In this article I look at the competitive strategies and the performance metrics that are driven by these strategies of the three largest traditional grocers in the U.S. [Kroger (NYSE:KR), Safeway (NYSE:SWY), and SUPERVALU (NYSE:SVU)] and how the companies are valued in the stock market. This analysis shows that investors seem to focus more attention on performance metrics such as identical store sales comparisons and return on capital than on the amount of income and cash flow that the companies generate. As a result of this Kroger is much more richly valued than SUPERVALU and the valuation of Safeway is in between the other two.
Kroger (A low cost operator)
Kroger’s competitive strategy is that of a low cost operator that is able to sell at relatively low prices and still generate good financial returns based on their cost structure. Supporting this is a marketing strategy of focusing on the customer. Kroger refers to this as their “Customer 1st” strategy. This marketing strategy drives sales and results in economies of scale that enable the company to offer lower prices without negatively affecting financial returns.
Since the early part of the current decade the “Customer 1st” strategy has taken the form of focusing mainly on price based on the company’s perception that one of the main things that customers seek is low prices. The company seeks to offer prices that are lower than other traditional grocers although not as low as what is offered by Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST). Also, the company cites its use of the data management and customer analysis firm, dunnhumby, as providing a competitive advantage in understanding the needs of customers and implementing the marketing strategy.
A key element of low cost and low selling prices is the fact that Kroger offers the broadest assortment of private label products offered by any of the traditional grocers. In the most recent quarter private label represented almost 27% of the company’s grocery sales.
This strategy has been working well for Kroger. For the last several years identical store sales excluding fuel sales have tended to be in the mid-single digit range, which are notably better than Safeway and SUPERVALU. Additionally, the company has been generating financial returns well in excess of their cost of capital.
Safeway (Differentiating itself)
Safeway has a clear competitive strategy of differentiating itself from other grocers based on enhancing the shopping experience. A key component of this strategy is the adoption of the “Lifestyle” store format. These stores have an earth-toned décor, subdued lighting, and custom flooring, which impart a warm ambience that is appealing to customers. At the end of 2008 about 74% of Safeway’s entire store base will be in the “Lifestyle” format, and by the end of 2010, 91% are projected to have this format.
The company also focuses on differentiating itself from its competitors by providing superior quality perishables. These include produce, meat, seafood, bakery, deli, and floral products.
Safeway is also intent on pricing more competitively in order to drive sales. Part of this initiative is offering a wide array of private label products.
Whereas Kroger is already realizing significant benefit from its low cost competitive strategy, Safeway may still be at the early stages of realizing the full benefit of its competitive strategy based on differentiation. The strategy is already working to a certain extent as evidenced by identical store sales excluding fuel sales that have tended to be in the low single-digit range for the last several years. Also, the company generates financial returns that are slightly better than its cost of capital. These returns may improve as the growing number of “Lifestyle” format stores and the focus on superior quality perishables attract more customers.
SUPERVALU (No clear strategy)
Kroger and Safeway have clear but very different competitive strategies. However, SUPERVALU does not have a clear strategy.
The closest SUPERVALU has come to identifying something that resembles a strategy is to indicate a focus on local execution, merchandising, and consumer knowledge. They also refer to achieving economies of scale from the combination of their retail and wholesale businesses.
As such, the focus on local execution, merchandising, and consumer knowledge has not translated into growing sales, which then might be used to support more competitive product pricing. This is evidenced by identical store sales excluding fuel sales that have tended to be about unchanged in recent years. Also, while the company’s size gives it a competitive advantage relative to most other grocers in the industry, which are smaller, it is not nearly as large as Wal-Mart or Kroger, the cost leaders.
With the absence of a clear competitive strategy, SUPERVALU is profitable and generates significant cash flow. However, its financial returns barely equal or fail to equal its cost of capital.
This is a problem for SUPERVALU, and it begs the question of what it might do to address the problem. The following are some alternative considerations related to a competitive strategy that the company might pursue.
It is unlikely that SUPERVALU could target a narrow customer base that it can serve better than its competitors and thereby generate superior financial returns. Therefore, I would rule out a focus-based competitive strategy.
One way to get the scale necessary to be a low cost operator would be to make a sizable acquisition. However, SUPERVALU’s low stock price probably precludes using stock to make an acquisition, and the company already has a significant amount of debt, which makes borrowing cash and the assumption of more debt to fund an acquisition undesirable.
Another more viable way to become a low cost operator would be to pursue an aggressive expansion of private label products to where these products comprise perhaps 50% or more of total retail sales. If this were implemented, SUPERVALU would have probably lowered its cost structure significantly to where it would be generating financial returns well in excess of its cost of capital. This would be a significant change for SUPERVALU, since private label sales are currently only about 17% of total retail sales.
A differentiation strategy might be viable. SUPERVALU could focus on customer service to the extent that the company’s stores develop a reputation for having the friendliest and most helpful employees in the grocery industry, and thereby increase sales and profitability based on this differentiation. Examples of other companies that have successfully pursued this kind of competitive strategy are Nordstrom (NYSE:JWN) and Eagle Hardware & Garden, which was bought by Lowe’s (NYSE:LOW).
One other possibility might be for SUPERVALU to mimic Safeway and remodel its stores to significantly improve their ambience. However, not only would this be very costly, but SUPERVALU would not be achieving meaningful differentiation, since Safeway has already implemented such a strategy.
The following table shows how investors are currently valuing these companies.
click to enlarge
This table shows that Kroger currently is valued much more richly than SUPERVALU with the valuation of Safeway in between the other two. I believe this valuation discrepancy exists because investors focus attention on performance metrics such as identical store sales and return on capital more than they focus on the amount of income and cash flow that the companies generate. In general Kroger generates mid-single digit identical store sales and financial returns well in excess of its cost of capital, while at the other end of the spectrum SUPERVALU generates unchanged identical store sales and financial returns that barely equal or fail to equal its cost of capital. As with valuation Safeway’s identical store sales and return on capital are in between the results of the other two companies.
Competitive strategies are important, because they drive performance metrics. Both Kroger and Safeway have competitive strategies that are working well, while SUPERVALU does not. The implication of this analysis is that SUPERVALU may continue to be valued more cheaply than Kroger and Safeway until it implements a viable competitive strategy that generates better performance metrics. It is arguable whether this makes good financial sense, but it does seem to be the way that investors are currently valuing these companies.