Tuesday Talking Points Memo

Will the Big 3 Supermarket Chains Challenge Whole Foods in its Niche?

Now that Whole Foods Market, Inc. has cleared it's last hurdle in acquiring Wild Oats Markets, Inc., and is in the process of assimilating Wild Oats Inc. and its stores into the Whole Foods corporate structure and culture, Natural~Specialty Foods Memo (NSFM) is thinking into the future of the supernatural retail grocery niche.

With the Wild Oats acquisition this is a niche Whole Foods now has pretty much to itself. By no means does this mean the grocer has anything close to a monopoly in terms of selling natural and organic products. To the contrary the category is competitive--and getting more competitive-- at retail with Wal-Mart, Target Stores, major national supermarket chains, and regional chains and independents, all increasing their merchandising and sales of natural and organic products. Additionally there still remain numerous regional natural foods retailers who are extremely competitive in their respective markets.

What the Wild Oats' acquisition does mean to Whole Foods, as well as to the industry and consumers, is that it leaves the grocer pretty much alone in what has come to be know as the supernatural retail supermarket category.

This category essentially refers to retailers who operate large, full-service supermarket style stores (Whole Foods' new stores range from about 55,000 square-feet to 80,000 square-feet) which contain all the departments (and often more) that a modern supermarket has. These departments include groceries, perishables, food service, produce, non-foods and more. The premise of these stores is based on natural rather than general product merchandising across all departments. And in Whole Foods' case (and others) they have a "bible" which dictates what types of products can and can't be included in the retail product mix.

Whole Foods is actually much more today however than just a supernatural grocer. (but the term fits well so we will use it.) It really has become an upscale retailer where consumers can do their primary shopping as long as they are willing to keep their shopping within the confines of Whole Foods' product philosophy, which is rather broad today.

Whole Foods also is a specialty retailer which offers an extensive variety of specialty, gourmet and ethnic products all selected within its natural product guidelines. As such it also serves as a secondary retail store for many people who may shop for example at Costco, a major conventional supermarket, and also Whole Foods. It's meats, seafood, produce, perishable and in-store food service selections are a major draw for these shoppers along with its extensive natural and organic product selections.

Last but far from least Whole Foods' stores offer "experiencial" shopping. Shoppers love the retail store environment the grocer creates, it's in-store restaurants and bakeries, and the retail theater the grocer conducts on a daily basis in-store.

All three of these aspects of what Whole Foods is make it the retailing success it has become. They also help explain the value of being in the supernatural retailing category. It is a space in which a retailer can draw both primary and secondary shoppers. Mass Merchandisers, conventional supermarkets and most other retail formats, can't make that claim or have that advantage in most cases.

The Big 3 Chains and Supernatural Retailing

This gets us to what NSFM believes is a major question for the near to medium-term future. Will the big three supermarket retailers: Kroger, Safeway Stores, Inc. and Supervalu decide to challenge Whole Foods in the supernatural niche either by growing existing store formats, creating new ones, or acquiring smaller existing natural foods retailers? (I know it sounds like gloliaths challenging David but it is the retailing niche that's important rather than the realtive size of the retailers.)

The short answer is maybe. But probably not anytime soon. However lets examine the potentials and possibilities a bit.

Kroger, the largest U.S. supermarket chain, had 2006 sales of $66 billion dollars. It is a multiple banner supermarket chain ( 20 supermarket banners) and also owns convenience stores (5 banners) and jewelery stores (3 banners). It's 20 supermarket banners range from upscale--QFC and City Market are two upscale examples--to mid-range and discount. Kroger has the grocery retailing landscape pretty well covered.

Kroger also is getting into natural and organic foods in a very big way. Not only are they increasing the selections of fresh produce, perishables and branded natural/organic groceries in many of their banners, they also have created a major natural and organic grocery corporate/private label program and are agressively growing it with new skus. Kroger's CEO has said he wants the chain to be the retailer who brings organic groceries to the masses at reasonable prices. (Wal-Mart CEo Lee Scott has said essentially the same thing.)

One of Kroger's banners, Fred Meyer, has been an innovator in natural grocery merchandising. It was one of the first supermarket chains to place large, comprehensive natural foods store-within-a-store centers in its stores, doing so in the 1980's. Today new Fred Meyer stores have multi-thousand square-foot natural products centers inside them.

NSFM doesn't believe its likely Kroger will create a new supernatural retail grocery banner and enter the category against Whole Foods. Rather we believe the chain will continue to add depth in natural and organics retailing to its existing relevant banners and expand the natural category dramatically in it's new stores under these relevant banners. NSFM also doesn't think it likely Kroger will acquire one of the few remaining multi-store regional natural foods retailers in the U.S. and use that acquisition as a springboard into the supernatural retail category.

In fact Kroger looked closely at buying Wild Oats and decided not to make a bid for the natural grocer. Kroger had a pre-Whole Foods acquisition relationship with Wild Oats. Supermarket industry investor Ron Burkle, who owned 15% of Wild Oats' stock, was a member of Kroger's board of directors. Burkle sold Ralph's Grocery Co., Fred Meyer and some other banners to Kroger in the 1990's.

A number of Kroger stores also merchandised Wild Oats' corporate/private label natural and organic grocery products for the last couple years, although this was most likely a way for the chain to learn what sold well in the categories prior the roll out of their own line of natural and organic grocery products.

Therefore, NSFM suggests Kroger's natural and organic strategy for the future will be to grow the chains presence in the natural and organic business via their existing store banners, remodeling existing stores, adding items in the categories and creating an expanded presence in new stores.

Safeway Stores, Inc., the number two largest retailer in the U.S. with sales of about $41 billion in 2006, also has been getting into natural and organic retailing in a big way in the last 10 years. About 10 years ago the chain created an in-house specialty and natural foods department and has been growing its expertise since. Today this department, based at the chain's Pleasanton, California headquarters, is responsible for all national specialty and natural foods corporate marketing, direct purchasing by the chain nationally, and working with distributors.

Safeway also has used natural foods in a big way in its successful Lifestyle store format, which is now the dominant theme for it's new stores. This format is being deployed across all of Safeway's supermarket banners in all of the regions it does business. Currently about 50 percent of all Safeway and other banner stores has been converted to the Lifestyle format. This format is upscale, features extensive perishables departments, a strong selection of specialty and natural/organic products along with mainstream ones, and in-store prepared foods departments.

In fact, there are many similarities to a new Safeway Lifestyle format store and a new Whole Foods superstore. They are about the same size (55,000 to 80,000 square-feet) and have very similar departments, features and the like. Whole foods still merchandises considerably more natural and organic products than Safeway Lifestyle stores of course. And unlike Whole Foods Safeway doesn't put any restrictions on the types of products these stores sell. The point is though the new Safeway Lifestyle stores and new Whole Foods stores look more alike than they do disimilar with the caveats I mentioned and some significant other operational and merchandising differences.

Safeway currently operates seven retail banners. All seven of these banners have stores that range from having very extensive natural and organic foods selections to stores which have minimal selections. Like Kroger, Safeway also has created a comprehensive natural and organic grocery corporate/private label line. The chain also recently created a "healthy foods" corporate label brand called "Eating Right."

So where does Safeway stand in terms of entering the supernatural retail channel with a specific banner. NSFM thinks the possibility of the chain doing so is higher than Kroger but that the probability of Safeway doing so anytime soon is rather unlikely.

We believe this for a number of reasons. First, Safeway's current corporate merchandising philosophy is primarily upscale. Creating supermarkets under most of its banners which offer basic food and grocery products at decent retails but also place considerable focus on perishables, produce, meats and seafoods, prepared foods and specialty, ethnic and natural/organic product is the chain's focus/ This is in essence the Lifestyle format.

This acroos-banner Lifestyle format is so important to Safeway at present we doubt the chain has either the desire or strategic belief that entering the supernatural retail category either via an acquisition or by creating a new banner makes sense for them. Rather we see them continuing to focus their natural and organic products merchandising on the Lifestyle format across all of their supermarket banners.

Safeway believes this format competes with Whole Foods--although as a retailer that does $41 billion in sales annually competing with Whole Foods is hardly a top priority. The chain's primary goal vis-a-vis Whole Foods is to not lose any of its primary customers to the grocer. They also want to convert as many of Whole Foods' primary customers as they can to their Lifestyle format, which is part of the reason for their corporate label natural/organic line, which is priced at only about 10%-15% higher than conventional grocery products.

Supervalu, the number three largest U.S. grocery chain with 2006 sales of about 38 billion, might just be the most interesting of the three in terms of creating niche banners and growing it's natural and organics products business both that way and inside it's numerous other retail banner stores.

Supervalue operates 14 retail banners, ranging from super discount (Save-A-Lot) to super upscale (Bristol Farms). The chain also operates the Shaw's, Star Market and Shop N Save banners in the east coast. All three are well know for their natural products depth. The recently acquired Albertson's chain also has a history of extensive natural foods merchandising at its west coast stores; a tradition Supervalu is growing.

Supervalu recently created a stand alone natural foods store called Sunflower Market. The chain opened the first Sunflower Market in 2006 and plans to open at least 50 Sunflower Market stores over the next 5 years. The Sunflower Market retail philosophy is to provide natural and organic foods at the best prices possible (read cheaper than Whole Foods and some others). Sunflower Market stores are only 15,000 square feet but have all the standard supermarket departments, even an in-store restaurant and a wellness center/department.

Supervalu: Best Poised of the Big 3 Chains

NSFM believes Supervalu is the chain best poised of the top three to take a successful run at the supernatural retail category--and as such at Whole Foods. The two formats in which Supervalu can use to do this are Sunflower Markets and Bristol Farms.

Supervalu acquired Southern California-based Bristol Farms in its buyout of Albertson's, Inc. Albertson's had purchased Bristol Farms, at the time a multi-store independent, as a way of getting into the upscale specialty and natural foods retail niche.

There are currently 16 Bristol Farms stores in operation, 15 in Southern California, and one in San Francisco which just opened earlier this year. The stores are very upscale and have extensive specialty, gourmet, ethnic, natural and organic products selections. They have expansive perishables departments and in-store restaurants; usually more than one. Many industry observers consider Bristol Farms to be the finest upscale format operating in the U.S. This is arguable--but they are in the top five without question.

What does Supervalu need to do in order to use these two formats--Bristol Farms and Sunflower Market--as their entree into the supernatural retail category providing a competitive alternative to Whole Foods?

Bristol Farms

Regarding the Bristol Farms banner/format NSFM believes Supervalu needs to basically do three things. First, they need to enlarge the store footprint. Bristol Farms stores are relatively small compared to today's supercenters--and to Whole Foods' new stores. This has served Bristol Farms fine because of their merchandising focus. However to move into the supernatural category the stores need to be larger. NSFM suggests stores ranging from 50,000 square-feet to about 80,000 square-feet depending on the market.

Second, with this extra square-footage Bristol Farms can add expanded natural and organic groceries in the core of the store and increase their produce and perishables departments with a focus on natural and organic. They should keep their existing upscale, specialty-gourmet focus adding this expanded natural element to it.

Third, they will need to fine-tune their product and merchandising philosophy. The retailer already does many things similar to Whole Foods and other natural grocers but would need to look at things like product policies, environmental initiatives, buying local programs and related concepts. Much of the supermarket industry is moving in these directions anyway so it wouldn't be much of a stretch for them to do this, and doing so is essential under this strategy.

Whole Foods and Bristol Farms actually have much currently in common in terms of retail positioning. Whole Foods is essentially a natural products-based grocer which has in recent years also become a specialty and gourmet foods grocer. Bristol farms is at its heart (it was founded in 1982) a specialty-gourmet grocer which in recent years also has become a significant natural products grocer.

NSFM believes by expanding store size, marrying a natural products focus to its specialty one, and creating a more natural foods-oriented culture Bristol Farms (Supervalu) has the potential to be a major national player in the supernatural retail category, while at the same time keeping it's specialty focus.

Sunflower Market

The Sunflower Market banner also provides Supervalu with a vehicle to enter the supernatural retail category in a big way. First, the chain will need to expand the size of the stores from its current 15,000 square-feet to about 35,000 square feet for the strategy NSFM has in mind. This strategy positions Sunflower Market as a natural products "category killer." As such it isn't exactly a supernatural grocer but the category fits well enough at present.

The "category killer" Sunflower Market stores would be 35,000 square foot upscale, yet discount natural products grocery stores. The merchandising focus would be on national natural products brands and private label groceries (produce, perishables and meats as well) sold at retail prices 0f 10%-15% below Whole Foods for the national brands and at least 15% below Whole Foods' corporate brands for the private label items. (Sunflower already sells an extensive line of corporate/private label natural and organic groceries called "Natures Best," a brand Supervalu created for the chain.)

The Sunflower Market stores would have all they have now--natural and organic perishables departments, produce, an in-store restaurant and bakery. The extra square-footage would allow the retailer to expand it's produce department and a few other perishables areas which would be necessary for this positioning. And of course the additional square-footage would allow for the expanded "category killer" grocery core of the store. In essence Sunflower Market would be a full-service natural foods superstore, with the added feature of being a "category killer" on pricing.

The stores are already somewhat "no frills" so the current basic design format would work well with just some minor adjustments. Since Supervalu is a grocery wholesaler as well as retailer, and thus has huge buying power, it would be able to make the buys necessary for this "category killer" price strategy to work. Additionally, since the stores would be smaller than say a new Whole Foods, and less fancy but still upscale, operating costs would be lower, thus providing another advantage when it comes to the pricing strategy.

NSFM believes if Supervalu decided to develop this one-two-punch--Bristol Farms as a national, upscale natural and specialty foods superstore, and Sunflower Market as a national, few-frills but fairly upscale natural foods/products "category killer"--the chain could become a major player in the supernatural retailing segment.

Imagine locating both a Bristol Farms and a Sunflower Market in an area where there is a large Whole Foods store. Since the Bristol Farms would also offer a large, tailored selection of basic groceries--as it currently does--plus a full natural products selection, as well as retaining its specialty focus, it could challenge Whole Foods for primary shoppers. It also would get secondary shoppers from Whole Foods who would want to shop Bristol Farms for their basics at times and for the specialty and gourmet selections they can't buy at Whole Foods do to the product ingredient restrictions.

Having a Sunflower Market fairly close also adds to the competitive mix. Natural Foods store primary shoppers (eg: Whole Foods) would likely shop as well at Sunflower because it would offer natural and organic national brand and private label groceries, produce, perishables and supplements at significantly lower prices than the competition. Also since it is an orthodox natural foods store these primary shoppers would feel at home with the retailer's product and related policies.

NSFM believes having either one or both of these banners near a Whole Foods store would change the complexion of regional markets considerably. On a selected national basis (just as Whole Foods is national but selectively so) this strategy could position Supervalu solidly in the supernatural retail category. Since this is a category where margins tend to be higher this would make since from that standpoint for the chain. Additionally, the consumer market for natural and organic products is the fastest growing of all grocery categories. Having a major position in the supernatural retail category would enable Supervalu to take advantage of this growth not only in terms of sales of natural and organic products in their existing banners but by becoming a major mainstream player with the categories' primary consumers and shoppers.

NSFM thinks this retail category is one to watch as Whole Foods consolidates Wild Oats into its corporate culture and retail merchandising philosophy in the coming months. In addition to the "big 3" we have discussed in this piece, their are obvious (maybe even more obvious) opportunities for smaller chains--and perhaps even startups--to enter the supernatural category. There also are a few regional natural foods retailers who might step up and grow their store counts rapidly like Whole Foods and Wild Oats did. NSFM will be looking at all these aspects of the supernatural category in future pieces.