Source: Kroger

Bigger is better in the food retail market, if not the entire retail industry. Despite being the largest grocer in the U.S., Kroger (NYSE:KR) generates less revenue than retail giants such as Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST). In an industry where scale-based cost advantages are critical to success, does Kroger have what it takes to compete with Costco and Wal-Mart in the food retail market?

Food war
Food offerings are seen as key traffic generators for retailers, as replenishing food supplies is one of the main reasons for customers stepping into a retailer's premises. Costco understands this logic well and has traditionally used fresh food offerings as loss leaders to lure customers. For example, Costo is selling about 60 million of its $4.99 rotisserie chickens every year.

The loss leader (and cross-selling) strategy didn't work too well for Costco in the recent quarter, as its net profit declined by 15%. This was partly because its customers weren't buying enough of the other high-margin items. However, Costco's Chief Financial Officer Richard Galanti has reiterated during its recent results conference call that Costco will stand by its pricing strategy. This suggest potentially lower volumes and thinner margins for grocers like Kroger.

In addition to scale-based cost advantages, there are two key reasons why Costco is able to keep its costs and prices low. Firstly, Costco generates significant income from membership fees. As of the end of fiscal 2013, it has more than 70 million members who pay a minimum of $55 per year in dues. The membership fees help to subsidize the discounts that Costco offers on its fresh food. 

Secondly, Costco's SKU minimization strategy has allowed it to reduce inventory holding costs and maximize bulk purchasing discounts. Costco carries about 3,700 SKUs per store, significantly less than the average 30,000 to 50,000 SKUs that a grocer will hold.

However, Kroger isn't helpless when competing with companies like Costco. In fact, Kroger has delivered positive same-store sales growth for 41 consecutive quarters. Its gross margins (20%) are also higher than Costco's (13%), and the companies' operating margins are on par at about 3%.

Kroger has two secret weapons at its disposal. One of them is its loyalty card program. With famed customer analytics vendor Dunnhumby (the same one that Tesco uses) assisting with its customer data analysis, Kroger sent out more than 8 million mailings offering targeted discounts to its customers last year. Compared with blanket discounted offerings from Costco, Kroger is able to more effectively reach out to its customers based on their individual preferences with the help of data mining.

Another weapon is its private label strategy. Kroger stocks about 13,000 private label items per store, of which 40% are manufactured in-house. As a result, Kroger has a significant cost advantage over other retailers which typically substantially outsource all of their private label production to third party vendors.

Source: Kroger

Online battle
The new battleground for food retail is online instead of in physical stores. In the e-commerce space, scale-based cost advantages matter less than getting the strategy right.

In January of this year, Kroger completed its merger with Harris Teeter, a regional upscale grocer with a significant presence in the southeastern and mid-Atlantic parts of the U.S. Not only does the merger increase Kroger's scale and geographical presence, it also significantly expands Kroger's online capabilities.

Prior to the merger, Kroger relied solely on its King Soopers HomeShop's store-to-home delivery service, which only services the Colorado region. In contrast, the addition of Harris Teeter's "Click & Collect" store-based pickup model could be a big boost to Kroger's online sales. This is because the inherent nature of fresh food products makes it more likely that e-commerce customers will want to check their products prior to final acceptance.

In contrast with Kroger, Wal-Mart is considered a late-mover in the U.S. e-commerce space. Wal-Mart has made good progress with respect to its online operations overseas, including China (Yihaodian), U.K. (Asda) and Japan (Net Super). In the U.S., however, Wal-Mart has only test-launched its grocery-delivery service To Go in San Francisco and Denver, though plans are under way to launch this service in more cities nationwide.

While arguments can be made for late mover advantages in terms of learning from competitors' experiences, Wal-Mart's moderate pace of progress may allow companies like Harris Teeter/Kroger to gain brand loyalty. Moreover, there could also possible be psychological factors at play here. As the largest retailer in the U.S., Wal-Mart may be reluctant to expand online grocery sales at the expense of cannibalizing its own physical store sales.

Foolish final thoughts
Notwithstanding the size and might of retail giants like Wal-Mart and Costco, Kroger has managed to stand its ground against its rivals. Its loyalty card program, in-house manufacturing of private label products, and recent merger with Harris Teeter give it the necessary ammo to fight the grocery war. Kroger's recent financial results offer further validation of its resilience, with it achieving record diluted earnings per share on the back of a strong 13% growth.   

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.