Friday, July 25, 2008

Retail Field Report Memo: Specialty Retailer Cost Plus World Market Is At A Serious Crossroads: We Offer Analysis and Suggestions For Moving Forward

On June 9, the import housewares and gift retail chain Pier 1 Imports made an offer to acquire specialty foods, wine and imported housewares, furniture and gift retailer Cost Plus World Market in an all-stock acquisition deal, offering Cost Plus' board of directors $4 per-share of Pier 1 Imports' stock for the company.

Under the terms of the proposal, Pier 1 Imports, Inc. would have issued 0.6000 shares of its common stock for each share of Cost Plus common stock. Pier 1 Imports currently operates 1,034 stores in the U.S.

Based on the closing stock share prices of Pier 1 Imports and Cost Plus on June 6, 2008, three days before the offer was made, the proposed exchange ratio of the deal implied a value of $4.00 for each share of Cost Plus World Market common stock. The offer represented a premium of approximately 31% over the Cost Plus closing stock share price on June 6, 2008, and a premium of approximately 34% over the average closing price of Cost Plus shares for the last 30 trading days.

The total all-stock acquisition price of the Pier 1 Imports proposal for Cost Plus was about $88 million.

Here's what Pier 1 Imports' CEO Alex W. Smith said on June 9 when making the offer:

"We believe that the combination of Pier 1 Imports and Cost Plus is extremely compelling and would create significant value for the stakeholders of both companies.

"Given our similar customer bases and broadly similar business models, but distinct market positions, we believe Cost Plus is an excellent fit with Pier 1 Imports. We are confident that combining our two companies would create a stronger and more competitive company that is better positioned for future growth.

"Furthermore, we believe the combination will result in improvements in Cost Plus' operating margins and significant synergies, anticipated to come from organizational efficiencies in the supply chain management, shared services, store operations and other general administrative costs. Cost Plus shareholders will enjoy significant benefits from the combination, including improved operational liquidity of the combined company as well as a more active trading market for their shares."

Sounds good so far.

About a week after Pier 1 Imports sent a letter to the retail chain's board of directors offering to acquire Cost Plus in the all stock $88 million buy, Cost Plus World Market told Pier 1 Imports it wasn't interested in its offer, saying essentially not only was the offer too low (not to mention there being zero cash involved) but that it made very little business sense for Cost Plus and its shareholders to allow Pier 1 to acquire the retail chain.

Can't blame Cost Plus for saying no thanks; it was a desperation offer by Pier 1 Imports, which was searching for a way to jump start its sales and expand its offering by being able to get into the food and beverage categories by virtue of that fact both categories contribute the most in sales overall to Cost Plus' sales top line and profits bottom line. Of course, right now Cost Plus World Market is a desperation stock. Therefore we can't fault Pier 1 Imports for making the offer it did.

Pier 1 Imports apparently agreed with our analysis. Just a little over a week after the Cost Plus Board of Directors rejected the offer, on June 25, Pier 1 withdrew its all-stock $88 million acquisition offer saying in a prepared statement that the change of plans was due to an inability to acquire a majority interest in Cost Plus at a price that would make sense for its shareholders.

The primary reason for Pier 1 doing so though was that after it announced it intention to acquire Cost Plus it's own fledgling stock drop even further, thereby making the cost of even the original $88 million acquisition offer prohibitive. Pier 1 Imports also announced a substantial sales loss about that same time, which combined with its sinking stock put it in no position to acquire Cost Plus or any other retailer for that matter.

Both Pier 1 Imports, which sells only durable goods, and Cost Plus, which sells consumables like domestic and imported specialty and natural foods and beverages, wines and craft beers, confections and premium coffees, along with durables like furniture, housewares and gift items, are performing poorly, reporting losses in their respective most recent quarters.

We agree with Cost Plus World Market's decision not to be acquired by Pier 1. Why? Although Cost Plus is performing poorly, its due primarily by the durable goods side of the business, which is about 50% of the retailer's total sales, consumables making about approximately the other half.

On the other hand, Pier 1 Imports sells only durable goods such as furniture, household items, gifts and other similar items, the majority of which are imported.

The poor state of the U.S. economy has consumers cutting way back on purchases of durable goods like those Pier 1 sells (100%) and Cost Plus (about 50% of inventory) sells, which is the primary reason sales and profits are down so much for both retailers.

In addition, the sad state of the U.S. dollar is making the imported goods both retailers buy to sell in there stores far more expensive, which combined with the consumer retreat on durable goods purchasing is a perfect store of bad sales news for both Pier 1 Imports and Cost Plus.

However, the silver lining for Cost Plus is that because specialty-natural foods, beverages, wines and craft beers, items consumers will still by in a down economy even though in reduced amounts, comprise about 50% of its revenues, along with being its top sales category, it has the potential to adjust its merchandising practices---devoting more store square feet to consumables and taking away some square feet say from furniture for example--as a way to increase sales and potentially profits.

On the other hand, since Pier 1 has no current system or supply chain for food and beverage merchandising--distribution centers, buying staff and the like--it's pretty much stuck in the durable goods-only retailing business, which means in our analysis it faces a far greater chance of filing for bankruptcy if its sales and stock share price continues to drop, than does Cost Plus, which has the flexibility to focus more on consumables as a way to ride out the poor U.S. economy.

It is important to note though that unless Cost Plus makes some serious changes that improve its sales and cash-flow, it will likely face a serious liquidity crunch, as its sales and profits continue to drop along with its stock share price. Our analysis is that Cost-Plus World Market is in a better position (if it makes changes) than Pier 1 Imports in the short and medium run because of its consumables category to improve its position considerably. However, the fact is thus far it has failed to do so.

Conversely, Pier 1 is currently in a better liquidity position than Cost Plus. However, with its sole focus on durable goods, our analysis is that the retailer, unlike Cost Plus, is all things being equal, in a worse short -to- medium range position due to its merchandising reliance on only the durables. (Note: Pier 1 Imports announced last week it will close about 30 -to- 40 of its most underperforming stores, out of the 1,034 stores it operates in the U.S.)

In fact, it's our analysis Cost Plus should be putting a far greater focus on consumables in its stores right now than it is doing. This should include taking some of the space devoted to merchandising furniture and gifts in its nearly 300 stores across the U.S. and giving that space over to more consumables like discounted natural and specialty foods and related products.

The retailer already has been growing its World Market store brand of natural and gourmet foods, and has started to promote those items, along with branded specialty food and beverage items, more aggressively in its weekly ad circulars and in-store. Even in down economies consumers will buy affordable indulgences like natural and gourmet foods, especially if priced right and merchandised well.

What Cost Plus calls the "gourmet" category--its offerings of natural, specialty and related foods--has historically been a good one for the retailer. Cost Plus generally takes about a 43% gross margin on all the branded specialty and natural foods items it sells in its stores and takes a gross margin of about 50% on its store brand items.

Of course, it takes less margin on some items, but those tend to be the highest volume products such as the Knorr brand of specialty foods items and similar well-known brands. The same with its store brands--fast moving skus can be priced to return a lower than 50% gross margin.

Cost-Plus also has historically been very aggressive in getting deals from suppliers. In fact, branded specialty food and beverage suppliers that sell to Cost-Plus tell Natural~Specialty Foods Memo that Cost-Plus buyers have been negotiating for even deeper deals with vendors because they know sales by specialty foods companies are down significantly in the current poor U.S. economy.

In our analysis, it only makes sense for Cost-Plus to expand the percentage of square feet it devotes to specialty-natural foods, beverages and wines in its stores, at least for the next couple years, until their is improvement in the U.S. economy.

Additionally, with its buying power in the categories, we suggest the retailer look at coming up with some creative value-based specialty food and beverage marketing and merchandising schemes designed to position it as the "value leader" in specialty foods retailing, which ironically was a reputation the retailer had many years ago before numerous new retailers selling specialty foods came on the scene.

Natural~Specialty Foods Memo recently asked a team member, who has 20 years food and grocery retailing and category management and merchandising experience, to visit a Cost-Plus World Market store and do a field analysis of the consumables category--specialty-natural foods and beverages, wines, craft beers and related items--and offer an analysis of what the field researcher found, also including suggestions regarding the category in the stores.

The store where the field report was conducted in one of the retailer's newest, and thus has one of the larger consumables sections, stores located in the Southern California city of El Segundo.

Below (in italics) is the Cost Plus store field report by the member of the Natural~Specialty Foods Memo team:

Cost Plus World Market "One World. One Store."

El Segundo, California store: Open about 1 year.

Overall the store is very difficult to maneuver. The layouts and planograms seem odd and the aisles feel cluttered. There isn't a straight line to anything. You pretty much have to zig-zag around the store.

I believe the store needs better aisle signs too. Other than just basic overhead signs for the different departments that says "Food", you really don't know what section you are in. Maybe this is their intention, forcing you to wander up and down each aisle but to me it's frustrating.

I also feel they can improve on the shelf price tags, there are so many different sku's on the shelf that it's very difficult to match the price to the product. This is especially true on the products that don't look like they have a permanent location. Sometimes they have priced the products individually, sometimes they have 1 small price tag shown on the outside of the displayable case, sometimes there is a sign reflecting the price but the worst is sometimes there is no price anywhere at all. When there is no price at all, that's when I believe most people just put the item down and pass on purchasing it all together, which is a lost sale.

I think Cost Plus could also benefit from doing some more cross merchandising. They do it well with wine by stacking it in other departments, and they also have wine bags in the wine department, but I think they could do it with a lot more categories...

Suggested Cross-Merchandising Examples:
Coffee and Tea (with mugs and tea cups)
Small food components (with gift basket, clear wrap, bows, etc)

I used to think of Cost Plus as a place to go to for unique imported items, from rugs from India to imported biscuits from the UK . Now, it appears they are going more mainstream because they have quite a bit of domestic products, such as Sourdough Pretzels and Chewy Caramels. But the message they are sending to the public is we are selling 'Gourmet Foods.' Even in their advertising flyer the say "Discover World Market Gourmet" and the tag line is : " When you see our name on any of our gourmet offerings you can count on three things, great taste, superior quality and incredible value."

I suppose that advertising lends itself to a even bigger discussion, and that's, "What's Gourmet" anymore?" I think the word "gourmet" may have been dumbed down or let's say has gone mainstream because anything and everything is called gourmet. I think all the food categories are being crossed these days, so who can really tell the difference between gourmet, speciality, natural, ethnic, etc.

I suppose I was confused because they did have everything from natural, imports, organic, and run of the mill products--and dare I say, they also had "gourmet." Even their own private label runs the gambit. Some of it was Natural (Tortilla Chips), Imported (Extra Virgin Olive Oil), Run of the Mill (Sourdough Pretzel Nuggets), and "Gourmet" (Legend BBQ Sauces and Brix chocolates for example).

Store Brands-Private Label

I really like their World Market store brand label and their packaging, but the range is a little odd. I feel they were heavy in certain categories but completely ignored others. For example..They have a nice range of snacks (i.e. nuts and chips but no salsa, in private label).

They also have huge amount of sku's in spices and Extra Virgin Olive Oil - Organic and regular (but no private label pasta). They also had a nice range of Chocolate Bars with some unique flavors such as pomegranate. Again, all their private label products were either natural and/or organic (most of the chips for example).

Pricing: The pricing on the store brand (World Market brand) pricing was all over the place. Some items seemed extremely expensive (a small little tub of private label M&M type candy for 6.99) but other items seemed very much in line (private label 3 oz candy bars 1.99 to 2.99). So there didn't seem to be any consistency.

There's that word ...consistency. There didn't seem to appear to be any consistency in the way they operating in the consumables categories. That goes from the way they are merchandising, pricing and ranging.

I think Cost Plus as it is currently is a great treasure hunt type store, but not a store where you go frequently because it's just not convenient or easy. If they want to do food and beverages better, I think they need to figure out a way to make it a destination point.

Cost Plus used to be a destination point for "imports" but I believe they have gotten somewhat away from that. There are just too many stores where you can buy the different types of product they are selling these days, and those stores specialize in those categories (whole Foods Market ) or beat them in price (Trader Joes), are two examples.

Why not online consumables sales: It's my analysis Cost Plus has an opportunity to sell their food products online. They have a very nice website but it looks like food is one of the only categories you can't order online. For now you just have to be satisfied looking at the pictures and reading that it's available only in the stores. The nice thing is they do list some of their food with their retail prices online.

After visiting and analyzing the El Segundo Cost Plus store, I just can't figure out where "in the world" they wanted to go. However, Cost Plus has the opportunity to better define its retailing world--and positioning with consumers--by making some basic changes, improvements and additions.

Mine is only the ethnographic field reporting and analysis of one person. However, many of the suggestions I make in this report come from years of working in and observing retail across all formats.

With better focus on the basics--simple things like store layout, shelving, shelf price tags--along with more precise merchandising, better and more consistent pricing, a little creativity like using more cross-merchandising and in-store displays, Cost Plus could improve its positioning--and probably its sales in the consumables category--significantly.

While the field report presented above is only that of one person, albeit and experienced one, Natural~Specialty Foods Memo suggests the key theme to take away from the ethnographic analysis is two-fold: that Cost Plus has the potential to improve its sales and profits by focusing more and better on its consumables category, and that the retailer has many areas of product, merchandising and pricing issues in which it can dramatically improve on.

There was a time, up until about the late 1980's, in which Cost Plus was arguably the "best" natural foods specialty foods retailing chain in the U.S. However, like the Natural~Specialty Foods Memo field reporter suggests in the analysis, since then numerous specialty players like Whole Foods Market and Trader Joe's--along with many others--have dramatically grown the number of stores they operate, along with greatly improving on their natural and specialty foods merchandising

Additionally, numerous new specialty and natural foods retailers, chain and independent alike, have come on the U.S. retailing scene in the last 20 years. Many of these newer retailers are cutting edge.

Further, numerous previously more mainstream conventional supermarket chains--Safeway Stores, Publix, even Kroger are a mere three examples of the many--have moved dramatically into the natural and specialty foods retailing space, including creating their own natural, organic and gourmet store brands.

Meanwhile, over the last 20 years Cost Plus has essentially remained static. The specialty food and beverage and specialty wines departments in the stores have changed little since the late 1980's. In fact, one could reasonably argue they've gone downhill since then.

In our analysis, part of the reason for this is that Cost Plus historically burns through category managers and buyers at its corporate offices in Oakland, California. It often seems that just when a Cost Plus buyer is just getting into his or her groove, they leave.

This lack of often not first finding good talent and of properly nurturing talented buyers and merchandisers when it has them, is in our analysis a key contributor to Cost Plus' lackluster performance in the consumables, as well as the durable goods, categories. In other words, it is a senior management issue and problem in the main.

The good news is that Cost Plus is in our analysis on to something with its current expansion of its World Market store brand, focusing on combining natural and organic ingredients with premium ones in many of the new items.

The retailer also has started to promote its World Market brands more, both in its weekly advertising circulars and in-store. It needs to do more of that.

We suggest a greater focus on both store brand and manufacturer brand specialty-natural foods items will help Cost Plus gain its footing back. The retailer, which once was the premiere seller of dicsounted specialty wines in the U.S., also needs to review and revamp it's wine departments.

There are currently opportunities we think the retailer is missing to generate increased sales in the category. How about more wine tasting events? Meet the winemakers events in the stores? Make some better buys; and offer some blowout deals that are heavily promoted as events in-store.

Cost Plus World Market needs to create some excitement around its specialty-natural foods and wine departments. Poor sales performance should be the mother of marketing and merchandising creativity. But that's yet to happen at Cost Plus in our analysis.

Perhaps its time to bring in some new creative merchandising and promotional blood, with a focus on the consumables category. After all, sometimes bringing in people who come from outside the box (the Cost Plus structure in this case) leads to thinking, ideas and programs that are outside the box (but good ones).

Right now, Cost Plus could benefit from some new, imaginative and creative marketing and merchandising thinking for its consumables category, regardless if that thinking comes from within the chain or outside of it.

The question is: Why isn't the retailer's top management realizing that fact? And, even more so: Why isn't the company's Board of Directors demanding it? If the Cost Plus board doesn't demand, along with becoming an active part of the solution, some changes and improvements, we suggest it might want to call Pier 1 Imports' CEO up and restart acquisition talks; if it isn't too late of course.

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