Deciphering the Economics of Home Shoppinghome shopping is a threat that keeps supermarket executives awake at night?LEVIN: It already does keep supermarket executives awake at night, when they think of their longterm planning.There are a lot of operators out there who offer Internet, supermarket-type retailing opportunities. It's huge, actually, when you start looking at it.CERANKOSKY: What we often

Deciphering the Economics of Home Shopping

home shopping is a threat that keeps supermarket executives awake at night?

LEVIN: It already does keep supermarket executives awake at night, when they think of their longterm planning.

There are a lot of operators out there who offer Internet, supermarket-type retailing opportunities. It's huge, actually, when you start looking at it.

CERANKOSKY: What we often forget when we think about Internet shopping is that people like to go out and shop, perhaps not every single day but most of the time. And in general a good market of any sort can attract people into the store and coax them to trade up and buy more, and that's easier to do on an in-store basis -- where you can have product sampling and demos -- as opposed to going down a pre-set shopping list and clicking off items.

There's a danger here of confusing value-added to customers with the novelty of technology. The Internet is certainly efficient for routine shopping at home, but the whole proposition of business is doing something for customers, and simply selecting the order and getting it home is where computer-based systems have a great degree of difficulty competing with the do-it-yourself model that often provides better food quality.

ZIEGLER: Do you think the economics of the Internet are any good?

LEVIN: It doesn't matter if the economics are working because there are so many people who want it to grow.

ZIEGLER: But it'll die off if the economics aren't working.

LEVIN: I don't think it's going to die off. Look at in terms of books. It's not making any money, but the stock is growing. It's investing in the business, and it just keeps growing.

I think that everybody sort of gets in this land-grab mode and they feel they have to just invest and build up the infrastructure. For example, I think Hannaford has certainly invested some real dollars in home delivery, and that could work for it longer term if they've got it right, but they're not ready to make a determination.

ZIEGLER: Look at Boston Chicken. Everybody got scared of that. It was a hot stock, and now, where is it? You've got to make money in the end. And I don't think anybody has gotten the economics right yet.

LEVIN: But the economics are dependent upon volume, and volume depends on usage.

ZIEGLER: But there's no volume the way that business is designed. You can't do volume. You can do volume on the order-taking, but you sure can't on the fulfillment. I just think it's a real problem, and I think we're blowing it all out of proportion.

I think you have to experiment with it, certainly, but I just don't think it's going to be viable.

COMEAU: I agree with most everything you've said. But I wouldn't underestimate somebody figuring out that business. And I agree that nobody's really figured it out yet. But there's a clear, broad demand for delivery of some product, whether it be consumables, staple products, even nonfood, like the Albertson's model or something more elaborate like Peadpod. There's a pretty big demand for that, and if a supermarket chain or a group of smart people figures out the economics, it could be very viable, even if it's still only a small base, so to speak -- New York City or Boston, a metro market, not nationwide.

CERANKOSKY: Of course computer shopping will work better in some areas, just like EatZi's will work in some areas, but maybe these programs need to be owner-operated, geared to specific localized tastes, and that's difficult to deliver from city to city.

HUSSON: But earnings are usually the problem, because there's a great anticipation in a lot of these Internet stocks. But unless somebody finally starts to deliver, no one's going to stump up 50 million times 1993 to 2003 earnings in order to buy into it.

BERNSTEIN: The supermarket chains have been incredibly good and incredibly talented at adapting, and I think they'll continue to be. If buying nonperishables or even perishables over the Internet becomes a successful means of doing business, supermarkets will start doing that. They already have a lot of infrastructure in place to do it.

But the point is that, in the whole grand scheme of things, selling food and selling nonperishables is not that tough, and a lot of people do it, and there are an infinite number of ways to do it, and whether the Internet or clubs or whatever is a fad that continues on indefinitely or not, any new hit to supermarkets is really felt and it's significant, because it's such a low-margin business.

So whether it's coming from the Costcos or from Peapod or from another supermarket competitor, just the added drain out of the industry is important.

Warehouse Clubs as a Food Force

HUSSON: The thing I want to go to is just how flexible supermarkets are, and if supermarkets see the Internet as a growing market and if the supermarket is successful in turning itself into a brand -- many of them are brands already -- then there's no reason why supermarkets can't just copy best practices or get someone to do it for them and get that piece of the pie.

I don't think you need any of this stuff on EatZi's or these Chevron stations or Internet shopping.

Look at the clubs. When the clubs initially came out, all the forecasts were going through the roof in a great big straight line, and they hit the ceiling pretty quickly and bounced back down.

ZIEGLER: It keeps going through the roof. There's been a lot of consolidation in that sector. I see Costco comping at 8% on top of 11%. I mean, what supermarkets are doing that?

MARK HUSSON: It's fantastic. But it's in an early stage of its growth.

ZIEGLER: What early stage? A $22 billion company? It's a pretty big company, and so is Sam's, and Sam's is also comping well.

COMEAU: But their food comps, if you quantify them, are relatively small in the scheme of things.

ZIEGLER: I disagree. I think Costco, for example, is comping at 8%.

COMEAU: On food?

ZIEGLER: They run an $85 million club.

COMEAU: How much is food?

ZIEGLER: Half is food. Food is comping at 8% on sales of $40 million. That's taking share out of the market. Food is a big part of Costco's business now. It's really expanded in food. It wants the repeat customer. Costco is in the food business, and you guys should all be covering Costco, because it's a food retailer.

The point is, when you look at California, the clubs are probably averaging $125 million per store and they're comping at 8% throughout the state and throughout the Northwest -- their comps are bigger than some supermarkets' volumes are, and they're doing it year in and year out.

CERANKOSKY: I also like the clubs, like Costco and BJ's.

They have certainly sustained themselves over a long period, and they've learned about local markets, so over time they've been able to customize product offerings to the local marketplace, and the local marketplace has learned to work those stores into its shopping routine.

HUSSON: Costco is a great example of market segmentation. Their customer profile is very specific. It's 25 to 45, college-educated, two cars, upper-income, average household income $70,000 plus, but that isn't necessarily mainstream supermarket shopping.

You're certainly taking a huge chunk out of that market where it exists, but it's the Volvo, Land Rover, Discovery, soccer-mom market.

Anytime you go into a club, you drop 200 bucks without even thinking about it. But I wonder what happens to club usage when the stock market no longer grows and people don't feel as good about their financial income.

We're all concerned with profitability here. I guess this used to be a really low-margin business, but I think it's a pretty high-margin business in some supermarkets right now, with 9% EBITDA margins, and I don't think there's anything wrong with the return on investments.

COMEAU: I don't know how you quantify the loss of the business to leak-out. You look at total supermarket sales, and they go up just marginally every year, but they go up. And on one end you've got vitamins coming in and HMR and all kinds of other stuff, and you've got other things going out the back door that used to capture business, sales that you're losing to Wal-Mart or drug stores.

And you sort of look at it all and see the number of pure supermarkets opening every year increasing and getting larger, with much better managements -- and more thoughtful managements -- running bigger-scale operations, and having to generate a return.

So at the end of it all, I agree with Mark -- I wouldn't necessarily count them out, but I also wouldn't underestimate the ability of the supermarket companies to recapture a lot of business, whether it be from organics or better fresh or HMR or toiletries or anything else.

BERNSTEIN: Supermarkets have certainly adapted, and they will continue to adapt. I'm not predicting the demise of the industry by any stretch of the imagination.

But regardless of where the pressure comes from the outside, I think supermarket operators have to be aware of it and take it into account. If it is something they can use to their advantage, that's what they're going to have to do, because relative to a lot of other businesses, a 6% to 9% EBITDA margin is nothing.

The Capital Expenditures Imperative

HUSSON: EBITDA margin is irrelevant if the return on investment is strong and the ROI is rising. If you were to look at each of the last five years, you'd find that the large supermarket retailers have seen an increase in rolling five-year cap-ex in every single year, and that's coincided with a big splurge in capital expenditures and large amounts of store openings.

And looking at those store openings, I know people have been worried about sales per square foot, but I think it's a total red herring. Sales per square foot are an inadequate measure compared with gross profitability or net profit per square foot, and profits have been static in the industry, and square footage is growing, and I think that's a very healthy sign.

COMEAU: But if you look at the smaller companies who represent a smaller piece of the pie, you can see where an awful lot of the larger companies have gotten it from.

LEVIN: I think the interesting thing is that the return on investment in new stores has by and large paid off for most of the companies. But the issue in my mind is what about the older stores? I think those are the ones that are at risk to lose sales and profitability. They may still be marginally cash-flow positive because of cheap rents, but as those leases expire, I suspect a lot of companies will just walk away from these smaller stores.

SN: But hasn't the focus of capital expenditures been more and more on remodeling and expanding some of these existing stores?

LEVIN: You do see a lot of emphasis on remodeling spending, but I would say net square footage growth continues to increase for the large companies, and there's a huge emphasis on new stores.

It's absolutely crucial for a company to keep its store base fresh. If it doesn't, then longer term it will definitely lose market share.

CERANKOSKY: Nobody likes shopping in a shopworn store. People like nice stores. They don't have to be fancy, but just clean and inviting, all of which produces an atmosphere conducive to shopping.

The industry certainly is more capital-intensive than it used to be, and a company usually invests in a store as part of a strategy to gain market share. And as tastes change, stores have to change with them, including changing the product mix as well as decor.

HUSSON: There could be an issue here that might turn around and bite us in two or three or four years' time, and that is the remodeling cycle. If the life cycle of a store really starts to shorten, then instead of having 20-year-old stores, which were perfectly good until a few years ago, the 50,000-square-foot store of today may be inappropriate for the market of 2005, which casts a pall over return on investment.

With all this investment going in, it's going to start looking pretty odd if companies have to go and reinvent the entire chain.

SN: Will that still be the case if consolidation seriously reduces the number of operators out there, since there won't be as many competitors to compete against in that sense?

LEVIN: It always seems like there are new competitors popping up, whether it's new formats or actual new competitors.

I think there's a remarkably dynamic and shifting landscape in the broad retail arena, and you will see continued change. So we can talk about EatZi's as being a serious competitive threat, and it only operates three stores now, but it's something that has tremendous growth potential.