Getting Defensive

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\"RR_GettingWhen you’re under assault, build a bigger fortress.

That’s what supermarkets in the U.S. are doing now as they come under siege from deep-discount stores, membership clubs and mass marketers on one front and upscale specialty stores on the other flank.

In a very short time, the industry has become dominated by three big chains that, in the aggregate, sell well over 10 percent of food for at-home consumption. These behemoths are Kroger, Albertsons and Ahold-Delhaize. The rest of the food retailers are much smaller than any one of the big three.

Before we take a look at how the big three came to be, let’s consider one frequently posed question: in a low profit business like supermarkets, what benefit does becoming a large-scale retailer mean?

The biggest potential benefit of becoming a larger company comes in the form of cost savings through post-merger synergy. Those savings can lower the operating cost of the combined company to the point that even two loss-making companies become profitable. If the newly merged entities were previously profitable, so much the better.

One form of synergy comes through the combination of two headquarters into one. Most likely, one headquarters building with its satellite offices and staff can be completely eliminated. So even if the remaining headquarters needs to add staff, the cost won’t be anywhere near the overhead involved in two separate headquarters.

There can also be savings in the cost of product acquisition and distribution. It often happens that when two companies merge; some distribution centers can be eliminated, with the remaining ones capable of supplying all stores. Moreover, advertising costs can be spread across more stores; private labels can be culled to make way for a unified label that can be used across all stores.

Another benefit of mass is sheer cash flow. Even if profitability is elusive for a while, cash flow can be used to pay the cost of capital, if not to partially discharge debt.

These theories of synergy often work out, but not always. It didn’t for A&P, which operated hundreds of stores in the New York-Philadelphia region. A few years ago, A&P merged with Pathmark and Waldbaums with the idea that synergy could restore those loss makers to profitability. A&P is now liquidating.

Now, let’s take a look at the big three to see how they became mass marketers, each in completely different ways.

Slow Food Movement

Kroger, the largest and most profitable conventional supermarket in the U.S. with revenues approaching $100 billion, did it the hard way: by growing little by little over a period of time. It augmented gradual growth by an occasional large-scale acquisition, until it became a huge retailer with nearly 2,700 stores planted in 34 states, covering most parts of the country except the Northeast. Traditionalist by nature, the vast majority of Kroger’s stores are conventional supermarkets, although it also has a fleet of convenience stores, supercenters and jewelry stores too.

While Kroger is a slow-growth company, it has made one recent major acquisition, its first in 15 years, namely Harris Teeter, based in North Carolina. At the time of the acquisition, Harris Teeter had 227 supermarkets, all using the large, high-service model. That made it a good fit with Kroger.

High Finance

Albertsons, Kroger’s closest size rival, leapt into the ranks of the behemoths with its acquisition of Safeway earlier this year. That move gave it about 2,400 supermarkets under various banners. Albertsons is largely owned by Cerberus Capital Management, so, not surprisingly, it is as much of a financial proposition as it is a supermarket operating company. Indeed, in October, Albertsons was set to make an Initial Public Offering intended to raise some $1.6 billion to be used to pay down some of its prodigious debt load of $12 billion, and to improve stores. If things hold true to form, many of its top executives would share in that bounty too.

However, the IPO was abruptly withdrawn because it was to have been offered on the same day Walmart acknowledged that its profitability would be sharply down, which pulled down the equity value of Walmart itself and that of supermarket companies in general.

There’s no telling when Albertsons try again with an IPO, but when it does it almost certainly won’t raise as much money as was earlier hoped. This puts Albertsons at a significant disadvantage to Kroger because so many of its store facilities need an upgrade. On top of that, Albertsons has purchased several dozen A&P stores in the liquidation sale. They will be operated under Albertsons’ Acme banner. That only adds to Albertsons’ need for capital to refurbish stores.

Ominously, Albertsons\’ sales volume is declining and it’s running at a loss. But these are early days, so we’ll see how it goes.

Global Footprint

Rounding out the big three is the Ahold-Delhaize combination. Ahold, based in The Netherlands, and Delhaize, based in Belgium, struck a merger agreement in June. Both companies have significant supermarket holdings in the U.S.

Ahold will have majority interest in the combined company. The deal was valued at about $10.4 billion, plus equity. When the deal is completed next year, the U.S segment of the company will have about 2,000 supermarkets nearly everywhere up and down the Eastern seaboard, generating about $26 billion in revenue.

Ahold’s supermarkets in the U.S. are under the Stop & Shop and Giant store banners, along with the Peapod home-delivery business. Delhaize operates under the Food Lion and Hannaford banners. There’s little overlap among the stores, so Federal Trade Commission authorization should be readily forthcoming. Ahold is also growing because of A&P’s liquidation, having scooped up numerous A&P stores that are now being converted to Stop & Shops.

Worldwide, Ahold-Delhaize will be a whopper of a company. Combined, it will have 6,500 stores in several countries yielding some $44 billion in revenue. That makes it larger than either Tesco or Carrefour.

Incidentally, it’s important to recognize that despite Walmart’s declining fortunes, it remains the largest grocery purveyor in the U.S., producing revenues from grocery product alone well in excess of those of the big three conventional operators combined.

What’s the Future?

The big-picture lesson here is that attaining mass offers some protection from the disruptors that flank middle-market retailers. But the real learning is for heritage retailers is to take a look at what the disruptors are doing and adapt some of their methods and product offers. After all, it’s consumers who are voting with their dollars, and there’s no way to remain successful without following the customer.

Among the big three, Kroger is clearly the one that’s best adapting to the changing tastes of the consumer. That chain has introduced two major private brands that are aimed directly — and successfully — at the space occupied by Whole Foods. They are Simple Truth, an organic and specialty label, and Hemisfares, an upmarket imported label.

On top of that, Kroger is the most successful in lowering its average price point, allowing it to successfully compete with its low-price flank. Ahold-Delhaize is likely to follow that path too once dust from the acquisition settles. Albertsons with its huge debt and declining sales has the highest mountain to climb.

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