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3'O Clock High: Grocers Can't Produce


"I... just... want... the... diapers."


Beware grocers promising Margin Expansion...

Whole Foods Markets (WMFI) is going to kill the super market industry without having to ever really be part of it. Whole Foods is successful because they aren't a food merchant to the masses. They are selling an image, a lifestyle and self-opinion but they aren't playing smash-mouth over having the lowest price for a 12-pack of Diet Coke.

They were started from scratch with the idea of being a decided alternative to that historic Piggly-Wiggly vs. Ralphs vs. Krogers type of knife-fight. Evidence of Whole Food's success in getting this separation can be found in WMFI's P/E exceeding its would-be industry average by nearly 4x. Whole Foods' stock doesn't look like a super market or trade at super market multiples because the chain isn't, by any measure ex-the selling of food, a supermarket.

But that's not stopping Safeway (SWY) and others from trying to capture some of the WMFI-margin-love for themselves. Safeway is spending untold billions revamping their Safeway stores to make them more upscale. They are creating more "destination experiences" such as coffee, deli's, expanded produce, film processing and a wide array of wine and spirits.

Hothouse Flower Remodels

From a management and investing perspective there isn't anything more frightening than a chain trying to remodel its way up the consumer food-chain. These are the "ambitious" remodels that effectively rebuild the entire chain, one store at a time. They cost a huge amount of money but, hey, you gotta spend money to make money when you're targeting a higher-income customer who doesn't mind handing over some fat margin.

Of course, you don't see these efforts in industries where margins are truly fat. You see it in the sub-sectors of retail most desperate to ward off becoming Ford (F). To paraphrase Henry Kissinger, "the fighting in retail is so vicious because the stakes are so low".

In electronics, it's what Circuit City (CC) is doing by belatedly emulating Best Buy's (BBY) larger footprint stores. Though any number of grocers are trying to capture Whole Food's magic, Safeway is the farthest down the line. They are well into a multi-hundred million revamping all designed to make their stores "warmer" and "easier to shop"; presumably enabling Safeway to gain higher margins.

As is often the case, Safeway is spending big bucks recreating themselves. At our local outlet they ripped the old store down to the parking lot and rebuilt from near-scratch. They added a Starbucks (SBX) and all the other fuzzy amenities discussed earlier.

The place was dazzling for about one month. Once the bloom was off the rose, and corporate attention had shifted elsewhere, the store started slipping. Aisles became cluttered even as pegs were left empty. Nobody seemed to know where anything was and all the independent "stores within a store" had the effect of creating neighborhood rivalries within the same store. The deli guys don't like the Starbucks kids and neither one can abide the know-it-alls back in the pharmacy who are constantly shoving their educations in everyones' faces.

The trap for managers is that the ROI can probably be stretched into something looking decent. It's a bigger store and almost certainly does larger dollar volume than the Safeway which stood there previously. But it's a worse operation. It unravels under the strain of real customers showing up, expecting to buy real groceries rather than a "triple, no-foam, non-fat Latte'".

So management Oks a chain-wide rollout on a concept which slowly eats itself, as a retail operation. By the time the flaws of the remodels become obvious the chain will be half done and, hey, at that point "what are you gonna do?"

The Takeaway: Give it Time

The lesson here isn't to be a snotty kill-joy when you hear a retail turnaround story from a friend or on a conference call. The lesson is to take a little time before you get invested in the idea. Let the stores age with the new model and check the traffic patterns after three-months.

And if you're looking to buy a grocer as "sort of a Whole Foods play" you may want to stick with Whole Foods (understanding our long-standing rule to consider "specialty retailers the place love goes to die" in terms of buy and hold stocks).

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