June, 2000

Fruits of Thought

Margin Creep

Gross margins at produce departments in highly consolidated markets in which competition is real estate-constrained and in which supercenters have not made major inroads are running a good 10 to 15 percentage points higher than the departments were realizing pre-consolidation. Less than 2 percentage points of this increase can possibly be attributed to better buying, so the vast majority of this increase in gross margins has been accomplished by raising prices.

It is time for the produce industry to act. Simple principles of supply and demand dictate that higher prices for fruits and vegetables serve as disincentives to consumption. Therefore, as it is public policy, trumpeted by the National Cancer Institute, to encourage increased produce consumption, public policy should also ensure that consolidation does not become an enabler of higher produce prices for consumers and thus a cause of less consumption and poorer public health.

If you want to know why there is so much consolidation in the supermarket business, you can forget all the cant about buying efficiencies and think real estate and think labor – these are the two big constraints on expansionary growth.

Imagine that instead of buying Vons, Safeway had wanted to compete with Vons. No amount of money would have enabled Safeway to compete with Vons because there is no way that Safeway could have secured sufficient prime real estate sites to build a competitive number of stores. If, by some miracle, Safeway did build the stores, there isn’t a pool of tens of thousands of people waiting to staff such an instant empire.

Add in the fact that if Safeway did build the stores and did find the people, Vons would have been a ferocious competitor, so margins would have sunk low. In other words, after doing the impossible by building the stores and hiring the staff, Safeway wouldn’t have made any money for a long time.

The business skills of the acquiring companies should not be overrated either. The supermarket business is a very old and mature business. And most of the companies being acquired are already giants buying quite efficiently. These are not tiny chains buying less than trailer loads and struggling to meet minimum orders. So all the talk about extraordinary efficiencies to be gained from the mergers is mostly, well, let’s be polite – still hypothetical.

What supermarket management has noted is that, despite the fact that there is loads of competition by everyone from McDonald’s to the drugstore, people still find supermarkets valuable, and most markets are now limited to very few supermarket competitors. All of them want higher margins to justify their acquisitions, so when management finds it can raise prices, it does so.

Unfortunately, produce is bearing the brunt of this margin-creep for the simple reason that produce is not sold as widely in competitive venues to supermarkets. There are a lot of places a consumer can buy Pampers, but not that many where consumers can buy broccoli rabe.

A few chains, notably Albertson’s and the supercenters, have been willing to open a few stores in a market, thus trading off higher distribution and advertising costs to get a foot hold in the market without accepting sub-prime locations.

The big monopoly buster, though, will be e-commerce. Ahold is not going to build a supermarket chain in Los Angeles to compete with existing brick-and-mortar retailers there. And post consolidation, it may get too expensive to buy a chain, but if people are willing to buy on the Internet, it is infinitely easier to build a distribution center rather than a few hundred stores. So its Peapod investment might be seen as an option on a national rollout of Ahold food supply to consumers.

For the produce industry, the battle has to be joined to achieve lower gross margins in produce, but in a different way than it has been in the past. All too many growers perceive lower prices as a supply-and-demand valve to be turned off in the short term – so if peaches are cheap, these growers want cheap prices to move current volumes.

Retailers have answered, correctly in most cases, that on most items, lower prices don’t necessarily translate into higher sales. There seem to be natural set-points that lead to maximum dollar sales. Besides, selling a lot more product is a lot more work for a store, and it is not sufficient for supermarket management to justify a lower price to just sell a little more; there have to be sufficient gross profit dollars to justify all the labor expended in boosting sales.

But these conflicting visions are completely short-term oriented. Over long periods of time, less expensive produce leads to a comparative advantage for produce over other foods – meats, snack foods, etc. It leads to changes in dietary habits.

The produce industry has to begin searching for pressure points to insist on lower retail margins on produce. One option is for growers to seek out e-retailers such as Webvan and make deals to blast produce margins down in particular markets. Consumer protection groups might start demanding assurances on this front when more mergers are proposed but not yet approved. Governmental bodies may get involved, as the public’s health is perceived to be hurt by chains’ pricing decisions.

Of course, all this could be headed off. A chain could just lower prices on produce and announce that to encourage healthy eating, it is going to accept lower margins in produce. Since produce is a high-draw area, it might even boost customer count. It certainly would boost the public image of a chain as one that prices in such a way as to contribute to its customers’ good health.  pb