Earning A Top Spot On The Grocery List

Investor's Business Daily

Whole Foods last month announced plans to open a store tailored to a growing population of posh-loft apartment dwellers in downtown Los Angeles. The fresh and natural foods grocer also announced a new flagship location in Brooklyn, complete with rooftop gardens. At the other end of the spectrum, in June it opened a store in an embattled section of Detroit, just a month before the city filed for bankruptcy protection.

"The Detroit store is doing way beyond our expectations, doing twice as many sales as we expected," said David Lannon, executive vice president of operations at Whole Foods (WFM) . "We're in it for the long haul with the city. There is a burgeoning foodie culture there that goes across all economic groups and they all shop there.

Supermarket chains largely abandoned inner-city areas during the 1980s and 1990s, leaving "food deserts" typically served only by small corner markets. More than a decade of investment to revive inner-city areas across the U.S. has spurred an uptick of upwardly mobile residents in those areas.

As a result, major players like Whole Foods, Kroger (KR) and nontraditional grocery stores like Target (TGT) are building new stores in urban centers.

But the grocery trade, driven by changing consumer demands and rising competitors, is in flux. Traditional grocers are consolidating and duking it out with big-box retailers, dollar stores and even Internet retail sites, as well as smaller local and regional chains, in a battle to lure customers through their doors.

Price Isn't Everything

Grocery stores have always operated on tight margins. But price pressure is growing even more intense as Wal-Mart (WMT) continues to expand its produce and food selections. Traditional grocers and big-box retailers alike also face a potential threat from Internet-based challengers including Amazon (AMZN) and Google (GOOG) .

Wal-Mart drew more than half its U.S. revenue from groceries last year. In the second quarter, the retailer reported its food, consumables, health and wellness categories gained 14 basis points of market share.

Kroger, the largest chain of traditional groceries, has successfully reduced its prices over the last 10 years to within 10% of Wal-Mart's. It has also gained market share systemically, said Andrew Wolf, analyst for BB&T Capital Markets.

Kroger last month agreed to pay $2.5 billion to acquire Harris Teeter supermarkets, a chain of 212 stores spread across the Southeastern U.S.

Other chains have given up ground in the Wal-Mart fight. In June, Safeway (SWY) inked a $5.8 billion deal to sell its 213 stores in Canada to Nova Scotia-based Sobeys.

Supervalue (SVU) has fought a losing battle to lower its prices in order to compete with Wal-Mart. It had to divest most of its conventional retail supermarkets to a private equity firm.

But price isn't always everything to customers, particularly as the economy starts to improve.

"Once you get within 10% of a store's pricing other factors begin to shine, like a more pleasant store environment, fresher produce, etc.," Wolf said.

According to a Market Force study released in late July, Whole Foods, along with Trader Joe's and Publix Super Markets, were the three favorite U.S. grocery store chains, based on customer satisfaction. Wal-Mart received poor marks from the 6,600 customers surveyed.

Whole Foods' reputation for high prices once earned it the nickname "Whole Paycheck" among many consumers. The chain has worked to sharpen its price points, and works to keep its private label brand prices comparable with other grocery chains.

Grocery store prices need to be price competitive, said Janet Eden Harris, chief marketing officer for Market Force, but shopping at the store shouldn't feel like a cheap experience. Decor, selection and friendly staff are all second only to price.

Groceries As Growth Stocks?

While grocery stores are generally seen as slow growth stocks, the industry has posted three long-term rallies in the past two decades. The 25 stocks in IBD's Retail-Super/Mini Markets industry group have collectively climbed 95% from a March 2009 low, and are up 40% so far this year. That's better than double the S&P 500's 18% gain.

The group ranked No. 31 on Friday out of the 197 industries tracked by IBD.

Brian Yarbrough, a consumer analyst with Edward Jones, said the overall grocery store industry tends to grow in single digits. Within that growth, traditional grocery stores have been squeezed as high-end and low-end stores gain market share.

The industry's organic and natural foods segment has expanded about 15% a year from 2005 to 2012, Yarbrough says. Natural-food grocery stores account for $41 billion in revenue per year. The total U.S. grocery store industry is $600 billion.

Discounters — Wal-Mart, Target and a growing number of dollar store chains — have also swiped market share from traditional grocery stores over the past 15 years.

"Wal-Mart is the biggest disrupter of the conventional supermarket industry," Yarbrough said.

Still, the big box has its limits. Known for its sprawling suburban stores, Wal-Mart faces resistance entering urban markets.

Last year it backed out of opening a store in the East New York section of Brooklyn against opposition from the community. In July, the company stepped back from three of six stores planned in Washington D.C., after local legislators raised the city's minimum wage requirements.

Kale And The Cutting Edge

With the rise in obesity and health care costs, increasing numbers of consumers are avoiding processed foods with lists of ingredients they can't pronounce. Instead, health-conscious consumers focus on fresh and natural foods. Organics and gluten-free options are rapidly becoming more popular.

"You have to have a good produce department or else you are going to go out of business," Wolf said.

Whole Foods has helped turned natural food options into requirements for mainstream grocery stores. Kroger and Safeway have boosted their organic offerings to compete with Whole Foods and up-and-coming players including Sprouts Farmers Market (SFM), The Fresh Market (TFM), Natural Grocers by Vitamin Cottage (NGVC) and privately held Trader Joe's.

Investors have taken notice. Sprouts leapt 126% on its first day of trading Aug. 1. The Fresh Market is up 145% from its November 2010 IPO price. Natural Grocers has climbed 129% in the 13 months since its public launch.

To compete, Whole Foods has kept on the cutting edge of food trends through a decentralized store model, Lannon explains.

"Each store is testing so many ideas, the best ones get elevated and replicated across the company," he said. "We like to think we started the kale trend. You now see kale at fancy restaurants.

Seeing the success of Wal-Mart and Target in the grocery trade, Google and Amazon also have expanded to include groceries.

Amazon Fresh is available in Los Angeles and Seattle, and offers same-day delivery for items from fresh vegetables to diapers. Google launched a test service of its Goo—gle Shopping Express in the San Francisco area in March. It, like Amazon, offers same-day delivery.

But Eden-Harris of Market Force doesn't see the Internet giants as major rivals to traditional grocers yet.

"It's an urban trend, in places where a large number of the population doesn't have automobiles," she said.

"Why don't we have milkmen any more?" Wolf asks. "Because home delivery is an expensive process.

'Fresh' Means 'Expensive'

Natural- and fresh-food grocers are even less likely to feel the pressure. While Amazon can easily get shelf food staples and supplies people need in bulk — like baby food and diapers — fresh food is harder and more expensive to deliver.

"People want to pick their own peaches, seafood and meat," Lannon said. "You can't really get that online. There is nothing like talking to an actual person in a store. Customers want that connection to real people that know the products and can turn them on to new trends.

Knowledgeable and experienced staff were key in helping Whole Foods outrank other retailers in the Market Force survey. The company has also begun to offer concierge services at over 40 of its stores, allowing customers to email in their order and pick it up at the store.

Outlook

Yarbrough sees the overall grocery industry continuing to grow in the low single digits, 2%-3%. For the next few years, he says, the organic food industry will continue to see double digit growth, but at some point that will slow.

Wolf sees Whole Foods and other natural grocery stores dominating urban centers as more baby boomers and empty nesters continue moving to the city.

For lower-income areas, he sees Supervalu's Save-A-Lot stores doing well as they run prices lower than Wal-Mart and don't face the same community backlash Wal-Mart does.

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