Whither Consolidation?

Retailers are more likely to engage in fill-in acquisitions in adjacent markets than in large-scale mergers, industry analysts said here during SN's 12th annual Financial Analysts Roundtable (Part One of the Roundtable was published in last week's issue.) Fill-in acquisitions of stores that are adjacent to a company's existing infrastructure are the ones that work, Mark Wiltamuth, executive director

Retailers are more likely to engage in fill-in acquisitions in adjacent markets than in large-scale mergers, industry analysts said here during SN's 12th annual Financial Analysts Roundtable (Part One of the Roundtable was published in last week's issue.)

“Fill-in acquisitions of stores that are adjacent to a company's existing infrastructure are the ones that work,” Mark Wiltamuth, executive director at Morgan Stanley, New York, said. “The big mergers have been value-destroying, and we haven't seen a lot of synergies fly out of those deals in the past.”

Bryan Hunt, managing director of high-yield research for Wachovia Securities, Charlotte, N.C., echoed that thinking. “The financing market has tightened, which should lead to companies cherry-picking stores, as Kroger has done in Detroit, more so than large acquisitions.”

Andrew Wolf, managing director at BB&T Capital Markets, Richmond, Va., suggested the environment for large acquisitions may still exist, with Ahold's U.S. assets — including Stop & Shop and Giant Foods — considered potential “plum cherries” that could come up for sale.

Other potential acquisition targets the analysts mentioned include Roundy's, Milwaukee; Weis Markets, Sunbury, Pa.; Bashas', Chandler, Ariz.; and Marsh Supermarkets, Indianapolis.

With industry operators striving to differentiate themselves, supermarkets have almost become alternative formats in themselves, analysts said.

“Every store has increased fresh and healthy offerings, increased organics and increased international foods,” Carla Casella, managing director of high-yield research for JPMorgan, New York, said, “so the local supermarket is becoming the alternative format.”

Mark Husson, New York-based managing director and global head of consumer research for HSBC Securities, London, said he agreed. “In some ways supermarkets are becoming the alternative format, given the behavioral shifts we've started to see as gas prices have gone up, [which is] prompting people to shop more locally.”

According to Hunt, with so many retailers tweaking their formats, “it's hard to use the term ‘format’ as a general term.”

As the discussion shifted to organics, food safety and general health concerns, Hunt said he believes organics merchandising will continue to grow rapidly, particularly in private-label categories. “The industry is very young and has few dominant brands, so this high-margin category is ripe for private label,” he said.

Chuck Cerankosky, managing director at FTN Midwest Securities, Cleveland, said he gives Whole Foods credit for focusing industry attention on “great fresh foods,” regardless of whether they are natural or organic.

According to Wolf, product recalls and other reports of tainted food drive consumers to seek out an organic or natural product “[that] they believe is a safer alternative.”

Consumers have come to depend on retailers and the government to ensure food safety throughout the supply chain, Wiltamuth said. “You only have one reputation with the consumer for food safety, and so far the U.S. consumer has been pretty trusting of our regulatory bodies. But if you start to lose that, you can have a real problem if you run into a major scare, as we saw in the U.K. and parts of Europe.”

The complete text of Part Two of the roundtable follows:

SN: Do you anticipate a new round of mergers in supermarkets, and what are some of the possibilities you see?

CARLA CASELLA: I think we'll see small acquisitions, as opposed to large-scale mergers.

BRYAN HUNT: The companies out there that are owned by private equity groups are Roundy's, which has been owned by Willis Stein for five years; Bi-Lo, which is owned by Lone Star Funds; and Albertsons LLC, which is owned by Cerberus. Of the three, I believe Roundy's is the largest and most desirable asset that could be sold in the near term. But in terms of acquisitions in general, the financing market has tightened, which should lead, in my opinion, to companies cherry-picking stores — as Kroger has done in Detroit — more so than large acquisitions.

MARK WILTAMUTH: I'm not sure investors would applaud a large acquisition. I think fill-in acquisitions of stores that are adjacent to a company's existing infrastructure are the ones that work. The big mergers have been value-destroying in the past. Part of that could be because they overpaid, but we really haven't seen a lot of synergies fly out of those deals in the past.

MARK HUSSON: Kroger-Fred Meyer worked.

WILTAMUTH: But look at the rest of them that didn't.

ANDREW WOLF: I agree. But look at the changes we're seeing, with Tesco entering the market without buying someone, and Kroger having a chance to buy the premier Albertsons assets but taking a pass. So things have changed, and the environment's gotten better. Among the plum cherries that could come on the market are the Ahold assets, and I think there would be an auction for Stop & Shop and Giant if they were put up for bid.

SN: Do you see any strong regionals likely to be picked up or putting themselves up for sale?

GARY GIBLEN: Weis Markets is just sitting out there, and something has to happen with it. That would be logical, and it wouldn't overlap with much of anybody's geography, except, of course, Ahold's current holdings.

CASELLA: It's so hard to get into the heads of a family, but Bashas' is in a dense market, with probably too many operators than there need to be [in Arizona], and it would be a good sale.

CHUCK CERANKOSKY: Sun Capital bought Marsh Supermarkets, and that's a group of stores that's non-union and might be marketable down the road. It needs work, but it might be marketable.

Alternative Formats

SN: The whole subject of alternative formats is one that comes up at every roundtable, and the discussion is different every year to some extent. What alternative formats are making the biggest share inroads today?

HUSSON: In some ways you could say supermarkets are becoming the alternative format, given the behavioral shifts we've started to see as gas prices have gone up.

For example, people don't want to get into their truck to drive 15 miles to the Wal-Mart and another 15 miles back, even though they know they are going to save three or four bucks there, because they don't want to spend the money getting there. So people have started to shop more locally, and I think that's one of the reasons why supermarkets have recovered somewhat — because people have discovered conventional supermarkets aren't as bad as they used to be perhaps, and it's quite nice having some service.

I think there are some behavioral shifts that are happening with higher gas prices. Roughly 50% of the population knows the price of only one thing, and that's gas, so if a supermarket has a sharp price on gas, it can have a big impact on the consumer's perception of its overall prices in the store too. And if you look around the world, U.K. food retailers now have over 20% of the gas market, so it belongs naturally with this business, and it's constrained only by the fact that retailers tend to lease, and the actual owner of the land is usually unwilling to have you bury a tank of poison in his ground.

HUNT: The majority of the operators are trying to tweak every format in every market to cater to local tastes more and more, so it's hard to use the term “format” as a general term.

One company I write about is Ingles, which has added fuel to many of its stores in an extremely successful manner. Every time it adds a fuel depot in front of a store — and it's lucky, because it owns the real estate in a majority of its locations too, so managing that process is really very simple — it's a big needle-mover, with in-store sales increasing at least $25,000 per week on the low end. In many instances a fuel center has added $50,000-plus in merchandise sales. Ingles ties fuel to its gift-card program, so if you go inside to buy the fuel with a gift card, you get a discount. Ingles is using fuel to drive traffic into the store, and it's been a huge ROI generator for the company.

WOLF: On a same-store sales basis, the supermarket industry has improved a lot, though not by adding footage. If you look at market share, which is obviously based on total sales, which includes new-store growth, you see the usual suspects, with Wal-Mart tamping down store footage growth to 5% and comping at 5%, and likely to still see 10% food growth through the supercenters; Costco growing at 10% to 15% through its warehouses; and Whole Foods still growing 15% to 20%, plus or minus. So these major alternative formats are still performing better on a total market-share basis overall relative to supermarkets, although as the solid same-store sales growth for supermarkets indicates, supermarkets would appear to be doing well maintaining share in established markets.

CASELLA: In addition, every store has increased fresh and healthy offerings, increased organics and increased international foods, or at least it has consolidated international foods in one area of the store. So the local supermarket is becoming the alternative format.

Sustainability

SN: How important are sustainability efforts for supermarkets?

CERANKOSKY: If it contributes to sales and earnings, it matters. If it attracts customers, it matters. If it reduces costs, it matters. A group of corporate managers asked me not too long ago if Wall Street cares if public companies are being green, and my response is, I think we care about it if it makes sense. But if a company is doing things that are uneconomical and calling it green, and it turns out to be a bad quarter, there's no such thing as an environmentally good earnings decline.

WOLF: I think it goes back to the idea of how society's wishes affect corporate behavior. It's pretty obvious that the process is accelerating, and while I don't think companies are going to do stupid things that kill their earnings, I think we're going to see more and more retailers getting involved with these efforts because their customers are telling them they want it.

Organics

SN: What's the outlook for organics merchandising?

HUNT: Organics merchandising will continue to grow rapidly, especially in private label. The industry is very young and has few dominant brands, so this high-margin category is ripe for private label and should represent a growing profit generator for retailers.

WILTAMUTH: This is one of the categories that's been growing sales at 20% a year, so it's no surprise that Wal-Mart and the conventional grocers have really plowed into this area following Whole Foods' lead. I think there's plenty of room for everyone to grow. Sometimes analysts make too much of the infighting between Whole Foods and the conventionals. It's a big, growing category, and there's lots of room for everyone.

CERANKOSKY: I think one of the neat things inherent in all the discussions about what Whole Foods has done is that it puts a focus on great fresh foods, great, quality seafood — with people rediscovering that line-caught salmon is different from farm-raised salmon, for example — and they're discovering dry-aged beef. An item doesn't have to be natural or organic, but it's that kind of better product that helps the entire retail food system. It's great to see a fish department that doesn't smell like a dock, and citrus fruits you never heard of on display, but Whole Foods is bringing that kind of variety to the store — plus it's adding categories, adding items and improving prepared foods, and the whole industry has picked up on it.

WILTAMUTH: There's no question the whole perishables game has been raised in the last few years, along with basic factors like a clean, neat store that consumers traditionally look for. Putting organics in has been just part of that equation. My sense is that most retailers are using organics as a margin and traffic enhancer. I don't think we're really at the point where we're seeing a lot of price battles in that area.

CERANKOSKY: I can't tell you how many times I've gone into a Whole Foods store where there are people three deep at the fish case or at a prepared foods counter, but nobody in the center of the store. That place is about fresh foods, and Whole Foods does it so well. And that's what “lifestyle” is about — Kroger's trying to get better at it, and look at Wegmans, look at Harris Teeter.

SN: So it's not just about the fact that something is officially organic — the lifestyle thing is almost inseparable from that?

CERANKOSKY: Yes, I think so.

WOLF: I think there's a specific aspect of organic and natural that is relevant and that drives demand. When consumers became aware of the tainted dog food that was coming out of China, you saw organic and natural dog food sales jump 50% to 70%, according to some sources, so there's a definite trust factor that is demonstrated whenever there's a crisis in the conventional food chain, because we see a spike in natural and organic sales of that product. So what Chuck said is completely spot-on. And it's been very good for the supermarket channel to take share from restaurants, for example, because if the food's better, people are going to bring it home — aside from the pure health element that's relevant, and that shouldn't be ignored.

Food Safety

SN: Given everything that's happened in the past year, we'd be delinquent if we didn't ask about food safety and how that's been impacting the industry. Are supermarket companies taking the right steps in responding to food safety scares, and if not, what should they be doing?

CERANKOSKY: I just read that not all retailers took a particular line of botulism-tainted canned food off the shelf — the big chains did and the small guys didn't — which shows there's more progress to be made dealing with these recalls. But it looks like the more sophisticated chains understand that if there's a problem, they should throw the product in the Dumpster and do whatever else they need to do, rather than taking the risk of upsetting customers, or else those customers are going to be flocking to Whole Foods, to what they believe is a safer alternative, if you're not taking care of their health and safety.

WILTAMUTH: At this point, consumers expect the retailer to drive safety all the way down through the supply chain, and I think they rely on retailers to be sure companies they don't control have a safe supply chain. We're seeing that in the restaurant business, with testing all the way down to the field level going on now, and of course the growers are not even owned by the restaurant operators. So food safety is a bigger and bigger issue.

This past year we had problems with spinach, and then there was an E. coli problem at Taco Bell, and a number of products coming out of China were a concern. You have only one reputation with the consumer for food safety, and so far, knock on wood, the U.S. consumer has been pretty trusting of our regulatory bodies. But if you start to lose that, you can have a real problem if you run into a major scare, as we saw in the U.K. and parts of Europe.

WOLF: You're starting to hear talk again about country-of-origin labeling for beef and poultry, and it seems like it's heading that way — just more expensive science, if you will, and better tracking, especially in a global economy.

Other Retailers

SN: Who are some of your top-of-mind retailers?

WOLF: Wegmans is certainly top of mind, along with Whole Foods, because they run exciting stores that I like to visit and, more importantly, mobs of shoppers do as well.

CERANKOSKY: One company I'd highlight is Spartan Stores. There's been just an amazing turnaround there, led by Craig Sturken and his management team, in western and northern Michigan. They've done an amazing job there, in the face of three supercenter operators, and it is very sustainable.

CASELLA: I have to mention my hometown favorite in Dayton, Ohio, Dorothy Lane Market. Right now it is implementing a system for fingerprinting to identify customers for couponing and other programs. It's always been great at rewards and loyalty programs, and that's how it's held its own in the face of strong competitors like Kroger, Meijer and Wal-Mart's entry.

WOLF: I'd like to mention Publix. It seems to me it's stopped progressing as much as it once did. I had long considered it the best pure-play conventional — you can look at the Q's and see the numbers — and it's been the most successful growth retailer, other than Whole Foods. But of late, I've heard its pricing image might not be as strong with consumers, and I get the sense it hasn't been pushing the envelope to the extent it had been. I still think it's No. 1 in the Florida market by a mile, but I'm wondering if other people have the impression Publix isn't the company it used to be.

My impression is that pricing may have gone up a bit. Publix used to have a certain spread with other conventional operators, which may not be there anymore — or maybe the conventionals simply came down. With that said, you still know a Publix when you're in it, because it's different and it does have appeal, but price is always a huge element.

CERANKOSKY: When I visit a Publix store, I'm still impressed by people coming up to me and making sure I'm finding what I'm looking for — that go-to customer service that is probably equaled only by Harris Teeter, where service is such a big part of how it runs the business, with very outstanding stores. Harris Teeter has also done a good job of taking advantage of the Bi-Lo and Winn-Dixie exits in the Carolinas, and now it's moving into the D.C. area, so it's doing a pretty good job.

WOLF: Ukrop's is No. 2 in Richmond, behind Food Lion, but with Whole Foods coming to town, I sense management is finally realizing that it's got to improve what it does. Ukrop's is still the market-share leader for higher-end conventionals, but Kroger is growing and putting capital in the market, as are others, so I believe Ukrop's needs to not reinvent itself but maybe just push the envelope a little more.

CERANKOSKY: One company that's been fun to watch is Giant Eagle. It's No. 1 in Pittsburgh and No. 1 in Cleveland, and now it's in Columbus and Toledo, Ohio. Giant Eagle is a very good operator of combination food and drug stores, and its fuel program is extremely aggressive and has really served it well. It's been just amazing to watch the strategic interaction of its stores with the fuel program and what Tops tried to do to counter it in Cleveland. Tops ended up taking down its tent and leaving, and I think Giant Eagle acquired maybe 15 to 18 of the store sites.

There's a very different look to the stores from one neighborhood to another, but they all still say Giant Eagle. It's a chain that's very much on top of things — it's a trend-setter, with a good private-label program.

Private Label

SN: Do you see supermarkets getting deeper into private label?

GIBLEN: I see some companies fine-tuning their private-label programs. Generally, private label is increasing, but it's also being expanded to a point where it's meaningless — private-label notebook paper, for example, doesn't provide much value. BJ's has pulled back on a lot of private label — it's getting rid of private-label pickles, for example.

HUNT: The success of private-label retailers such as Trader Joe's, Aldi and Sav-A-Lot, and the greater margin opportunity private label offers, has brought greater focus to private-label merchandising, and it should continue to expand. U.S. retailers continue to carry a narrower assortment of private-label product than their European counterparts. We have also seen many retailers succeed through private-label tiering, including Harris Teeter, and I believe those successes will ultimately be duplicated throughout the country.

WILTAMUTH: Brand consolidation is important. Safeway went down that road, and now Supervalu is getting ready to do that as well. It makes sense to have a private-label program, but not to have 20 different private-label brands.

CERANKOSKY: Supervalu is cutting back private labels from triple-digit numbers as part of the integration of Albertsons.


Labor

SN: Let's talk about the settlement of the labor contract in California, where the two-tier system was eliminated and the United Food and Commercial Workers union apparently won back a lot of what it had given up three years ago. What does that settlement mean for the industry?

CERANKOSKY: I want to actually get a contract and see what's in the work rules before I can comment definitively. It's amazing, when you get into the work rules, what's actually in the economics of a contract. That was very apparent in a new grocery contract signed last year in Cleveland, where the headline news about health care coverage was huge, but when you got into the actual work rules it was amazing to see that 40% of full-time employees did not qualify for the health care plan. I'm not saying that's the case in Southern California. I'm just saying that you've got to look at all the data points.

Bottom line, what you have still in the grocery industry is a group of unionized food markets going up against a lot of competitors that remain non-union, and that's not going to change. The UFCW hasn't organized anybody new, so it's going to keep going to the bargaining table with the same group of companies every few years, some of whom are closing stores — including some of the Cerberus-owned Albertsons that are unionized and that will end up with other uses — which means the union is increasingly dependent on fewer healthy companies. So the UFCW's got to play ball with some very strong players, and in some cases it's still got to make concessions — perhaps not as much as it did three or four years ago in Southern California, but it's a continuing trend.

CASELLA: In regard to Southern California, I think you can book it as a win-win for everybody. The union can say it broke the two-tier system and all current employees got a raise; and the operators can say the new contract did not collapse the 10,400 hours required to achieve journeyman status. In fact, most employees will probably turn over well before they reach 10,400 hours, though I think there's a little bit of a hit for employers in the short term, because everyone got bumped up to the next rung on the ladder, but it's not significant. So I think it's a win, really, for both sides.

WOLF: I see it as a minor win for the union, since its members got better health care. The health care plan is markedly improved, and that's a big expense. On the other hand, since the two-tier wasn't working out quite the way the employers had hoped — with more turnover than they had anticipated — it may actually have been a plus for the operators to get rid of it, which represents a little tweak, from my own thinking, which was that it was best to get the cost structure down to as low as possible. In the end, while it may cost more for employers on a present-day basis, the retailers may actually get a more stable workforce, so it may not be too bad.

I think the way to diagnose these things is to determine who has more to lose. Going into these negotiations, it's clear the operators had a lot to lose if there was another strike, in terms of losing the earnings and the market share they'd just spent 2½ years fighting to win back — with Tesco about to enter the market. So that was part of it.

And if you look at it from the employees' point of view, most of them are in the bottom tier, so they had little to lose if they struck, because they could just go down the street and get essentially the same casual retail job that also doesn't pay much. I think that's the prism through which to look at this settlement.

GIBLEN: The other headline that looks pretty good for the employees is, they received about a 3% quantum-leap wage increase, and to Chuck's point, while determination of who's really eligible for that might mitigate it, on the surface it appears to be a healthy increase that's on the high end of what we're seeing these days.

CERANKOSKY: And the union needed it, after the last contract.

GIBLEN: Yes, but I don't think in any way you can look at it as a big victory for the employers.

HUNT: What was interesting for me in the contract negotiations was that Stater Bros. jumped in and negotiated a deal first. Strategically, in my opinion, it did it because it was not experiencing the same benefits the other operators were from the two-tier labor system. Stater never had the labor turnover that Albertsons, Ralphs and Vons had, so it didn't see the benefit from the two-tier wage system. And if Stater wasn't seeing the benefit, why allow its competitors to be at a cost advantage? Jack Brown [Stater's chairman and CEO] has been very labor-friendly over his career — he started as a bag boy himself — so he structured a labor contract that was a benefit to his competitive position and to his employees. Plus, he gave employees better health care benefits and in effect put the screws to all the major operators in the Southern California market.