Wal-Mart Rumbles in the Supermarket Jungle (Fool on the Hill) March 7, 2000

An Investment Opinion

Wal-Mart Rumbles in the Supermarket Jungle

By Richard McCaffery (TMF Gibson)
March 7, 2000

The rumble in the supermarket industry isn't the wave of online grocery stores coming to a city near you. It's the roar of discount powerhouse Wal-Mart (NYSE: WMT) and it's getting louder.

Wal-Mart's Supercenter concept combines the company's traditional discount stores with full-size grocery departments including bakery, deli, frozen food, meat, dairy, and fresh produce departments. The idea isn't new. Wal-Mart opened its first Supercenter in 1988, but it's gaining speed and taking marketshare by the fistful in an industry with slow top line growth.

Imagine investing in a grocery chain that offers a 24% return on equity and very manageable debt?

Wal-Mart's expansion has helped drive the median size of grocery stores from around 40,500 square-feet two years ago to 52,400 square feet last year, according to Todd Hultquist, a spokesperson at the Food Marketing Institute, a trade association representing about 1,500 supermarket companies nationwide. Wal-Mart's Supercenters average 150,000 square feet.

The concept is spurring consolidation, perhaps the biggest trend sweeping the industry today. Over the last few years, the percentage of the market owned by top supermarket chains has grown rapidly, according to Dave Wellman, editor of the grocery business section of Supermarket Business magazine. The top 100 chains capture about 75% of the industry's revenues, and this trend is expected to escalate as greater scale improves a company's pricing power and ability to improve distribution efficiencies.

In fact, Wal-Mart has a shot at becoming the first truly national supermarket chain since the 1960s when The Great Atlantic & Pacific Tea Company (NYSE: GAP) operated about 12,000 stores under the A&P brand. Today, Albertson's (NYSE: ABS) and Kroger (NYSE: KR) are the closest thing to national chains, with about 2,500 and 2,269 stores, respectively. Wal-Mart currently has 721 Supercenters, opened 157 last year, and plans to open 165 more this year.

The company could double or triple the number of domestic Supercenters over the next decade without saturating the market, according to Edward Townsend, research director at market research firm Trade Dimensions.

At the rate it's growing, Wal-Mart Supercenters are set to overtake industry leader Kroger in sales volume this year. Supercenter sales totaled $45 billion in 1999, up about 41% from $32 billion a year ago. More to the point, the company's grocery sales grew an estimated 36% last year to about $14 billion, much faster than either Kroger or Albertson's, though it's building from a much smaller base. Kroger and Albertson's 1999 sales grew 6.1% and 4.5%, respectively.

There are a handful of trends driving the Supercenter concept. Price-conscious consumers are looking for better values and Wal-Mart has done a bang up job marketing its "everyday low price" strategy. On average, prices are about 11% lower at Wal-Mart's Supercenters, and about 24% lower at wholesale clubs like Costco (Nasdaq: COST) and Wal-Mart's Sam's Club, Wellman said. Wal-Mart's pricing power with manufacturers is a major reason for the cost savings it offers consumers.

This is an increasingly important trend for retailers. Over the last few years pricing power has swung from brand name manufacturers -- companies like Gillette (NYSE: G) -- to powerhouse retailers like Wal-Mart, Costco, and Home Depot (NYSE: HD). These companies, with their enormous scale and distribution capabilities, basically call the shots with manufacturers today, dictating the prices they'll pay and other terms of delivery. Smaller chains just don't have the same clout.

Another trend is the time crunch felt by consumers. Nobody wants to make trips to three different stores after working all day, and Supercenters give customers the ability to combine trips and buy in bulk. It's a tough model for smaller format, local stores to compete with.

Gross margins at Supercenters are lower than at Wal-Mart's traditional discount stores, but the concept is about getting customers inside stores more often. People shop for groceries about 2.2 times per week -- a lot more often than they shop for shirts, mops, CDs, and towels. Plus, the average purchase is larger at Supercenters since consumers look to fill more of their needs in one trip.

Does this mean traditional supermarkets will go the way of the typewriter? No way, though Wal-Mart's helping change the way consumers shop and I expect it to eventually become one of the country's top three grocery chains. (It was number nine in 1998.) Also, I think it will make the concept work nationwide, debunking the idea that supermarkets are too driven by local tastes to become fully national chains, or that national chains can't be responsive enough to make the concept work.

That doesn't mean Supercenters don't have limitations or that local chains haven't found ways to compete through differentiation. Privately held Wegman's, which runs a chain of about 60 stores mainly in New York, caters to a higher-income consumer than Wal-Mart, has enormous selection, and offers extensive in-store eating concepts, such as freshly prepared Chinese food.

Privately held Stater Brothers has about 112 smaller format stores in Southern California that cater to ethnic tastes and lower income areas. Townsend said the company's stores generate high traffic because the company understands what products its customers buy. Up and down the food chain, companies that adapt can offer customers choices very different from Wal-Mart.

Supercenters can't offer everything. Wal-Mart goes with the best deals it can cut from food manufacturers, which means it offers just two or three brands per category, rather than the full array many shoppers expect. Don't plan on having much choice in terms of package size either since the company is going for bulk sales.

But Wal-Mart has had so much success in the grocery business it's testing a new concept called Neighborhood Markets, which could hit convenience stores hard. Rolled out abut 18 months ago, the company has seven Neighborhood Markets and plans to open 15 or more in the next year. If all goes well, expect invasion.

Neighborhood Markets are scaled down versions of Supercenters, ranging in size from 40,000 to 50,000 square feet. They sell a full line of groceries as well as general merchandise -- CDs, light bulbs, motor oil, etc. The big advantage to Neighborhood Markets -- and the reason why they're such a threat to convenience stores -- is location. Wal-Mart can't park a 200,000 square foot Supercenter close to your house, and it takes the company two years on average to get one built because of zoning laws. These two factors mean Superstores aren't especially convenient, and local retailers have plenty of time to react.

Neighborhood Markets will sit a lot closer to your local food shop and should get built faster than a typical Wal-Mart. The company just opened two in Oklahoma City and is opening several more in the Dallas-Fort Worth metro area.

Convenience store owners and operators of plain vanilla grocery stores, get ready to rumble!