Which Grocery Stores Will Survive Amazon? The Case Of Market Basket

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Includes: AMZN, KR, SVU, TGT, WMT
by: Mike Berner

Summary

Commentators wrongly believe that grocery chains need to invest in tech, build websites, and cut labor costs.

The correct way to combat Amazon is to keep waste low and invest in people and store experience.

Consider Market Basket, a private regional supermarket which succeeds by not using any tech, paying workers well, and keeping prices low.

Winners of grocery wars will dominate either the low or high ends; middle will be squeezed.

Walmart looks like a winner in this new reality.

When Amazon (NASDAQ:AMZN) rocked the investing world by announcing a buyout of Whole Foods (WFM), commentators were sent into an absolute tizzy. The business press largely agree on several ideas about the challenges facing supermarkets. The first is that grocery, like much of physical retail, is moving online. Because of Amazon's established expertise in logistics, it will be difficult for traditional supermarkets to catch up. Moreover, in-store technology (a la Amazon Go) will win over customers from chains that do not adapt. Then there is the ongoing price war and rising labor costs, two immediate concerns that have weighed heavily on margins. The antidote, most agree, is for grocery chains to build up online operations, invest in technology, and cut labor costs extensively.

I believe that solution is mostly wrong.

Now I am no expert in grocery stores, but I did toil at one for seven years. From ages 14-21, I worked at a successful New England supermarket chain called Market Basket. The private company is not widely known outside the region, but some readers may recall hearing about the major worker strike back in 2014. Although many people may be more familiar with the chain's internal drama than its financial success, the latter cannot be overstated. Market Basket is likely one of the most profitable grocery chains in the country, with an operating margin reported at 8 percent in 2014. When you consider that mega grocers Kroger (NYSE:KR) and Supervalu (NYSE:SVU) achieved 2014 operating margins of 2.8 percent and 2.6 percent, respectively, Market Basket's achievement is simply astounding. Even Whole Foods only mustered a 6.8 percent operating profit at the height of its success.

How does Market Basket do it? Certainly not with technology. The company does not even operate a website, let alone self-checkouts or a mobile app. Department managers order product using their own knowledge rather than a computerized tracking system. A journey to a Market Basket store is like going through a time warp, with the same linoleum floors and color scheme that chain featured decades ago. The recent installation of price checkers on the sales floor was considered a major addition.

photo source: The Valley Breeze

Almost everything that has made Market Basket such a success is the exact opposite of conventional wisdom. The store pays both low-level clerks and full-time managers above average wages, even when annual bonuses (yes, bonuses) are not factored in. Even though employees get paid generously, Market Basket is also known for astonishingly low prices - 15 percent below competitors, according to the most recent Nielsen survey. Even Walmart (NYSE:WMT) has a tough time keeping up with Market Basket's discounts.

With little technology, high labor costs, and rock-bottom prices, how is a store like Market Basket even in business, let alone thrashing the competition? If we look a little more closely, it is obvious that all of the factors I described actually work in concert. Eschewing technology eliminates high administrative costs for a service that few of its customers care about, as only 1 percent of Market Basket shoppers buy groceries online. CEO Arthur Demoulas remains adamant that technology diminishes the customer experience and adds needless complication to the business.

Turnover is virtually zero among managers, and it is not unusual to run across veterans who have been with the company for fifty years. Even lowly clerks tend to stay longer, since pay at Market Basket increases with tenure. This saves the chain money in the long run. Talented managers stay for life, and the company does not have to waste money and diminish the customer experience by constantly training new employees. The fierce loyalty that many employees feel for the company also reduces shrinkage (that is, broken or stolen goods), since employees are often the biggest source of theft at retail establishments.

Instead of beating down suppliers, Market Basket strives to maintain good relationships with vendors. Rather than waiting 60 or 90 days to pay for merchandise, as is typical in retail, Market Basket pays right away. This means that the chain can move quickly and negotiate better prices than the competition.

Other operating procedures defy convention, such as the practice of stocking shelves continuously during the day rather than at night. Not only does this save on night crew overtime, but it also fills the stores with clerks who can attend to customer concerns. Indeed, the focus on customer service is drilled into every employee's head from day one and is an integral part of the company culture. Managers also focus relentlessly on cutting down waste, even criticizing clerks who use too many plastic bags.

There are zero stores in Boston, where operating costs are high. Rather, Market Basket serves suburban markets and is especially prevalent in low-income neighborhoods. Market Basket plows all of these savings into its low-price model, resulting in enormous foot traffic and massive lines on its busy days.

Many of these unique company quirks would never show up on a balance sheet. No business school teaches anything about customer service, and conventional management techniques involve paying employees as little as possible. Yet Market Basket's results speak for themselves. The chain now enjoys record sales, having grown store count at 4 percent annually since 2008 and stealing market share in the process. I have often thought that Warren Buffett would probably be interested in acquiring the company if the Demoulas family ever wished to sell.

The lesson here is that supermarkets should get back to basics if they want to succeed in the cutthroat world of food retailing. Technology is not a panacea and will probably only result in large capital expenditures and little marginal return. Great customer service, fantastic management, and low prices will remain the foundation of the grocery business for many years to come.

So what about the grocery sellers that fell hard in the wake of the Whole Foods deal? Kroger and Supervalu have both plunged double digits. Walmart and Target (NYSE:TGT) were down about 5 percent each. In light of the ideal that I described, are any of these companies worth a look?

Kroger and Supervalu are probably the most traditional grocers on the list. Like Market Basket, Kroger promotes most of its managers from within and seeks to pay a decent wage. The chain is also plowing money into lowering prices in order to defend market share. However, both Supervalu and Kroger tout their large and ongoing investment in technology, which I do not think will produce market-beating results by itself. Even when I looked at Kroger stock before the current mess, the company did not appear to possess a durable competitive advantage. It is not the price leader, nor does it offer the highest quality.

In many ways, Walmart is the antithesis of Market Basket, despite the fact that both chains follow a low-price model. But lately the company has been moving in the right direction. CEO Doug McMillon, a Walmart lifer, recognized the need to drastically improve customer service and increase employee pay early in his tenure. The public widely perceived Walmart as a lousy place to shop and work. Just 15 percent of stores met internal criteria for customer service.

Under McMillon's leadership, Walmart has demonstrated substantial improvement in a remarkably short time for such a large company. Today 75 percent of its stores meet standards for customer service, and the company voluntarily increased hourly wages by an average of over 15 percent. Meanwhile, Walmart has moved quickly to correct course on ecommerce, significantly improving its formerly atrocious online operations.

Like Market Basket, Walmart also locates stores away from urban centers. The core Walmart shopper is middle or low income and resides in America's vast suburbs and rural expanses. Amazon, on the other hand, caters mostly to affluent urbanites. The Whole Foods deal will help Amazon consolidate its grasp on the high end, but the company has a long way to go before it can truly take on the likes of Walmart and Market Basket.

For these reasons I am fairly bullish on Walmart, but not on companies like Kroger, Supervalu, and Target. At 17 times earnings, Walmart offers decent value compared to the overall market. The management team has correctly identified internal problems and is succeeding in solving them. Even though the investments have cut into the bottom line, revenue rebounded to a record $485 billion in 2016.

Just as middle market department stores found themselves squeezed between discounters and high-end retailers, I think that mid-tier supermarkets will have a difficult time outperforming for the foreseeable future. At the bottom we have firms like Market Basket, Walmart, and German chains such as Aldi and Lidl. The top is dominated by purveyors such as Whole Foods and Trader Joe's. Where does that leave everybody else? Investors considering jumping in while shares are down should carefully weight their response before buying.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.