How Grocery Chains, Warehouse Clubs, and Dollar Stores Compete for Your Retail Dollars

In this episode of Industry Focus: Consumer Goods, the team opens the mailbag for another listener question: Mat wants to know whether the recent pullback for Kroger (KR 0.64%) and Costco (COST 0.84%) stock presents a buying opportunity.

As it turns out, the Amazon (AMZN 1.49%) and Whole Foods merger is already taking its toll on the grocery industry, but some companies will be able to withstand the competition better than others.

The cast also breaks down the latest results from Dollar General (DG -1.36%) and what those results have to say about the often overlooked dollar store retailers.

A full transcript follows the video.

This video was recorded on Sept. 5, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen, and we're in studio here at Fool headquarters getting this show ready for Sept. 5. If you haven't heard it already, be sure to check out our bonus Labor Day weekend episode with an introduction to the Industry Focus podcast, our newest host, Sarah Priestley, and some trends and companies that we're watching in each of our sectors.

For today, we're answering another listener question, been really busy with the mailbag. Then, we're going to revisit a corner of the retail industry that many analysts were ready to write the obituary on not too long ago. Joining me via Skype is senior Fool.com contributor, Asit Sharma. Welcome back, Asit!

Asit Sharma: Thanks Vince! It's always great to be with you.

Shen: This question I have for you is related to our first topic. To kick things off, I want to ask you, what is your preferred grocery store chain?

Sharma: My preferred grocery chain is actually one owned by Kroger, it's Harris Teeter. Extremely close to my house, bright stores, well stocked. But our family, we shop second most at Whole Foods, we have a Costco membership, we stop in at Trader Joe's. One or two things we get from Food Lion. And a Sprouts just opened around the corner from this Harris Teeter, so we frequent six to seven grocery stores. How about you, Vince?

Shen: I'm surprised. I found, asking this question to some of the Fools here, that a lot of people have quite a bit of loyalty to their favorite chain. I guess depending on what's most convenient to them.

But I'm from New Jersey, and you'll hear a lot of us commiserate that there aren't nearly enough Wegmans in the DC metro area. It's too far out, not that convenient to get to, but we love Wegmans back at home. Another place I've grown pretty fond of since joining the Fool is Whole Foods, because there's a location just a few minutes away. I never used to shop there previously. We've spoken several times now about the Whole Foods acquisition by Amazon, how the two companies are likely to leverage each other's assets and strengths.

It's pretty safe to say now that Amazon isn't wasting any time implementing its vision for Whole Foods. The deal closed just in the past week, and there's already a bunch of reports indicating that Amazon is cutting prices across the board at Whole Food stores for a lot of essential items. There's a report from Bloomberg that they did some sampling at a New York City location, and some of those staple items, like bananas, eggs, and lettuce were priced around 10% to 40% lower. Considering how Amazon has disrupted other industries in the past, I imagine these price cuts are just the beginning. 

That brings us to our listener question. Mat has been investing since 1999, when he first bought stocks with some student loans. Unfortunately, he lost 60% in just 12 weeks. I'm very glad that didn't scare him off. Mat asks, "Does the sell-off of grocery stores present a buying opportunity for Costco and Kroger?" In the past month, Kroger, Costco, and Wal-Mart (WMT 1.02%) shares have all pulled back. We bang on this drum a lot -- Fools, remember not to put too much weight into short-term share price moves. But there's no denying that the threat that Whole Foods poses now is much larger with the backing of Amazon, even for some of the country's biggest retailers that I mentioned. Let's start with Kroger, which is down about 10% in the past month. Asit, are you as bearish as the rest of the market seems to be on this company right now?

Sharma: Vince, I'm not so bearish on Kroger, but I am cautious. But first things first, Mat, wow, you use leverage to invest in stocks but not in a very conventional way. I'm very impressed by that. Maybe you got more out of your investments than you did your education. I don't know, sometimes I feel, looking back, it's 50-50.

But to Kroger, Kroger is interesting. It's one of the largest global food retailing companies, food grocery chains. It has 2,800 locations across the United States in 35 states. But it's a conventional grocer. It's not a discounter, and it's not a high-end grocery like Wegmans or Whole Foods. So it's in an unfortunate position just now. I know on this show, I believe you and Dan have talked about the onset of Aldi, which is going to spend $3.5 billion -- this is a German discount chain which will ramp up from 1,600 stores to about 2,500 stores by 2022. German grocery Lidl, I hope I pronounced that correctly, is also establishing a beachhead on the East Coast. They will have 500 locations in the U.S. very soon. Wal-Mart this year said that they are going to reaffirm their everyday low pricing philosophy in light of this discount competition.

And here's Kroger, which had some problems before the Amazon-Whole Foods merger was even announced. Really briefly, those problems started about a year-and-a-half ago in that Kroger was one of the first chains, because of its breadth and scale, to experience grocery deflation. There are two types of deflation. There is cost deflation, that's when farmers have bumper crops and they can offer their goods at lower prices to grocery stores; and there's retail deflation, which is when, those groceries, instead of taking the profits that the farmers give them, they pass it on in the form of price discounts and promotions to get an edge on the competition. So, Kroger and the rest of the industry has been embroiled in a slow-burn of both cost and price deflation. They're starting to compete with each other as they get savings from farmers. 

So Kroger had this problem. And I think, Vince, in some notes that you and I traded, I pointed out the year before, on Dec. 29, Kroger stock peaked at $41.50 per share. And it's down over 50% since then. There are two reasons to be cautious -- the price deflation that Kroger is undergoing, and this increased industry competition that it's also exposed to being in the middle, not a discounter and not a high-end store. What are your thoughts about it, Vince? 

Shen: I'd say that, for Mat, what you mentioned in terms of its position and the increasing competition, that's the big takeaway. This is an $800 billion industry. It's massive. And the companies involved are all dumping billions of dollars themselves to reinvest in the pricing and expand and remain competitive. In that environment, Kroger does lack a bit of that edge or that competitive moat that a lot of Fools like to see in a company. They've acquired other chains in the past. I think they've done a good job increasing their scale and purchasing power. But if I told a regular Kroger shopper that Whole Foods now offers a majority of the items on their shopping list at equal or better prices, I think a lot of them would go to see what the hubbub was all about. That's another thing -- it's not like Amazon only has that one option with Whole Foods in that it can only compete on price. It can offer so many things in terms of, they're already releasing some of their smarthome speaker offerings at Whole Food stores, they can also bring in some of the benefits of a Prime Membership to increase how attractive it is to go to a Whole Foods.

Sharma: Yeah. The reach of Amazon is really interesting, because you may have read articles in the news that, Whole Foods only has 460 odd locations between the U.S. and U.K. and Canada, most of those in the U.S. But what you mentioned, Vince, is very interesting, if Amazon starts activating its Prime members. And nobody knows how many Prime members there are. Bloomberg cited estimates last week that there are over 80 million Prime customers, about a quarter of the U.S. population. If that's true, and Amazon starts incentivizing Prime members to buy Whole Foods items online, they can cut into store traffic, and they can cut into the average basket size at places like Kroger, even if there's not a Whole Foods in proximity anywhere near a Kroger. And that's a really surprising and interesting aspect of this deal that none of us really saw coming a few months ago. I want to add one more thing on what exactly Amazon and Whole Foods just did starting Monday. The items that they lowered prices on are core staples. They're organic eggs, beef, fish. These are items you buy every day, they're not exotic items. And this is a G-rated show, so I'll put it this way: that kicks Kroger right in the place where it hurts most, because Kroger is experiencing this core deflation in its staples, these very items. So that's going to hurt Kroger's margins. 

In terms of valuation, Mat, Kroger does look attractive on paper. On this show, I always talk about the forward P/E ratio -- what a stock sells for versus a year's worth of earnings if you look out. Kroger currently trades at around 11 times forward earnings. That's half of what most grocers trade at. Most grocers trade at above 20 times forward earnings. But it's a hard call. Kroger's management has said that they are going to stand by price as one way to keep their customers. And that sounds to me like not the greatest strategy. Although, we should mention that they have introduced a lot of other innovations into their business.

Shen: Yeah. I think some investors were actually pretty concerned based on the news coming out, in terms of comments from the CEO and what they said about their insistence on potentially fighting on the pricing side, what kind of damage that does in terms of their profitability and how sustainable that really is long-term.

I do want to move on to the other company that Mat mentioned specifically, and that was Costco. I like to think that this is somewhat familiar territory for Costco. You look at a Wal-Mart and its reputation for low prices. The company has a gross profit margin of about 25%. Costco, just half that at about 13%. And Costco thrives on undercutting the competition, because it's able to look past its store aisles when it comes to its bottom line. If anything, Costco is kind of a grizzled veteran when it comes to a pricing war. What do you think about the company?

Sharma: Costco is the opposite of Kroger in this one respect. I said at the outset that Kroger is a conventional grocery store. And usually what we mean by that is, a grocer that tries to offer everything, hasn't changed much since its conception in the 1950s, when grocery stores first came about in their present form. Costco is non-conventional in that it entices customers to buy in bulk. So, it has a differentiation that other grocery stores don't. You have to have an edge in the grocery industry if you're going to survive. Only a few companies have survived at any type of scale over the years. Kroger is one of them. It's an industry which sees multiple bankruptcies every few decades. Maybe coming in for another cycle, but that's a different story, different segment, which maybe we can tackle later.

I like Costco because, as you said, it's a grizzled veteran. It manages to find ways to grow comparable sales. I think this last quarter, comps grew 3%, and Costco showed an 8% total top line increase. And it's done this by a differentiating not just its total offering but the services component. We should mention that Kroger also has a few of these. Kroger owns some beauty salons, it has stations with gas in some of its grocery stores. Costco has its automotive centers, it sells its memberships, it has another path to revenue in its co-branded affinity card with Citi Visa. So it has a real diversified approach to its revenue, which has served it well.

The other thing I really like about Costco is that it's not so concentrated in the U.S. Kroger, as I said, is a global company, but most of its operations are right here in the U.S. Costco has about 30% of locations outside the U.S., and that pace is accelerating. This year, it's going to open a total 26 new locations. Half of those will be international. So on all fronts, it's got a little more insulation than Kroger does against the pricing onslaught that's coming not just from Whole Foods and Amazon, but the German grocers that we talked about, and others in the industry.

Shen: Yeah. I think the established international presence that Costco has, that's a very important runway for growth that a lot of investors look to. And even something beyond some of the services that they offer, I think Costco is another star, or a really good example of leveraging their in-house brand with Kirkland Signature, a very highly valued offering that customers love and will return to Costco for. Of course, a lot of these grocery stores have invested a lot in their private label brands, but I just feel like Kirkland Signature is one of the cream-of-the-crop examples.

Otherwise, Mat, we hope you follow up and let us know if you end up investing into any of these companies in this space. Thanks again for sharing your story and writing in. Again, for such a rough experience starting out with that student loan play for the stocks, I'm glad that you're listening and that you're still in it. If any other Fools want to write in and ask a question, share your thoughts or anything, you can email us at [email protected], or tweet to MFIndustryFocus.

Alright, Asit, we talked about doom and gloom a little bit here for Kroger and some of the other big grocery stores in the first segment. I want to flip it around now. The increasingly low pricing that these companies have had to offer to draw in customers should potentially also shrink the moat and take some of the luster away from another corner of the retail space, and that's discount retailers and dollar stores. Dollar General leads this corner. Competition, we're starting to see it manifest itself in the company's results. They just reported today.

Sharma: Yeah. Dollar General reported earnings that looked great on the surface. Sales were up 8.1%, same-store sales were up 2.6%, and this is in an environment where most grocery store chains and discount food chains are showing flat comps or negative comps. So I thought those were great results. But the stock is getting beaten up in the market today. I saw it early this morning, I think Dollar General was down 7%. Shortly before we went on air to tape, it was down about 5%. The reason -- the company gave up 1% in operating margin to achieve those results. And I think that's a really great illustration of what's going on in the grocery sector in general, and why these two sectors are lumped together.

Most dollar stores have the preponderance of their sales in consumables, in food. I think for Dollar General recently this year, about 76% of its total sales are related to consumables. So what happens in the grocery industry obviously affects these companies. Dollar stores have found that they can indeed raise their revenue by opening a lot of stores, by enticing customers in. So they've been able to stick around, surprisingly, in the face of all this competition. But they're having to give up margin to do it, to use promotional discounts to get those sales. And investors don't like that. What are your thoughts on these results today?

Shen: I think with Dollar General and some of the ongoing strategy that they've had success with, for example, offering the speed and convenience in value that customers want, and also often pushing with locations and expansion into areas that maybe aren't as well served by some of the big chains that we mentioned so far on the show. But ultimately, a thought that I had in terms of Kroger being in the middle -- not premium, not really discount, doesn't have as much of that moat. At the same time, I look at some of the stores in the discount space, these are not destination stores. The way I thought about it, you're unlikely to spend an hour lazily browsing at a Dollar General. But I've done it myself, I can definitely see customers doing that at a Whole Foods or a Costco.

With dollar stores offering that convenience, speed, and value that I mentioned, they're ultimately getting attacked on a few different fronts now. The grocery price war, as you mentioned, chips away at that value proposition. Then the bigger focus the major chains have also made in terms of creating these small-format stores or upgrading their store layouts so that customers can get in and out more easily, it takes away from that speed and convenience advantage as well. I found a report that some of the biggest competitors, like Wal-Mart, have even resorted to undercutting competing dollar stores on staple items, and they will specifically lower prices at stores located nearest to a Dollar General location, for example, to essentially steal some of that traffic and hopefully get a leg up in terms of that competition.

Sharma: I agree with you, Vince, in that dollar stores in general don't have a very wide moat. I would say, though, instead of a moat, they have a really muddy, swampy rivulet running right in front of them. The big stores like Wal-Mart keep looking at the dollar stores, and when they turn their attention to them, they do exactly what you're saying, they try to hurt them and then they get distracted by other bigger competitors.

And one thing that these stores have is a lot of flexibility. They are very light footprint stores, it's easy to close them and open them up. I think Dollar General has about 14,000 stores in 44 states, and it regularly will close or relocate several hundred in a year. They're very good at popping into areas which are underserved by traditional grocers, so they have some insulation against these types of tactics. I want Wall Street at some point to show these guys a little love. Dollar General trades right now at a forward P/E ratio of 16.9 times. Dollar Tree, its competitor, trades at a P/E ratio forward 15.6 times. So these are lower than your average grocery stores, but they have a much higher margin. At the end of the day, Dollar General has a net profit margin of 5%. We were talking about Kroger earlier, their net profit margin is 0.8%, less than 1%, and that's a good quarter for Kroger. Costco, which has a little higher profitability, has a net profit margin of 2.4%.

So you have an industry which is somewhat insulated from these price wars, has better margins, can grow a little quicker, but they don't trade at the high multiples that grocery stores do. And that's because, as you point out, investors have a fear that at some point, Wal-Mart and Costco and these other stores will really get serious about the dollar stores, join hands and try to force them out. But it hasn't happened yet. And I find it interesting that they manage to stick around.

Shen: Yeah. Thank you, Asit, again for being here today. That's about all the time that we have. I hope that the ending discussion that we had with some of these companies like Dollar General gives Mat and other investors interested in the space an idea about another option, and a closer one, I think, in terms of the valuation to being a value play.

Thanks again, Fools, for tuning in. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!