THE YEAR OF CHANGING PLANS

Mark Hamstra

Supermarket companies are rethinking their real estate strategies in light of the current over-stored retail environment, the weak economy and the competitive climate.

The nation's three largest traditional operators -- Kroger, Albertsons and Safeway -- have all been shifting their store-development plans toward remodels and away from building new stores in 2003 as they seek less risky growth opportunities. Those companies that are building new stores have become much more cautious in their site selection and increasingly flexible in their store designs to accommodate individual market needs.

Also, with an abundance of retail property available from discount-store bankruptcies and supermarket reorganizations, food retailers are increasingly looking to convert existing stores rather than build from the ground up.

Many companies that are remodeling are enlarging their stores to include larger perishables and nonfood departments, fuel centers, expanded pharmacies and other features to better compete against other retail formats.

Analysts see the moves as a response to the relatively weak performance of traditional supermarkets.

"With return-on-invested capital coming down during the last two years, and certainly with the group's underperformance, I think managements have really started to take a more careful look at store development, not just from an overall standpoint but market by market and store by store," said Lisa Cartwright, analyst, Salomon Smith Barney, New York.

At Safeway, Pleasanton, Calif., the shift toward fewer store openings began last year. In 2002 the company opened 71 new and replacement stores, down from 91 the year before. The decline reversed a trend in which it had been opening an increasing number of new stores in each of the preceding three years.

The trend is seen continuing in 2003 at Safeway and its major rivals. Albertsons, Boise, Idaho, recently projected that it will open 43 new or replacement stores in 2003, down from 93 last year. Kroger, Cincinnati, said it expects to open 100 to 110 new, relocated or expanded stores in 2003, down from 151 last year. Square footage is expected to increase between 2.5% and 3%, vs. 4.3% in 2002.

Kroger expects its capital expenditures to remain about the same as last year at $2 billion, as it shifts funds toward remodels: It plans to refurbish 160 to 200 stores in 2003, compared with 138 in 2002.

"Given the backtrack of cap-ex dollars allocated by nearly all the chains, new stores and new builds are getting pushed out -- and in some cases cancelled altogether," said Jason Whitmer, analyst, Midwest Securities, Cleveland. "I think with a lot of these companies, they need to catch up on remodeling their bases -- they are just too outdated."

He noted that supermarkets see faster returns from remodeled or enlarged stores than they do from newly built locations.

Productive Return

Harvey Gutman, senior vice president, real estate and store development, Pathmark Stores, Carteret, N.J., agreed. "An enlargement is a more productive investment than a new store," he said. "An enlargement will produce a return right away, whereas a new store will have a maturation factor that will have to come into play. Also, an enlargement is a less risky type of investment because you already have a base of business -- the customers already know you. When you open a store in a new area, there's always that fear that customers won't come."

Cartwright said she sees supermarkets strengthening their competitive positions with remodels by highlighting their points of differentiation from discount centers and club stores.

"The square-footage increases that we've seen from other formats, like Wal-Mart supercenters and clubs, have maybe led to a rethinking of the [traditional supermarket] format," she said. "So, while they're doing that, it's probably more prudent to pull back on new stores and instead focus on ways to remodel your existing store base to better address consumer needs. Why are they shopping the clubs and the supercenters? That's the question."

Cartwright said she sees supermarkets trying to answer that question by adding departments like natural foods, expanding their perishables and general merchandise sections, adding branded areas like Starbucks Coffee outlets and Toys R Us aisles, and, in the case of Albertsons, adding whole drug stores to the existing supermarket site.

Albertsons' dual-branding effort, which involves combining existing supermarket locations with one of its drug store banners, is generating strong sales gains at about one tenth of the cost of building a separate drug store, according to Whitmer.

Many companies also have been expanding their perishables offerings when they remodel.

Joe Azzolina, president and chief executive officer, Food Circus Supermarkets, a Foodtown operator based in Middletown, N.J., told SN that he recently received approval for a 20,000-square-foot addition to a store in Ocean Township, N.J., that will include more space devoted to fresh foods.

"We're just going to completely redo the store, with a greater variety of produce and perishables," he said.

The company has been negotiating for permission to do the remodel "for years," Azzolina said. "It's a long, drawn-out process," he said, illustrating how difficult it can be for supermarkets to even get approval to expand their stores.

Outside Adjuncts

Real estate developers said supermarkets also are waging battles to add exterior features to their existing stores -- especially drive-through pharmacies and fuel centers.

"With the advent of freestanding drug stores, you're seeing supermarkets want to expand that profitable part of their business," said Jodie McLean, president and chief investment officer, Edens & Avant, Columbia, S.C., which operates 227 shopping centers. "The drive-through is increasingly important to these guys, and we're also seeing a lot of chains going to fuel centers in the out-parcels," which are pieces of property adjacent to the strip centers themselves.

"You're definitely seeing more expansion rights in the leases," she said.

Among the larger chains, Kroger said it plans to add 100 to 110 fuel centers to its supermarket sites in 2003, and Albertsons plans to add 37.

McLean also said supermarkets are seeking longer-term commitments in their leases.

"As far as terms go, they are wanting more action periods," she said. "Typically, a grocery-anchor lease is between 20 and 25 years, initial term, and it used to be that everybody wanted four- or five-year options. Now you're seeing that extended to eight- and 11-year options, so you're seeing much longer-term leases."

Supermarkets also have increasingly been taking advantage of existing retail site opportunities.

Pathmark's recent new store development efforts reflect the industry's changing dynamics. Of the 16 new stores the company has opened in the past three years, only four have been "green-field," or constructed from the ground up. The other 12 have been conversions of existing retail space.

Such development strategies have become increasingly common among supermarkets as they seek to build their top lines in an overpopulated retail landscape. In recent months, both Shaw's Supermarkets, East Bridgewater, Mass., and Stop & Shop Supermarkets, Quincy, Mass., have acquired groups of former Ames department stores for conversion to their respective supermarket formats.

Kroger said it is using a conversion strategy to expand the Food 4 Less banner, and just last week the company said it would add two new Kroger stores in Michigan through the conversion of existing IGA stores that it acquired there.

"That's what they've been doing -- trying to find cheaper real estate and rebuild those stores rather than trying to build from the ground up," said Whitmer of Kroger's Food 4 Less strategy. "I think they can save substantial money. There's just too many stores out there. You can probably get some good deals for stores."

Gutman said the motivation for converting existing sites rather than building new stores isn't always financial. Although it can be less expensive, it's also a matter of risk and efficiency.

"Typically, you don't have to go through a lengthy and risky approval process if the building was already operating as a supermarket or is still operating as a supermarket," he explained.

Site Ownership and Development

Marc Jampole, spokesman, Penn Traffic, Syracuse, N.Y., said his company also has noticed an increase in the number of new supermarkets that are being converted from other banners in its markets, including Syracuse and Buffalo, N.Y.

"In this part of the country, there's more renovation than new store development," he said.

Supermarkets are also seeking to become more flexible by buying their own sites rather than leasing them, and by tailoring store designs to suit the needs of individual sites.

Safeway, for example, said in a recent filing with the Securities and Exchange Commission that it owns about a third of its sites and "prefers ownership because it provides control and flexibility with respect to financing terms, remodeling, expansions and closures."

Developers said supermarkets also have become more versatile at site development.

"In the old days, supermarket companies were inflexible," said Doron Valero, president and chief operating officer, Equity One, a North Miami Beach, Fla.-based developer of supermarket-anchored shopping centers. "They had their prototype design, and that was it. Now they are much more flexible -- they have different designs that they can use in different locations."

Publix, Lakeland, Fla., for example, had been constructing larger stores but recently has built a network of smaller stores -- about 40,000 square feet -- just one mile apart in Dade County, Fla., Valero said.

H.E. Butt Grocery Co., San Antonio, has also become much more flexible in its store design, he said. The company, which builds stores up to 75,000 square feet, varies its prototype according to the needs of the local market, with certain designs meant to appeal to middle-class and upper-middle-class consumers and other designs geared for working-class neighborhoods.

"The days of relying on a cookie-cutter site plan with a store, a traffic light and 300 parking places are pretty much gone," said Gutman of Pathmark. "The more successful supermarket companies recognize the need for flexibility in the site plan -- things like rooftop parking and, in some cases, both rooftop parking and ground-level parking, which we have in some places."

Although the average size of new supermarkets had been growing for several years -- and some say it still is -- others say they see the size leveling off.

"The newest stores are not bigger than last year's model," said Jampole. "They are about the same size. It's kind of leveled off at 50,000 to 70,000 square feet for traditional operators."

However, he also acknowledged that in some of the rural areas where the company operates, it has built 35,000-square-foot stores that are considered large for the community.

"In real estate, you need to show diversity," he said. "There are different dynamics in every market.

"On a certain level, the supermarket business is a real estate business," he added. "You have to go where the customers are."