UNCHARTED WATERS

"'Gauging Global Opportunitiescompanies out there like Ahold and Carrefour and Wal-Mart and Costco that are all looking outside the borders of the United States, while the rest of the industry is looking at domestic opportunities.But at some point I think the industry has to start looking at some of the less-developed countries where there are a lot of mouths to feed and not a real organized infrastructure.

"'Gauging Global Opportunities

companies out there like Ahold and Carrefour and Wal-Mart and Costco that are all looking outside the borders of the United States, while the rest of the industry is looking at domestic opportunities.

But at some point I think the industry has to start looking at some of the less-developed countries where there are a lot of mouths to feed and not a real organized infrastructure. That's probably got to happen.

HUSSON: I think that as consolidation continues, U.S. retailers are going to become much more self-confident about their ability to compete on a global scale.

If you look at European ownership of U.S. food retailers like A&P and Food Lion and you consolidate all that, you'd get 14% of the market, and there isn't anybody in the United States with international holdings, with the exception of A&P and Safeway in Canada and Safeway in a small joint venture in Mexico, and that's it.

If Safeway's any good, and it really believes it is, then surely it will be looking for a role on the global stage at some point.

COMEAU: Still, that has to be a ways off, I would think -- many, many years away. I think when companies are pressed for growth three to five years down the road, that's when they may start to look at some of those global opportunities.

HUSSON: The consolidation party isn't over then.

Wal-Mart's Next Moves

SN: Once U.S. consolidation runs its course, what kinds of chains will be left?

HUSSON: I think $50 billion is a nice round number, isn't it? That's the level of sales you'll see.

ZIEGLER: Well, with Wal-Mart becoming a $250 billion company, do you think $50 billion is enough? It's a no-brainer that Wal-Mart is going to be there fairly shortly, since they're at $135 billion this year, and it doesn't take a terrific leap of the imagination, especially since it's gone from being an organic growth company to an acquiring company, to see Wal-Mart getting to $250 billion very soon. A lot sooner than Sam Walton thought it was going to get to $100 billion. So $50 billion isn't the stopping point.

HUSSON: But that's only going to be $50 billion in food, isn't it?

ZIEGLER: Well, food is growing more rapidly than general merchandise.

COMEAU: But still, for Wal-Mart to get to $50 billion in food is a big leap from where we are right now.

LEVIN: Except that if you really looked at sales of all consumables, Wal-Mart is pretty close to that now. The way you chop up Wal-Mart's data is, it still sells more consumables than any other supermarket operator right now.

COMEAU: But when you talk about Wal-Mart, it's virtually excluded, at least for the moment, from almost two-thirds of the country, just in terms of most metro markets. Wal-Mart would be hard-pressed to build a store in Chicago and get away with it. Maybe that changes in a few years time, but I agree with Mark -- I think that $40 billion, $50 billion or $60 billion is a workable number for a large company like Albertson's or Safeway to penetrate metro markets.

CERANKOSKY: The size of a company right after a merger doesn't really matter. Once the merger with American Stores is completed, Albertson's will be a $36 billion company, but if it sells off some divisions, then sales will be lower. And as other chains make acquisitions, they're likely to divest some of what they buy too.

The question to focus on at the end of the day is, what does the customer like. A&P was once the largest chain, but like Kmart and Sears, it's had to adjust its store count to focus on what customers want.

So operators can't afford to become too cagey about the need to grow bigger because product and service needs are much more important.

SN: Is Wal-Mart going to become an acquirer of supermarkets?

HUSSON: It has to. It's real estate-challenged right now in terms of supermarkets, and it doesn't have any square footage it can use, other than supercenters.

Supercenters are a powerful means of unlocking major edge-of-town sites or unlocking a shop for filling up with dry groceries and a little bit of fresh on a monthly basis, but they're not very good at feeding people on a daily basis.

The Wal-Mart Neighborhood Markets -- the 40,000-square-foot prototype that Wal-Mart will open in October -- look like a Food Lion with a Rite-Aid bolted on the side. Where are they going to get 40,000-square-foot units from?

COMEAU: Wal-Mart has 500 of them right now. It's going to roll those out in its dark stores for the moment. But the end game for them, I think, is to penetrate the metro markets.

HUSSON: But their dark stores are not 40,000 square feet.

COMEAU: They're 40,000 to 60,000, and Wal-Mart has about 500 of them in that range.

HUSSON: Have you seen the plan of the Neighborhood Markets? It doesn't fit 60,000 square feet.

COMEAU: Well, there's not a lot of difference between 50 and 60 or 40 and 60 when you're Wal-Mart and you're doing that type of project, whether you put in a patio shop or something else.

I'm not saying it's going to use all 500 dark stores for these units. I think it will use the Neighborhood Market format as a means to at least recycle some of its older real estate that's either dark or sitting there under the Bud's name doing $2 million a year in volume, or something like that.

And eventually it will penetrate metro markets in a pretty big way. It will be similar to what it's done with supercenters. Wal-Mart used a replacement-store strategy for the first two or three years and then really began doing more with brand new sites, not just replacement stores, as it's continuing to do.

But Wal-Mart is still largely a rural-based, secondary market-based food retailer, and there's no reason why its Neighborhood Markets can't be put into 200 to 300 stores in the next couple of years in conjunction perhaps with entering the metro markets through an acquisition or with stand-alone units.

CERANKOSKY: Don't count Wal-Mart out. It obviously likes the food business and wants to grow, but it knows it can't put supercenters as close to one another as you can put supermarket locations. But it's developing this Neighborhood Market prototype, and the next logical step may be jump-start the format's growth with an acquisition of an existing retailer.

Wal-Mart's Supermarket Entry

SN: When you compare the challenge to conventional operators from both the Wal-Mart Neighborhood Market and supercenters, in what ways are the challenges different and in what ways are they similar? Is it going to affect different operators differently?

ZIEGLER: If the 40,000-square-foot Neighborhood Market goes into suburban areas or central cities, it's going to hit where it hurts.

Gary Michael [Albertson's chairman] talks about how his weekend traffic drops off because of the supercenters, which indicates that what they've become is a stock-up outlet.

I don't think they're a strong format for doing HMR, for example. The 40,000-foot stores will put Wal-Mart in that business, and the drug portion of those stores is going to be a drive-through.

HUSSON: Which is why the locations need to be so convenient, if they're going to have a drive-through pharmacy.

ZIEGLER: On the other hand, I don't think the Neighborhood Market is going to have the economics of the supercenter. Assuming Wal-Mart doesn't make an acquisition, it's going to be higher-cost real estate and it's got to get labor for it.

The GM in the mix is going to be relatively smaller than it is in a supercenter, and pricing can't be as aggressive in food as it can be in a supercenter, so the store is going to have to draw on convenience. It's going to be a different formula.

LEVIN: In the big picture about Wal-Mart and who it impacts, the issue is capacity. And if Wal-Mart commits to a format like the 40,000-foot Neighborhood Markets, as we've seen them do with the supercenters and Sam's Clubs, it becomes a capacity issue because it has such huge cash flow, and it's not that Wal-Mart really runs better formats than any of the supermarket operators but it will drive competition, which puts pressure on operating margins.

Pressure on operating margins gets you right back into how to improve economies of scale, which leads back to market consolidation activity.

HUSSON: I agree. If Wal-Mart opens 40,000-square-foot stores in any numbers in metro markets, then the pie that's out there is cut yet another way. But we don't even know if this format works yet.

BERNSTEIN: I think it's an important point that this 40,000-square-foot format is still a prototype, and Wal-Mart hasn't committed to it yet. And it's interesting in that it will put Wal-Mart squarely in competition with the good supermarket operators.

And I still contend that supercenters, while they do take sales from the supermarket operators, don't always appeal to supermarket shoppers who don't want to commit the time or to walk through the entire store.

So when Wal-Mart does go to 40,000-square-foot units, it will appeal to broader classes of consumers, and it will also run up directly against the good supermarket operators, and that will be interesting because Wal-Mart is not the best food merchandiser out there. It has a long way to go in that regard. So it will be an interesting fight.

Performance Outlook: Focus on the Top Line

SN: Let's discuss the near-term outlook for the industry in terms of financial performance, same-store sales, operating earnings. Are we looking at a positive future?

CERANKOSKY: Despite a lack of food inflation, the industry is doing a good job controlling changes in the cost of goods, which often means paying less for merchandise than you did a year ago.

Even if there's an uptick in inflation, consumers overall have to be happy with the stable food prices, and food operators are finding that, when you manage your business properly, you can enjoy some deflation in the cost of goods sold, which improves gross profit margins. LEVIN: I think there are still benefits to be had from investments in technology, in new stores and distribution, and that's where you'll see increases in earnings coming from -- but those earnings increases will come in the context of a very tough competitive environment with no inflation, and so really all the operators have to fight to improve their identical-store sales, and I don't expect inflation to help, because even if it picks up, it's going to pick up only slightly. It's just not going to be a big factor.

BERNSTEIN: Efficiencies and margin improvement will help overall profitability and cash flow, but I think there's still a tremendous amount of pressure on the top line for a variety of reasons, and one of the biggest is, there's a tremendous amount of sales leakage outside the traditional supermarket industry to supercenters, drug stores, general merchandisers -- companies that are selling food and the like -- and I think that's hurting the same-store sales growth across the country significantly.

COMEAU: I'd say the second half of the year is going to continue to be somewhat of a mixed bag, depending on who you're looking at.

Some of the big guys, like Fred Meyer, Safeway, Kroger and probably Albertson's, will all have good second halves, while others may or may not. And some of the marginal operators or other companies that have been prone to competition or shortfalls will probably have shortfalls.

If you look at last year's results, the overall industry did reasonably well in food profitability.

But with the leveraging and some of the acquisitions that have occurred, you have continued to see ongoing fallout, so I think the view for the balance of the year would be no inflation and a mixed bag of operating results more or less gravitating toward the better, larger and even better-managed companies delivering the goods in terms of earnings in the second half, while others, perhaps, continue to have some difficulties.

ZIEGLER: Perhaps there are some new issues developing right now that seem to indicate the virtual calm in some markets might heat up again, because whenever there's a change in ownership, the guys in the market step up pressure just to grab customers who are in play, so to speak, as we've seen in southern California with Hughes and Ralphs, and now we have another potential change there, with Albertson's and Lucky.

Chicago is a hot bed of activity right now with the changes that are going on there, even before the change in Jewel's ownership, so I'm not really sure we can predict how that's going to be. Suffice it to say that getting that top-line growth is going to be a real battle, and how happy can we be when the top player in the industry gets 5% comps? I mean, that's good.

At least, that's what we think is good, but years ago you were getting 9% to 10% comps. Now we're happy to see a plus in front of it.

LEVIN: But you had a different inflation picture years ago.

ZIEGLER: That's correct, and we had a problem with inflation. I think we suffer from two forms of deflation -- too much commodity deflation and too much real-estate deflation -- though I think they're starting to find a cure on the real-estate side.

SN: Are you referring to irrational pricing coming into the picture?

ZIEGLER: Yes. I think that when you have changes in ownership, pricing by the other guys gets more aggressive because they say, "Oh, these customers are in play. There's going to be a change in ownership and maybe a change in format. Let's see if we can pick them up."

And so what we have to watch out for now is the competitive reaction to the changes in ownership. As these changes in ownership continue, which I expect they will, we'll have more of that. And things will just get intensely promotional. For example, the frequent-shopper card introductions are kind of running their course now, and we're probably over that hurdle this year.

HUSSON: I think there's always a tendency to try and beat the bushes and see if any bird flies to a different bush when ownership changes.

COMEAU: With changes in ownership, you do have some greater volatility in the interim, but you end up with a little more volume going back out into the market, and closings, and ultimately more rational operators.

HUSSON: And things will change as the ECR promise starts to be fulfilled.

As space is liberated in stores because stores will no longer need to hold stock, stores will stop being warehouses and start being marketing tools, and then you're going to start seeing food retailers putting their hands in other people's pockets and taking market share back on some consumable items because the supermarket is such a logical place to shop on a daily basis.

Using Marketing Muscle

SN: To what extent are operators going to have more difficulty merchandising to local tastes in the midst of continued consolidation?

BERNSTEIN: At the end of the day, no matter how few major chains there are, supermarkets are still going to be a local business, and I think that overall, while the core of the store is going to be what's supplied and what's purchased centrally, there's always going to have to be some sort of community focus.

If it's a particularly ethnic community, you're going to have to reflect that in the food. Otherwise, there really is no point of differentiation. And that, I think, will continue to survive.

LEVIN: With information coming from point-of-sale systems and category management, companies are finally starting to use the information, although they're still in the very beginning stages.

In addition, they are getting better and better at understanding what they are selling, how many facings it should have, how they should price it, how they should promote it, what the selection should be. They can do much more in terms of tailoring their selections to a neighborhood, and I think supermarkets are just going to get better and better at that as they use the information that's coming through.

That's particularly true with those companies that have loyalty-card programs and have a real sense of what individual customers are doing and what their best customers are doing.

BERNSTEIN: The micromarketing aspects of the frequent-shopper programs are probably the most appealing component, if that information is used properly, though I don't really know any supermarket operators that are using it to the utmost.

It's an extraordinarily powerful promotional tool, and it's simply a matter of using the data they're capturing, rather than just storing it on a hard-drive somewhere.

It's a matter of pro-actively merchandising the individual store based on what they've learned. I think that as more data is collected and operators get smarter in using technology and using the technology investments that have been made recently, you'll see that. In the next several years you'll see a lot of growth in that area.

SN: How is the data being used?

HUSSON: A friend of mine whose a lecturer at UCLA went away on holiday for about a month, and when he came back there was a voucher on his doorstep from Vons saying, "We missed you, and here's $10 off your next $50 purchase."

And he had a child recently, and within two weeks of starting to buy baby products -- Gerber was not something he ate normally -- he started getting vouchers for diapers and things for his baby daughter.

Main Courses For Meal Merchandising

SN: A year ago, there was a lot of negativity in SN's roundtable about meal solutions and whether or not operators really should be in this business to the extent that people were talking about. Has thinking changed at all in the course of a year, because companies certainly have not stopped talking about growing their home-meal programs.

ZIEGLER: There's so much that has to be accomplished to make HMR profitable and to make it work, and the industry probably is a year further along than a year ago.

But I think it has to be in the business. It's got to win back that share of stomach from the restaurant industry or the take-out industry, but there are so many issues beyond just moving tonnage -- labor training, thinking like institutional food-service folks -- to make it really hum.

And I think we have as many years of evolution ahead of us as we do with frequent-shopper cards and consolidation. This industry is in a real state of flux, although it's moving in the right direction and learning something all the time about how to tailor each concept. But I'm not hearing anybody that's happy with the bottom line on HMR.

LEVIN: The real challenge is keeping that profitability, but I would point out that Dominick's has done a fine job just emphasizing perishables in general at its Fresh stores, which have a lot of home-meal replacement, and I think it's done a really strong job with those stores -- so much so that it's changed the Omni warehouse stores over to the Fresh format. And even though it took a significant loss in sales, I think that's going to start building back up.

And Fred Meyer has some real opportunities to learn from Quality Food because it has done a lot with home-meal replacement as well.

I suspect Albertson's will take a look at what American Stores has done in the individual divisions and at its own Quick Fixin's program, and it will probably be able to further refine that program.

So I think progress is definitely being made, but the challenge remains getting those profits.

COMEAU: Hot prepared food has really come a long way in this industry in the last few years. And everyone is experimenting. In fact, they were probably at the peak of experimenting a year or two ago.

But in terms of prepared meals to take home and eat the same evening, I don't know if I've seen an awful lot of progress in that area, despite a lot of experimentation. I haven't seen any real material change in HMR from a year ago to now, other than agreeing with Jonathan that we're a little more knowledgeable about it.

When you compete with restaurants, aside from just the food quality and the labor issues, you've got a big issue concerning convenience, and it's still an awful lot more convenient many times to stop off at a fast-food Chinese or pizza place instead of going to a supermarket to get your meal on the way home.

HUSSON: Coming from a European perspective, I have some very black-and-white views on the whole home-meal replacement issue. And my views are that, any food prepared in the store is wrong because no one's convinced it's fresh and also because the labor is just prohibitive because you're working on pathetic batch sizes.

And any food heated up in the store and sold other than in a canteen in the store, which I'm still not convinced makes any money, is probably wrong, too, for the simple reason that it's probably not going to be convenient and, by the time you get it home and nuke it in the microwave, the eating quality is disgusting, and that doesn't build brand loyalty and doesn't do anybody any favors at all.

I think the real problem with home-meal replacement in the United States is not so much with the retailers, it's with the manufacturers. There just aren't any manufacturers that have got a vision for this. No manufacturers have taken the time to build plants, to deliver goods that are chilled, never frozen, fresh eating meals that you can put in a fridge with a three- or four-night shelf life.

Perhaps until now, the distribution chain in the United States has just been too long to deliver product that has only a three- or four-night shelf life effectively to a consumer and not incur massive amounts of waste on the shelf in the store.

The final point is retailers don't have enough refrigerated equipment in the store. You have to invest huge amounts in refrigeration.

So I think the answer is to do this with scale, to do it chilled, to get somebody else to do it, because good retailers aren't good manufacturers -- and that just hasn't happened. The good manufacturers just haven't taken the ball and run with it, and the retailers' amateurish efforts at doing it in stores I think are doomed to failure.

ZIEGLER: I agree that the food has to be prepared off-site. That's the way Ukrop's does it, and it's been successful.

And you need market share to make that commissary effective. And you need to get probably three deliveries a day in the store for each meal time, and you've got to clean it out. If you're going to do breakfast, it's got to be out by 8:30 or 9 a.m., and then be empty for a while and then come in at 11 with lunch and then clean it out.

And it can be done. We spent some time with 7-Eleven in Japan, and they do it over there. They have three deliveries a day. Now that's a different country than this, but I think that on a micro basis, you can take a market like Richmond, Va., where Ukrop's has significant market share, and they can make it effective. That's what has to happen. So that's another reason for consolidation and building share.

HUSSON: Part of the problem in the United States is, you have massive cities and then you have big distances full of nothing. And if you've got three days of shelf life and you're spending a night or two on the road, it becomes very difficult to distribute that product from a central manufacturing facility.

However, if you are Kroger in Atlanta, which is a massive and a relatively affluent market, it would probably work, just for the Atlanta market. So big retailers with large market shares can do it in big cities, and little retailers are just stuck.