Wisconsin-based supermarket chain Roundy's (NYSE:RNDY) made a bold statement about its future growth prospects in December, agreeing to buy 11 of Safeway's (NYSE:SWY) metro Chicago-area stores. The purchase nearly doubles Roundy's position in the Chicago market, where it operates under the Mariano's brand name. Safeway is exiting the market after failing to compete against a host of well-heeled competitors, from Whole Foods Market at the top end to Wal-Mart at the bottom. So, should investors bet on a growth trajectory for Roundy's?
What's the value?
Despite a food wholesaling history that dates back to 1872, Roundy's is a relative newcomer to the food-retailing space, moving aggressively into the area only after the company's 2002 acquisition by investment firm Willis Stein. Roundy's operates stores that target a primarily value-conscious customer base using a variety of banners, including Pick N' Save, Rainbow, and Mariano's. With a top market share in most of Wisconsin's major cities, including Milwaukee and Madison, the company has had to search elsewhere for growth, hence its move south into the larger metro Chicago market.
In FY 2013, Roundy's has posted mixed results, with a small top-line gain being more than offset by a drop in its profitability level. The company's operating margin was hurt by its primary focus on a value-priced customer base, a segment that requires heavy promotional activity in order to drive customer traffic. Roundy's was also negatively affected by the health-care industry's continued shift toward generic prescriptions, a trend which hurt the company's pharmacy business, a major source of higher margin sales that accounts for roughly 16% of total revenue.
While Roundy's may see gold in selling food stuffs to Chicago's roughly 2.7 million residents, investors should be cognizant of the failures of like-minded competitors to crack this high-cost market. Safeway's Chicago area stores, operating under the Dominick's brand name, have been a drag on its overall profitability lately, reporting a -3.4% segment margin in the current period. If a larger competitor like Safeway, owner of a strong ecosystem of bakeries, bottling plants, and procurement facilities, is heading for the exits, perhaps Roundy's desire to fill the void isn't the wisest of decisions.
Chasing the leader
Of course, Roundy's is trying to reduce its reliance on its home Wisconsin market through its ambitious growth plans, while also hoping to create greater efficiencies in its overall network. The company's strategy of pursuing a general food-retailing business, as opposed to concentrating on a specialty niche, will likely require it to gain much larger scale than its current base of roughly 160 stores, if it hopes to compete with mega chains like Kroger (NYSE:KR). Despite being the neighborhood grocery category's kingpin, Kroger continues to be in growth mode, recently agreeing to buy smaller competitor Harris Teeter for $2.5 billion, a transaction that added 10% more stores to its overall network.
In FY 2013, Kroger has posted generally favorable financial results, with a 3.7% top-line gain that included its 40th straight quarter of comparable-stores sales increases. The company is a master at operating in a low-margin environment, having cobbled together a strong supporting network of production facilities, which allows it to produce 40% of its growing roster of private- label product offerings in-house.
In addition, Kroger has built a massive fuel operation, accounting for roughly 20% of total sales, which it uses to create customer brand loyalty and bring higher traffic into its stores. The net result of the company's efforts has been strong operating cash flow in the current period, allowing Kroger to further improve its competitive position and continue to reward shareholders with stock buybacks and dividend increases.
The bottom line
The growth plan at Roundy's has the company expanding to the big city, specifically the Second City, as the next step in a progression toward becoming a national player. However, ultimate success in that endeavor is far from guaranteed, given the recent exit of competitors, like Safeway and Supervalu, which were each unable to build a sustainable business in that geography. While Roundy's is an interesting small-cap story in the grocery business, more so given its current 5% dividend yield, investors should force it to deliver on its growth plans prior to taking a position.
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Robert Hanley owns shares of Safeway. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.