Consolidation: Phase II

When Kroger Co. recently announced its earnings and revealed its strategy and assessment of the industry, shareholders of virtually all publicly held supermarket chains saw the value of their stockholdings tumble.

Why would this be so? It is because, beyond the specific situation of Kroger, the company laid out an understanding of the industry that implied we are entering a new age. Kroger’s Chairman and CEO put it succinctly: “Competition has grown more intense as (discount) supercenters continue their rapid expansion and traditional food retailers lower their prices in an attempt to maintain sales and stop losing market share.”

Although Wal-Mart has been viewed for years as the greatest threat to supermarkets, up to this point large chains have been able to plausibly maintain that Wal-Mart has not really hurt them.

Partly this is geography at work – Wal-Mart’s strength is still rural. This is, however, rapidly changing. Wal-Mart, for example, now has 685 supercenters in markets where Kroger operates, more than double the number in 1997.

But even when supercenters were opening in markets where the big chains operated, the claim has been and results generally confirm, that though the chain stores may take a short-term hit, in time they recoup.

The undercurrent that allows this to occur, of course, is that independents and weaker chains go out of business and so create an opportunity for both Wal-Mart and the large supermarket chains to seize market share.

The stock market value of supermarket operations dove because what the market took from Kroger’s comments is that this stage of consolidation – where big companies could keep growing in sales and profits as the industry consolidated – was at an end.

And, all too likely, the next stage involves Kroger, Safeway and Albertson’s turning on one another in their individual attempts to gain market share.

The key to Kroger’s announcement was that Kroger intends to do four things:

  1. Increase its identical food store sales growth target.
  2. Reduce operating and administrative costs.
  3. Leverage its size to achieve economies of scale.
  4. Reinvest in its core business to increase sales and market share.

The challenge issued sotto voce to every other retailer: “Kroger will make substantial gross profit investments to achieve identical (same-store) sales growth of 2 to 3 percent plus product cost inflation over the next two years. This new goal represents a significant increase over the Company’s previous growth target of product cost inflation plus 1 percent.”

The translation: Kroger will cut prices to grow market share.

The problem with all this is that nothing in this strategy will worry Wal-Mart very much. Wal-Mart has always been a price leader and, in the end, Kroger can’t offer lower prices than Wal-Mart if it buys more expensively and operates less efficiently. So focusing on operations makes sense, but it is unlikely that Kroger will get its operating and administrative costs below Wal-Mart.

The size issue actually cuts the other way. Kroger is smaller than Wal-Mart overall and will soon be smaller in food, so leveraging its size doesn’t seem likely to make Kroger a Wal-Mart beater. Reinvesting in the core business – well, once again that won’t be sustained unless the earnings justify it and cutting prices will put pressure on earnings.

In fact, the whole direction doesn’t really seem an answer at all. As Wal-Mart is the low-cost operator on everything from the cost of capital onward, Wal-Mart will win. In time, if the supercenter can’t squeeze in everywhere, Wal-Mart will use Neighborhood Markets or other concepts.

Produce and other perishables are often bandied about as the weakness of the supercenter and the salvation of supermarkets. And certainly well managed perishable departments are crucial to the success of food stores. But Wal-Mart has come a long way from start-up status. Its departments are competitive and getting better.

So what is the answer to how to compete with Wal-Mart? The only answer is the answer in all marketing – to be first in something. Even in discount stores, Wal-Mart does not have hegemony. K-Mart may flounder as it tries reviving Blue Light Specials, but Target is in a much stronger position. Why? Well, while Wal-Mart is the discount store king with families with incomes under $50,000 a year, Target has become positively chic with the more affluent crowd. The company made a deal with noted architect Michael Graves to design a line of products and bring a little high fashion to the discount world. All the sudden millionaires across America are bragging that they bought it at, pardon the French, Tar-zhée. So Wal-Mart can be beaten if one segments the market. Produce, with its variable nature, regional production and numerous grades and sizes is the ideal for segmenting a market.

Lao Tzu in “The Art of War” advises that when faced with overwhelming force, one should shift the field of battle. Starting a price war in groceries hardly seems the battlefield shift likely to help one beat out Wal-Mart.