FINDING MIDDLE GROUND

NEW YORK - Despite the growth of supermarkets at the high and low ends of the price and service spectrum, there is plenty of room for companies that opt to operate in the middle, participants said here at SN's 11th annual Financial Analysts Roundtable."There is absolutely nothing wrong with the middle," John Heinbockel, vice president, Goldman Sachs here, pointed out. "But if you are going to survive

NEW YORK - Despite the growth of supermarkets at the high and low ends of the price and service spectrum, there is plenty of room for companies that opt to operate in the middle, participants said here at SN's 11th annual Financial Analysts Roundtable.

"There is absolutely nothing wrong with the middle," John Heinbockel, vice president, Goldman Sachs here, pointed out. "But if you are going to survive in the middle, you have to eliminate any glaring weaknesses. Your pricing has to be better than everyone's but Wal-Mart and your perishables must be better than everybody's but Whole Foods.

"And at the end of the day, you are still going to have to draw the bulk of your business from the middle 70% of the population," he said. "I think every good large supermarket operator should have multiple formats to get the other 30%, but I still think your standard banner is going to have to be all things to all people."

According to Mark Wiltamuth, executive director of Morgan Stanley here, "I don't think any retailer is striving for the middle because you're vulnerable to attacks from both sides when you're in the middle. Differentiation is probably the name of the game, [and] Whole Foods is probably the shining example of the differentiated store. But not everyone can be Whole Foods, and Whole Foods is not big enough to feed America, so we still need someone in the middle."

Meredith Adler, managing director at Lehman Bros. here, said consumer shopping habits are determined more by geography than by income level. "People at almost every income level still want to shop at a nice-looking store," she pointed out. "They want a store that gives them assortment and high quality and various degrees of service."

Andrew Wolf, managing director at BB&T Capital Markets, Richmond, Va., said the shrinking amount of meals made at home from scratch is likely to prompt more operators to shift part of their business to prepared foods, "[and] then the question is, can they execute it?"

He said strong regionals like Wegmans, Ukrop's and Harris Teeter, along with Safeway's lifestyle stores, are ahead of the curve in that shift.

While operating in the middle may not be the most optimal position, Wiltamuth added, it has the flexibility to offer a wide range of products. "There are things you can do in the middle - go more toward prepared foods [or] cater to the person who's not willing to do the full cook from scratch at home and give them something they can warm up."

Among potential new offerings, Heinbockel said health clinics may be "the next big thing, [but] you just have to guard against poor execution."

However, he said he believes health clinics are likely to be more lucrative at drug stores than supermarkets "due to the physical convenience and the clinic setting. Supermarkets may put clinics in, but I don't think they're really going to move the dial on the store's pharmacy franchise or pharmacy sales."

Adler said selling office supplies or toys - programs Albertsons was pursuing before it was sold - should work for supermarkets. "Albertsons tried to do too much too quickly, and it didn't ever get executed as well as it could have," she noted.

She also said general merchandise offerings - such as table-top goods as a fashion category aimed at middle- and upper-income female shoppers - is working well for Kroger.

According to Wolf, "If the industry wants to chase the consumer intelligently, I think the obvious growth areas are natural and organic, which are growing at double-digit rates."

The analysts also discussed the prospects for labor unrest in the aftermath of the 141-day Southern California strike-lockout at the end of 2003 and early 2004. According to Wolf, "Both sides were very bloody at the end of it, and a lot poorer for it, and certainly the grocers were in a hole coming out of it."

Adler said she doubted further labor unrest in Southern California when the UFCW contracts come up for renewal there early next year, "but you have to look around and say, where are the contract terms out of line with the rest of the market?"

She said union contracts with A&P, Pathmark and Acme Markets in the Northeast are potential sources of future conflicts. "Forget about the West Coast - that battle has already been won - but concentrate on the East Coast, where the retailers are much weaker," she said.

According to Wiltamuth, "The unions have an entrenched position, and I don't think we'll ever see the day where they are out of the industry. But I think the question the union membership needs to ask itself is how much leverage does the union really have in negotiations?"

While the UFCW remains relevant because of its long-term relationship with the traditional grocery industry, it has essentially failed in its mission to level the playing field by organizing non-union operators like Wal-Mart, Wolf added, "and it is also the cause of the structural disadvantage for the unionized grocery business."

SN published Parts One and Two of the roundtable in the issues of Sept. 4 and Sept. 11. The final section of the discussion follows.

SN: Is there still room for a conventional supermarket operating in the middle - one that tries to be all things to all people - or are we heading for a future where stores are designed to appeal to upper-income or lower-income shoppers, with fewer opportunities in the middle?

JOHN HEINBOCKEL: I think Kroger is really in the middle - it hasn't moved as dramatically as some companies have. Maybe Ralphs in Southern California is a little more upscale, but that's because Food 4 Less [also in Southern California] effectively covers the lower-income customer base. So most of Kroger is really in the middle, and at the end of the day, you are still going to have to draw the bulk of your business from the middle 70% of the population.

Having said that, I think every good large supermarket operator should have multiple formats to get the other 30% it may not be getting. If you want to do Food 4 Less, that's fine, or if you want to do Save-A-Lot, that's fine. That gives you something on the low end and room for something else on the high end. But I still think your standard banner is going to have to be all things to all people.

MEREDITH ADLER: It seems to me there is more difference in people's shopping habits by geography and region than there is by income level, and that people at almost every income level still want to shop at a nice-looking store. They want a store that gives them assortment and high quality and various degrees of service. But I'm not sure it's true that people always want to shop at a barebones store.

MARK WILTAMUTH: I don't think any retailer is striving for the middle because you're vulnerable to attacks from both sides when you're in the middle. Kroger's position is to try to segment itself within that middle position where it has stores that cater more to upper-, middle- and lower-income customers. So differentiation is probably the name of the game in the industry. Whole Foods is probably the shining example of the differentiated store, but not everyone can be Whole Foods, and Whole Foods is not big enough to feed America, so we still need someone in the middle.

ADLER: Kroger would probably say it's not even trying to appeal to upper, middle and lower - it would say it is simply trying to figure out what the customer wants without defining it in those terms. It's asking who are our customers and what do they want from us, and based on the data it has, it can make informed decisions. And its conclusion could be, the customers are not affluent, but they do eat sushi.

ANDREW WOLF: According to data I've seen, 57% of meals at home are made from scratch, compared with 65% 10 years ago, so the core ingredients business is declining. As a result, supermarkets will have to shift into the part of the business that's growing - prepared foods. Then the question is, can they execute it? Safeway is a great experiment in that direction. And as John pointed out, Wegmans runs a very good store, and perhaps companies like Ukrop's and Harris Teeter and other regionals are thriving because they are ahead of the curve.

HEINBOCKEL: There is nothing wrong with being in the middle per se because if you think about it, not everyone can be at the extremes. So there is absolutely nothing wrong with the middle. But if you are going to survive in the middle, you have to eliminate any glaring weaknesses. Your pricing has to be better than everyone's but Wal-Mart, as Kroger's is, and your perishables must be better than everybody's but Whole Foods. That's not a bad place to be because as a $35 billion-plus company, you really do have to have mass appeal.

WILTAMUTH: There are things you can do in the middle - you can go more toward prepared foods, you can try to cater to the person who's not willing to do the full cook from scratch at home, and you can give them something they can warm up and add a little bit to.

HEINBOCKEL: Nonfoods is another big opportunity. It's a business just about everyone wants to be in because it represents rare incremental growth potential. However, you have to be able to source it, price it and merchandise it right. Kroger could not do that if it didn't own Fred Meyer, but it does. It will be much harder for other companies to effectively get at this opportunity.

NEW OFFERINGS

SN: So much of retail strategy really deals with trying to predict where the consumer is going. What new categories or departments do you see supermarkets getting into?

HEINBOCKEL: I think health clinics are the next big thing. The customer experience is actually very good, the wait is a lot shorter, prices are much lower than a doctor's office and the overall environment is better, so it's a home-run from a consumer perspective. You just have to guard against poor execution. That would not only hurt the clinic operator's credibility but the host store's as well, and it would set the whole concept back years.

But I believe in-store clinics are going to be a lot more lucrative in a drug store than a supermarket due to the physical convenience and the clinical setting. People who are sick and not feeling well will go to a clinic that is close to home, and that means a drug store. That is the same attraction as a drug store pharmacy. Supermarkets may put clinics in, but I don't think they're going to really move the dial on the store's pharmacy franchise or pharmacy sales. That's far more likely to occur in a drug store.

ADLER: I agree with John about health clinics being more logical in drug stores, though there are some areas of the country where supermarket drug stores are highly successful, and they could work well there.

Among other new offerings, it's been interesting how effective fuel has been in terms of driving price image for supermarkets. And companies that didn't have fuel, as the old Supervalu did not, could clearly see they were being out-competed by chains that did have fuel.

Also, there are some things Albertsons was doing in terms of offerings that were actually really interesting - office supplies and toys, for example - but it never had a chance to make those ideas work. Albertsons tried to do too much too quickly and it didn't ever get executed as well as it could have, which is too bad because somebody might draw the conclusion that those concepts didn't work. But I'm not sure they ever really had a chance to be successful. You would think anything you could offer the customer that is basic and where convenience matters, like office supplies, would make some sense.

People sometimes say Kroger doesn't do anything innovative at store level, but I've visited one of their new stores in Cincinnati that was selling a lot of general merchandise, and it was a very interesting store. It had a lot of Target-like elements, clearly aimed at a middle- and upper-middle-class female shopper, including table top merchandise as a fashion category, that required Kroger to do a whole lot of educating at store level about how to manage a fashion category - how you have to keep turning it, how you have to keep it fresh and to mark it down. Supermarket people aren't used to marking down food products, so there was a whole learning curve for them. The challenge isn't just about getting the ability to buy products well - it's also about teaching the stores how to manage those kinds of products. I don't know that I consider table top a convenience purchase, and yet Kroger seems to be very excited about where it can go.

WOLF: If the industry wants to chase the consumer intelligently, I think the obvious growth areas are natural and organic, which are growing at double-digit rates.

LABOR

SN: How relevant is the United Food and Commercial Workers union, and will the next round of negotiations, particularly next year in Southern California, be any kind of indicator of whether labor will continue to be a force in the industry?

WILTAMUTH: The unions have an entrenched position, and I don't think we'll ever see the day where they are out of the industry, so they're always going to be a force. I think grocers are just going to continue to negotiate with them and try to drive down costs each year.

But I think the question the union membership needs to ask itself is how much leverage does the UFCW really have in these negotiations? In the last major strike [in Southern California], neither side really won. The grocers were punished for a long period, but they got the longer-term benefit from lower cost structures, and I don't think union employees really benefited that much.

WOLF: I think going forward all will be quiet on the Western front.

ADLER: It's very unusual to have a strike for two contract negotiations in a row - I don't think that has ever happened - so I don't think there's a concern with Southern California, though there may be others you would worry about. But you have to look around and say, where are the contract terms out of line with the rest of the market?

It's probably not true in any West Coast markets, but I've visited with A&P and they talked about needing to go back to the unions in both Long Island and Philadelphia because their contracts there are just too expensive. A&P also knew it had to make a trade-off to get its growth going again. I don't know if this is true for all of the country, but on the East Coast, most contracts have a bumping feature - if you close a store, the highest-paid workers get to work anywhere they want within the chain and you bump any workers with less seniority. As a result, when you're closing stores in the marketplace, your cost structure is getting higher and higher at each store. One of the ways to fix that is to buy more stores or start building more stores, and then you've got to get some concessions from the union, and A&P has talked about the need to address those issues. And Pathmark's labor contract is even higher than A&P's and I think Acme has a very expensive contract as well. So I would say, forget about the West Coast - that battle has already been won - but concentrate on the East Coast, where the situation is different because the retailers are much weaker.

WOLF: My bottom line on the union is, there's a quid pro quo, which is that the union is supposed to organize the competition, that is, Wal-Mart, and create a level playing field for the incumbent, and that's sort of the bargain. And it's failed to do that. The UFCW remains very relevant through its traditional arrangement with the grocers, but it is also the cause of the structural disadvantage for the unionized grocery business. So it continues to be as relevant as ever, but not in a positive way. I don't have any anti-union bias per se, except to say as an analyst, the union creates a higher cost structure for the most part.

Some people say that about Costco, but that's an exception because it doesn't have a lot of store employees. But for the unionized grocery business, the union creates a cost-structure impediment. Yes, it's been shrunk somewhat, but there's still a big gap. And when you look at that [Southern California] strike, however you characterize it, everyone took heavy losses. You may say this guy won or that guy won, but both sides were very bloody at the end of it, and a lot poorer for it, and certainly the grocers were in a hole coming out of it.

ADLER: Another part of the labor issue is that Safeway and Kroger are taking different approaches to labor buyouts, either because of different experiences or just totally different views. Kroger says a retailer always ends up buying out its best employees and damaging its service, and it's not worth it, while Safeway says we've done it before and it's worked. Maybe the difference is that Safeway has had a focus on service for quite a while so that's very entrenched in the organization, and it believes it can lose experienced people without too much impact on it, while Kroger doesn't feel as secure about it. It's very interesting that they both signed the same labor contract and then took totally different approaches to looking at buyouts.