Thursday, December 20, 2007

Retail Memo: Natural-Born Category Killers

The small store, no-frills, price-impact food retailing format revolution has arrived in the natural and organic foods retailing category, as well as in the conventional food retailing segment. The rapid growth in the natural and organic products categories has created an opening for category-killer formats, and a couple are emerging. Both are small format stores compared to supernatural grocers, and both recently announced major growth initiatives.

Supervalu Inc.'s 15,000 square foot Sunflower Market (pictured above) is one of the two small format, price-impact natural foods stores we believe has the potential to be a real player in the natural and organic foods "category killer" retailing segment. The format is no-frills but extremely attractive in design.

In August and September of this year, when the U.S. Federal Trade Commission (FTC) was vigorously opposing the acquisition of Wild Oats Markets by Whole Foods Market, Inc., we wrote about and offered our analysis on why such opposition by the FTC (and others) made little sense in light of the realities of today's natural and organic foods retailing environment.

The FTC's chief argument in opposing the merger in a federal court was that it would create an anti-competitive situation in the supernatural food retailing category, allowing Whole Foods (combined with Wild Oats) to be able to raise its retail prices whenever the grocer desired.
(Although the U.S. Federal Court in Washington, D.C. denied the FTC's September, 2007 pre-acquisition legal challenge, and denied an appeal a short time after that--which allowed the merger to go forward and for Whole Foods to begin to integrate Wild Oats' operations into the Austin, Texas-based grocer's culture--the agency again filed a post-merger lawsuit last month, asking the same federal court to review the deal. To date, the court has avoided the FTC's request to give it another hearing on the merger.)

We argued then, and still do, that although acquiring Wild Oats and removing it as a competitor would provide Whole Foods with some near-to-medium-term competitive advantages, those advantages would not be all that significant--and would be rather short lived at best.

Boulder, Colorado-based Sunflower Farmers Markets is the other small format, no-frills, price-impact natural foods retailer we believe has the potential to create a serious impact in natural products retailing with its 20,000 to 25,000 square foot stores.

Why? First, huge supermarket chains like Safeway Stores, Inc., Kroger Co., Supervalu, Inc., Publix and others (all four mentioned have annual gross sales at least ten times that of Whole Foods), and smaller but big regional chains and multi-store independents throughout the country, have moved into the natural and organic products' retailing space in a big way--and it's getting even bigger.

For example, Safeway's Lifestyle stores are looking more and more like a hybrid upscale conventional supermarket/Whole Foods-like format these days. The same with many Publix, HEB and Wegmans' stores, to name just a handful rather than taking a couple paragraphs to list the many more doing the same. Further, dozens of large, regional grocers (Raley's in California, Giant Eagle, Rice Epicurean, Bristol Farms; the list goes on and on) are creating new stores that are going head-to-head with Whole Foods' stores in their market areas.

On top of all that, mass merchandisers Wal-Mart, Target, BJ's, and Costco Wholesale are offering more an more natural and organic items in their stores, as well as creating their own store branded organic grocery products.

Next, in terms of the Wild Oats' acquisition allowing Whole Foods to be able to raise its retail prices at will, we argue that is far from the case. First, Wild Oats' wasn't a big enough chain in terms of market share to even make that kind of difference. In other words, swallowing up Wild Oats did not make Whole Foods a monopoly in any real terms, even if John Mackey though it would.

Second, with its "Whole Paycheck" nickname (which company executives detest) firmly established in the food retailing lexicon (as well as in the minds of many consumers) Whole Foods has become hyper-cautious about its retail price structure, and about raising prices.

Lastly, if one really makes a close analysis, they will find Wild Oats Markets' wasn't even Whole Foods' chief competition. Most of their stores were too small, their merchandising practices were outdated in many aspects, and their in-store prepared foods programs were minimal compared to today's industry standards.

Rather, that chief--and growing--competition comes from the types of retail formats the grocers mentioned above, and others, are creating and growing rapidly. It also comes from mass merchandisers like Wal-Mart, Target, and Costco Wholesale, all who have moved aggressively into the natural and organic products retail space and continue to do so. It's a brave new natural and organic products retailing world folks, and with all do respect, Wild Oats was in many ways still living in the old world.

Part of this new natural and organic products retailing world (NOPR 2.0 we call it) is the successful creation, selling and growth of store brand organic grocery lines from the likes of Safeway, Kroger, Target and many others.
The store brand organics are proving wildly successful. For example, Safeway recently said its O' Organics store brand has been the most successful private label brand launch in the chain's history of developing store brands. In fact, Safeway plans to begin selling the O' Organics line to food retailers in other countries beginning early next year. Additionally, Giant foodservice distributor Sysco has started distributing a number of O' Organics items to some of it's customers, and plans to do so nationally.

Kroger's store brand organics line (as well as its all-natural brand) has been such a huge success that the chain is currently expanding it into more categories and adding scores of additional skus. Kroger's CEO has said his plan it to be the chain that sells organic groceries to the "masses' in the U.S.

The hundreds of millions of dollars in brand new sales from these store brand natural and organic grocery products has had to come from somewhere. It's not just from shoppers who have traded up from conventional groceries to organics. Rather, the new sales are coming from a variety of places: replacing and reducing sales of some manufacturer brands to be sure, some consumer trade up from conventional grocery items of course; but more significantly its also coming in large part from natural products retailers, especially Whole Foods. The supermarket store brands are taking share away from Whole Foods and other natural foods retailers in the grocery products segment.

Shoppers who shopped a supermarket and also Whole Foods, and bought all of their natural and organics at Whole Foods, are now finding they can get a large share of those same items at the supermarket, and generally at better prices. As such, Whole Food's "share of the stomach" in the natural and organic grocery category is getting eroded by these store brand Organic lines.

Whole Foods knows this, that's why the grocer keeps innovating, putting new types of restaurants in their stores, becoming a prepared foods guru, adding wine cellars, mini day spa's and other cutting-edge features in-store. The retailer's executives knows what's happening in terms of the natural and organic grocery sales environment, and they plan to be ahead of the retail curve in terms of not finding themselves overdependent on natural and organic grocery sales in the future.

Lastly, we argued this phenomenon--the growing number of big food retailers going after the natural products consumer--would also be met with a new one.

That new phenomenon is the emergence of a handful of food retailers (and formats) that have determined the natural and organic categories are ripe enough--and growing fast enough--to "pick off" by the creation of category killer formats designed to undercut Whole Foods (and others) significantly on price. That category growth is without a doubt here, with much more to come. Organic foods' category growth has been 25 to 30% per year in the last five years. Further, projected growth for the next five years is about 20 to 25% annually.

These retailers have realized the market is there to create a natural foods store format with the following characteristics: small format (or footprint), no frills design inside and out, limited category assortment and--the major positioning point-- everyday low-price, price-impact across all product categories and sectors. These stores offer more than just bare bones departments and selections, but do so in a no-frills but attractive, small format box.

These elements not only tap into the desire by a growing number of consumers to be able to buy natural and organic products for less, it also opens the category to new shoppers. It's an expansionistic format all around. Further, the format taps into the growing desire by many shoppers to be able to buy groceries in a more convenient way. Rather than spending lots of time in a huge store, they want to get in and get out--but still be able to get the natural and specialty products they want. Convenient, in-and-out shopping, a good product selection, and low prices--does anybody really believe the natural products consumer isn't ready for that combination?

Natural-Born category killers: Sunflower Farmers Market and Sunflower Market

In previous pieces on this topic (but in less detail) we identified two natural foods retailers--Boulder, Colorado-based Sunflower Farmers Market and Supervalu, Inc.'s Sunflower Market--as the most likely candidates to create a category killer application (format) in the natural and organic foods retailing space in the U.S. Further, we suggest these two retailers are the two best candidates to provide a retail one-two punch to Whole Foods in terms of taking market share from the supernatural grocer. (By the way, don't be confused by both having Sunflower as the major part of there names. It happens to many. In fact, it happens so often that Supervalu has a link on its Sunflower Market website that says, "Looking for the other Sunflower Market? Click here.)

Based on a couple of recent developments, one just this week, it looks like we might have been right four months ago. First, Supervalu recently announced that their Sunflower Market stores, a format which is only a little over a year old, have exceeded the company's expectations. And as a result of that, the grocer said its going to aggressively increase its new store opening time- table for the stores, building 50-60 new Sunflower markets in the next 4-5 years.

As part of this growth plan, Supervalu also said it plans to open stores in states it currently isn't in with the stores. Sunflower Market stores (five so far) are currently located in Illinois, Ohio and Indiana. Plans include expanding eastward. The small format stores are only 15,000 square feet and offer a limited assortment of natural and organic foods, non-foods, fresh produce, meats, fish/seafoods and perishables. They also have a fresh-baked bakery/cafe in-store, a health and wellness department and full wine and craft beer departments. (read more about the format here.)

The small format stores are no-frills but also offer a slightly upscale look to them in both design and style, do to the in-store bakery/cafe and attractive health and wellness departments. (It's important to note the assortment is limited relative to Whole Foods and other large supermarkets. However, it isn't limited in terms of the industry standard, in which most independent natural foods stores still aren't any bigger than 15,000 square feet.) Numerous market basket price checks have shown Sunflower Markets' overall everyday prices on natural and organic products to be 10-20% cheaper than the everyday prices on like items at Whole Foods' stores.

The other Sunflower, Arizona-based Sunflower Farmers Market, also is a small format, no-frills, price-impact, natural and organic category killer format like Supervalu's Sunflower Market. Sunflower Farmers Market also has something else in common with it's namesake natural foods retailer--its expanding dramatically as well.

Earlier this week, the small format, price-impact natural products' grocer announced it has received a $30 million investment from California-based PCB Capital Partners to build new stores and expand into other states. The company currently has 13 stores in Arizona, Nevada, Colorado and New Mexico. With the $30 million in hand, Sunflower Farmers Market plans to have a total of 50 stores in the Western U.S. in five years, including expansion into Utah and Texas, which is where Whole Foods Market, Inc.'s corporate headquarters is located. The retailer will open about 13 new stores next year.

Sunflower Farmers Market was founded in 2002 by Mike Gilliland, who also is the founder of Wild Oats Markets. He left Wild Oats a number of years ago. This time around Gilliland and company are taking a price-impact, value approach to natural and organic foods retailing. In fact, the grocer's motto is: "Serious Food at Silly Prices." That should tell you much about its positioning.

The stores, similar to Supervalu's Sunflower Market, are fairly no-frills. They also offer a limited assortment of natural and organic products across all categories. The selection is ample though, and looks far from bare bones. The centerpiece of the stores, which are about 20,000 to 25,000 square feet, are its produce departments, the one place the natural grocer departs from its limited assortment merchandising philosophy and offers an extensive selection, including lots of organic produce items. The farmers' market-style produce departments, which are placed in the center of the stores, represent about a third of total store sales, according to Gilliland.

In fact, he says when fresh meat is added to produce in terms of sales, both represent about 50% ot total store sales. Groceries, health and body care, nonfoods and vitamins/supplements comprise the other 50% of total store sales.
Gilliland says he's set Sunflower Farmers Market's pricing structure so that shoppers will pay 20% to 30% less on natural and organic groceries, perishables and the other items featured in the stores than they would pay at Whole Foods and other natural foods stores. Produce prices are particulary hot, do in large part to the fact that the grocer self-distributes all of its own produce, cutting out the middle man and distributors.

With 50 stores in the Western U.S. in five years, the natural products category killer should be a major force in natural foods retailing, and its pricing structure, which is considerably lower than Whole Foods across the board, could position it well to take market share from Whole Foods and others in its market regions.

As a category grows, its logical that competition will follow, and formats will morph

We aren't suggesting Whole Foods Market, Inc. is in any imminent--or even long-term for that matter--danger of failure. What we are suggesting is that we're seeing the beginnings of a small format, price-impact movement in the natural and organic food retailing niche similar to what is happening in conventional food retailing. The scale is much smaller, the players fewer and they're not nearly as large in size and scope overall. However, we believe the natural and organic foods category killer concept and format is real. And, with 100-plus stores combined between the two "Sunflower" chains in as little as five years, they're going to take a nice chunk of category market share.

The prime drivers of this phenomenon are the super growth of the natural and organic categories, a lack of price reductions by existing retailers to reflect that growth, and a desire on the part of many consumers for faster, more convenient stores to shop in. If you combine these key trends, a small format, no frills, price-impact store focusing on the natural and organic categories makes much sense--and has huge growth potential.

Obviously, Supervalu's Sunflower Market and Sunflower Farmers Market are both betting on that concept. Along side them are numerous conventional supermarket operators like those we mentioned in this piece and many others who are betting on the categories growth to drive their sales and profits. That's why they're investing in upscale, "Whole Foods-style" stores, creating and marketing extensive store brand natural and organic grocery lines, and positioning their stores more and more towards the natural products consumer.

Taken along with what's occurring in the small format revolution being led on the high-low end by Tesco--with it's Fresh & Easy Neighborhood Markets chain which has already opened about 30 stores in one month, with 200 to be opened by the end of next year--and German food retailer ALDI--which is opening up 100 of its small format, no-frills, price-impact stores a year for the next few years (on top of the 850 small format stores it already operates in the U.S.)--what Supervalu and Sunflower Farmers Markets are doing with small format store rapid growth plans further solidifies the reality of the small format food retailing revolution across all product retailing categories and types of positioning.

In fact, Whole Foods itself is getting into the small format food retailing game. Early next year it will open a prototype Whole Foods Express store in an old Wild Oats store building in Boulder, Colorado. The store will be about 15,000 to 20,000 square feet, and is said to offer a mix of grab-and-go prepared foods, a limited assortment of natural and organic groceries and perishables, and other convenient offerings.

By the way, we don't believe the Whole Foods Express format will be a natural/organic category killer, but stranger things can happen. And, if the grocer's new Whole Foods Express format did turn out to be a natural and organic foods category killer, that would make things really interesting.

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