December/January, 2003

From the Editor

Cost Obsession

Is the deli department going to be procurement-driven or merchandising-driven? That will be the preeminent question before the industry over the next several years. There seems to be powerful forces pushing for a procurement-based model, but such a direction may pose grave dangers for the very institutions that see this model as a savior.

The single fact most important to remember is that large supermarket chains are obsessed with Wal-Mart. And well they should be. There are over 1,000 Wal-Mart Supercenters in the U.S., and the company is building over 180 a year. That means that every single year Wal-Mart adds the purchasing power and sales of a sizeable supermarket chain.

Up to this point the big supermarket chains have not been hurt by Wal-Mart’s growth. Partly this is a matter of geography. Wal-Mart started building in rural areas and, even today, most Supercenters are not in the top 100 markets. But the situation is rapidly changing.

In 1997 there were 300 Wal-Mart Supercenters in areas where Kroger operates. By 2001 there were 685 Supercenters in areas where Kroger operates. And the competition will only get more intense as Wal-Mart continues to expand.

Beyond geography, in the initial stages of Wal-Mart’s growth, it was possible for Wal-Mart and large supermarket chains to squeeze out independents. That is why if you have gone to National Grocers Association meetings, they often sound like anti-Wal-Mart revival sessions.

But this process is coming to a close. With Wal-Mart increasingly moving into more suburban and urban areas and the sales of independents being squeezed fast, large supermarket chains — especially the big three: Albertson’s, Kroger and Safeway — are scrambling to come up with a strategy that will allow them to survive and grow.

In a recent conference call, top Kroger executives told Wall Street that they were going to expand aggressively and would do so by accepting lower gross margins. To make this possible, Kroger executives indicated that the supermarket chain would focus on centralizing procurement in order to leverage its size to get better deals.

Not long after this call, Ahold announced that it would also be centralizing perishable procurement, and similar sounds are coming from most large chains.

The stock market reacted nervously to all this, sensing a price war in the offing.

The reaction is not surprising. Wal-Mart has a lower cost of capital than most of these chains, is a larger buyer than these chains and operates more efficiently than these chains. So launching a price war doesn’t seem to be a particularly promising strategy to beat Wal-Mart.

And centralized buying is Wal-Mart’s forte, so the best that can be hoped for is large supermarket chains will buy more efficiently than they do today, but, in all likelihood still less efficiently than Wal-Mart does.

Kmart’s recent travails should have taught everyone the peril of attempting to copy your competitor’s operations. When Kmart introduced its “Blue Light Always” program, in which the company cut way back on special circulars and advertising deals and instead put 30,000-odd SKUs on at permanently lower prices — thus aping Wal-Mart’s Every Day Low Price format — Wal-Mart responded by lowering prices still further. Kmart had no viable response and collapsed.

This is the problem with centralized buying. Although theoretically such efforts could simply be efficiency driven, with attempts to reduce the number of buyers etc., such savings would really be trivial. The real savings come from being able to offer manufacturers guaranteed distribution in larger numbers of stores.

But this attempt to leverage a retailer’s size against manufacturers tends to influence product mix if it is going to be effective. After all, if a supermarket chain is going to carry brands that are regional favorites, low-volume specialty items and similar parts of the merchandising mix, the chain loses the ability to force distribution of selected products. But if one offers the placement uniformly in all the stores —one also loses the chance of using product mix to hone the competitive edge.

And lest we all forget, supermarket delis, bakeries, produce departments, floral, seafood departments, specialty food offerings — these all serve not only to make a profit, but to differentiate one’s offerings from the competitors.

So centralized buying is likely to lead to bland stores that ape Wal-Mart in product offering and still have a higher cost structure than Wal-Mart.

In listening to that Kroger conference call, what was most shocking was that in all these plans to sell more and be more efficient, there was scarcely any attention being paid to actually offering food and services that would cause customers to prefer the supermarket chain’s stores over its competitors.

It struck me that the “savings” from centralized buying were quantifiable and thus of interest to Wall Street. The increased sales and profits from offering a more attractive product mix and merchandising it better were too uncertain for Wall Street. But analysts on Wall Street have never run a food store, and what might be easy to analyze is not necessarily the most important.  DB