Facing Headwinds

Facing Headwinds

Retailers are unlikely to be able to raise gross margins over the next year as consumers hold onto their value orientation about food shopping, according to a panel of industry financial analysts at the 15th annual SN analysts' roundtable. I don't believe we're in a recovery it's more like we've had our economy reset, and shoppers have become more pragmatic, Neil Currie, executive director for UBS

Retailers are unlikely to be able to raise gross margins over the next year as consumers hold onto their value orientation about food shopping, according to a panel of industry financial analysts at the 15th annual SN analysts' roundtable.

"I don't believe we're in a recovery — it's more like we've had our economy reset, and shoppers have become more pragmatic," Neil Currie, executive director for UBS Securities, New York, said. "To some extent, any improvement in spending activity might not necessarily include food spending."

According to Gary Giblen, executive vice president of Quint Miller & Co., New York, "The chains have done a good job cutting costs where they can, [but] cost-cutting has been all wrung out and played out, to some extent."

Scott Mushkin, managing director at Jeffries & Co., New York, expressed similar sentiment. "People continue to struggle financially [so] it's a very different macro-environment, and people are reacting by being careful how they spend money and by saving more," he explained.

The industry has lowered gross margins about as much as it can, the analysts pointed out. "The industry has given back a lot of price to the consumer, and it's not going to snap back," Mark Wiltamuth, executive director at Morgan Stanley, New York, said. "The price sacrifice we saw last year is here to stay, and if we get a recovery coming out of this, it is not going to be sales plus gross margins going higher."

The drop in margins was lead by Kroger Co. [4], Cincinnati, which may have gone too far, the analysts noted. Speaking of Kroger, Currie said, "It got the balance wrong last year in going for too much volume at the expense of margin."

Andrew Wolf, managing director at BB&T Capital Markets, Richmond, Va., also said Kroger "went a little too far and forced everyone else's hands more than it would have liked.

"I wouldn't expect gross margins to go up anytime soon at Kroger, but if the industry is going to have a better year in 2011, then Kroger is going to have to lead the way within the conventional channel in being more rational. It could stop investing in price ans still maintain its price image."

Wiltamuth offered a similar prediction. "What Kroger has to do is show more margin discipline. It doesn't necessarily have to involve gross margins going up, but it has to involve not slashing prices as much as it has in the past. Kroger needs to have that balance between sales and margin — that's what it needs to focus on."

As far as Mushkin is concerned, Kroger has to give some consideration to boosting margins so it can get "that return on capital moving in the other direction, and the only way to do that is to get margins going in the other direction."

For Pleasanton, Calif.-based Safeway [5], it's a matter of getting customers to believe its new pricing policy is for real, Giblen said. "Safeway was late to the game of price parity to begin with, so it could be that the rest of the year is going to be tough for it on both sales and margins," he pointed out.

Wolf said he thinks Safeway could "come up against a dilemma" next year about changing its price image. "If Safeway is serious about its price image, it is going to have to go through what Kroger did" after if lowered prices several years ago, he said.

Wiltamuth said he isn't sure Safeway really wants to be a price player. "I don't think Safeway is going to change its stripes and become the next Kroger. Safeway wants to be differentiated and a little higher quality, and I think it will be happy to charge a little premium if the customer will take it."

If Wal-Mart Stores [6], Bentonville, Ark., is able to move into more urban markets, that could impact Safeway significantly, Susan Anderson, senior analyst at New York-based Citigroup, said. "Safeway probably has the least overlap of anyone with Wal-Mart, so if Wal-Mart is successful going into more Safeway markets, you are going to have a huge issue unfold," she said.

Wal-Mart is going through a transition of its own as it tries to move away from some of the moves it's made over the past three years and get back to trying to appeal to its core base rather than expanding the base, analysts said.


“What the supermarket industry faces is the threat of a Wal-Mart that understands it's lost some pricing image and wants to get it back,” Currie said. “I think the risk for the sector is that, while Kroger potentially becomes more disciplined, we will see a Wal-Mart armed with significant SG&A improvements that could enable it to potentially reestablish its pricing image.”

For Mushkin and Currie, the biggest challenge from Wal-Mart could come if it's able to tap more urban markets with a smaller store footprint. “That's the No. 1 threat Wal-Mart poses right now — urban,” Mushkin said.

With more big cities, including Chicago, willing to accept Wal-Mart, “Wal-Mart's going to have a much more coordinated approach toward urban markets,” Currie said. “I see urban markets as an $80 billion to $100 billion opportunity for Wal-Mart, and I think politicians want and need the tax dollars, they want the job creation [and] they want the low prices in food deserts.”

The full text of the first portion of the roundtable follows.

SN: What are the macro-economic factors that are impacting supermarket performance going forward?

GARY GIBLEN: It is the interaction of unemployment and deflation that are the top two factors — the chains are not able to pass on the inflation they thought they could, and that squeezes margins,

In addition, there is a correlation between unemployment and food-at-home sales. The adage, “Everybody has to eat,” is true enough, but there are many ways the consumer is trading down.

Finally, you have some maturation of private label, which is not as much of a safety net as it had been. Shoppers switching to private label is one form of trade-down that improves margin percentages and often penny profit. Unfortunately, private label is approaching the point of being maxed out in many cases, and the remaining forms of trade-down are a lot less benign for the grocer.

MARK WILTAMUTH: I think employment and consumer confidence are two of the big factors weighing on the big picture — then, as you get a little closer to the supermarket group, inflation hasn't moved fast enough to drive sales, and we still have a consumer that's focused on maximizing value and grocers who are still falling over themselves to reduce prices and show that value to the consumer.

ANDREW WOLF: I agree about the macro factors driving supermarket performance, but I think things have bottomed out and real demand is about flat, depending how you measure it. A year ago, we all agreed volumes were down, so that's an “up” statistic. The “down” statistic comes when you look at the amount of pure price investment — those who were calling it a price war turned out to be right — and at how much price investment it took to get there.

That's not atypical for the industry. When the industry enters a recession, it's got two choices: Try to maintain profits or try to maintain market share. That's the best it can do in a bad time. And it turned out that some operators were able to pull off one or the other. For example, Kroger was able to maintain market share but obviously at a steep cost to profits, while others retailers — like Supervalu and even Safeway — couldn't maintain profits or market share.

But that was the year that was, and now Kroger and Safeway have gotten to a point where they are maintaining share. In fact, Kroger has been building share — one of the few operators able to do that.

SCOTT MUSHKIN: I would say the major factors impacting performance are employment, employment and employment. Employment is the engine, while inflation tends to be the caboose. You get high inflation and low employment, and as we've seen, that's bad. Where we are right now, it's really hard to tell.

I agree that maybe we've bottomed out. We saw pricing roll over significantly in April with Wal-Mart's activities, but that's dated at this point, and until we see a big trend change in employment, it's hard to get really worked up on the positive economic factors. That makes you focus on companies that can perform no matter what the economy does, and we believe Kroger fits into that bucket.

NEIL CURRIE: I think every income level has its challenges right now, with lower-income people facing threats of unemployment or limited income growth; middle- income shoppers worried about the housing crisis and what savings they may or may not have; and upper-income people probably feeling a little better about the stock market but still facing the prospect of tax increases to come. Shoppers are still coming to grips with where the economy is going and how they should change their shopping habits.

I don't believe we are in a recovery of sorts — it's more like we've had our economy reset and shoppers have become more pragmatic, and they also have new aspirations of what they want out of life. Gone are the days of wanting a second house or a boat or a fancy car. Today it's more about whether they can own a home, send the kids to college or whether they can retire — all of which leads people to look for ways to save money.

At the same time, the conventional supermarkets are facing continued threats from alternative formats. Conventional supermarkets really have struggled to raise prices, so whether they have a healthy future really depends on what prices they can get.

GIBLEN: A further challenge from the employment situation is, what happens when the government inevitably stops extending unemployment benefits? It's hard to imagine yet another round of extensions after the November midterm elections. Significantly deeper trade-down would likely result from cessation of unemployment benefit extensions. This would apply particularly to operators with lower-income demographics — say, Winn-Dixie, Food Lion or stores in the Pathmark division of A&P.

SUSAN ANDERSON: On top of that, you have the higher food-stamp utilization, which is keeping consumers to their budgets.

MUSHKIN: People continue to struggle financially, and there is a great deal of uncertainty about tax rates as we move toward the end of the year. It's a very difficult macro-environment, and people are reacting by being careful how they spend money and by saving more.

We also had a very mediocre [Gross Domestic Product] number come out, and given where we are in this economic recovery, we should be showing very strong GDP numbers, and I think that's causing people to be cautious.

CURRIE: I think there have been times during the year when people have had frugality fatigue, and they're coming out for seasonal events and spending on entertaining at home perhaps — or if they need a new washing machine, they probably spend a little bit of money, though it's not necessarily on food but rather on more discretionary items they haven't bought for a long time. And to some extent, any improvement in spending activity might not necessarily include food spending.

WILTAMUTH: That's one of the lessons from the downturn — we found out that grocers are a little more cyclical and there's more of a discretionary component to grocery demand than we all believed. This industry is not the safe-haven consumer staple that a lot of investors think it is. It's definitely a major down cycle in the economy, and the grocers are feeling it.

CURRIE: It was defensive only when there were just supermarkets. But while consumption of food may be relatively immune to economic downturns, the places where you can buy food have changed a lot in the last 15 years, and people have a lot more choices of where they can buy the same brands and similar-quality products.

WILTAMUTH: Factors like the trade-down within the store and the crank-up of private label point to the cyclicality of the sector now.

GIBLEN: The silver bullet of cost-cutting is not so penetrating in the supermarket industry. Unlike in manufacturing or other sectors, you can't just massively fire people. You have minimum store staffing requirements, and you have union restrictions. The chains have done a good job cutting costs where they can, but it's not as big a safety net as it would be in other industries. And in any event, cost-cutting has been all wrung out and played out, to some extent.

WOLF: Much of the industry is disadvantaged compared with alternative formats, whether it's Wal-Mart or Target, because of their union cost structures. I've looked at a few companies and how their cost structures have behaved in the downturn, and not surprisingly, the unionized companies have not been able to get their costs down — and as a matter of fact, they went up a lot as sales were hit — whereas nonunion chains like Ruddick [operator of Harris Teeter] and Whole Foods have had more labor flexibility and were able to pare their cost structures.

While the unions have given something back to the companies in terms of two-tier wage and health care plans, a lot of the work rules and seniority rules remain. So for companies like Safeway and Kroger, if demand is slow, they can bring down labor hours by reducing hours of employees at the lowest tier but not the folks with seniority that cost twice as much and have the best health care plans.

So unionized supermarkets are going to have high labor costs relative to nonunionized supermarkets because they have a relatively high fixed-cost structure, and when you get the kind of huge cyclical headwind we just had, it really gets exacerbated.

I think these kinds of structured union contracts, especially with what we've just come through, really hurt the big chains. I would say the proof is in the pudding because if you look at the nonunion businesses — like Whole Foods, which also had sales issues — they had a lot more flexibility to bring down costs.

GIBLEN: A good illustration of what Andy is talking about is Safeway, which is perhaps the most skillful cost-cutter — it prides itself on that and has innovated in health care cost reduction in ways emulated across all of corporate America. Yet despite all that, its [savings, general and administrative cost] is now going up as a percent of sales.

That's the litmus test. And if Safeway is suffering from de-leveraging of its cost structure, then it's scary to think what we might see at other companies.

SN: Is there a new normal among consumers and a new frugality that will stick around after the recession?

MUSHKIN: I hope not, and it doesn't have to be this way. We can either run our economy into the ground and grow at 2% or less, or we can put policies in place that don't do that.

WILTAMUTH: There are some new normals, and one of those is that we have a new gross-margin level. The industry has given back a lot of price to the consumer, and it's not going to snap back. I think that price sacrifice we saw last year out of the major grocers is here to stay, and if we get a recovery coming out of this, it is just going to be same-store sales grinding higher, but it is not going to be sales plus gross margins going higher.

CURRIE: I think it's dangerous not to assume the status quo will continue because there's nothing out there to indicate change — no shoots of recovery within the sector, and many more competitive threats than five years ago and five years before that.

One thing about gross margin in the industry is that there are still two different business models among conventional retailers. There is the Kroger and H-E-B model, which is based on low gross margin and higher turns; and the Supervalu and Safeway model, with high gross margin and lower work productivity, and the jury is still out as to which one of those is the better version.

On the one hand, you feel you'd rather be in Kroger's shoes by having the higher sales per square foot, which helps leverage your cost structure. But if you look at the cash-flow generation, it suffers because of the low gross margins, whereas Safeway is generating a lot of cash flow now because of its high gross margins, but who knows if that is sustainable? Right now it doesn't look like it is sustainable because Safeway can't generate positive sales growth.

WILTAMUTH: Safeway's high cash flow is also a function of the end of its overall remodeling campaign, which means it's got a good four-year runway of higher free-cash-flow yield.

CURRIE: But if Safeway had Kroger's gross margins, or if its gross margins fell at the rate Kroger's did over the last few years, it wouldn't be generating nearly as much cash flow.

WOLF: I think the deflation picture has gotten better, and I think the worst is definitely over, and part of the reason — when you look back at the industry and what happened — is that Kroger went a bit overboard a year ago with price and kind of forced the issue.

There probably would have been some kind of price war without Kroger, but it had a major influence on everyone else, being the largest conventional chain. However, it went a little too far and forced everyone else's hands more than it would have liked, though there would have been regional skirmishes that would have been very ugly.

A lot of what happens going forward will depend on what Kroger decides to do. It has kind of signaled it is willing to be much more rational, and I think we are going to see the impact of that right away because it is the company that has the easiest comparisons, given its big investment in profits. We should be seeing soon to what extent Kroger is moving in that direction. I wouldn't expect gross margins to be up anytime soon at Kroger, but we should see some signs of less gross margin investment.

Wal-Mart

SN: Wal-Mart has been in the news a lot lately with its price rollbacks. How does that play with the public?

WILTAMUTH: It's interesting that Wal-Mart gets so much attention because all of our price surveys show it has not widened its price lead over the conventional grocers. The items it is discounting are a little more tangential to the core grocery basket, so we don't think it's that big a fundamental threat but more of a valuation overhang for the group right now.

Its rollback campaign started in April, when it rolled back prices 15%, then it moved to 25% in May and now we're back to 15% again, but the items it is discounting — Cheetos, Twinkies, snacks — are not core traffic drivers. Wal-Mart started to get into beverages a bit in the May period, but those items have now disappeared from its rollback list.

So Wal-Mart gets a lot of attention, but I think the real issue here is grocer-on-grocer competition, more so than what Wal-Mart is doing.

CURRIE: I think what has changed at Wal-Mart is that it's been less price aggressive this year, and it's done some price optimization stuff that led to its price image being eroded, and I think these deep rollbacks over the last few months have been an attempt to grab some headlines. Ultimately, I think what we will see with back-to-school season is more of a return to the Wal-Mart of old, with more rollbacks across the basket in an effort to affect the overall basket costs rather than highlighting some heroic brands and key prices.

I think the risk for the sector is that while Kroger potentially becomes more disciplined, we will see a Wal-Mart armed with significant SG&A improvements that could enable it to potentially go out and reestablish its pricing image. Whether that is a real threat to the basket or not remains to be seen, but I think what the supermarket industry faces is the threat of a Wal-Mart that understands it's lost some pricing image and wants to get it back.

WOLF: In the pricing work I am doing around Virginia, at least on the commodity side, Wal-Mart is passing through inflating product costs on categories like dairy and meat. Wherever there's a lot of inflation, prices are going up for conventional chains and for Wal-Mart as well.

I've been checking the same random assortment of grocery items — about 70 items — for 10-plus years, and on that grocery basket, Wal-Mart has not taken down its prices. As a matter of fact, it is right with the market — sometimes more, sometimes less. My study seems to indicate it has done more. It is having issues with traffic, and that's what you do when you have issues with traffic.

WILTAMUTH: We are at a key juncture for Wal-Mart because the company changed its head of U.S. business; its chief merchant has resigned; it has already kind of scrapped some of the plans the former chief merchant had in place — cleaning out that center aisle of the store and letting store managers go back to putting pallets on display there — so there definitely is some change going on in the way Wal-Mart is behaving. The question is, has it come up with a new strategy? Right now it seems like it is just reverting to what it was doing before. The strategy it had wasn't working, so it has just gone back three years.

CURRIE: Three years and 30 days. That's the mantra for Wal-Mart, from the perspective of what customers see, not what they don't see. Wal-Mart is going to go back to where it was three years ago in terms of how it goes to market with pricing, how it dialogues with manufacturers, and how it sets the store up in terms of Action Alley — as you said, giving the option to store managers to go back to the way they were three years ago.

WILTAMUTH: It's really a broader question of pricing discipline for the industry. It's not just what Wal-Mart is up to but also a question of whether there is going to be more price discipline among the conventional grocers.

WOLF: I think Kroger and Wal-Mart are going to dictate that — I think Kroger has already signaled it will do that, and I think Safeway is always ready to let the market go up.

MUSHKIN: There's just no stomach in the industry for another round of what we've seen over the last six to 12 months — there just isn't. Our data, which is different from some of yours, indicates that Wal-Mart was trying very hard last summer and into the fall to reestablish a fairly significant gap with the supermarkets, which it did, and then it went into this massive price-cutting effort in April. We had baskets from January-February drop 8% in April, which is a pretty substantial drop.

In almost every market we tested, we saw this happening, and now Wal-Mart is starting to come back up — the big pullback. You are not seeing the $5 for 3 pounds of Maxwell House coffee anymore or $5 for 24-packs of beverages, and you are not seeing $1 for Heinz ketchup any more. It's all just faded.

CURRIE: You will see that, between seasonal events, Wal-Mart will go back to the grocery rollbacks, and when it has seasonal events, it will pull back and focus on the seasonal strategy.

MUSHKIN: I think it wants to have a gap, but the question is, is it throwing good money after bad in some of its markets? It just may be tapped out. It has a 35% share in Dallas, and I don't know if a 40% share is realistic.

What makes me nervous about Wal-Mart is the thought that it is looking for 40,000-square-foot boxes in Northern California. That's the growth Wal-Mart could tap because it's pretty tapped out in some other markets.

GIBLEN: Another issue with Wal-Mart is consumer price perception. I've done field work on that, and consumers — who are very smart — can see that Wal-Mart is not always the lowest-priced on everything. They have kind of learned it from the dollar stores, but now even supermarkets on promotion can beat Wal-Mart occasionally. So that's a huge opportunity for the conventional supermarket industry — that people who are underemployed or unemployed and have lots of time on their hands can realize that maybe they can cherry-pick and find some items cheaper at their regular supermarkets.

WILTAMUTH: That's one of the things we found in our price surveys — that if you shop private label at Kroger, at the entry-level pricing tier, you can match the lowest price at Wal-Mart in any category, so it can be done. It's just a matter of whether the shopper is paying attention to all those price points.

WOLF: For Wal-Mart, taking its pricing down would blow up its [profit and loss statement], just like it blew up the P&Ls of conventional grocers.

WILTAMUTH: Wal-Mart has a lot more ammunition than people think, as Neil has mentioned. It did a lot of resets last year, so its SG&A was high, but it doesn't have those this year. The question is, does it let the margins go higher or does it plow it back into lower gross margins?

WOLF: Just do the math. If you take a 1% or 2% haircut to Wal-Mart's pricing, you're talking billions of dollars in profit. The question is, are customers going to come in for that?

I agree with Scott's point. Supercenters are not completely saturated, but in some markets they are fairly saturated, and that's been the dilemma for Wal-Mart. During the last recession it experienced a trade-down and tried to hold onto more of the middle-class consumers with more fashion merchandising, and it couldn't even come close to figuring that out. This time it tried a cleaner store to appeal to a more middle-income customer.

One thing that hasn't changed about American consumers is, they are still aspirational. For better or worse, Wal-Mart is generally not emblematic of what customers aspire to. I think it was a great effort to try to change that, but it just didn't work. So now its dilemma is that it still has its core customers, and it has to decide if lower pricing will bring anyone back in.

In a new economy, where there's only a 2% GDP, maybe that wouldn't be completely futile, and maybe some of the folks who aspire to shop somewhere better will come back to Wal-Mart. But it's not a slam-dunk that, if it puts pricing back in the store and widens the price gap, customers will flood in.

WILTAMUTH: It's a price-elasticity question for Wal-Mart. It is already 13% to 20% below the conventional grocers on shelf price, and if it is another 5% lower, is that going to drive in more customers? Probably not.

CURRIE: I think the idea about the aspirational shopper is really outdated in America. I don't think people aspire not to shop at Wal-Mart any more — they aspire to very different things. In fact, I actually don't think many shoppers have left Wal-Mart.

If anything, Wal-Mart's biggest issue has been that it is the biggest company exposed to high unemployment. Its customers are right in the middle of the worst part of the economic downturn. The U.S. might be in a recovery, but not the Wal-Mart shopper. As for the middle-income customer, I'm not sure how many customers it has actually lost in the grocery section, and its comps are much better than the supermarkets in the grocery section — though by its own standards, the comps haven't been that good.

Wal-Mart has lost a little bit of edge. Throughout 2009 it was doing half the number of rollbacks that it did 18 months previously and half the level of discounts. So I think what we are going to see from Wal-Mart is going back toward a more traditional rollback strategy in an attempt to get traffic back to being positive. But it's not just about price — Wal-Mart made a whole host of other mistakes in the past 18 months.

WILTAMUTH: SKU rationalization would be at the top of that list.

CURRIE: The biggest mistake Wal-Mart made was doing things too quickly. For a big company, it can move very fast. Maybe clearing Action Alley is something it can aspire to over the next several years in certain stores, but after a small test, it was done in just a few months, and it was too fast.

MUSHKIN: What's really interesting about Wal-Mart in the food aisle is this: When you looked at Wal-Mart five years ago, the stores were sloppy, the checkout lines were long, the in-stock position was terrible, the decor was dated. But that has all changed, and yet you're really not seeing it grab share, especially where it is competing against Kroger. So it seems like there is this notion that in certain markets, it is tapped to a degree, and lowering prices may not help it all that much.

The interesting thing is, given some of the promoting it's done over the past year, has it damaged its vendor relations to a degree that is going to help someone like Kroger? Wal-Mart spooked the heck out of some of the CPG companies with what it's done over the last three to six months, and I'm not sure we are going back to where we were.

WILTAMUTH: The CPG guys want to put their promotional dollars with the retailer who is growing volume, and that speaks a little more to Kroger's favor.

CURRIE: I think what the CPG companies like is simplicity, and the Wal-Mart model has always been about simplicity and therefore vendors have been able to see it as a profitable business to serve. But it's become much more complicated in the last year or so, and CPG companies want to get back again to that more simplistic relationship.

WILTAMUTH: If you look back over the last year, Wal-Mart pushed private label to a higher profile in the store; it did SKU rationalizations, which may have angered some of the smaller suppliers; and then it had some rollbacks that were kind of unauthorized by vendors, which drove numbers those vendors didn't like. So there may be some bruised egos there, but I have to believe everyone's still got to play with Wal-Mart.

MUSHKIN: They've still got to play, but the question is, are the CPG companies going to make a concerted effort now to make sure they don't just have one customer?

Some manufacturers in the U.S. are above a 30% share with Wal-Mart already, and I think Wal-Mart might have shot itself in the foot. It will try to go back, but will the CPG companies go back to where they once were?

WOLF: Are you talking about “Win, Play, Show” and SKU rationalization?

MUSHKIN: The whole thing. But I think the icing on the cake was when it sold Heinz ketchup for $1 and you actually had smaller grocery stores going into Wal-Mart to buy their ketchup because they couldn't buy it at the same price from their distributors.

I think it really is the role of the CPG companies to watch how these retail companies behave, and a desperate Wal-Mart is not something these guys want. They want a “healthy” channel, to quote one of them — and a vibrant one.

WILTAMUTH: That's a good takeaway for the grocers, too — a desperate Wal-Mart is not a good thing for a grocer to compete with.

GIBLEN: Another thing Wal-Mart has to be concerned with is, if the White House pushes through [“card check” legislation favoring unions], then Wal-Mart could end up unionized, which would be nirvana for the retail food industry — and it could happen. President Obama has shown an ability to pass through his agenda on different issues, despite all odds, and I think Wal-Mart is in his crosshairs, so it's a distinct possibility. That would result in a huge change in favor of the supermarkets.

WOLF: Don't you think time's run out on that?

WILTAMUTH: There's a low probability of that resurfacing …

GIBLEN: … but it could happen if the Democrats hold seats in the midterm elections, although that is looking less and less likely.

CURRIE: Somebody mentioned the urban markets where Wal-Mart can grow, and that feeds into this because I think there's a lot more willingness to accept Wal-Mart. As we're seeing in Chicago and Washington right now, Wal-Mart's going to have a much more coordinated approach toward urban markets. I see urban markets as an $80 billion to $100 billion opportunity for Wal-Mart. And I think politicians want and need the tax dollars, they want the job creation, they want the low prices in food deserts.

And Wal-Mart over the past three years has changed its image quite significantly. It started with the $4 generics, but I think there have been other issues that have led to developing a better relationship on which to negotiate with urban governments.

MUSHKIN: To me that's the No. 1 threat Wal-Mart poses right now — urban.

WILTAMUTH: Even without all these new venues, if you take a top-down look at the grocery sector, the industry grows in the range of 1% to 3%, and Wal-Mart is still the biggest grocer, with grocery-related sales growing in high-single to low-double digits because of the unit growth it does, so it's still a big threat.

And that's one of the reasons the industry doesn't have pricing power — there's this consistent market-share pressure from Wal-Mart, the clubs and all the other alternative formats that are pushing on the space.

MUSHKIN: I think it's going to happen on the East Coast first in these underserved urban markets. It's not low-hanging fruit — the fruit is on the ground. Look at A&P — you can just pick it up. Just get a basket and pick it up.

So Wal-Mart is trying to move into more urban sites — and I would assume Bill Simon [president and chief executive officer of Walmart U.S] is really going to push that effort — because looking at it, that's really where Wal-Mart is going to gain some ground.

CURRIE: That's where Kroger has been the smartest among the larger conventional players — it has anticipated this for many years. It has understood that to survive in this industry, it needs to take share from other conventional players, but not until you allow the unconventional players to come in and take share also. So Kroger wants to be a share-taker alongside the likes of Wal-Mart and Aldi and whoever else comes in. And to do that, it has had to restructure its P&L.

Kroger Co.

SN: Given all the circumstances you've described, what is Kroger going to have to do in the next year or two to sustain its industry-leading position?

WILTAMUTH: What Kroger has to do is show more margin discipline. It doesn't necessarily have to involve gross margins going up, but it has to involve not slashing prices as much as it has in the past.

Kroger needs to have that balance between sales and margin, and that's what it needs to focus on. It is still probably the best-positioned of all the major grocers to weather this storm, because it has been investing in lower prices for nine consecutive years, and it's got the best conventional price point out there.

The tough thing for Kroger is, if you are playing a price-cutting strategy where you invest in lower gross margins each year and hope for some operating margin leverage, and everyone else is playing the low-price card, then you don't gain a lot of traction — that's the challenge.

SN: Does the fact Kroger's been doing it for several years put it in a better place to start?

WOLF: Absolutely, because it has a positive price image, like Wal-Mart does. And just to Neil's point, I concur that Kroger figured out that it doesn't have to beat Wal-Mart — it just has to beat all the other conventional guys. Kroger has a strong value image, and it has an opportunity to see if there's any pricing power.

I really think if the industry is going to have a better year in 2011, which I think it will — as long as the economy continues to show some upward trajectory — then Kroger is going to have to lead the way within the conventional channel in being more rational, and it is positioned to do it. It could stop investing in price and still maintain its price image, even as others might have a ways to go. It's all fluid, and I am deliberately being simplistic, just to make an argument.

CURRIE: I would probably agree with most of what's been said about Kroger. I don't think I would have done anything different from what Dave Dillon [Kroger chairman and CEO] has done with the company, and I also agree that it got the balance wrong last year from a short-term perspective in going for too much volume at the expense of margin.

Longer term, I don't see too much of a problem for Kroger trying to keep margins flat and going after long-term growth. The big question for me is whether or not being the best supermarket is an investable strategy because there are still massive question marks about the validity and relevance of the 55,000- to 60,000-square-foot supermarket.

That format was developed years ago when supermarkets were the only place to do food shopping, but things have changed. People shop differently today — they shop at multiple destinations. So I'd argue you just don't need a store of that size any more.

WOLF: I think it's more the cost structure issue that's the reason supermarkets have been in a secular decline. What has occurred in the last few years, according to Nielsen Scantrack data on shopper frequency by store type, is that supermarkets have stopped going down. Shoppers go to supermarkets 59 times a year, and that hasn't changed in the last few years — whereas supercenters are stuck at 26 visits per year. But if you go back 10 or 20 years, supermarket frequency was much higher and supercenters much lower.

So there was a point where people said they would drive to supercenters to save some money, or go to dollar stores because they are close and cheap. But if you look at these Nielsen Scantrack numbers, the channel shift has kind of simmered down, supermarkets have stopped losing share of visits, and the winners — the supercenters and clubs and dollar stores — have stopped gaining share of visits.

MUSHKIN: When I look at Kroger, the question is, can it stabilize its margins in the back half of the year and prove to the world it is not going to cede gross margin forever?

Even before its numbers fell out of bed last year, its “customer first” strategy was much more ambiguous as to whether it was actually working from a return perspective. Return-on-invested-capital was falling while return-on-assets was actually rising a little bit, but for a company that was gaining as much share as Kroger was, I would say that was kind of C-minus or D-plus as far as what you would expect.

In talking to the company, it seems management is not only unhappy with what happened last year but I think there is also a realization that Kroger wants to be a player and not just an also-ran company in an also-ran industry. To do that, it has to get that return-on-capital moving in the other direction, and the only way to do that is to get margins going in the other direction.

Kroger wants to grow, and if it can make that transition, the stock is going to be a home run for a number of years. It hasn't done it yet, but I believe there's a realization inside the company that it needs to prove it can get the returns up.

WILTAMUTH: How would Kroger do that?

MUSHKIN: it needs to get back on its demand curve. I think it's been falling off that demand curve, as was evident before 2009, at which point it became blatantly obvious it wasn't getting enough volume to justify the price investments, even though its volumes were high. Kroger has to get the balance right, and it's been working hard to do it. If it can double its free cash flow, there are a lot of positive things to come because it's a very virtuous cycle.

CURRIE: People talk about the cost issues connected with supermarkets being unionized, but there are many alternative formats that pay very competitive rates — for example, Costco, Aldi, Whole Foods. So it's not about cost — it's about top line, it's about productivity.

If you had to invent a supermarket today, you would not build a 50,000- or 60,000-square-foot store. Those are the world's biggest convenience stores, effectively. They are fresh food stores — the edge of the store is shopped very well, and that's why visits remain very high. But the whole store is under-shopped, and you just don't need that size any more, so the concept is wrong because there just isn't enough productivity. I think Kroger has done a very good job trying to put that right.

On the free-cash-flow side, though, capital spending at Kroger needs to remain high because it hasn't done what Safeway has done and remodeled all its stores.

MUSHKIN: Do you think we don't need a 50,000- or 60,000-square-foot store, or we don't need as many of them?

CURRIE: There's room for one category-killing supermarket within a market, and Kroger is fighting to be that one.

MUSHKIN: When it's just Kroger and Wal-Mart in a market, then in many cases those are Kroger's best market.

CURRIE: That's what its bet is — to be the good supermarket — but do you need five or six players in a market?

WILTAMUTH: There are still a lot of undisciplined medium-sized players out there that tend to cause problems — it's not just a Wal-Mart issue. They are all fighting it out there on price.

Earlier, Neil was saying that Kroger over-targeted volume and share, whereas I think it was so focused on defending price that it ended up with an outsized volume response.

CURRIE: Kroger couldn't get the balance right. It didn't need 8% or 9% volume increases necessarily — I think it would have been happy with 5%. But it was fighting fires everywhere, wasn't it?

WILTAMUTH: The challenge on getting margins up is that's probably the hardest thing to move. Everyone can go for share, but striking that balance between sales and margins is not an easy game.

All grocers have been expecting some sort of gross margin improvement in the second half over last year's misery, along with some sales improvement, so I just worry that we all were so down in the dumps before that analysts are just assuming that the second half is going to be better. We've already seen some capitulation on second-half estimates from Safeway, so one of the investment debates yet remaining is whether the numbers are still solid on this year's estimates. I don't think anybody's looking out to 2011 yet, and I don't think 2010's done.

WOLF: I have to disagree that the 50,000-square-foot store is obsolete, and I want to debate with Neil for a second. First, in addition to Kroger, many of the private chains like H-E-B, Wegmans and Publix are still doing well with the 55,000-square-foot grocery store, even if it might not be optimal. Wegmans runs a bigger store, but it is still a grocer, not a supercenter. So it's hard to say people aren't shopping the format because it's pretty obvious they are, as supermarkets are still the largest retail segment for groceries.

I've mentioned in the past that the nonunion chains have much more flexible cost structures, so they don't have the same ball-and-chain, if you will, of the unionized work rules — because it's the work rules and Cadillac health plans that kill their cost structure, not the relative wages.

The other side of that argument is whether people want to go to a supercenter to cross-shop the store and drive by a supermarket on a grocery trip because they might want to buy a basketball or kids' clothing. So why is a 150,000-square-foot store more attractive for a food-shopping experience, and why is it gaining share all this time vs. a 50,000-square-foot Albertsons next door if it's price? It's not that people don't want to cross-shop on every trip — it's price. Why else would you want to go into a big cumbersome store?

CURRIE: I think most people who use a supercenter, apart from very low-income shoppers, also use a supermarket. The average family in America uses five or six different formats to buy food on a monthly basis. Twenty years ago there were only supermarkets, so they did a big shop at supermarkets, along with the fill-in shop, the top-up shop and the convenience shop — all at the supermarket.

What's happened since then is, we've had multiple formats come in. Wal-Mart is not a convenience format — people go to Wal-Mart every week or every two weeks for stock-up trips. And they might go to Kroger or Safeway or the local independent to do the every two- to three-days in-fill shop, and as a result the edge of the store in the supermarket still remains very relevant — the format of the store is relevant — but the size is less relevant. So you don't need a 50,000- to 60,000-square-foot box to do the type of shopping trip that most people use a supermarket for.

There's certainly room for that big category-killing supermarket that we've seen for the past 20 years. You mentioned Wegmans, which I think is an outstanding format, because not only does it have that combination of low prices in the center of the store and a rationalized base of SKUs, but it also has that marvelous fresh food that you can shop for every few days just to do the fresh-food trip.

By the same token, Wal-Mart has not captured all of the market because it is not really used for that type of trip, although it is going to try to address that in the next few years with smaller formats. I just think it's more the case of people using the supermarket — and all these things tend to be generalizations — but a lot of people use supermarkets for largely perishable needs and some in-fill pantry items, and I think the business model and the size of the store was originally set up for something different.

MUSHKIN: Part of this is the fault of the companies. In “Good to Great,” Jim Collins talks about Kroger being a good-to-great company and just killing other competition — in part because it went to new formats.

Some companies have spent a ton of capital, but in the end that didn't move the business where it should have, and now those companies are paying the price in a lot of instances.

WILTAMUTH: It's also an attack from 1,000 different sources. You've got office superstores selling food-related items, you've got dollar stores selling food, drug stores are moving into food — it's every format you can imagine trying to use food as a traffic driver.

CURRIE: That's the same as it was eight years ago. There is no other country in the world where you can undercut the leading players by 10%, 15% or 20 % and hope to make any money. This is the only country in the world where you can do that.

Safeway

SN: Safeway has the most recently remodeled facilities and it's in the midst of establishing a new lower-price image. What kind of year is Safeway likely to have, and how will Wal-Mart and Kroger affect it?

GIBLEN: Safeway back-pedaled significantly in its second-quarter earnings call in terms of expectations on comp-store sales and margins — on everything, really. Plus, by many definitions, price parity is still not there. Safeway was late to the game of price parity to begin with, so it could be that the rest of the year is going to be tough for it on both sales and margins, and real improvement won't be seen until sometime toward the end of the year, if at all.

WILTAMUTH: The challenge for Safeway is, it was late to the party with cutting price, and it takes consumers a long time to change their habits, so you may not see a sales response for some time. The deflation Safeway keeps talking about is not really a market force that is happening — it's Safeway's own price cuts that are causing the price per item to go down.

MUSHKIN: As I look at it, the thing with Safeway that's somewhat concerning is that the company has taken a number of actions over the last 12 to 18 months and the sales response so far has been pretty muted. That doesn't mean it hasn't been there at all — it's just been less than we would have wanted to see. Safeway has cut its prices and it has done a much better job executing at the store level — and though it's not at Kroger's level, it is better.

Safeway launched a massive advertising campaign about a year ago called “Promise,” so that's a lot of attention by the chain to try to get the sales needle moving. I think the second quarter — while it wasn't an absolute disaster at negative-2.5% — certainly was not an endorsement that Safeway has really changed its trajectory, even though it has been working really hard at it for a year.

So that leaves Safeway more wedded to the economic backdrop than you would like, especially in California.

WILTAMUTH: Ultimately that may be a big part of the equation, affecting maybe a third of its stores, and if California is not swimming in the right direction, Safeway is going to have a real issue.

GIBLEN: If you take the totality of its markets, there are skirmishes or issues in many markets that add up to something significant. Western Canada has become significantly more competitive recently, and Safeway is obviously having trouble with Genuardi's since it just closed a handful of them. With Genuardi's you have a formerly high-brand equity player with an upscale clientele that is more protected from the economic forces, but Safeway is still obviously not doing well with it, and I think it is losing significant share in Baltimore-Washington, D.C, too. So Safeway illustrates how long and hard it can be for a supermarket chain to improve its price image — particularly when it seems to be pulling some punches and not committing 100% to it.

SN: So is the outlook for Safeway bright, dim or somewhere in between?

GIBLEN: Fairly dim intermediate term, in my judgment.

ANDERSON: And Safeway probably has the least overlap of anyone with Wal-Mart, so if Wal-Mart is successful going into more Safeway markets, you are going to have a huge issue unfold.

MUSHKIN: I wouldn't say the outlook is completely dim. Safeway does have great market share up and down the West Coast. You have to wonder, though, given the current environment, if it would have chosen to do things differently.

And if the debt markets open up — and given that Safeway is not very levered, has lots of good assets inside the company and has spent a lot of capital to upgrade the store fleet — then Safeway would be my No. 1 pick to be taken private, given its market shares up and down the West Coast and into Alaska and Hawaii. So there are definitely some things Safeway can do to create value.

WOLF: Safeway is going to come up against a dilemma next year as the market improves a little in terms of how serious it is about trying to rectify its price image. I think in 2011 it will be able to get earnings up, if the market starts to rationalize a bit, as a consequence of its price image, so it is really in the balance right now.

As I said earlier, Kroger is in a really nice position, with things easing a little and shoppers at least back in its stores and the economy picking up and employment picking up — those kinds of statistics are supporting the industry a little bit in terms of the macro backdrop. So Kroger has the luxury of letting its margins expand somewhat or contract less, but Safeway doesn't. If Safeway is serious about its price image, it is going to have to go through what Kroger did.

We heard Scott say Safeway has been investing heavily for a year and nothing's happened. Well, remember that it took two years for Kroger, so there's no magic. It takes decades to have your prices be too high, so why should it take just a little time for consumers to accept a lower pricing approach? That's what I think Safeway is going to be up against, whether it sticks to trying to be a price player, as Kroger is, and be a productivity-driven company — at the expense of not having good earnings in 2011, which would probably be a down year if that were the case. Or does Safeway, if the market starts to get a little better, just drift with it and try to print some earnings, which probably would be better for the stock?

WILTAMUTH: I don't think Safeway is going to change its stripes and become the next Kroger. Safeway wants to be differentiated and a little higher quality, and I think it will be happy to charge a little premium if the customer will take it.

CURRIE: Safeway has done a very good job of being differentiated. It has remodeled stores, so the assets are in good shape. You could say it was lucky it made the decision [to invest in the store base] at a time when the economy was a little different, or who knows what the outcome would have been? You could also say that maybe it was just putting off the inevitable, which is that at some point it was always going to have to address this issue that it has been forced to address due to the current state of the economy in California, and it is probably an issue that will remain around for some time.

WILTAMUTH: If you wanted to take a bullish stance, you could also say that if there is an economic recovery at some point and California is moving, Safeway would be more levered to stronger returns than Kroger would be, so some of this hinges on what's your macro view for the space.

MUSHKIN: One thing Safeway said that stood out was that it wasn't seeing that much trade-up yet, which is being offset by the trade-down. That's a big factor in supermarkets — when you talk about going from hamburger to sirloin, or from a $10 bottle of wine to a $20 bottle, that's a big deal, especially for the way Safeway is positioned.

In a lot of ways, it is kind of a middle-class trade-up, and if the economy can get going, Safeway could see a lot of P&L leverage — and I do think it would let the incremental sales fall to the bottom line.

WOLF: I agree with that — that's what I expect, and I think it would be better for Safeway stockholders in 2011. It's kind of a Catch-22, though, that goes back to what Dave Dillon [chairman and CEO of Kroger] said several years ago — that cutting prices was “existential,” and he meant it — that Kroger would be viable if it cut prices to help create the right value image. And Kroger has been the only one among the public companies to be that player.

So I just think it's an interesting time for Safeway because it is getting a little bit of traction, and if it lets things roll for another year, it might even get a little more traction and get some market-share back, which is not irrelevant to the boardroom whether it gets back market share or earnings to determine ultimately whether it is a viable company or not. I just think it has some pretty big decisions to make on pricing and whether it sticks to what it is doing.

But I do agree with all of you — that Safeway is going to try to finesse it and have the earnings come up.