SUPERVALU'S SAVE-A-LOT COMBO STORES

ST. LOUIS -- Save-A-Lot here, an extreme low-price food retailer, is picking up the pace.Helping to drive its growth going forward is Deal$ -- Nothing Over A Dollar. It's a dollar-price-point general merchandise format that Supervalu, the Minneapolis-based parent of Save-A-Lot, acquired in 2002 when it had 45 stores. Supervalu immediately began testing Deal$ by incorporating some of its general merchandise

ST. LOUIS -- Save-A-Lot here, an extreme low-price food retailer, is picking up the pace.

Helping to drive its growth going forward is Deal$ -- Nothing Over A Dollar. It's a dollar-price-point general merchandise format that Supervalu, the Minneapolis-based parent of Save-A-Lot, acquired in 2002 when it had 45 stores. Supervalu immediately began testing Deal$ by incorporating some of its general merchandise into its limited-assortment Save-A-Lot food stores.

By the fourth quarter of fiscal 2005, which ended Feb. 26, 2005, there were 466 combination stores offering both discount foods and dollar general merchandise from Deal$, representing 36% of the 1,287 total Save-A-Lot stores. In one year, Supervalu grew the Deal$ combo stores by 134%, up from 199 combo units in the fourth quarter of the previous year.

In retrofitting Save-A-Lots to the larger combo stores that are about 18,000 square feet, Save-A-Lot is optimizing already-existing store space, adding more space, or relocating stores.

"The first couple waves of remodels were basically adding sets of linear feet of integrated general merchandise," said Jason Whitmer, senior research analyst, Midwest Research, Cleveland. "They basically gut an aisle or two that gives lots of visibility in either center store or the side of the store for the Deal$ merchandise. It's not terribly fancy, but I know Save-A-Lot is going through interior and exterior remodeling where it will do some of these at the same time. It will really brand Save-A-Lot for a more contemporary feel."

Save-A-Lot does not co-brand Save-A-Lot and Deal$. It includes the mix of about 4,000 stockkeeping units of general merchandise into the majority of Save-A-Lots via dollar departments.

Supervalu plans to accelerate the expansion of the extreme-value combo, especially through Save-A-Lot licensees. Sixty-eight percent of Save-A-Lot stores are now licensed. Supervalu has said its goal is to eventually convert all of its Save-A-Lots to the hybrid format.

During its fourth quarter conference call last month, Jeff Noddle, Supervalu's chairman and chief executive officer, told analysts he expected half of all Save-A-Lots to be converted to combos by the end of the year. The company said it plans 90 to 110 new stores and 100 combo conversions for fiscal 2006.

The number of Save-A-Lot licensees has grown from 336 as of Feb. 26, 1994, to 879 stores as of the close of the fiscal 2005. The number of corporate-owned stores also grew during the period, from 75 to 408, or 31% of the total 1,287 Save-A-Lots.

Noddle said he wants to speed up the growth of licensees. "In major markets where we have opportunity, we want to look for maybe some unusual ways that we might grow business, and so we're putting a lot more emphasis on new ways to accelerate the licensee count and growth, and at the same time, really upgrade the Save-A-Lot fleet as we introduce our new interior and exterior decor," he said in response to a question during the conference call.

Licensing provides a cost-effective way for Supervalu to grow the banner. At a recent Merrill Lynch presentation, Yolanda Scharton, vice president of investor relations and communications for Supervalu, said the capital investment required for a Save-A-Lot licensee to open a store is $800,000 to $850,000, which the licensee must provide. "They invest the capital. We [Supervalu] provide turnkey solutions, including equipment and advertising support. They are obligated to buy the majority of products through our distribution centers," Scharton said. She added that licensees typically get back their initial investments within three years, and the return on investment is very high.

Whitmer said Save-A-Lot is "an extremely attractive return vehicle," given that most of its stores are licensed and the licensees front the capital for adding stores. Meanwhile, Supervalu picks up distribution volume from new stores.

The wholesaler projected annual new-store growth of 100 to 150 units. At the end of Supervalu's 2004 fiscal year, total Save-A-Lot store square footage totaled 4.1 million square feet. This increased by 6.4% by the end of fiscal 2005. Analysts put Save-A-Lot sales at the $4 billion-plus mark. That represented about 20% or more of Supervalu's $19.5 billion in total net sales, and 38% or more of $10.5 billion in retail sales reported for the year.

Supervalu is pursuing an aggressive remodeling program across its corporate-owned retail banners. Capital expenditures in 2005 was $326 million, including $63 million in capital leases. Save-A-Lot declined to comment on how much of its cap-ex budget will be spent on new corporate Save-A-Lot stores, remodeling, retrofits and upgrades.

"One of our points of emphasis this year is to convert and bring up to date a lot of the older Save-A-Lot locations, and that's both interior and exterior signage and remodeling, and really begin to enhance the brand by a national campaign," Noddle said during the conference call.

GROWING WEST

Supervalu is dedicated to its hybrid discount format. At last year's annual meeting, Noddle told investors the company plans to continue to invest heavily in growing the Save-A-Lot format nationally, with plans to focus on expansion "within our present geographic markets and judicious expansion into new markets."

Save-A-Lots were in 37 states at the close of the 2004 fiscal year, with a heavy concentration of stores east of the Mississippi River. Supervalu's strategy has been to develop corporate stores in large markets that require bigger capital investment, and discover where new stores can be added. Other markets like Texas, where Save-A-Lot acquired the leaseholds for 17 former Grocery Outlets last year, are retained for licensees.

New market expansion will likely be in the West, analysts said. "I think they want to do more in the West, and they are relatively light in California," said Chuck Cerankosky, analyst, KeyBanc Capital Markets, Cleveland. He also noted Save-A-Lot is expanding throughout its existing markets.

Another advantage of the Save-A-Lot model from an ROI perspective is its real estate. Most stores are leased under five- to 10-year renewal options. Conventional Save-A-Lots' 14,000-square-foot footprint is small and designed for quick turn inventory. Stores are often located in strip centers or in recycled stores that are in low-rent areas, requiring less capital investment. In general, "they aren't running triple-A real estate," said Cerankosky.

"We are going to start to run up against a number of stores who don't have the size to be combination stores," said Noddle during the recent conference call. "In many of those situations we look to relocate them when their lease is up."

Save-A-Lots are located in urban and rural areas where households on low and fixed incomes reside. In some situations, new store construction is financed by federal grants and city development funds. That's the case for a proposed $2.5 million store in Wichita, Kan., which is being developed by the Power Community Development Corp., a nonprofit community housing project, according to local press reports.

POOR MAN'S CLUB

The Save-A-Lot format is targeted to households with incomes of $35,000 or less. The low-income segment represents 44% of all households, or a customer base of 120 million people, according to Save-A-Lot. This figure is expected to grow with more older Americans retiring.

Cerankosky called the Save-A-Lot combo the "poor man's warehouse club." He said it's a format that works, but cited the ability of the targeted shopper to spend discretionary dollars.

"Instead of BJ's or Costco shoppers who have $200 to spend on fun stuff, you've got Save-A-Lot shoppers with $3 or $4 to spend on discretionary stuff. You aren't going to see a Bose home theater system like you might see at a BJ's, but you might see a $1 CD," he explained.

Whitmer described the Save-A-Lot combo as "ingenious" because of its ability to leverage the everyday grocery business and expand general merchandise. "It not only adds to the shopper's basket size, [but] it also adds margin," he said.

Analysts agreed the integration of the concept has gone well. However, one source said Supervalu favors the strategy of integrating some general merchandise into the food stores over integrating some food under the Super Deal$ general merchandise format, where it added frozen and refrigerated foods priced at $1.

Bryan Roberts, global retail research manger for Planet Retail, London, who just completed a study on dollar discount formats in the United States, thinks both strategies should work well.

"You've got the addition of grocery items into the Deal$ stores. Once people come in, there is the off chance of finding top-price general merchandise [sold at a rock-bottom prices]. Then they discover there is a regular supply of perishable foods, household cleaning and HBC. They are then likely to make that more of a regular destination, which should drive up regular customer traffic," said Roberts. "On the flip side, the general dollar ranges into the traditional Save-A-Lot grocery stores should lead to quality spending on higher-margin nonfoods."

Roberts said the format provides a real neighborhood convenience. "You can pop around the corner and get all your basics in a limited space of time and get big savings as well."

LOW PRICES/ CONVENIENCE

The extreme format was created to compete with large food chains and supercenters, with savings up to 40% less than at traditional supermarkets and 10% to 15% less than at a Wal-Mart supercenter. "They are better than Wal-Mart on pricing," said Whitmer of Save-A-Lot.

Save-A-Lot's model is built around simplicity, which combines efficiency, everyday low price and convenience. The food assortment is edited to fulfill about 90% of a shoppers' market basket needs. The average Save-A-Lot sells 1,250 popular food items in one size or variety.

While stores sell selected fast-moving brand names, about 80% of products are private label -- or what Save-A-Lot refers to as custom labels, which are often named after employees. "Our buying power lets us develop customer product specification for quality and price, while giving us leverage with manufacturers," states the company's Web site.

While analysts said they like the direction Supervalu has taken with Save-A-Lot, they said more can be done.

"They could do more with general merchandise and go beyond the $1 price point by adding general merchandise viewed as a great value below $10," said Cerankosky. "Whether $1 or $5, there is always the opportunity to see where they can reach and how high the customer is willing to go."

Roberts sees advantages with Save-A-Lot's private-label program, but he also said it lacks coherence, especially when compared to a tiered program like Dollar General's. "You don't get a sense of coherent brand positioning," he said. He also believes Save-A-Lot can improve its fresh produce selection and presentation.

Compared to the competing dollar formats that have been adding discount groceries, Roberts said Save-A-Lot offers a "real pedigree" because of Supervalu's background in food retailing. "In terms of experience, credentials in grocery, sourcing, distribution and merchandising, Save-A-Lot has the advantage," he said.

Examining the Returns

Although observers said the return on investment in Save-A-Lot combo stores is very high, exact figures are hard to come by. Here are factors to consider that may boost the returns:

* Small footprint designed for fast-turning inventory.

* High percent of sales in higher-margin private label.

* Low-rent locations -- majority of stores are leaseholds.

* 68% of stores operated by licensees, who provide building capital.

* Clout of Supervalu's operational efficiencies.

* Self-distribution through Save-A-Lot's 16 distribution centers.

* Nonunion labor.

* Less labor required with minimal service -- customers bag goods, and inventory stocked out of custom cartons.

* Simple store format with minimal fixturing.

Shopping a Combo

Save-A-Lot combo stores featuring Deal$ sections are about 18,000 square feet. The sections carry 3,000 to 4,000 stockkeeping units of dollar-priced general merchandise. Much of the merchandise is said to be seasonal, and in-and-out items imported from Asia.

The food side of the store contains about 1,250 SKUs of name brands and private label. Supervalu, the Minneapolis-based wholesaler that inherited Save-A-Lot with the acquisition of Wetterrau in 1992, has said its goal is to do about 20% of its sales in higher-margin general merchandise.

In addition to shelf-stable goods, household supplies, and health and beauty care, Save-A-Lot sells produce, meat, frozen food and dairy.

Bryan Roberts, global retail research manger for Planet Retail, London, recently visited a combo store in Arkansas. "The Deal$ combo I saw was very clean and well laid out. It had a degree of logic, and it was fairly stylish compared to what I was expecting."

Roberts said fresh produce consisted of a couple of shippers dumped in front of the door. He described the perishables and dairy selection as fulfilling basic needs.

Once through the door, the traffic pattern forced him to shop the general merchandise area first, located to the right side of the store. It consisted of household goods, garden supplies, toys, novelties and gifts. The traffic then wrapped into household cleaning, health and beauty care, then into grocery.

"The attempt to make you shop the whole store is cleverly laid out," Roberts added.

Chuck Cerankosky, analyst, KeyBanc Capital Markets, Cleveland, has shopped Save-A-Lots in Ohio as well. He said the stores provide a much more dignified shopping experience than shopping at an Aldi. Aldi is an extreme-value retailer imported by the Aldi Group, Essen, Germany, and is a competitor of Save-A-Lot.

"It has bright lights, it is clean and has multiple colors," Cerankosky noted.