Analysts' Roundtable, Part 3: Alternative Formats Continue to Gain Traction

Analysts' Roundtable, Part 3: Alternative Formats Continue to Gain Traction

Aldi poses an increasing threat to traditional supermarkets, according to analysts at SN's 15th annual Analysts' Roundtable. The Batavia, Ill.-based limited-assortment retailer is a very productive store with a true, very powerful value-for-dollar offering, said Andrew Wolf, managing director for BB&T Capital Markets, Richmond, Va. It's the stealth bomber, added Neil Currie, executive director at

Aldi [4] poses an increasing threat to traditional supermarkets, according to analysts at SN's 15th annual Analysts' Roundtable.

The Batavia, Ill.-based limited-assortment retailer “is a very productive store with a true, very powerful value-for-dollar offering,” said Andrew Wolf, managing director for BB&T Capital Markets, Richmond, Va.

“It's the stealth bomber,” added Neil Currie, executive director at UBS, New York. “It uses its buying power very well to engineer not only a low price point but also a very decent quality product.”

Susan Anderson, senior analyst with Citigroup, New York, noted that “some CPG managements think very highly of Aldi, and don't think of the lower-income consumer as its core consumer — they see it as more like a middle-income shopper.”

However, Scott Mushkin, managing director at Jefferies & Co., New York, noted that a shopping trip to Aldi “is a forced shop in a lot of ways. You can warm to it, but at first it's something that you're forced to do.”

Tesco [5]'s small-format Fresh & Easy Neighborhood Market concept, meanwhile, appears to have made some improvements, Mushkin and others pointed out.

Mark Wiltamuth, executive director at Morgan Stanley, New York, noted that although Fresh & Easy “had some missteps right off the bat,” the company “put so much capital into getting the infrastructure started, you knew it was going to be there for the longer haul, and Tesco would keep tweaking the marketing and merchandising.”

Analysts also discussed Whole Foods Market [6], Austin, Texas: “It's hard to change your price image, but Whole Foods did a number of things to get a credible price image, and it shows up in its same-store sales … [and without] the sacrifice of gross margin,” said Gary Giblen, executive vice president of Quint Miller & Co., New York.

Following is Part 3 of the Roundtable:

SN: Delhaize [7] recently announced that Bottom Dollar was moving into Philadelphia. Anybody have any ideas on its prospects there?

SCOTT MUSHKIN: Philadelphia is one of the toughest markets in the United States right now. Besides Delhaize moving up with Bottom Dollar, you have Wal-Mart [8] with a focus on its urban strategy and Target [9] coming in with P-fresh, plus Giant-Carlisle [10] coming in from the west and ShopRite [11] being very aggressive. Plus, you've got a little bit of A&P [12] down there, and you've got Genuardi's. So it's just a disaster market.

It's one of those markets where you'd think, in three or four years, that it's going to have to consolidate. We've all heard the same rumors — that Acme's for sale. Philadelphia is a market that's not always going to look the way it does now.

GARY GIBLEN: Let's not forget about Philadelphia's militant unions. That's been an impediment to Acme and Super Fresh/A&P there, and the unions would likely fight hard against the entry of a non-union operator like Delhaize.

NEIL CURRIE: As a general comment, I think it is wise for companies like Delhaize to explore alternative formats because you see so many other businesses going to other formats. That's the problem the supermarket industry has had for the past 20 years — it's failed to address the loss of share that it could have addressed itself with a multi-format strategy.

SUSAN ANDERSON: That's where Kroger [13] has been smart with Food 4 Less, and I also think its value private-label brand. Instead of letting that customer go to the discount supermarket, it's increased its penetration with the value brand.

CURRIE: I saw that happen at Tesco in the 1990s, when Aldi came to the U.K. market. Aldi never really got the foothold in the U.K. that it's gotten in other countries because Tesco said, “Well if my shoppers want to buy a very basic product, I should give it to them,” and it was prepared to develop a range of products to do that. It caused some margin degradation, but ultimately the marginal shopper is your most important, and you don't want to lose him.

SN: That said, how influential do you think Aldi can be in the U.S.?

CURRIE: It's the stealth bomber.

ANDREW WOLF: Way more influential than the dollar stores. Dollar stores don't do the business that Aldi does.

CURRIE: Dollar stores look relatively unproductive compared with Aldi.

WOLF: They matter, but the whole dollar store industry is the size of Walgreens' front-end, so we might as well be talking about Walgreens' fresh initiative as talking about the dollar stores' initiatives.

I was out with some of the people from Ruddick [owners of Harris Teeter [14]], and they were talking about Aldi coming into the market and how that's the newest threat and a company to keep an eye on. Harris Teeter is fairly upscale and Aldi is pretty downscale, but except for maybe Whole Foods, most grocery stores have at least some overlap with Wal-Mart supercenters and Aldi.

Even Wal-Mart probably sees more issues with Aldi than with dollar stores. Aldi is just a very productive store with a true, very powerful value-for-dollar offering for its customers.

CURRIE: A 15,000-square-foot Aldi can do the same sales as a 35,000- to 40,000-square-foot supermarket, so the size of the stores is somewhat illusory. But you'd probably get the same excuse from supermarkets that you got 10 years ago when it came to Wal-Mart — our customers don't go there. Well, enough of them do go shopping at these alternative formats to make a difference.

MUSHKIN: I agree with the comments about Aldi's productivity, but to me, an Aldi shop is a forced shop in a lot of ways. It's not like consumers say, “Hey I'm going to the Aldi and I'm pumped about it.” The U.S. consumer is still aspirational. We haven't completely beaten that out of the U.S. consumer.

Even Ruddick is talking about Aldi right now because the economy in the Southeast is horrid — unemployment rates are high, and it's just a terrible economy down there, so people go to Aldi. They are great operators, but it just seems to me like a forced shop.

CURRIE: Still, if you get somebody shopping there for a year, it becomes ingrained.

MUSHKIN: I agree with you 100%. I think you can warm to it — you like it, you try the private label and you may get converted. But I think at first it's something that you're forced to do.

The dollar stores are the same way. Most people shopping the dollar channel as their main source for food do so out of economic necessity, in my opinion.

MARK WILTAMUTH: The dollar stores are kind of a top-up shop. The ultimate shopper there is the lowest-income consumer who's interested in a low price point. It's not value per item — it's about the price point. Those stores are taking incremental shoppers from the grocers, but at the end of the day it's not a major threat.

CURRIE: The thing a lot of retailers underestimate about Aldi is that the quality is a lot higher than they assume — it uses its buying power very well to engineer not only a low price point, but also a very decent quality product. And while it might take somebody being distressed to go there, I think Aldi ends up with a lot of very loyal shoppers.

MUSHKIN: Again, I completely agree. A CPG company that does a lot of private-label business with Aldi would tell you at length about how quality-focused Aldi is in its private label.

CURRIE: In that respect it's similar to Costc [15]o.

ANDERSON: And some CPG managements think very highly of Aldi and don't think of the lower-income consumer as its core consumer — they see it as more like a middle-income shopper.

MUSHKIN: But still, for the American psyche, I think the first shop there means something bad has happened to you.

SN: Does any other company have a vehicle that can compete with Aldi?

CURRIE: Wal-Mart, which has been [exploring the idea of] 20,000- and 30,000- square-foot boxes with a pharmacy — not like Marketside or Neighborhood Markets necessarily, but a format that takes some elements of Marketside and some elements of Neighborhood Market with a pharmacy that offers a vehicle to go into, along with supercenters and more compact formats.

Wal-Mart has learned from Mexico, from other retailers, and from its own operations across the world that you get very good returns from smaller units when you tack them onto your infrastructure, and the company sees a big market-share opportunity.

MUSHKIN: What was interesting about the four Marketside stores Wal-Mart opened in Arizona is that they are like the un-Fresh & Easy. I feel like Wal-Mart got a lot right in those stores, though they didn't have the volumes because they weren't big enough and because they were converted from drug stores — and they didn't have pharmacies yet. But the Marketside shop was actually quite nice.

CURRIE: Wal-Mart saw what Tesco was doing, and it wanted to see what it might do with a small format, though I don't think Marketside is something it will move forward with. But Marketside has been very successful in some elements, such as developing a range of ready meals to put into a more conventional-looking small-store format.

WILTAMUTH: Wal-Mart has to get the right return equation. It's been playing with Neighborhood Markets for years, and nothing has really gelled from a return perspective. Drop it between the fingers of all the supercenters, and it can start to build a fill-in strategy. But it has to get a model that is going to get a return on investment.

CURRIE: I always thought the problem with Neighborhood Market originally was that it was Wal-Mart's attempt to do a supermarket. But why do something that isn't going to work long-term?

So I think the new version of Neighborhood Market is Wal-Mart's attempt to take a more “today” approach with a much more edited selection of high-volume products. The thing it will need to get right is the labor model and the packaging model, with more shelf-ready merchandise so it can handle the products a lot more quickly in the stores.

I also think we've written off Fresh & Easy far too quickly.

Fresh & Easy

MUSHKIN: I think you're right about Fresh & Easy. Many people have written it off, but it has undergone a lot of changes in the last six to nine months, and our market sources are saying it's doing much, much better.

WILTAMUTH: The thing with Fresh & Easy is, it put so much capital into getting the infrastructure started, you knew it was going to be there for the longer haul and Tesco would keep tweaking the marketing and merchandising. It definitely had some missteps right off the bat, and it's still not a size to be a threat, except perhaps locally here and there. Despite all the Fresh & Easy openings Kroger faced in Arizona, it just didn't feel anything from them.

WOLF: I always thought the price-to-quality ratio at Fresh & Easy was amazing. It's like a Trader Joe's with more perishables in a smaller format, and I thought the dollar-for-value there — just in shopping the store and buying quality sushi or ice cream at “x” dollars less per unit — was compelling. I don't know if it was the sterile environment of the stores, or just putting them in some non-descript Tier C strip centers and not advertising — clearly it's had a traffic issue — but the core offering to consumers struck me in a positive way.

That said, Fresh & Easy seemed to have a tin ear about how to connect with American consumers — we don't like sterile stores, we want to see a few people in the stores — but Tesco just didn't understand we don't relate to this vacuousness.

CURRIE: I think Fresh & Easy did a lot of research and built its business model around that research, whereas I think it should have evolved into the blueprint rather than laying out the blueprint straightaway. There were too few SKUs, and I think it's added about 1,000 SKUs in the past year. It's also raised shelf heights to accommodate that, and it actually feels more like a supermarket now, whereas it felt like too much of an alien concept in the beginning.

WILTAMUTH: It was trying to train the consumer into too many things at once. It was trying to push them into 50% private label in the store, and it was trying to push everyday low price, whereas the consumer likes high-low, so Fresh & Easy probably missed the boat there. And then consumers were saying they weren't seeing enough brands.

There was too much different at the start. Take, for example, the way you shop for produce there — the retailer has already pre-selected a bag of apples for you rather than letting you pick the individual apples. Some of those things were turnoffs.

MUSHKIN: Yes, not being able to touch and feel the produce was a disaster. We referred to it at the time as a “food prison,” and that's what it felt like. You felt bad shopping there. Again, it was just a misread of the American consumer. It goes back to the aspirational shopper point.

CURRIE: I think it was mis-execution. I think Tesco read how the American shopper was shopping and designed a blueprint based around a particular shopping trip that we talked about before [in the first part of the roundtable] — that you don't need a 60,000-square-foot store to do $100,000 worth of business a week.

But it wasn't a recognizable shopping trip from the get-go. There were too many revolutionary differences, including self-checkout. Maybe over five years it could move to self-checkout as people became more comfortable with the format, but to do it from the get-go was too bold.

WILTAMUTH: If you look at the original store locations, Tesco seemed to put a Fresh & Easy store in every type of demographic market to see what happened, and maybe now that it's gone through that first round, it can see which demographics it resonates in and maybe steer it a bit better from here.

Whole Foods

SN: Any thoughts on the rebound of Whole Foods?

GIBLEN: It's a reinvention, and it's extraordinarily impressive. It's hard to change your price image, but Whole Foods did a number of things to get a credible price image, and it shows up in its same-store sales. And it was not done at the sacrifice of gross margin — the lowering of prices was made up for with increased traffic, a richer merchandise mix and a cost-of-goods pushback on vendors.

WILTAMUTH: Some of it is just optics. I went through some Denver and Boulder stores, and there are yellow signs right when you walk into the perishables section promoting price — it hits consumers right when they come in the store, so they are a little more mindful of the price image now.

WOLF: I think the Whole Foods customer went on strike for six months like everyone else's customer and traded down to a cheaper store and then back to Whole Foods. So the customer did come back, and apparently volumes at Whole Foods are off the charts as consumers are back spending money. And Whole Foods has a high-end customer who realizes they're intact and that food is very important to them and that they can afford to pay a 20% premium — not for a swimming pool or an Audi but simply for organic chicken legs. So the Whole Foods customer is back, and therefore the prior level of business is back.

What I'm interested in, as we head into fiscal year 2011, is can Whole Foods still attract new customers? The inherent demand is there — a lot of tracking studies have been done on people's attitudes about natural foods, and it's still going up like clockwork — so the demand is there. The question is, will the people who want to eat better be able and willing to convert to a 20% price premium?

That's where I think things should get really interesting for Whole Foods — when it's up against tough comparisons, how will the basket vs. ticket flesh out? We can talk about trading up and trading down, but basically its base business is intact, and it has also benefited from having some conventional operators abandoning or at least ratcheting back on their organic business.

WILTAMUTH: The company has secured better buys on a lot of perishable products — that's how it's doing those produce ads up front.

WOLF: And it's gotten more active with all its vendors. It has coupon books the vendors are helping to fund.

GIBLEN: And it keeps on expanding private label, which is good because that's the tool by which it can offer comparable pricing to a conventional supermarket. It also has classes and seminars on how to shop the stores and — I've actually done this as a consumer — if you buy its Whole Deal specials from the chain's circular, your food bill comes out the same as or better than if you're buying high-quality foods at a conventional supermarket.

WILTAMUTH: Whole Foods has always been priced better on the exact same items than your typical conventional store because it has the buying power.

GIBLEN: And even if you buy the organic brand — if you're careful to buy it when it's on the Whole Deal special — it's the same as or cheaper than the conventional product at, say, Stop & Shop.

MUSHKIN: Isn't it really ironic, though, if we summarize what's happened over the last 18 months — that there's been a massive attempt to try to firm up the lower and lower-middle class and maybe the middle class while basically the people who are doing well are more well-off, and we've said Wal-Mart is struggling because the low and middle classes continue to struggle, yet Whole Foods is doing really well because the upper-end consumer is back? I just think that's so ironic.

CURRIE: I don't think they're back. I just think Whole Foods has done a great job of bucking the trend. The high-level consumer came back with the stock market for Whole Foods. I definitely underestimated its ability to attract that shopper back, but Whole Foods did a remarkable job, as Gary said, in a relatively short space of time, of really improving its price perception, which is really what it's all about.

MUSHKIN: I definitely don't want to take anything away from the Whole Foods management team because I agree it's really improved the chain's price perception by basically telling shoppers, “Hey, it's OK to shop here.” But at the same time, if you look at the higher end — Kroger said its higher-end stores are flying, and you see Fresh Market going public with its gourmet stores and Whole Foods doing well — I just find it ironic that we've had the high-end, at least in food, get much better.

WILTAMUTH: It may speak to the employment issue, where the upper-end consumer feels he's not going to lose his job and is therefore moving forward with the attitude, “I'm out of the crisis of 2008 and 2009 and now I can come back.”

GIBLEN: The key is, it's the “low ticket/feel good” indulgence, which you can still enjoy unless you're totally on the outs financially. I follow a wide gamut of companies, including beauty and cosmetic companies, and those companies are knocking the cover off the ball. You can buy a $15 cosmetic item or a $30 fragrance that can lift your sense of attractiveness and, indeed, your whole outlook. It's not called “hope in a bottle” for nothing.

CURRIE: With Whole Foods as well, there still remains that secular shift toward people wanting to eat healthier. You also haven't seen the restaurant industry recover yet — there have been two years of negative comps among restaurants, and to some extent, Whole Foods has benefited from that. But that's not to take away from the fact that it moved very quickly to improve its pricing image and made it easier to make that decision to eat healthier. But we're not talking about whole swaths of middle-income shoppers coming back because I'm not sure it's recovered completely all the customers it lost.

WOLF: The other thing Whole Foods did was it clamped down on its cost structure, which had been close to extravagant.

WILTAMUTH: It's kind of lapped out of that, and now it's all about the comp.

WOLF: Well, it's lapping out of it, but that doesn't mean it wasn't relevant. It took a lot of the cost savings and helped fund the price enhancements. And that gets back to Whole Foods being a non-union chain.

What I think it is going to do — what [co-CEO John] Mackey [16] has been hinting at — is get back into a stronger organic growth mode because he thinks Whole Foods can generate better returns with its current approach to new stores. Remember, aside from the economy, what got Whole Foods in the ditch was growing too fast, with a lot of huge, ostentatious stores that make sense in Manhattan but not in the middle of Ohio.

WILTAMUTH: And along with the Wild Oats acquisition, the knock on Whole Foods was, where's the return on invested capital?

WOLF: Yes, it was bleeding cash, but now it's going to build up a billion dollars in cash for a relatively small company, in a sense, and I think it's going to put it into some new-store growth. Management said the company has gone back to five years' break-even on an EVA basis, down from seven years, because it brought down the costs of running the store — just simple things like having more refrigerated space in perishables so things don't go bad if they're on the shelf for a few more days.

If you go in the stores, they're much simpler-looking. As an analyst you could say the stores look like a regular supermarket, until you notice they still have a lot of the bells and whistles of Whole Foods, but they don't have the obviously costly things like five in-store restaurant concepts that never could make much, if any, money. Just look at the engineering of the store — it's pretty obvious it's much lower-cost now.

MUSHKIN: I completely agree with what you're saying. The cost-per-square-foot was going up 20% to 25% in the boom times, which was just a ridiculous number, but management got control. The question is, is Whole Foods going to go too far over in the other direction?

CURRIE: I'd rather it be in that direction and let the products speak for themselves than the direction it was in before.

WILTAMUTH: Whole Foods is probably the only really differentiated food model out there. It really has broken out from the pack, as it always has.

MUSHKIN: With the possible exception of Fresh Market. I think Fresh Market has a decent model, and it's been growing quickly. It's an interesting format, with 22,500 square feet and lots of perishables. It is undoubtedly a true competitor.

CURRIE: There's a fine line between success and failure with the fresh food model. You've got to get the sales per square foot; otherwise, you have a huge shrink bill. So it's all or nothing.

MUSHKIN: Fresh Market does pretty well. In fact, its EBITDA margins are actually higher than those of Whole Foods.

CURRIE: The concept is a good one because it offers what people are buying on a regular basis from supermarkets, so why not just have a format based around that? The issue is, you need to have good productivity — otherwise, there's too much waste.

WOLF: A lot of retailing is culture and human capital. The thing about Whole Foods is that anybody who has experience shopping there knows its employees are incredibly knowledgeable and turned on, and that's a big part of retailing. Mackey talks about making food retailing fun, and Whole Foods does that, just like Wegmans does. That's the miracle of it, and that's what's hard to replicate.

MUSHKIN: The human capital is one of those things that's hard to quantify, but I always think people underestimate it. I did a tour of one of Whole Foods' Connecticut stores, and the store's communications director had a master's in communication from one of the state universities in New York. You walk into any of the traditional supermarkets, and there's no way someone like that would want to work there. This woman wanted to work at Whole Foods.

But when you look across retailing and look at the graduate business school students, those people are going to the P&G's and the General Mills or the Wal-Marts, but they aren't going to the Krogers and the Safeways.

WILTAMUTH: More importantly, you're going to find someone at the Whole Foods cheese counter who's a total cheese fanatic — who can tell you about every single one of those products on the counter, where it came from, what the provenance is. That's the real selling point in the store — that the employees are foodies, and they're trying to get you excited about food.

MUSHKIN: That's why Kroger really needs to make this transformation to attract the human capital. People are attracted to success, and if you're a company that's not growing and your margins are shrinking and you're just fighting for your life, you're not going to get the human capital you need.

GIBLEN: Once again, the unionization issue rears its head. It adds cost and reduces staffing flexibility and efficiency.

CURRIE: Does it, though? Look at Costco — look at its pay scale and benefits. It's a Rolls Royce. To Scott's point, it's a great investment for Whole Foods because it gets the highest productivity in retail, and not just in sales but in operating profit per employee as well.

WILTAMUTH: Low margin plus high asset turns equals high return on invested capital. That's the driver for Costco.

Coverage of the Roundtable was included in the Sept. 13 [17] and 27 issues [18] of SN as well and is available online. This is the third and final installment.