TRACKING WAL-MART'S MARCH

NEW YORK -- The threats and opportunities posed by Wal-Mart to retailers large and small dominated the discussion during the second half of SN's annual Financial Analysts' Roundtable here.SN printed the first part of the roundtable Sept. 3."Any seller who's going to sell out is probably doing so because Wal-Mart is pressuring them," Jonathan Ziegler, San Francisco-based managing director for Deutsche

NEW YORK -- The threats and opportunities posed by Wal-Mart to retailers large and small dominated the discussion during the second half of SN's annual Financial Analysts' Roundtable here.

SN printed the first part of the roundtable Sept. 3.

"Any seller who's going to sell out is probably doing so because Wal-Mart is pressuring them," Jonathan Ziegler, San Francisco-based managing director for Deutsche Banc Alex. Brown here, said. "That means that any buyer is then going to have to compete with Wal-Mart."

According to Mark Husson, first vice president of Merrill Lynch here, "When Wal-Mart enters a market, it's like the Black Death, and as the old and the weak die, the stronger companies see their market shares go up."

Backing up his comments, Husson cited statistics indicating that the top three chains in each of the top 100 metro markets in which Wal-Mart has operated for at least seven years has the same market share it had before Wal-Mart's entry, "while Wal-Mart's share has gone from nothing to 7% or 8%" or more -- all at the expense of smaller regional players, Husson said.

While Kroger has learned to cope with Wal-Mart over the years, Safeway may just be beginning its learning curve, and that could create margin challenges, the analysts said. Wal-Mart's impact is not limited to smaller operators, Lisa Cartwright, director for Salomon Smith Barney here, pointed out. "Safeway's and Kroger's inventory turns are basically the same, and their return on invested capital is the same, yet Safeway's margins are about 200 basis points higher. So what's the key difference? They don't compete with Wal-Mart, and Kroger does," she said.

According to Ziegler, as Safeway expands into more Wal-Mart territories, it may affect the chain's ability to keep margins up. "If you have to compete with Wal-Mart, then you're not going to have an ability to keep your prices up if you get productivity gains. You're going to have to pass a lot of it on with lower prices," he said.

Several analysts said they doubt Wal-Mart's Neighborhood Markets format represents the kind of threat some observers have predicted. "I'm just not as sold on the concept that even Wal-Mart is going to be hugely successful in knocking off these incremental trips to supermarkets with the Neighborhood Market format," Ted Bernstein, managing director for Dresdner Kleinwort Wasserstein-Grantchester here, said.

Because the Neighborhood Markets offer limited perishables assortments, "nice, well-run, good-looking stores at good locations are going to be very effective against the Neighborhood Markets," Debra Levin, executive director at Morgan Stanley Dean Witter here, pointed out. "But the threat they represent comes from incremental square footage in the market."

And if you think about the kind of distribution capacity Wal-Mart is thinking about adding, you could envision it having easily 1,000 to 1,200 Neighborhood Markets five years from now."

Jack Murphy, vice president, Credit Suisse First Boston here, said he doubts Neighborhood Markets will have as much influence as supercenters have had. "(Wal-Mart) could open 150 to 200 stores a year or maybe more, but the reality is 200 new supercenters a year is the bigger threat," he said.

Rather than expanding with Neighborhood Markets, Husson said Wal-Mart might be wiser to open conventional supermarkets. "I think Wal-Mart will realize that the best way to make money off a neighborhood is to open a 45,000- to 50,000-square-foot supermarket and do general merchandise the way food retailers ought to be doing it," he said.

Deborah Weinswig, food and drug chains analyst for Bear Stearns here, said the Neighborhood Market concept is likely to have more impact on drug stores than on supermarkets "because they both have drive-through pharmacies."

However, Meredith Adler, senior vice president, Lehman Brothers here, said she disagreed. "[With] 4,100 CVSes and 3,100 Walgreens, even if Wal-Mart doubles the number of Neighborhood Markets annually, it's not going to make a dent in the drug stores' sales," she said.

The panel also talked about home delivery, pointing out that, with most Internet-based delivery companies out of business, home delivery is likely to become just one of several services supermarkets offer as a matter of course. "Ultimately, home delivery is just another service offering, like drive-through drug stores," Gary Giblen, senior vice president and director of research for C L King Associates here, said.

The full text of the roundtable discussion follows.

The Wal-Mart Factor

The pace of industry consolidation will continue to be spurred by those companies willing to compete with Wal-Mart and those who would rather sell than fight, analysts said.

SN: Acquisition is obviously a way to boost sales, but is it still seen as a way of boosting earnings?

DEBRA LEVIN: Oh, yes. This is an industry where synergies work. The procurement synergies are huge, and the opportunities in distribution, systems and best practices are very significant, and I think all the major companies have bought into that. But while there are still opportunities to buy good quality assets, the timing is basically up to private companies like Wegmans or H.E.B. or any number of other really good quality companies with good solid market shares and facilities. I don't think the economy makes a difference to those managements. It's more about what pressures they see in their own internal dynamic.

MARK HUSSON: The accounting and the goodwill amortization are working, which is helpful. That's the positive side. But on the negative side, you've got this sort of catch-22, which is that the market wants to see retailers make acquisitions to reload the gun, but it won't give them the bullets to make the acquisitions because the price/earnings multiple is terrible. So if you can't make an acquisition, you can't get growth, and if you can't get a multiple, you can't make an acquisition.

JONATHAN ZIEGLER: There's another catch-22: Any seller who's going to sell out is probably doing so because Wal-Mart is pressuring them. That means that any buyer is then going to have to compete with Wal-Mart. Therefore, your multiple goes down more.

TED BERNSTEIN: Despite the fact that Wal-Mart continues to grow and roll out supercenters, it's still largely a regional factor.

ZIEGLER: There are some really strong independents who don't have any need to sell out. But when they reach the conclusion they want to sell, it's likely going to be because Wal-Mart is coming into the neighborhood. That is often the pressure point for them to decide to sell. And then the guy who buys that company has to compete with Wal-Mart.

HUSSON: When Wal-Mart enters a market, it's like the Black Death, and as the old and the weak die, the stronger companies see their market shares go up.

MEREDITH ADLER: And there is a lot of data to prove that. I've looked at 25 major markets, and the small players are being hurt. The No. 1s and No. 2s generally are doing OK, and some of the regional players are doing OK, but the little guys are getting decimated.

HUSSON: We looked at every one of the top 100 metro markets where Wal-Mart has been for seven or eight years, and in those markets the top three supermarket players now have the same market share they had the year Wal-Mart opened. They've added stores, of course, but their market shares are exactly the same, while Wal-Mart's share has gone from nothing to 7% or 8%, or in some cases 11%, 16% or even 19%.

ZIEGLER: But at what gross margin?

HUSSON: Well, the first thing to say is that everybody that's not Wal-Mart and is not one of the top three retailers has had an absolute nightmare in terms of comparable store sales, and they've been decimated. As far as the gross margin is concerned, Wal-Mart makes a return as well, and the experience is usually that you make it very hard to start with and it continues to be hard for a long time, and after you've had some shakeout, Wal-Mart allows prices to rise. Kroger or another operator probably initiates it, and Wal-Mart follows behind. I think what Kroger has learned is, if gross margin is running at 25% and it drops down to 15%, Wal-Mart is going to be there at 13%. And if you bring it down to 20%, Wal-Mart's going to be there at 19%. But at that level, just about everyone else in the market is EBITDA-negative, so that's all you need to sustain. You don't need to outrun the bear -- you just need to outrun the other guy, and he becomes bear food.

A NEW DYNAMIC: SAFEWAY vs. WAL-MART

Kroger is already competing head-to-head with Wal-Mart all over the country, but Safeway will have to face Wal-Mart -- and make adjustments accordingly -- as it expands into new geo-graphies where Wal-Mart is already a factor, the analysts pointed out.

ZIEGLER: When Kroger made its Fred Meyer acquisition, it got diversified away from Wal-Mart, but as Safeway expands, it will have to diversify into Wal-Mart territory, and to me that's kind of a problem, though I still think Safeway's got huge margin opportunities, though supply channels are ridiculously inefficient.

LISA CARTWRIGHT: Safeway's and Kroger's inventory turns are basically the same, and their return on invested capital is the same, yet Safeway's margins are about 200 basis points higher. So what's the key difference? They don't compete with Wal-Mart, and Kroger does.

HUSSON: Safeway is much more on the fringes of the country so its in-cost of buying the stuff is very high.

CARTWRIGHT: So what's the future? The future is going into Wal-Mart markets.

ZIEGLER : What about Safeway growing organically at 15%? What do you think of that idea?

JACK MURPHY: That's really the whole point. If you're looking at Safeway without an acquisition -- growing sales in the single digits and trying to grow EBITDA margins in the 10% to 12% range -- then it's a lot harder to get to 15% earnings growth than when you're growing the sales double digit and you're going from 8% EBITDA to 10%.

ZIEGLER: But Safeway does have an ability in the markets it's in, which I think the other guys don't, to raise prices more if it wants to.

CARTWRIGHT: You think that's the answer?

ZIEGLER: No, I don't think raising prices is the answer. I just think Safeway can keep prices up, whereas everybody else has to drop them in the markets in which it operates. So when Safeway gets productivity gains, which it's going to get through the supply channel, it can keep more of that for shareholders rather than passing it on to compete with Wal-Mart.

ADLER: The one thing Kroger has working in its favor is much more rationalized markets. Not everywhere, but in a lot of markets, Kroger has seen Wal-Mart come through, and those markets have rationalized considerably.

ZIEGLER: Kroger's got some benefits, like leading market shares in virtually every market it's in, and it still has the Fred Meyer card to play, so everything's going great for Kroger. My only argument is that if you have to compete with Wal-Mart -- and everybody does -- then you're not going to have an ability to keep your prices up if you get productivity gains. You're going to have to pass a lot of it on with lower prices. And if you don't have to compete with Wal-Mart, you're probably going to keep more for shareholders -- that's my only point.

CARTWRIGHT: Even if Safeway doesn't have to go into Wal-Mart markets, Safeway right now is in some of the best markets with the least competition in the country, so most of the places left for it to go will be markets with a higher penetration of Wal-Marts or greater competition rather than a duopoly situation like Chicago.

NEIGHBORHOOD MARKETS

Wal-Mart continues to take its time rolling out the Neighborhood Market format, and analysts said they are not sure that format will be as big a threat to supermarkets as was once anticipated.

SN: How are the Wal-Mart Neighborhood Markets doing? When are we going to see the big rollout Wal-Mart has been talking about?

DEBORAH WEINSWIG: From what I understand, Wal-Mart is not in test phase anymore, but it's not in rollout phase just yet either. Wal-Mart knows its average customer goes to a supercenter six times a month, while the average supermarket customer goes 10 times a month -- 2.5 times a week -- so it realizes it's missing out on four trips and it wants to figure out how to get that piece of the pie. The answer is to open Neighborhood Markets.

ADLER: Wal-Mart has said it needs to be very selective about where it goes with the Neighborhood Markets because it's acknowledged it cannot afford prime real estate.

WEINSWIG: It's going to back-build too, but it's not going to go into new markets.

LEVIN: The question is, can it get worthwhile returns? The costs of running a Neighborhood Market are tricky, and it wants to make sure it can do the pricing right.

MURPHY: I think Wal-Mart might be somewhat satisfied with what it's got now, but still, for all practical purposes, Neighborhood Markets do not have a meaningful percentage of the market by any stretch. And the scary thing is, if this is what Wal-Mart wants to do, it could open 150 to 200 stores a year, or maybe more. But I think there's still plenty of time, given how long it took for it to develop the supercenter, and it could very well end up building stores very much like a 109,000-square-foot supercenter that could be any number of things -- I think it's just really far too early to know. The bigger and more relevant threat is the supercenter. The Neighborhood Market is great to talk about because it's interesting and new, but the reality is 200 new supercenters a year is the bigger threat.

WEINSWIG: I think the bigger impact of the Neighborhood Market won't necessarily be on the supermarkets but on the drug stores, because they both have drive-through pharmacies.

ADLER: Wal-Mart has said it's going to double the number of Neighborhood Markets every year for the next five years or so, so if there are 21 now, then next year there would be 50. But there are 4,100 CVSes and 3,100 Walgreens, so even if Wal-Mart doubles the number of Neighborhood Markets annually, it's not going to make a dent in the drug stores' sales.

HUSSON: I wonder where Wal-Mart is going to get the sites for this undertaking, because the whole rollout is going to be real estate-driven. That's not a problem for supercenters because approximately 65% of those were existing or relocated discount stores, so it already had the sites. But if you drive through big cities, you don't come to an intersection with a supermarket over there and a drug store on this corner and an IHOP here and a big green field with a "for sale" sign stuck in the middle.

CARTWRIGHT: Do you think Wal-Mart will make an acquisition?

HUSSON: I think supermarket retailers are actually a bit smarter than people think they are, and I think Wal-Mart will realize that the best way to make money off a neighborhood is to open a supermarket -- not a Neighborhood Market and not a supercenter but to actually open up a 45,000- to 50,000-square-foot supermarket and do general merchandise the way food retailers ought to be doing it today but have so far screwed it up.

WEINSWIG: I completely agree.

LEVIN: The thing to remember about the Neighborhood Market is that it still carries a very basic assortment, with little or no bakery or deli and a very modest produce section. So when we say it's going to be this huge threat for the supermarket industry, I think we should make the point that nice, well-run, good-looking stores at good locations are going to be very effective against the Neighborhood Markets. But the threat they represent comes from incremental square footage in the market. And if Wal-Mart puts its power behind getting sites, then it will get them over time because there is enough recycling of sites in the country. And longer term, if you think about the kind of distribution capacity Wal-Mart is thinking about adding, you could envision it having easily 1,000 to 1,200 Neighborhood Markets five years from now.

ADLER: Distribution capacity is a problem right now, not because the supercenters are doing so well in any one market because they're kind of tapping out the distribution capacity. And then you have to ask, is there enough return to justify building new distribution capacity?

BERNSTEIN: It's not even capacity. It's so much harder to distribute to merchandise 1,200 Neighborhood Markets than it is a supercenter.

HUSSON: Don't forget that Wal-Mart has McLane, who knows how to distribute to little boxes.

BERNSTEIN: I agree that supercenters represent a much more significant threat to supermarket retailing than the Neighborhood Market simply because today and for the foreseeable future, when you drop down a supercenter, it draws from 15 miles in all directions, and you've got a regional operator there that has four stores crushed in that first year. But looking forward, I'm just not as sold on the concept that even Wal-Mart is going to be hugely successful in knocking off these incremental trips to supermarkets with the Neighborhood Market format.

DIFFERENTIATED CUSTOMERS

Consumers who rely on supermarkets for the bulk of their shopping will also shop at Wal-Mart to get good prices, analysts said.

HUSSON: We keep talking about Wal-Mart, but those of us in this room wouldn't be caught dead shopping in a Wal-Mart supercenter. The problem with Wall Street is, it's dominated shamefully by males who don't shop. We are financial analysts, and we spend our entire time thinking that numbers rule everything and that somehow the lowest price in a marketplace, rather like a low-pressure system, automatically attracts all wind to the low-pressure system and everyone shops there.

WEINSWIG: I think it's a matter of convenience. The average customer goes to a supermarket 2.5 times a week, and they go to a Wal-Mart supercenter 1.5 times a week. Wal-Mart has 100 million customers.

HUSSON: The point I'm trying to make is that the reason people shop at supermarkets is multidimensional -- it has less to do with price. Price is just one of the reasons. If you ask consumers what they really want, price is somewhere way down the list.

LEVIN: That's why the chains invest in remodels and why remodels can have a positive return on their investment. When a supercenter comes into town, what's the first thing supermarkets do? They invest in a remodel and make sure they have the very best ambience, and that works. That's how they can gain market share over time, because the weaker players fall off.

HUSSON: The other thing is that Wal-Mart has about 30% of its supercenters in the top 100 metro markets. Only 30%. That's leaves 70% of the supercenters where 40% of the population lives.

CARTWRIGHT: People do care about price on certain items. If you ask people why they shop at a supermarket, they're certainly not going to say price. But if you ask them why they shop at Wal-Mart or Costco or Target, they're going to say price. And it's the same person. That's the thing.

HUSSON: No, it's not the same person. I completely disagree. The demographic is different.

CARTWRIGHT: Wal-Mart, Costco, Sam's Club, whatever -- discounters and mass merchants -- the same people are shopping at all of them.

SN: Lisa, you're not saying the same customer is buying perishables necessarily in both places but you're saying they might be targeting certain price points.

CARTWRIGHT: Exactly.

HUSSON: But perishables in Wal-Mart are of a different order of quality.

CARTWRIGHT: Yes, that's not the same customer. That's not what I'm saying.

MURPHY: Given the fact Wal-Mart has a history of fixing every business process it gets into over time, the level of quality it can bring to the perishable side of the supercenter is a fixable problem.

HUSSON: I don't think that's true, either. It's not in Wal-Mart's interest to fix it. To them, it's not a problem because it can get fantastic price points with lower quality perishables, and that's how it makes a price impression.

ADLER: And I would argue that if you're a discriminating shopper, you certainly look at the produce. I was just in Dallas, and I thought there was some really crappy produce at the Kroger and the Tom Thumb and the Albertson's I was in -- it was mediocre everywhere. None of them do a good enough job in that area.

HUSSON : But in a supermarket produce section, there are three or four different grades you can buy. Wal-Mart is always trying to make a price impression that's right for its customers. But Wal-Mart shouldn't be trying to impress me. It should be giving a price point to its customers, and I think that's micromarketing, and I think Wal-Mart does that very successfully. It's a valid strategy and doesn't need to change.

WEINSWIG: I think Mark brings up a really good point. The person who's buying produce at, say, one of the big chains is probably not the same person who's buying produce at a Wal-Mart. So what you're actually seeing is some of the food retailers increasing sales of private label and using a lower opening price point for merchandise, but that's something that has impacted Wal-Mart's comps too -- the shifting price point merchandise is what's flying off the shelves. There's a huge shift to private label, and that's actually been depressing Wal-Mart's comps. So again, you can see that at least on the food side, you do have somewhat of a differentiated customer. I think that for general merchandise, as Lisa said, if you buy your produce at Safeway, maybe you'll buy your sheets and your towels at a Wal-Mart.

CARTWRIGHT: Or your paper towels, or your diapers.

WAL-MART INTERNATIONAL

Despite its marketing acumen in the U.S., the analysts said Wal-Mart has been less successful operating outside its home base, and they criticized its reliance on overseeing its entire global operation from Bentonville, Ark.

SN: What is Wal-Mart doing on a global basis? It said it would like its international operations eventually to be twice as large as those in the U.S., though right now, international at $3.2 billion is only about 17% of the total company size.

WEINSWIG: The goal is for one-third of sales and one-third of profits to come from international operations over the long term. I think Germany has obviously been a challenge for Wal-Mart, but Asda's really blown the doors off. And in Mexico, Wal-Mart was actually running on a high-low promotional pricing basis, rather than using its EDLP format [before it acquired Cifra]. But last January it implemented EDLP and really worked on educating the consumers there, and at the end of first quarter, its sales in Mexico were up 26%, mostly attributable to EDLP. I think there are opportunities in South America, despite some size constraints it is trying to work around in Argentina, and I think there is still a lot of opportunity in Asia, although Carrefour is kind of getting into some of those markets first, especially Japan. But I think there's still a lot of opportunity but also a lot of risk.

ADLER: One could be a skeptic, though, and say there are lots of places in the world where Wal-Mart hasn't gotten it right, and it would be fascinating to see what its return on invested capital in Mexico is. It started with EDLP there, then it bought Cifra because it clearly couldn't get it right. Canada is probably the only absolute home run for Wal-Mart internationally. But I've heard mixed reports about how Asda is doing.

HUSSON: Let's just say Wal-Mart's international experience has been spotty, at best. One of the things Wal-Mart has done is to throw up gazillions of free cash to make acquisitions because it knows you can't go into countries and just start opening up stores. Argentina and Brazil are huge embarrassments. Those stores haven't made any money. And in Germany, it made an acquisition but it bought the wrong company, then it bought another wrong company and put the two together, and it hasn't made anything like a dollar there. But in the U.K., it made the right acquisition. What Wal-Mart hasn't learned yet, unfortunately, is how to keep management. Just about all the senior Asda management guys are gone -- there's almost nobody left there that was running the ship in Leeds when Wal-Mart bought Asda. When you look at it from the standpoint of micromarketing, the question Wal-Mart has to try to resolve is how does it keep local talent involved in these businesses without trying to have this kind of global homogenization of talent, which is something that Wal-Mart, unfortunately, seems to want to do by controlling everything from Bentonville.

E-COMMERCE

Ordering over the Internet is still feasible but more likely on a niche basis in larger population centers, the analysts suggested.

SN: Let's talk a little bit about e-commerce. On the B2C side, there are only a few companies left that are really doing some very serious experimentation. How do you see that playing out over the next 12 to 18 months?

MURPHY: Just because Webvan went under doesn't mean e-commerce in the grocery industry is dead. I think there's definitely consumer demand -- it's just a matter of figuring out how it's going to work.

BERNSTEIN: It doesn't work right now, though the model that might work is the Ahold-Peapod approach.

MURPHY: And how about Tesco in the U.K.?

HUSSON: Tesco breaks even, if you fiddle the accounting and don't charge the business any central overhead, for instance.

MURPHY: That sounds like other loss-leader services in the grocery store, like pharmacy.

HUSSON: But I think it's a good service to offer because it's almost certainly taking market share from its competitors with so few operators offering it in the marketplace. If you've got 100% of the e-commerce orders in a certain town, 30% will come from your existing customer base and 70% will come from customers who are currently shopping with your competitor. So e-commerce is a vital and vibrant part of Tesco's business -- everyone I know in the U.K. has used it once. But it really is the big cities where it works best. In London, about 5% of sales go to e-commerce because it's a pain getting out of your apartment to do anything in London. In the rest of the places, it's 2% or less.

LEVIN: But at least the pace of expansion is going to be much more moderate. It's not this kind of free-for-all land-grab mode that everybody was talking about two years ago that made Webvan and Home Grocer feel they had to expand to stake out their claim before they figured out what their model was. Now at least the pace can be much more leisurely, and companies can figure out what model works and what consumer offering is right.

ADLER: You're making the assumption that the U.S. customer is going to do what the U.K. customer does, but the U.K. customer is getting the tiniest order delivered and paying 5 pounds for it, and I don't know if that necessarily translates.

CARTWRIGHT: In Europe people are used to paying more than we are, so I think the idea of paying 5 pounds or 10 pounds or whatever to have something delivered is not a horrible concept to a European. But over here, it's a hard thing to swallow. People like to drive, they like to shop, and it's not a sacrifice to get into your car or to stop on the way home and pick up what you need.

GARY GIBLEN: Ultimately, home delivery is just another service offering, like drive-through drug stores -- probably the same customer goes into the store one day, drives through on another.

LEVIN: It will also be interesting to see whether store pick-up takes off. I think that's something that Albertson's is working with now, and you'll see Safeway do some of that. I think that's something that has some opportunity, but it will be worked out over time.

ADLER: We talk about home delivery service, but we don't talk about services like dry cleaning or photo finishing in the supermarket. But we feel compelled to discuss a niche part of the business that frankly is just a service add-on at this point.

MURPHY: I believe that's right. It's not going to take over -- maybe it will do 5% in certain markets -- but you're going to see it. There will definitely be home delivery in markets like New York and San Francisco.

BERNSTEIN: There's been home delivery since the first supermarket. You don't need the Internet to do that. The explosion and growth of companies like Webvan was all part of the Internet phenomenon, and there's probably a model that works, but it's probably very market-specific like all supermarket retailing is. Right now, the only model I see that really has a chance of maybe being viable and meaningful in any way is the Ahold-Peapod one.

WEINSWIG: The biggest shock for Webvan, especially in the San Francisco market, was that customers shopped them four or five times and then would stop. Why? Because since people were 2 years old, they were going to the grocery store with their parents. It's a part of our habit. And I think a lot of people like to pick out their own produce and their own meats.

ZIEGLER: When all this e-commerce started, the Web wasn't very efficient in itself. The Internet is an information business, but you had to spend so much time on that Webvan Web site going up and down.

WEINSWIG: It took like four hours to set up your first order.

CARTWRIGHT: But it also seems Webvan felt that once the order was set up, people would order the same thing every time. Women do not plan the menus out for a month. It's usually, "What do you want for dinner tonight?" So the behavior changed too much for the technology.

LEVIN: I don't think that was the problem because I think people do buy mostly the same items over and over. The problem was trying to get four to five deliveries out every hour -- it was the economics that weren't going to work out.

HUSSON: People are used to mixing with people. There are only a few places where people meet socially -- the church, the sports stadium, the mall and the supermarket. Hunting and gathering is a social activity, and learning new things and using their senses is what people do. If you deprive them of that, then it's a very impoverished life that you have.

ZIEGLER: The point is, if shopping on the Internet did appeal to everybody, the concept wouldn't work. There is a limited niche market. But if it had massive appeal -- let's say it's a 20% market share -- then it would be a free-for-all, with everybody coming in and nobody making money. But if you have a niche market, and it's only big enough for one operator in a particular city, it might just work.

THE WHOLESALER OUTLOOK

Wholesalers are prospering, analysts said, with Fleming seeking business among alternative formats, Supervalu striving to improve efficiencies, and C&S and Nash Finch moving more aggressively into retail ownership.

SN: Let's talk about wholesalers a little bit and what they've been doing.

LEVIN: Well, I think both Supervalu and Fleming have said they've got to have retail that works. So Fleming decided to get out of the conventional business, and it sold over 200 stores, and Supervalu is doing that in selective markets, really evaluating what assets it has and what assets are working. But I think that's the same theme we've heard about supermarkets too -- you've got to make sure you've got appropriate returns.

ZIEGLER: These wholesalers are trying to be hyperefficient in distribution, and I don't think you'll see much consolidation. Obviously, Fleming did go into the C-store business because that's a different form of pick. And it did make an acquisition, and that brings in new expertise. I just think that one of the reasons Fleming did the Kmart deal was to have super-productive distribution centers. Buying huge volumes through the DC means you can become a low-cost operator and take share in what's considered to be an eroding market. Supervalu, on the other hand, is willingly giving up Kmart, and it's shrinking the organization so it will be super-efficient, so it can win back business and it doesn't have to buy anybody to get growth.

ZIEGLER: What's interesting is where the two wholesalers overlap -- they're both going into price-impact retailing, they're both EDLP operators and they both have similar limited assortment concepts, with Fleming's Food 4 Less and Supervalu's Cub, Metro and Shopper's Food Warehouse. And it picked up Save-A-Lot when it bought Wetterau years ago, and that's turned out to be a gem.

BERNSTEIN: At Fleming, Mark Hansen [chairman and CEO] realizes two things: Prior management had gotten into the bad habit of buying customers on the verge of bankruptcy, just to maintain them as customers, with the result that Fleming accumulated a portfolio of very, very weak assets -- assets that didn't improve under Fleming's management and in some cases got worse. So getting out of that was a very smart thing for the new management team to do. And management also realized that if there's any kind of format a wholesaler should be able to run and run efficiently, it would be a big-box price-impact format. The Food 4 Less format has been pretty successful in California, for instance, and other areas in which it operates, and it seems to be the most viable sort of operation for Fleming. So I think these were conclusions the new management team recognized that the old management team, for whatever reason, just didn't.

MURPHY: One of the big challenges for Fleming is that a lot of its future growth in the core distribution business is nontraditional customers, and a lot of those nontraditional customers -- drug stores, dollar stores, general merchants -- have their own distribution. So Fleming is basically in the position of talking people into outsourcing something they've essentially invested a lot of money in throughout the last 10 years, so it has to come up with something so compelling on an economic basis that they will effectively write off these assets. It's going to be a very long road to do that.

SN: What is happening with other wholesalers?

BERNSTEIN: C&S has moved boldly and quickly into the retail business and has really become a relatively large player in the metro New York area as the result of picking up assets of Grand Union, a company it was supplying. So it went from zero stores to close to 100 Grand Union stores. Ultimately, I don't know if C&S wants to be in the retail business. It may want to find a friendly buyer that wants to enter into a distribution contract.

SN: Beyond that retail aspect, is C&S going to grow as a wholesaler?

ADLER: It's the fastest growing wholesaler out there right now.

BERNSTEIN: I certainly expect it to grow. Looking at what it's done over the last several years and how much it's grown, it's been pretty dramatic -- and it seems to be a very aggressive and well-run operation.

SN: Given its supply contracts with Safeway, Pathmark and Ahold, can C&S grow its business as those companies expand in the East?

LEVIN: Oh yes. C&S has a compelling cost advantage because it's nonunion, so if it runs its business well, it should be able to continue to grow.

SN: What about the long-term prospects for Nash Finch?

WEINSWIG: I think Nash Finch is trying to become more of a food retailer. It's continuing to do what for one of the larger chains would be bite-sized acquisitions but which are actually pretty substantial for its store base. And for Nash Finch, the margins in food retailing are higher than in distribution, and it actually has a pipeline of potential acquisitions when the companies it currently distributes to decide it's time to wave the white flag.

MURPHY: I think the Nash Finch story is pretty simple -- it's basically trying to grow something of a retail business that it will eventually sell to one of the bigger companies. And then the big question is going to be, if it pulls that off, what to do with a relatively low-return wholesale business that the company's management has done a very good job of turning around, putting in basic business practices and growing earnings and doing a very nice job. Right now it's still in the process of building those assets up, with only about 100 stores in what it calls the Upper Midwest region.