and there are major structural costs involved. But it may work -- Safeway could be a more convenient version of Whole Foods with slightly less high prices, though it is an awfully thin wedge of positioning to pursue.

MARK HUSSON: But even if you've got 50% of the market in supermarket hands, 25% in the clubs and supercenters and 25% in other random formats, is that the end of supermarkets? No, and statistically speaking, in 10 years' time we'll still be saying no. But if you look beyond the percentage of the market Wal-Mart and the clubs have got, then the other 50% will look like Ukrop's in some markets and Wawa [convenience stores] in others, though I think there are more opportunities left for supercenters to open up across the country in areas where they haven't yet gone.

But I think the structural argument is patently wrong because right now there are more supercenters, discount stores, clubs, wholesalers and hard discount stores than there have ever been on the face of the planet, particularly in the United States, and yet comparable-store sales are moving upward at precisely the moment when mathematically the structural argument would tell you they should be moving down continuously. What I think you're actually seeing is Wal-Mart's comp-store sales moving down toward Kroger's, and next year we may see them bisect or we may see Kroger with better comps. Wal-Mart said recently general merchandise is doing better than food as its supercenters are getting older. Those stores usually comp strong in the second, third and fourth years, and now many are reaching five years old, so if you take Wal-Mart's immature stores out of the comparison, Kroger is already beating Wal-Mart supercenters on comp-store sales.

WILTAMUTH: But you can't look at just comp-store sales. You have to look at the margin sacrifices that go along with comps because some of those comps were generated through deep discounting and promotional activity. And since we're looking at who is winning the game, we have to look at both the sales and margin components of the equation.

BRYAN HUNT: What about the 30 supermarket bankruptcies in the last 10 years and the vast number of liquidations? There has been a structural change in the industry. Examine consumer behavior, and the statistics speak for themselves -- supermarkets are losing market share. So is the traditional supermarket moving toward extinction? No. Consumers will always pay a premium for convenience, service or some other differentiating factor. But these other channels will continue to evolve, with the players who have the ability to adapt in the discount and service segments and in the various food retail channels surviving. Retail segmentation will evolve as consumer behavior and values evolve, but the keys are having the capability to interpret those changes and the flexibility to adapt.

HUSSON: The structural argument implies supermarkets always lose and Wal-Mart always wins, but even in terms of profitability, that's not necessarily the case. If you look down in the Delta markets where Wal-Mart has been the longest, Kroger's market share is as high as it's ever been, and its profitability is as high as it's ever been and its return on invested capital is very strong. So the structural change actually ought to be defined not as all supermarkets losing and all alternative formats winning but as a bifurcation between winners and losers. If that's structural change, then I agree with it.

Pathmark

SN: Let's talk about Pathmark and the possible impact the $150 million investment by Yucaipa Cos. will have.

JOHN HEINBOCKEL: Pathmark will probably be a consolidator in the Northeast, just because that's what Ron Burkle [Yucaipa's principal] does. He's pretty much said the Northeast is very unconsolidated and that he wanted an acquisition vehicle, and Pathmark is it. Having said that, I think he's got to get that ship righted first, and that may take awhile. First, Pathmark has to establish a more consumer-centric culture and a truly differentiated shopping experience. I think you're going to see a lot of what Yucaipa did at Dominick's end up at Pathmark, including the development of a fresh store and perhaps the development of a better Omni warehouse format.

I think Burkle would readily admit that Pathmark, despite terrific sales productivity, is underachieving in perishables. A fresh store would address that deficiency. In addition, if you are going to compete effectively with ShopRite, the market price leader, you probably need a price-impact format. It will, of course, take time to develop that format, roll it out, tweak its execution and, ultimately, restore EBITDA [earnings before interest, taxes, depreciation and amortization, or operating cash flow] to the $200 million level. We must also remember that ShopRite can be an aggressive -- some might say irrational -- competitor from time to time, and this might be one of those times, with both Pathmark and A&P in a state of flux operationally. So I don't think Pathmark will become an acquisition vehicle anytime soon.

CASELLA: Pathmark is already highly leveraged and limited in its financial flexibility, so Yucaipa's investment was a shot in the arm. It's hard to bet against Burkle, but I think the competitive environment is going to give Pathmark a run for its money.

HUNT: What's interesting to me is whether $150 million of capital is enough to repair Pathmark's image. There are only two major suppliers left in the Northeast market -- C&S and Wakefern -- so at the end of the day, from a competitive standpoint, it's going to be extremely difficult for anyone to differentiate its product cost from a supply chain perspective. With relative costs across the market on a similar footing, Pathmark must execute a strong merchandising strategy to gain market share in slow- or no-growth markets. Yucaipa has had successes in the past, and hopefully its team can bring some fresh ideas to the table as the current Pathmark team has stumbled a couple of times in recent years.

A&P

SN: With the sale of its Canada operations and the potential sale of at least some of its Midwest stores, does A&P have enough on the ball to sustain investor interest and to turn around its business?

HEINBOCKEL: My primary concern is that A&P's execution historically has not been very good. It had a fairly aggressive capital program about three years ago, when it spent a lot of money and built quite a few new stores and then ended up closing some of them. So just having more capital to spend isn't necessarily a great thing.

If you look at A&P's fresh market and Food Basics formats, there are real question marks with each one. With respect to the fresh markets, can shrink be controlled effectively and will their price image suffer? Rising shrink, in particular, could well offset a lot of the benefit from the sales lift. As for Food Basics, I think it's a nice, somewhat differentiated format for metro New York. However, it's really a 'tweener. It does not have the scale and merchandising firepower of a 50,000-square-foot warehouse store like Food 4 Less, and it is not nearly as convenient or cheap as a 15,000-square-foot hard discounter like Save-A-Lot. Therefore, I'm a little more skeptical about a sustainable turnaround at A&P beyond the asset restructuring. We will need to see much more executional consistency before we can buy into such a turnaround.

CERANKOSKY: One big problem for Food Basics is, it's union-organized.

HUSSON: I think A&P's strategy is to try to sell off the bad bits if it can find someone to buy them and then to sell off the good bits because it can't survive with the debt, and what you're left with are the average bits. And what's average for A&P is poor for everybody else, so I think you're left with a rusty old bicycle in the garage after you've sold a car that worked. Now A&P has some money and it's bought itself some survival time, but nothing it has done in store format development in America for the last 15 years appears to have worked.

CASELLA: All the retrenchment A&P is undergoing is occurring in a very competitive market in the Northeast. Pathmark now has more money to spend, and ShopRite has always been a very formidable competitor that doesn't have to withstand the public market scrutiny. And we'll probably see more discount formats coming into the area as well.

HUNT: I agree, and I believe the propensity for a price war in the metro New York area within the next 24 months is very high.

ANDREW WOLF: That's because the metro New York market is the most structurally fragmented in the country. In fact, you could argue it's the only market that hasn't developed a semi-oligopoly.

HUNT: Everybody's got deep pockets right now, and no one is going to invest all that capital and then stand by and watch uninspiring same-store sales. There's not enough pie to go around, and there is inevitably going to be significant investment in price.

HUSSON: I think the Tengelmann family [that owns the controlling shares of A&P] ought to do the honest thing and buy out the minority. If they think they've returned value to shareholders by selling off the Canadian business and if their strategy going forward is to spend a bunch of that money on some unproven formats, as the company has said it plans to do, then they ought to do that as a private company and not gamble public company money.

Winn-Dixie

SN: What about Winn-Dixie? Do you see improvements in a post-bankruptcy Winn-Dixie?

CASELLA: Some think it might ultimately go into liquidation.

HUNT: If Winn-Dixie comes out [of Chapter 11] within the next 12 to 18 months, I think it could go back into bankruptcy pretty quickly. The company has failed to define a strategy or reinvest in its stores at this point, and it's continuing to lose market share in its core markets. Furthermore, it has a weak value image and may require a significant amount of advertising and capital to even maintain its current market position against deep-pocketed competitors like Delhaize America, Publix and Wal-Mart.

WILTAMUTH: I think Winn-Dixie's market exits will be incrementally positive for competitors in those areas. For example, Delhaize has over 20% of its stores competing with Winn-Dixie stores that are exiting nearby, so it will get a little bit of a pickup. Wal-Mart has about 10% of its supercenter and Neighborhood Market base down there, and Kroger has about 5% of its stores near one of the Winn-Dixie exits. I think in some ways Winn-Dixie's situation is one of the signposts of what Wal-Mart has been doing to the industry. If you look at the 326 stores Winn-Dixie is closing, two-thirds have a Wal-Mart supercenter within 5 miles.

HUNT: Another competitor that's going to benefit is Ingles, which has 195 stores, with about 40 that overlap a Winn-Dixie, so there's a huge opportunity for them to benefit. And Publix also stands to benefit. One of the Publix strategies has been to find the most profitable and highest volume Winn-Dixie stores and then open across the street, so Wal-Mart was not the only cause of Winn-Dixie's problems.

CERANKOSKY: Winn-Dixie is a good example of how consolidation to kill excess capacity proceeds.

Ahold USA

SN: Now that Ahold has moved past its crisis over vendor accounting practices in its food-service distribution operation, what are its prospects?

CERANKOSKY: Ahold seems to have a rotating attention span with its various divisions, letting them fall into disrepair and then resurrecting them with a new strategy. We recently saw it sell Bruno's and Bi-Lo, but we don't see the long-term corporate-wide execution I think a better-managed company would show.

GIBLEN: One of Ahold's ultimate challenges will be to avoid being penny-wise and pound-foolish by building the business and doing more than just cutting costs. A lot of its impetus for combining Stop & Shop and Giant Foods was cost-cutting, but if you lose your regional merchandising, then arguably you could come out worse than you were before. And Ahold's history in the U.S., frankly, has been to be penny-wise and pound-foolish, and I think by definition it's going to do better than it historically has because, post-crisis, there is now the ability and appetite to invest in price, remodels and other basics and to stop cutting back labor. So I would think Ahold will get a bit of a bounce, though a sustained building of market share or sustained enhancement of competitive position could prove more challenging.

Regional Chains

SN: Let's talk about some of the regional companies. Can they continue to exceed the performance of the publicly traded companies, and are there things the public companies can do to emulate them?

CASELLA: I think it's a bit tough for the large chains to emulate them because they are so good at knowing their regional market, whereas many of the public companies are too big. While some of the chains have been good at not trying to spread the same concepts and strategies to every market, I don't think they ever become as good as the best regionals like Wegmans, H-E-B or Harris Teeter.

HUNT: Most successful regional companies are not necessarily small, but they are nimble and creative. Some very successful operators seem to be very involved in the community, and I think that's a fault of the large publicly traded companies. Although the large players are involved in the community, rarely does the community receive the same degree of attention provided by companies like Stater Bros., Ukrop's or Harris Teeter.

CERANKOSKY: I think what Wegmans shows is how outstanding you can be in perishables, get paid for it and get that great customer follow-through that you see in its stores.

Another regional I'd like to mention is Giant Eagle, which does a great job in Pittsburgh and Cleveland in terms of private label and store layout. I think it's an under-appreciated regional.

HUSSON: We think of successful retailers in the U.S. as being cults or tribes. The cults are the ones that can translate across borders -- companies like Save-A-Lot, Wal-Mart, Costco, Aldi and Whole Foods. They have kind of an extreme market position where customers and employees all understand that they're kind of special and different. The tribes are companies like Wegmans, Ukrop's, Publix, Farm Fresh, Hannaford Bros., H-E-B -- companies that are embedded in the local communities, often with extremely strong local market shares. But they often have a tough time getting out of the local market. Food Lion, for example, had a tough time trying to get into Texas. The tribes' areas tend to be defined by the tribes to the north, south, east and west of them, and you rarely see them successfully moving into another market where there's a strong tribe. If there's a weak tribe, then sometimes it works.

WOLF: The distinction is size. If you're a big company, you're going to go for economies of scale, and if you're a small company, you can't, so you go for something else. Giant Food [of Landover, Md.] and Stop & Shop are good examples of two excellent regional companies that were damaged when they were put together by Ahold to achieve economies of scale, though they've since partially recovered, with the EBIT margins back to about where they were. But there was some fallout in the process. So good small companies generally win on merchandising, while big companies are able to garner economies of scale. And often those big companies were put together through a combination of other companies that were once the kind of small regionals we're talking about, like a Smith's Food & Drug or a Ralphs, both of which are now part of Kroger.

HUSSON: When you look at Kroger, you see it is actually a collection of very strong regional tribes, and Kroger hasn't screwed them up.

WOLF: I agree Kroger has done the best job [of consolidating regional chains].

GIBLEN: Another interesting thing about these smaller regional companies is that whenever they get bought out by the big three, they go downhill -- for example, Seessel's wasn't successful after Albertsons bought it out, and Genuardi's has clearly declined under Safeway's ownership. We'll have to see what plays out with Bristol Farms under Albertsons' recent ownership.

CERANKOSKY: One company somebody mentioned earlier was Harris Teeter, which runs a very nice food chain. It's attached to a corporation that also owns a thread company, so it's a little bit difficult to follow, but you can see the operating numbers there, and it runs very impressive stores with good comps. It's taken the upscale stance in its marketplace, and I'll note that it operates without a union.

Alternative Formats

SN: We know Wal-Mart has changed shopping patterns tremendously in the last 17 years, but what about some of the other alternative formats?

CERANKOSKY: The membership clubs are the upscale version of the discounter. They offer a huge value proposition in consumables -- in paper, pet supplies, alcoholic beverages, snacks, food, fresh food. And then they have that great opportunity, once you've got the member in there, to get him to spend a lot on discretionary items. And it's not dollar-store stuff -- it's not buying three candle holders for $3. It's buying a big-screen TV for $3,000 or go-carts for $1,500. If the clubs have a vulnerability over the long term, it might be over-expanding. But they have shown that by getting closer to their customer base, convenience plays a role, and they can pick up frequency. I think it's a powerful format because it combines value with grabbing a bigger chunk of discretionary spending. People like shopping there, though it's clearly inefficient to shop at because the product selection is so variable and sometimes they're out of a category.

WILTAMUTH: I think club stores are still gaining share, and given their unit growth and their comps, I estimate their supermarket-related sales are still growing in the 6% to 8% range -- more than double what grocers are seeing.

GIBLEN: Costco is particularly formidable because it can get into some of the blue states that have been challenging for Wal-Mart to enter. In Connecticut, for example, Costco has basically become a preferred shopping venue over Stop & Shop and Shaw's because it offers a combination of great prices, superior perishables and some high-quality food-service types of items that are not available at supermarkets and that are handy for large-sized families, and that's a combination that's hard to beat.

SN: How about dollar stores, which seem to be running into some problems recently?

GIBLEN: The big blow in the future could come from dollar stores going into food in a major way. That would have a huge impact.

WOLF: It sounds like that would be tougher on the convenience-store industry, which is not, by definition, a big-store format. But a lot of dollar stores are adding freezer and refrigerator space, making them eligible to accept food stamps, and that should be beneficial to sales. There's also a convenience element to that, but these are not stores that do a lot of volume, though there are thousands of them, and I think as far as supermarkets are concerned, they are more like a pest than they are some sort of tsunami.

SN: How about convenience stores taking market share from traditional food chains?

HUNT: Convenience stores are not a destination, and consumers may never heavily scrutinize prices in the convenience store channel due to the inability to fill a total basket, plus the often unplanned nature of the retail event. What's been more interesting in the C-store channel is that it's been adding more and more quick-service restaurant capabilities and more home-meal replacement items.

CERANKOSKY: With all the political pressure to keep taxing cigarettes, what does that do to the profitability and volume of the C-stores? I think we're going to see some of them start closing because of that.

HUNT: According to market data, C-store channel merchandise sales grew 14% last year to $132 billion and roughly 7% compounded annually over the last five years. In the cigarette category, the convenience store channel has been consistently taking market share from supermarkets and other retailers due to the social pressures associated with the purchase. Some consumers purchase cartons of cigarettes outside the grocery channel to avoid the shame factor associated [with buying cigarettes] in a large open venue such as a grocery or discount store -- they sneak out to the C-store and buy tobacco products there.

HUSSON: I think restaurants arguably are taking market share away from the supermarket industry every year. Maybe it's just 1%, but maybe restaurants together are half as potent as Wal-Mart in taking share away from the supermarkets' share-of-stomach.

Wal-Mart

SN: We've seen a lot of negative publicity about Wal-Mart lately, between the various lawsuits that have been filed against it and the opposition to its growth in a lot of markets, especially California. Is Wal-Mart losing momentum in terms of its growth, and how will that impact the rest of the industry?

HEINBOCKEL: Wal-Mart's food comps have weakened a bit in the past year, but the number of supercenter openings has remained strong. Indeed, Wal-Mart has been committed to 200-plus supercenter openings a year, and because some markets are more real estate-constrained than others, including California and New York, it is adding more and more capacity to core markets like Texas, Florida and Georgia, which makes those Sun Belt markets even more over-stored and competitively challenging. On the other hand, the real estate-constrained markets are currently experiencing very little Wal-Mart pressure. At present, Wal-Mart has only five supercenters in the entire state of California, with a few more on the drawing board. It will eventually get to its original target of 50, but it might take longer than expected. There are no supercenters in metro New York, and it will be many years before a sizable presence is achieved. So the degree of capacity additions does differ markedly by region. As a result, constantly increasing capacity is the primary competitive problem, not the level of Wal-Mart's food comp, which is not that much higher than Kroger's now.

One of the best things that could happen to the food retail industry would be the unionization of Wal-Mart, though no one should hold his breath waiting for that. The next best thing would be a marked slowdown in the number of supercenter openings, which would remove incremental competitive pressures from the market and benefit food retailers' profit-and-loss statements. Unfortunately, this probably won't happen either. So Wal-Mart is still a significant challenge, though it's not the only one, and its influence varies greatly on a regional basis. What's encouraging is that over the past year, the comp spread between Wal-Mart, Kroger and Safeway has narrowed considerably -- to 2% to 3% from 8% to 9% -- suggesting that at least a handful of companies are beginning to crack the code and successfully compete in this environment.

HUSSON: I think there's a red state-blue state issue here because if you look at the number of Wal-Mart supercenter openings, there are about 4.5 supercenters for every 500,000 people in the red states but only 1.1 supercenters for every 500,000 people in the blue states. So when people say Wal-Mart is adding 2% market share a year and that's all the growth in the industry, that's certainly all the growth and more in the red states, while it's just not a factor in the blue states. I think all the negative publicity about Wal-Mart is coming from friction fires in places where its rubbing up against the blue states, which is where the unions are, where the Democrats are and where a lot of industry pressure groups are, and I think it's inevitable that as Wal-Mart is forced to go into more and more urban areas in blue states that it's going to encounter this kind of backlash and all these negative folks and industry groups coalescing and rejecting planning applications.

The second point is that Wal-Mart's stores are reaching middle age. While it's still opening 240 or more supercenters per year, that's a smaller percentage growth every year than it was the year before, and the percentage of supercenters that are now middle-aged are not comping as aggressively as they were when 60% of its stores were less than five years old. And as that percentage keeps getting smaller and smaller every year, comps are going to go down and down. Any single Wal-Mart store opening starts off in the same way they always have, with strong sales and stronger comps from year to year, and for Wal-Mart that hasn't changed. It's just that the number of those stores relative to the total size of the business is getting smaller. That doesn't make them any worse than they were or any better than they were, but in percentage terms it means the perception of the threat is going to diminish. I also think that in the early days, some investors on Wall Street over-emphasized how potent a threat Wal-Mart was. It's just another food retailer going through the same maturity cycle as everybody else goes through.

CASELLA: I think Wal-Mart is having to fight a lot more internally to address external perceptions in terms of keeping its employees focused on their jobs rather than on the stock price or the negative press or the fight to get into California, and that's sapping some of its energy. Part of that is having to defend slowing comps because as you become more and more of a food retailer, your comps have to slow. But the key thing you can't ignore is that if Wal-Mart ever gets as good in food execution as it is in general merchandise, there's a whole other level of threat in the markets where it already is. Maybe the blue states are still safe, but in the red states, it will just get worse.

GIBLEN: That's precisely the point -- Wal-Mart seems to have plateaued. It went from poor to passable food execution, but it's remained passable for a few years and it seemingly can't get to a higher level.

HUSSON: Its format is not good. It's been in supercenters for 10 years now, and I think it's going to get a little better. But unless it starts to broaden the appeal of its basic offering away from the core customer base, it's not going to get people buying fish at its stores. There are only five [stockkeeping units] of fish at Wal-Mart, but if it starts selling tilapia at $14 a pound and most people at Wal-Mart make about $9 an hour, it's going to risk alienating its core customer base.

WOLF: I think the food sections in Wal-Mart's supercenters are highly productive...

HUSSON: No one is arguing with that.

WOLF: ...and I don't think it needs to go upscale because that's not who Wal-Mart is. One of the reasons its comps are down is it's cannibalizing itself. That may not be good for Wal-Mart shareholders, but neither is it good for the supermarket industry. What would be good for the supermarket industry is to unionize Wal-Mart or for this blue state theory to work out, particularly because that's where the unionized supermarkets are.

HUSSON: I don't think cannibalization accounts for more than 1%, so I don't think that's really a factor.

WOLF: Well, it's putting the stores closer to each other. But even if Wal-Mart's same-store sales are slowing down, what's more relevant is the capacity addition, which is not [slowing down].

HEINBOCKEL: It's not just the annual capacity additions but, more importantly, the fact that prior additions simply don't go away. In fact, getting a supermarket to go totally dark and serve some other purpose, like becoming a bowling alley, is one of the toughest tasks in retailing. Someone new is always attracted by the stable sales and cash flows and the hope it will be the one to finally turn around a failed location. With Winn-Dixie, we don't know how many of the 326 stores it is seeking to sell or close will actually go out of circulation, but probably not enough. Personally, I'd like to see a lot more failures, Chapter 7 liquidations and real-estate deployments to alternative uses. That would make those that survived a lot healthier. Unfortunately, it does not happen that quickly.

WILTAMUTH: If there is a challenge for Wal-Mart, it could come from the investment community. If it doesn't keep showing solid returns and the growth isn't what the market expects, then it may have to change some of its strategies. In the coming years, Wal-Mart is going to face higher cap-ex requirements per square foot as it starts to expand more on the West Coast and along the I-95 corridor on the East Coast, and that's going to put more pressure on it to execute at a stronger level at its existing stores.

CERANKOSKY: What I think Wal-Mart does extremely well is sell that price level, that low-price merchandising. That's what it's great at. It goes up to a quality level and a price point in every category, whether it's paint or ladders or sporting goods or clothing. I think what would actually help it is a weaker economy where it affects not the person who's impacted by the cost of fuel but somebody who's in a dual-income household that perhaps becomes single-income and who starts thinking about trading down by going back to Wal-Mart. Everything we've talked about in terms of differentiation -- for companies like Safeway, Kroger or Harris Teeter -- involves perishables and more upscale seafood for the most part, but there's no such thing as upscale Doritos. If someone says they want to cut out that floral bouquet or the $30 bottle of wine and they want to gravitate more toward a budget shopping format, Wal-Mart has it all.