Profiting from the Grocery Shakeup

Seems just like yesterday when shopping for food meant a simple trip to the local grocery store. Times have changed. Today, consumers have a dizzying array of options depending on what they value most when shopping for groceries. Looking for the cheapest box of Wheaties? Go to  Wal-Mart (WMT). How about some premium imported bleu cheese?  Whole Foods Market  has it. Need to make a quick stop somewhere on the way home to pick up some milk? How about your neighborhood  Walgreens (WAG)? For investors seeking to unearth just which food retailers are best positioned for success over the next decade, we'll start by exploring how the industry has evolved over the course of the last decade. From there, we'll explain which retailers we would bet on at the right price.

Wal-Mart's Influence
It's no secret: The company that has most prominently altered the grocery retail landscape in the past decade is Wal-Mart. In the early 1990s, the company saw an opportunity to leverage its expertise in price leadership and double the size of its existing stores, offering consumers a full-size supermarket in addition to a traditional discount store. These supercenters created a windfall for Wal-Mart and decimated many traditional supermarkets. Wal-Mart today accounts for one-fifth of food sales in the U.S., and it may capture one-third of the market by 2010.

We believe Wal-Mart's foray into grocery retailing set the stage for segmentation in the grocery market. Wal-Mart met the needs of price-conscious consumers who wanted to be sure they were paying the lowest possible prices. Other retailers have since looked to piggy-back on Wal-Mart's success and deliver their own unique offerings for value-conscious consumers.  SuperValu's  Sav-A-Lot stores, with a limited assortment of generic products, appeal to those who care more about the price of a can of green beans than the label on the can.  Costco Wholesale (COST) and Wal-Mart's own Sam's Club offer lower prices through membership fees and bulk purchasing. Whole Foods successfully carved out a niche among folks who really care about the quality of the food they eat. Whole Foods created a premium supermarket where consumers could count on getting the very best produce, meats, and dairy products, and a huge selection of alternative organic and natural foods. These consumers are willing to pay more for top quality. Other alternative grocers that grew out of this trend are  Wild Oats  and Trader Joe's.

More recently, drug stores, such as Walgreens, and dollar-stores, such as  Dollar General (DG) and  Family Dollar Stores  , have found that they can use their convenient locations to offer everyday grocery items. They figured the last thing a time-strapped individual wanted after hard day's work was to drive 20 minutes to the nearest Wal-Mart store, park a mile away, walk a mile in the store, wait in line for 20 minutes, and walk a mile back to the car just to stock up on milk. These stores give consumers the ability to run in and out quickly and pick up what they need. With smaller designs, these stores are often closer to where people live and work, which further promotes the idea of convenience.

Breaking with Tradition
Whether it's convenience, quality, or price that's most important, the bottom line is that when it comes to buying food, many consumers today can be more discerning in their choices. This evolving grocery landscape has created massive headaches for the traditional supermarkets that customarily made up for low margins by generating high, reliable traffic patterns in their stores. Because of this heightened competition for the consumer's food dollar, many traditional supermarket operators have either been forced to consolidate, close their doors permanently, or, at the very least, watch their businesses and stock prices decline.

Traditional supermarkets in recent years have desperately tried to adapt to the changing industry by cutting costs, slashing prices, and refining product selection to emphasize high-quality perishables. Despite these attempts to patch up their businesses, traditional supermarkets remain broken. The more regional retailers, such as  Winn-Dixie Stores  and  Marsh Supermarkets , are now basically on life support. The larger supermarkets, such as  Safeway ,  Kroger (KR), and  Albertson's , are continually looking to find points of differentiation while they heavily promote themselves to the public to try to stem the tide of customer defections. The problem for traditional supermarkets, in our view, is that they have gone from being the center of attention to being stuck in the middle. Upstarts have been successful in taking something specific consumers want out of a food shopping experience and running with it, whether that's low prices, high quality, or maximum convenience. Traditional supermarkets can't really stand out in any area. They can only sort of do some of these things well. As a result, many of their customers continue to get pulled in different directions.

We believe that what the traditional supermarkets face today mirrors what has befallen traditional department stores.  Kohl's (KSS) and  Target (TGT) have pulled away price-conscious consumers, while more upscale retailers such as  Ann Taylor Stores  and  Chico's FAS   have roped in many of the higher-end buyers. Watching customers flee their stores and revenues begin to decline, many department stores have since been forced to consolidate operations while watching their new competitors continue to thrive.

Defending Their Turf
In our view, the most successful businesses are those that exhibit price leadership or those that maximize value for buyers who are willing pay up to receive the highest quality. For a long-term investor, we believe those qualities best indicate a company's ability to offer consistent, above-average returns. For retail, we consider industry leaders such as Wal-Mart and Walgreens to have wide moats because we believe they have built sustainable competitive advantages that they continue to strengthen year after year. Wal-Mart is the low-price leader, while Walgreens offer the best locations for people craving convenience and willing to pay for it. Other companies we think have built narrow moats include Whole Foods and Costco. Both have developed loyal followings among specific consumer segments, but we don't believe their businesses are necessarily impervious to potential new entrants.

Consolidation Looms
So, what does this mean for traditional supermarkets? To be sure, we don't foresee the end of the traditional grocer altogether. We just wouldn't bet on these stuck-in-the-middle companies offering any more than just average returns over the long run. Further, with Wal-Mart continuing to build 200-250 supercenters per year, and Whole Foods, Costco, Walgreens, and Dollar General rapidly expanding, further consolidation in the food-retailing industry appears inevitable to us. At the right price, we would rather put our money on companies that continue to strengthen their own economic moats at the expense of the now stuck-in-the-middle traditional supermarkets.