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NEW YORK -- Traditional supermarkets may have a hard time winning back consumers from Wal-Mart and other alternative formats once the economy recovers, a panel of industry analysts said here during SN's eighth annual Financial Analysts' Roundtable."The weak economy really shined the light on the price differences between the conventional grocers and other channels, and one of the big debates is going

NEW YORK -- Traditional supermarkets may have a hard time winning back consumers from Wal-Mart and other alternative formats once the economy recovers, a panel of industry analysts said here during SN's eighth annual Financial Analysts' Roundtable.

"The weak economy really shined the light on the price differences between the conventional grocers and other channels, and one of the big debates is going to be, will there be a switch back to the conventionals when the economy snaps back?" Mark Wiltamuth, executive director of Morgan Stanley, New York, said. "I think once people have shopped at some of these other formats and are comfortable there, I don't see what the incentive is to go back."

Even if spending does pick up, it may not impact supermarkets right away, Meredith Adler, managing director of Lehman Brothers, New York, said. "What will probably happen, as we start to see a better employment picture or see people feeling better, is that discretionary spending will come back before food spending will, just because people change their habits on big expenditures first."

Lisa Cartwright, managing director of Salomon Smith Barney, New York, said she disagreed. "While it's true to a certain extent that people do change their patterns [in a recession] and they may not go back, the people that are still shopping in the supermarkets two times a week will probably expand their expenditures."

Andrew Wolf, managing director of BB&T Capital Markets, Richmond, Va., said he believes the economy has already begun to turn upward, but the presence of 1,200 to 1,300 Wal-Mart Supercenters that did not exist at the end of the last recession in the early 1990s may make a difference in terms of supermarkets' recovery. "The competitive environment is a lot worse today [than it was then]," he pointed out.

The quality of Wal-Mart and other alternative formats is also better than it was at the end of the last recession, Gary Giblen, senior vice president and director of research for C L King Associates, New York, added, "so the cumulative consumer franchise [of the alternative formats] becomes more powerful as there are more of them and as people identify [them] as a reasonable place to buy food."

Cartwright said she believes the reason so many consumers shifted to alternative formats had more to do with the economy than with the growth of Wal-Mart. "Most people believe Wal-Mart is the entire reason why food retailers' earnings growth has decelerated," she said, "but it can't be that dramatic, and I think the economy is having a much bigger impact than people are willing to admit."

Mark Husson, first vice president of Merrill Lynch, New York, said he agreed. If comparable sales in general are down 2%, he said, "then I think 1.5% of that is due to the economy [rather than Wal-Mart]."

Edouard Aubin, retail analyst with Deutsche Bank Securities, New York, said the recovery for supermarkets may be slower this time because of "the quality of the offering, with independent players with very inefficient capacity being replaced by very efficient capacity discounters," which has lowered the profitability of the supermarket sector.

Among other comments from the roundtable discussion:

Adler said Wal-Mart's impact in California as it begins opening Supercenters there may depend on its ability to secure real estate. "The challenges on the West Coast are going to be higher than the challenges in Springfield, Mo.," she said, "and with real estate come challenges on zoning."

Husson argued that the strong comparable-store sales numbers emanating from Wal-Mart Supercenters -- in the range of 5% to 6% -- stem primarily from the fact most of those stores are less than five years old, "[so] we're seeing an exaggerated picture of how good Supercenters are," noting that a look at comps from Kroger stores that are less than five years old would show similar comps.

Cartwright said investors "don't believe that the conventional supermarket format is competitive or can take share. They believe the supercenter format, the club format, the dollar store format, even drug retailing is better in terms of growth and in terms of what consumer demand is dictating."

The text of the roundtable follows. Additional portions of the discussion will be published in future issues of SN.

Challenges Ahead

SN: What do you see as the biggest challenge in the food industry today?

MARK WILTAMUTH: I would say the industry is really facing two major problems. The first is competition from Wal-Mart and other non-traditional retailers, and the second is the difficult operating environment, which is really just exacerbating the first problem. If you look at the industry from 50,000 feet, it is really a slow- to no-growth industry, yet we've got a lot of industry players chasing high growth. Wal-Mart is growing supermarket-related sales at 20% a year, major club stores are growing supermarket-related sales at 8% to 10% a year, and the major grocers are shooting for 4% to 5% sales growth. That's a lot of competitive pressure in a no-growth industry, and I think that's going to impose structural pressures for years to come. And the operating environment -- with the deflation, trading down and price wars that we're seeing right now -- just makes everything worse. So we've been advising investors to stay away from the major grocers for this year.

MARK HUSSON: On top of that litany of challenges, I would add an inappropriate cost base in a historically very labor-intensive industry. Seventy percent of the business is unionized, and 70% of SG&A costs is labor, so you know the unions have a huge impact on the competitiveness of the entire sector, and there's a bit of a crusade, I think, among food retailers to try to reduce labor as a percentage of sales over a period of time -- probably not overnight, but I would say over a long period of adjustment. That's because of the nature of these [labor] contracts -- they expire every three years, and you cannot reduce those numbers easily or quickly.

Another challenge retailers have in an industry that is always trying to be all things to all people is trying to differentiate the players.

MEREDITH ADLER: On the issue of being all things to all people, the industry has a very broad definition of who the customer is that it is servicing, and we've seen very successful niche players come in and satisfy the needs of different groups. At one end are the fresh-oriented operators like Whole Foods, and at the other end, you're seeing the dollar stores tapping into the biggest segment of the U.S. population, which is low-income people -- not totally for food but more for non-perishable items -- and that leaves the supermarkets that go after the middle in a difficult position and with excess capacity, at least in part because their business is being eaten away at either end.

LISA CARTWRIGHT: I guess I would agree about supermarkets being stuck in the middle. There's really been a lack of innovation. Bigger is not necessarily better, as the industry found out in terms of competing with Wal-Mart, and sometimes the smaller niche players have been able to maintain or gain share in Wal-Mart's wake. So I think the supermarkets really have had a tough time figuring out how to differentiate themselves, and a lot of that has to do with management. When you look across all retail, I think management quality in the supermarket industry is sort of average to poor, relative to other retail businesses and among some of the niche operators.

ANDREW WOLF: I'd like to underline what Mark said about labor disparity because I think that's the biggest issue. I think the second biggest issue is what Lisa is talking about, which is that core merchandising ability is lacking. There are some good supermarket merchants, but they're just generally not the large public ones. In the past the large public chains didn't need to be good merchants because they had economies of scale relative to regionals, but unionization took away many of those economies through traditional labor-management antagonism, and labor has done very well in this industry. Now Wal-Mart has emerged with a hugely un-level playing field advantage in labor, so clearly the biggest issues involve getting the playing field more level, and the faster, the better.

GARY GIBLEN: One way the industry has tried to address all these challenges is through acquisitions, seeking to grow in a different manner, but unfortunately, that hasn't been successful either. The biggest examples are Safeway, which is really having indigestion with all its recent acquisitions, and Albertsons, which bought Seessell's and pretty much didn't succeed with that, and all of their smaller acquisitions really haven't amounted to much either. Overall, the mega-mergers were very difficult and still are not perfectly integrated, and I think it's fair to say that American Stores and Albertsons are still not entirely integrated, although it's much better than before. So acquisitions are not a panacea to growth, and that might be why you don't see many acquisitions being done.

HUSSON: But look at the acquisitions Kroger has made. They've integrated slowly over time and have been successful and have actually seen return on invested capital go up as a result rather than down. So at the end of the day I think it's execution of the acquisitions that is the problem, not the idea of the acquisitions themselves.

CARTWRIGHT: Or overpaying for assets. Kroger didn't have to write anything off.

WOLF: Or having the Federal Trade Commission make you divest too many stores, which hurt Albertsons' acquisition of American Stores.

EDOUARD AUBIN: Besides Wal-Mart growing stores so rapidly, the challenges come from the quality of the offering, with independent players with very inefficient capacity being replaced by very efficient capacity discounters. And obviously the profitability of the sector has been going down because of that.

The Economy

SN: How has the economy affected supermarket performance, and what impact will economic improvement have?

GIBLEN: The economy has been bad enough that people are actually spending less on food. You can see it in every sector of retailing -- even in supposedly bulletproof areas such as restaurants and pet supply, with people eating out less or buying less pet food, as well as buying less at the supermarket. And unfortunately, that's corresponded with a period in which private label has somewhat maxed out -- not entirely, by any means, but the large gains in private-label mix have already been achieved at many chains, so we're seeing the offset of people trading down to private label, which is more profitable for the chains on a dollar basis and isn't really there on a percentage basis because there's only so much private label that can be sold, and that's one reason we've had poorer sales results from the supermarkets and the economy.

ADLER: I have to disagree on private label. There's evidence coming out of the manufacturers, plus IRI and Nielsen data, indicating that private label is growing, possibly at a stronger pace than it was, and in general, working private label puts pressure on sales. So in fact, the weakness we've seen in sales is probably directly tied to the fact that private label is becoming more popular.

But I think if you go back to 2001, food retailers had a good Christmas but discretionary retailers did not, and the general economy didn't recover and at some point it got weaker, and people started looking at food, which is the second or third biggest monthly expenditure, and they cut back their budgets. And what probably will happen, if we start to see a better employment picture or see people feeling better, is that discretionary spending will come back before food spending will, just because people change their habits on big expenditures first.

WILTAMUTH: The weak economy really shined the light on the price differences between the conventional grocers and the other channels, and we saw some consumers shifting to Wal-Mart and club stores and other low-priced venues. I think one of the big debates is whether or not there will be a switch back to the conventionals when the economy snaps back. I think once people have shopped at some of these other formats and are comfortable there, I don't see what the incentive is to go back.

WOLF: There is a convenience incentive, if you have a job and you want to save time.

CARTWRIGHT: It happened after the last recession in 1990 and 1991, when there was a bounce back, although it took about three years. But there was a recovery. And while it's true to a certain extent that people do change their patterns and they may not go back, the people that are still shopping in the supermarkets two times a week will probably expand their expenditures.

HUSSON: But just one more thing.

WILTAMUTH: Or make less use of club cards.

CARTWRIGHT: I personally think the pendulum has swung completely. I mean, for a long time, people thought Wal-Mart didn't matter, and now most people believe Wal-Mart is the entire reason why food retailers' earnings growth has decelerated. But it can't be that dramatic, and I think the economy is having a much bigger impact than people are willing to admit.

HUSSON: I think if you look at comparable-store sales among food retailers today -- and I'm generalizing here -- but if they're down 2%, I think 1.5% of that is due to the economy.

ADLER: The economy and deflation.

WOLF: In tracking the movement of sales over the last few months using government statistics, real sales were better in the June quarter than the March quarter -- a lot better -- so to me, the industry has actually bottomed, probably some time around the fourth or first quarter, and that's why the stocks are outperforming in the second quarter. And if you look at retailers like Publix, Weis Markets and Harris Teeter, they're all posting positive comps, and that's sort of the theory we were talking about -- that the regionals are out-merchandising the bigger guys. The industry is in a recovery mode on a top-line basis, and while the recovery may be slow and the slope may be bumpy, it certainly looks like it's turned upward based on some of the macro-evidence that we get out of the government and industry fundamentals from the better regionals.

WILTAMUTH: But I think it's a little disturbing how much margin has been sacrificed. The companies have all been cutting prices and been more promotional, and we haven't really seen much sales impact from all those sacrifices.

CARTWRIGHT: Well, it takes a while -- something like nine to 12 months.

WILTAMUTH: It does take time. But the concern I think a lot of people in the investment community have is, if everybody is sacrificing price at the same time, doesn't that just erode your gross margin permanently?

WOLF: It probably does, to some extent, which I agree is a major issue.

GIBLEN: And you aren't going to make it back on operating expense.

CARTWRIGHT: There's no doubt the supermarket companies are never going to be returning 17% to 18% ROIC figures to their investors again -- we're talking about a much lower-return business -- but we'll see a recovery from the low point of negative 20% earnings growth and ROIC dipping down below 10%, maybe going back up to 11% to 12%. You definitely can catch that -- it's just knowing when to sell.

ADLER: And when you talk about margin, you start to get into the issue of competitive factors. I think what some people forget is that there are advantages to being a regional operator. I believe that the regional guys have done a very good job, but being multi-regional has its advantages, too, and there is not a need to invest in every market today. So there's this idea that it will keep getting worse and worse year over year, whereas the reality is that geographically and regionally, you move on and take care of what you need to take care of.

I was also going to mention some very interesting data about market share. We focus on market share per store, which adjusts for any changes in capacity that have occurred within a market for any individual player. Market share seems to go up, but then you discover a company bought five stores or it built five stores. In markets where a conventional player has exited after Wal-Mart has entered, what we see first is that Wal-Mart takes market share. Eventually, in some markets, a weak player will go out of business, and then the share shifts back to the conventionals. Wal-Mart doesn't pick up a lot more share -- there is little more share on a per-store basis after the conventional goes out of business, and it's the other conventionals that pick up that share. And that is certainly what we've heard companies like Kroger say, and I've seen data that supports the fact that does really happen.

HUSSON: We used to call that the "Black Death effect." It's when the plague comes to your village and everybody gets sick but not everybody dies. And two years after the plague has come, when the old and the weak have perished, the market share of those who survived has gone up.

The Recession: 1990 vs. 2003

WOLF: When you compare recessions, I want to make the point that Wal-Mart is a bigger factor than it was earlier for a number of reasons. Most obviously, it wasn't adding 200 highly productive supermarkets per year 10 years ago, and if you look at how earnings rolled over in the last recession for food retailers, it wasn't as severe as it is now. There were other mitigating circumstances -- for example, retailers were more leveraged, so when their operations flattened and they had all that debt, it impacted earnings more severely.

CARTWRIGHT: But supermarkets have had the highest growth, as Gary was saying. You had big increases in private label in the early 1990s, and you had other factors offsetting that. If that's your point, I have to disagree with it. You had a bigger cushion for private label in 1990 and 1991, coming out of the 1991 recession, and 1992, 1993 and 1994 saw huge growth in private label.

WOLF: And the ID sales didn't roll over, and earnings didn't roll over as badly in 1992.

ADLER: And you didn't have inflation.

WOLF: There was a deflation, too.

ADLER: But that's very different than last year.

HUSSON: Lisa is saying that from 1990 to the bottom of 1992, the rollover was dramatic. I remember coming into the market back then and everyone telling me that all the alternative formats were going to kill the food retailing industry and it was all over. We had four club store chains back then. They were stamping all over the world, and just like Wal-Mart analysts today, club store analysts of yesterday were outdoing each other trying to forecast the total number of clubs that competed in this country. And then the comp-store sales rolled over and discount stores opened in 1993 and 1994, and they said the club industry was dead, which of course it wasn't either -- it was just a bit of a mirror effect.

WOLF: The only operator who had negative ID sales in the early 1990s was Safeway, while the other major players stayed positive. Now everybody's negative and has been for three or four quarters, which tells me that the competitive environment is a lot worse today because there are 1,200 to 1,300 Wal-Mart Supercenters taking a disproportionate amount of share.

SN: So Wal-Mart is a more important factor than the economy in the downturn?

WOLF: You can't say the economy is worse now than it was 10 years ago.

WILTAMUTH: But things have changed. In 1997 Wal-Mart had 6% of the market, and today it has 12%, and if you add in Sam's, it's up to 16% of the market.

WOLF: I'm not saying it's all Wal-Mart. I'm just saying it's more Wal-Mart now than it was in 1990 to 1992.

HUSSON: There is also the capacity of the alternative formats.

GIBLEN: Costco has turned out to be a great perishables merchant, and Wal-Mart is not a joke in terms of their food retailing execution, whereas previously they really appealed only to the very lowest stratum. So I guess it's not only the number of stores that comes into play but also the quality of them, and the cumulative consumer franchise becomes more powerful as there are more of them and as people identify Wal-Mart as a reasonable place to buy food, instead of just an oddball place.

CARTWRIGHT: I think that between the 1990-1991 recession and today, food retailers have also become more cyclical. They have added more general merchandise and more health and beauty aids -- things that actually can create a more negative impact in a downturn.

ADLER: Unfortunately the data doesn't actually support that. It doesn't look like it took that much in terms of share.

CARTWRIGHT: Kroger in 1990 and 1991 didn't have Fred Meyer, and that aspect could lead to a slightly more negative comp or a bigger decline in sales.

ADLER: It's also a different recession that we're seeing this time. The regions are different. Arguably the employment situation has been different.

I don't know that this necessarily relates to the issue, but one of the things that is a basic fact of the grocery business is that capacity doesn't go away quickly. Eagle Food Centers was a troubled company 10 years ago, and it's in its second bankruptcy now and talking about liquidating this time. And Penn Traffic is going through a bankruptcy again, and Grand Union went through three bankruptcies. So in a way a problem for the industry is that you don't get the flushing out of the weak players.

The Wal-Mart Factor

WOLF: Do you think Wal-Mart's high single- to low double-digit food comps are all in one- and two-year-old stores?

HUSSON: They haven't got high single-digit food comps.

WOLF: Well, they have traditionally, and now it's 5% or 6%. The point you're making is their mature stores flatten out, and I find that hard to believe.

ADLER: That's what the data seems to say. We don't have any really great quality data on market share for Wal-Mart, but the data we have seems to indicate that if they're not adding square footage, they're not really picking up a huge amount of share.

HUSSON: I think if we're going to look at comp-store sales numbers at chains like Kroger in the same way we try and work out comp-store sales numbers for Wal-Mart Supercenters, we're going to get a different view, because if 65% of Wal-Mart's Supercenters are less than five years old, that's going to impact the comp-store sales mix dramatically. I think if you looked at 65% of Kroger stores that have opened in the last five years, I would guess comps are in the mid-single digits -- probably a little bit below where Wal-Mart is right now. But we're seeing an exaggerated picture of a company and an estimation of how good Supercenters are because of the mix of youthful stores. There are a lot of very old Wal-Mart Supercenters that are negative in comp-store sales.

ADLER: In fact, because so many of the Wal-Mart Supercenters are conversions of existing discount stores, that may explain the differential as to why they're able to comp higher. That's an opportunity you'll never have at Kroger.

WOLF: That seems to explain why Wal-Mart has to have a lot of stores. You just said their old stores are really bad.

HUSSON: Sure. And their return on capital in new stores is good, which is important.

HUSSON: Another thing that we haven't mentioned so far that is vital to understanding this industry is that Wal-Mart has got two-thirds of its stores outside the top 100 metro markets. They open about 210 Supercenters a year, but 75 of those show up in big cities where all the big retailers are. The top 100 metro markets are where 70% of the food retailing dollar is spent, and Wal-Mart is hardly there. So Wal-Mart looks big, and maybe they're taking in 14% to 15% of the incremental dollar, but it's not in big cities, it's just in small-town America. You do not want to get caught in an open field with Wal-Mart around you, but if you're hiding behind big city walls, that's OK.

WOLF: I'd like to rebut that. All of us, I think, try to figure out the exposure of the industry's stores to Wal-Mart Supercenters, and based on my calculations outside of California, 47% of Kroger stores will compete with a Wal-Mart Supercenter by the end of 2003, along with 42% for Albertsons and 25% for Safeway. And these chains' exposure to Wal-Mart Supercenter competition is growing by 5% a year on average.

HUSSON: It's in 18 out of the top 48 markets.

WILTAMUTH: I think we need to look at it on a store-by-store basis. We just did a study of 9,000 stores to determine how many have a Wal-Mart Supercenter within 10 miles, and we were getting similar numbers to what Andrew just presented -- 43% of the Krogers with a Supercenter within 10 miles, 38% of the Albertsons and 23% of the Safeways. So the next question is, where is Wal-Mart going next? They are moving westward, and that's going to have an impact on Safeway and Albertsons.

HUSSON: Kroger's got some smaller markets, but again, if you look at the big cities -- the New York/New Jersey metroplex, Philadelphia, Boston, Detroit, Baltimore, Washington, Chicago -- Wal-Mart has gone past all of those cities, in some cases as long as 10 years ago, and their market share in all of those markets is 2% or less. So as Wal-Mart moves into California, you have to figure out whether California is going to look like Oklahoma City or Mobile, Ala., or is it going to look like Philadelphia?

WOLF: Well, I think it will look like both. It's the fifth largest economy in the world and it's our salad basket, meaning it has the biggest and most populous rural areas in the U.S.

HUSSON: That's very similar to where Wal-Mart is going. Wal-Marts are going in the same kinds of areas in California as they are, say, in Chicago.

CARTWRIGHT: Well, there's no doubt they are going to be the low-cost provider, even if their cost structure is going to be higher.

HUSSON: But in terms of market share, their impact is going to be negligible. In San Francisco you're going to have to go across two bridges to get to the first Supercenter. And we haven't even started to address the issue of market segmentation and what kind of customer base they historically target. Wal-Mart said themselves they plan to open 40 stores in California in the next four years, and that's enough for a 1% market share in California.

WILTAMUTH: That's not all it's going to be. You know it's going to be a bigger number than that.

CARTWRIGHT: It's not just Wal-Mart. It's Costco, BJ's, Trader Joe's, Whole Foods -- there are a lot more issues than just Wal-Mart.

GIBLEN: And all of that lowers margins for the whole region. And there's another element here -- the fact the chains have historically made way above-normal returns in the outpost markets that were non-competitive, and now that's over. So it might not be that big a part of Wal-Mart's sales base to have stores in the Central Valley [of California] or over those two bridges Mark mentioned, but at the same time, the conventional stores in those areas have been disproportionately profitable for chains like Safeway and Albertsons, and now they won't be.

CARTWRIGHT: I believe the Wal-Mart challenge for Safeway is probably two years out, or at least a year out.

ADLER: Anybody who's being realistic has to believe that the challenges for Wal-Mart in terms of real estate on the West Coast are going to be higher than the challenges in Springfield, Mo. And with real estate come challenges on zoning, and it gives the unions an opportunity to pull levers -- and they will pull them. I personally think Wal-Mart said 40 stores over four years because they recognize that the challenges are there and they don't want to commit to the market something they're not absolutely sure they can deliver on. I will argue with you, though, that the first three or four stores that open in California happen to be in markets like Bakersfield and Chico -- markets where Safeway operates.

GIBLEN: Areas like Bakersfield are probably where Safeway gets a disproportionate share of its profitability.

WOLF: I've looked at the first five Wal-Mart Supercenters that are opening in California -- in Chico, Bakersfield, Reading, La Quinta and Hanford -- and in those markets, there are 15 Safeways, eight Albertsons and no Krogers. Wal-Mart is not going to impact all those stores, but certainly many of them.

WILTAMUTH: I think one of the other things you can look at, if you're looking at California, is that Wal-Mart pursues a strategy of doing conversions of existing discount stores wherever possible. They've already got 135 discount stores in California, and I think that's a hint at where they could start spreading out.

ADLER: They still need zoning approvals, though, to do those expansions, especially in California. And you're talking about a significant issue for some communities because a Supercenter means they're going to get so much more traffic, and where it's OK for Wal-Mart to operate a nice discount store in an area, the community isn't necessarily going to like it to be a Supercenter. It's not Texas or Arizona.

AUBIN: I believe Wal-Mart entered California with discount stores very late -- in August 1990 -- and at that time they were already testing the supercenter format. They opened their first Supercenter in 1988, so if you talk to Wal-Mart, they're going to tell you that they bought a lot of land around those discount stores in California. And if you make a very conservative assumption that two-thirds of the discount stores will be expanded, with no new openings, then you are looking at about 100 Supercenters at least in California in the next few years, which will obviously have a very significant impact.

HUSSON: But that kind of impact over several years is glacial.

CARTWRIGHT: But that glacial impact over the last 10 years or so has impacted supermarket stocks, particularly in the last three years.

HUSSON: With respect to the stocks, I don't disagree with that at all. What I do think is that people have mistaken a lot of this cycle for Wal-Mart, and it's not Wal-Mart.

The End Of Wal-Mart?

SN: How long can Wal-Mart continue to be the powerhouse that it is? All companies and all institutions fail at some point. How could that happen to Wal-Mart?

WILTAMUTH: Without some sort of regulatory intervention or without unions somehow working their way into the Wal-Mart system, Wal-Mart is going to continue to grow for at least the next decade. We estimate that Wal-Mart will reach 30% market share 10 years from now.

HUSSON: Look at A&P, which was the Wal-Mart of its generation. In the 1930s it was only the second company in America to make $1 billion in sales, and at one moment it was actually the largest sales company in America -- it was the Great Atlantic & Pacific. It had 10,000 stores coast-to-coast, and legislation like the Robinson-Patman Act was written to curb the growth of A&P's business. There's a very good poem by Shelley that illustrates what might happen to Wal-Mart. It's called Ozymandias, and it's about this wreck of a statue in the desert. "Look at my works, ye mighty, and despair. ... Round the decay of that colossal wreck, boundless and bare, the lone and level sands stretch far away." At some stage it's going to happen to Wal-Mart.

CARTWRIGHT: Over the long, long term, given the aging of the population, Wal-Mart's Achilles' heel could be its large stores, and that's why it is smartly developing the Neighborhood Market concept. Right now I think it's a trade-off for Wal-Mart -- when they look at opening up a store in a bigger market where they feel there's room for a Supercenter, they go with a Supercenter because they prefer to use a good manager to run a store with $150 million in sales rather than a Neighborhood Market with $20 million or $30 million in sales. But over time they could end up going after more near-term growth and sacrifice a better return by pursuing a strategy that uses the smaller stores as fill-ins to capitalize on that aging population.

HUSSON: And in America, drive time doubles every 10 years, and Wal-Mart is the biggest landlord of inconvenient retail space in the world.

ADLER: I would argue that returns are also an issue for Wal-Mart -- that they rightly choose to enter markets where they are likely to have success -- non-union markets, markets where real estate was not a barrier. But if they put too many stores in California too quickly, I think that could pressure returns. And I happen to believe the Neighborhood Market does not generate as good a return as a Supercenter, so for somebody to believe that they're going to finish opening Supercenters and then build 500 Neighborhood Markets -- well, looking at the returns, it wouldn't be a good proposition for them.

CARTWRIGHT: That's why they're not doing it. But at the end of the day they end up with these huge stores in the market. And they said that one of the reasons they researched and developed the Neighborhood Market concept was because when they interviewed consumers, they said they wanted a smaller format. So Wal-Mart is balancing ROIC vs. changing consumer needs.

ADLER: But it's not balancing because it's not opening Neighborhood Markets right now, so I think it still faces that issue. And its track record on international has been very mixed. I think Wal-Mart has demonstrated that if it tries something very different from what it knows how to do -- such as operating stores overseas -- that's very challenging, and that means the question becomes what is the next thing that helps it maintain returns over a longer period. It's continuing to expand internationally, and I think it recognizes it has to start getting ready for the time when the easy returns on Supercenters are done, so it has something else ready that won't be too challenging, the way Germany has been challenging on returns.

I believe that if you go out long enough, there could be some arbitraging of Wal-Mart's advantages. Over a long period of time, its labor advantage will narrow, and I think some of its operational advantages will narrow as well. However, it will always have an advantage when it comes to capital, which probably can never be arbitraged away.

CARTWRIGHT: Can you explain what you mean about Wal-Mart losing its labor advantage?

ADLER: Well, I think we're seeing what Kroger has said about markets where it competes with Wal-Mart. Kroger has some union contracts that have three tiers, and if you wait 10 years and the oldest part of the workforce has retired, then everybody new is coming in at a rate that's a lot closer to the Wal-Mart package. And Kroger is also about being creative -- one use of capital, aside from investment in the stores, is buyouts, where you can bring in lower-wage people, and over a period of 10 or 15 years, Wal-Mart may have used up its opportunities in non-union markets, and over the following five years it will be facing some of the same pressure the conventional chains face today. Maybe Wal-Mart's wage or benefit packages in California, although they won't be unionized, will have to be a little different, and its costs are certainly going to go up in California. Just look at workers' comp there.

Gross Margins: Up Or Down?

WOLF: I'd like to return the conversation to what Mark [Wiltamuth] brought up about margin structure. I think what comes before dividends and free cash flow models is what free cash flow is going to be, and I'd like to know what everyone thinks. If you look at the big turnarounds in this industry in relationship to the margin structure of the industry -- EBITDA growth from 1993 to the peak in 2001, when EBITDA margin was up about 3% for the Big Three, gross margin was up about 4% and cost structure was up about 1% -- my numbers indicate gross margin is going to go down half a percent in 2003 or maybe be flat to slightly up in a best-case scenario.

HUSSON: I'm not sure about net margins but I'm pretty sure gross margins are going up next year.

ADLER: I want to know how much confidence you have in your 2004 forecast?

WOLF: I haven't published a 2004 forecast because I think the competitive environment is rampant and there's too much capacity right now, so I think gross margins are really dependent on the economy. If the economy rebounds, gross margins might be flat or slightly up at best next year.

WILTAMUTH: That raises a good point. The earnings base and the stability of the earnings base is really the key here, because if you look back over the last year, I cut my estimates by 20% to 40%, depending on which company it was, and that makes for a fairly dangerous place for investors to be looking. This group has been a terrible value trap for the last two years.

AUBIN: With such an imbalance between supply and demand and with bad capacity exiting the market extremely slowly and discounters opening space at a very fast pace, there is no way that gross margin is going to go up in 2004 and even in 2005. In any given industry, when you have such an imbalance between supply and demand, pricing is going to have to come down. So in our model, we have gross margin going down and profitability coming down in 2004 and 2005.

Lehman Bros., New York, requested that SN run the following disclosure statement in connection with publication of the SN Roundtable:

Meredith Adler covers Kroger, Safeway, Albertsons, Winn-Dixie, A&P, Whole Foods Market, Supervalu and Nash Finch. Meredith Adler does not sit on the board, nor does she own any stock in these companies. Lehman Bros. has an investment banking relationship with Safeway, A&P and Nash Finch. Lehman Bros. does not own 1% or more of any of these companies. Meredith Adler is not aware of any material conflicts with regard to these companies.