What are Grocers Doing When Faced with a Dry California?

This year has seen California's worst drought in the last 500 years. And what does it mean for Kroger and Safeway? How do they compete against Wal-Mart?

Apr 10, 2014 at 2:34PM

The Golden State is thirsty these days and it's going to impact how much people will spend for food. California's drought will add the to the cost of food since the state is a major agricultural producer. Overall food, food-at-home, and food-away-from-home prices are expected to rise 2.5% to 3.5% in 2014, compared to a rise of just 1.4% in 2013.  For consumers, they will need to add another $15 to $20 to every $100 they used to spend at the grocery store. 

How are the grocers Safeway (NYSE:SWY) and The Kroger Co. (NYSE:KR) dealing with the increased food costs? How will pricier California produce change their business? 

How bad is it?
California has had drought the last two years and the dry trend will continue. The year of 2014 will likely be the driest one in the last half-millennium for the state. As of March 4, 2014, 91% of the state remains in severe drought. The snowpack from the Sierra Nevadas, which provides a key source of water later in the year, is only at 25% of its normal amount. 



This image was acquired on Jan. 18, 2013 by a NASA satellite. (Photo/NASA Earth Observatory) 


A NASA satellite obtained this image on Jan. 18, 2014. (Photo/NASA Earth Observatory) 

Ironically, models that outline climate change predict that global warming would result in a wetter California. While seasonal and annual changes in precipitation are up to Mother Nature, a few factors have exacerbated the drought situation.

First, California farmers have not gotten their promised allocations of federal water supplies even when there is an above-average annual rainfall. Second, regulations have also made expanding or building reservoirs to take advantage of wetter years more challenging.   Third, some farmers blame federal regulatory efforts to protect the water environment for the three-inch delta smelt and cold water salmon at the expense of agriculture.   Finally, more than 255,000 homes and businesses in California do not have water meters, which makes monitoring and managing residential water usage harder and impacting the available water supplies that could be diverted toward farm use. 

What's (not) growing?
The Golden State is a major source of agriculture. In terms of U.S. agricultural production, California grows 99% of all almonds, 99% of all walnuts, 95% of broccoli, 92% of strawberries, 91% of all grapes (please note, you oenophiles), 90% of all tomatoes, and 74% of all lettuce. 

The drought has already made for a dreary outlook -- 500,000 of prime acres are expected to go unplanted due to the drought.  The limited water supplies has resulted with agricultural water prices skyrocketing up 30 times from just a few years ago. Some farmers are drilling deeper wells at a cost of up to $1 million per hole. However, deeper wells may only last five years, their groundwater is often too salty for crops, and the depleted aquifers may lead to long-term permanent damage. 

How Safeway and Kroger are mitigating the produce price hit
Both Safeway and Kroger have taken steps to limit their exposure to the California drought conditions. First, both have been active players in consolidating with other grocers, which cuts their operational costs. In March, the private equity firm Cerberus Capital Management, who owns the grocer Albertson's, announced plans to acquire Safeway for $9 billion. Earlier this year, Kroger completed its $2.4 billion acquisition of the Harris Teeter grocery chain, and may challenge Cerberus to acquire Safeway.

Both Safeway and Kroger have hedged the costs of California produce toward minimizing any pricing impact. At the February earnings call, Safeway's CEO Robert Edwards said that overall inflationary impact of the California drought would be around 1% for 2014.   At a March presentation, Kroger CFO J. Michael Schlotman noted that the grocer was able to find other suppliers to get their produce, which includes Florida's oranges and strawberries.

Every crisis leads to an opportunity
Taking a page from their supercenter and grocer competitor Wal-Mart, both Safeway and Kroger have turned their focus toward effective retail efforts.

At Safeway's February earning call, Edwards noted that the grocer was leveraging customer data to drive the store's loyalty program, Just for U. Just for U monitors the customer's spending and allows Safeway to push forward personalized deals. Edwards noted that there were 6 million registered Just for U customers at the end of the 2013. Furthermore, Safeway's private brand sales, which help build customer loyalty, went up 28.1% of total grocery sales last year. Most notably, Safeway's organic brand Open Nature label accounted for $200 million in sales.     These efforts have made Safeway an attractive target, as Cerberus has offered to buy Safeway at $40 a share in early March, when the grocer's stock was trading around $30 in February. 

At Kroger's March earning's call conference, COO Michael Ellis said that its acquisition of the digital coupon marketing provider YOU Technology helped Kroger connect with customers. Kroger's organic brand Simple Truth is expected to top $1 billion in sales in 2014. Ellis noted that Kroger's retail efforts have resulted in growing market share against Wal-Mart Supercenters in 12 of 13 select Nielsen markets.  Kroger's financial results were impressive too: Total sales for 2013 rose 3.9% to $98.4 billion and its adjusted EPS grew 13% to $2.85 per share.

So what is the takeaway for the investor?
There's no question that the drought conditions in California will hit both Safeway and Kroger as the cost of produce will rise. However, both grocers have taken active steps toward mitigating the drought's impact with through the use of more effective retail efforts. Furthermore, in the case with Kroger, the efforts have resulted in gaining targeted market share against Wal-Mart. These efforts can lead to competitive advantages which can attract the investor even after the drought's impact has been minimized. While the window of opportunity to invest in Safeway may be closing shortly, if Kroger can continue with improving its retail experience, Kroger looks to be a great long-term investment. 

Johnny Chen has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill. 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.

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