Coriolis Chart Watch Q2 2006 Part 2

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With much fanfare and backing up traffic on the motorway, The Warehouse Group opened its first Warehouse Extra hypermarket in Sylvia Park, Auckland. The store was packed with people and doing a roaring trade when we visited on June 8th, 2006. But the questions on everyone's mind was "Is it going to work?"

What did you see in the store?

1. Using the American layout

They have clearly studied the global leaders in the hypermarket/supercentre format. The store was a typical of the now standard United States model for a supercentre, with the big box general merchandise offer taking up 60%+ of the floorspace and the supermarket offer taking up 30-40% of the floorspace, with the aisles running parallel to the front of the store.

Here are two existing examples to demonstrate how close they are following the American model:

Sample Store Layout: Meijer 34 (Royal Oak, Michigan)

Sample Store Layout: Typical Wal-Mart Supercenter

It is very different to the typical British-style hypermarket, best demonstrated by Tesco Extra:

Sample Store Layout: Tesco Bar Hill

Notice how the U.K. style hypermarkets cluster the perishables in the centre of the store and blur the lines between the grocery/food offer and the general merchandise, reflecting Tesco's heritage as a supermarket retailer.

2. Limited Perishables / All Pre-packaged

Warehouse management certainly understand the concept of making a statement with fresh. The first thing you see when you enter the store from the Mall is mass displays of fruit and vegetables - green and fresh. It really catches the customers attention - they're not embarrassed by it - they didn't hide it down the back in a corner somewhere. And they have done it quite well (for a first attempt).

However, they are hedging their bets somewhat by having a limited perishables offer in many departments (usually only one or two skus in any sub-category), by having bakery as a concession and by having only prepackaged products.

If you want oranges, apples, sliced ham, are only available in a bag, and a big one at that. You couldn't buy just two oranges and one apple - it was a big bag or nothing. The total use of prepacking clearly allows them to avoid the expense of installing weigh scales at the checkouts and simplifies store operations, It is very similar to the offer made by the limited assortment discounters - Aldi, Netto, Lidl and Save-A-Lot. However, we've never seen it work in a full-range supermarket. If some of the products don't sell as well as they expected and start to go off, how do they recover any value from them, as usually occurs in a supermarket or greengrocer through reworking? What is going to happen to the big bags of pre-packaged oranges when one orange goes off?

The Bakery is a Brumby's concession run by a franchisee, which would seem to be a good idea. In-store bakeries are highly capital intensive, require a lot of specialised skills, are difficult to manage, especially for one store, and often don't make much money when evaluated using any kind of activity-based costing. That said, I'm not sure the Brumby's relationship will survive once they have 20 stores.

3. Pricing in-line with the market

The pricing, while not the cheapest you would find in the New Zealand market, was broadly in line with that of the average mid-market supermarket.

Is The Warehouse Extra Going to Work?

We've spoken to a number of people who have visited the store - from reporters to retailers, analysts to manufacturers - and there is a diversity of opinions on the new store. First the perceived challenges facing The Warehouse Extra:

1. New Zealand shoppers don't want big stores

Strangely this argument is most commonly heard from reporters and reminds us of the saying:

"Everyone generalises from a sample size of one; well at least I know I do."

The argument seems to revolve around the convenience of the shopping trip. Clearly shopping in a 12,000 square metre big box at the far end of a massive mall isn't a convenient as popping down the road to the local supermarket. However, there is more than one type of convenience: speed-driven convenience (a quick top-up shop) and range-driven convenience (a one-stop-shop solving a number of pressing errands). Just as the supermarket evolved from a group of separate shops (butcher, baker, etc), the hypermarket just represents a wider collection of separate shops for the convenience of the customer ("a mall under one roof").

We believe many consumers will recognise the convenience of a wide ranging one-stop-shop, for example: dinner for tonight (the Warehouse Extra sold out of rotisserie chicken on opening day), a present for a child's birthday, some new underwear and some new wine glasses all in one stop.

We believe the impact of The Warehouse Extra will be even stronger outside Auckland, where traffic congestion is not a major deterrent.

In addition, Pak'n Save, Bunnings and others are currently very successful with "big box" offers.

2. The Warehouse can't deliver operationally

This argument is most often heard from competing retailers and suggests that either some part of grocery retailing is so complex or some part of The Warehouse team is so deficient that The Warehouse will not be able to master the operations of this kind of store. The criticism is usually pointed at perishables - "the meat was rubbish" or "the fruit was poor quality" - not at shelf-stable grocery, which is more fault tolerant.

New formats and new market entrants are seldom as good as the incumbents. However, without their commitment to the status-quo they are able to try new ideas and different models. The history of retailing suggests that new entrants are looked down upon by existing players up until the point where they "upset the apple cart." The Warehouse Extra's use of all pre-packaged produce is a good example of trying something that a conventional supermarket would never risk.

That said, there is an old saying in retailing that "Retail is detail." Consistent execution day-in, day-out, on all of the little things that make a supermarket successful will prove challenging for The Warehouse. While they have recruited a team with supermarket experience, the knowledge those people have will need to filter through the organisation, especially down to the shop floor, where they will be asking people on minimum wage to learn and grow quickly.

We also believe they are initially disadvantaged by their choice of low level shelving with no overstock or pallets above, combined with their use of their own distribution system and plan to cross-dock all merchandise through this. This appears to be a cost-adding exercise during the initial stages of the process. Compare this with both the first Pak'n Save store and many Pak'n Save stores to this day, which buy 70%+ of what they sell directly from manufacturers in pallet and truckload quantities and stack this above the shelves. The early Wal-Mart Supercenters also bought significant volumes directly and held significant inventory in store. As a result we expect out-of-stocks could pose a significant challenge shortly.

3. The Warehouse can't deliver on low prices

The Warehouse has one grocery store. It is competing with Woolworths Australia with over 1,000 supermarkets in Australia and New Zealand and Foodstuffs with almost 170 supermarkets in New Zealand. It will clearly not buy anywhere near as well as either of its competitors.

However, on the other side of the equation, purchase price is only one components in determining the final shelf price of an item. Other costs may favour the supercentre format in general and The Warehouse Extra in particular. For example:

As a result, we believe The Warehouse will be able to offer competitive prices by having lower total operating cost and having lower profit requirements, due to having less capital tied up in the supermarket operation and due to a willingness to sacrifice margin to achieve scale.

Why do you think it will succeed? What is the opportunity?

1. Food is by far the largest untapped opportunity for growth for The Warehouse

The Warehouse, like other discount department stores, currently makes a strong offer across a wide range of general merchandise (consumption goods, softgoods and hardgoods) categories, including a consumables (FMCG) offer that now accounts for about 10% of turnover.

Looking out across the New Zealand retail scene (excluding automobile dealerships and auto related retailing), the primary outstanding opportunity for The Warehouse to achieve strong and sustained sales growth is food and grocery related retailing. As the following chart shows, food/grocery retailing now accounts for 54% of New Zealand retailing (again excluding automobile related), while department stores (including the Warehouse) only account for about 9%.

Note: Petrol stations on this chart only includes the food/grocery component of their sales (ie excluding petrol).

From this chart it is apparent that there are a large number of food and grocery related dollars available for The Warehouse to target. While it faces formidable competition in the supermarket space, most of the rest of the food/grocery/liquor space is much more fragmented and less competitive and should prove a soft target for the group. The central presence of the Warehouse Cellars beer and wine offer and the Coffee Club cafe in the Sylvia Park store is an excellent example of the ability of the group to target softer competitors than supermarkets.

2. The Concept has worked elsewhere in similar markets

Hypermarkets, primarily general merchandise retailers that have moved into supermarket retailing, have generally succeeded in other countries around the world:

The one major failure of the hypermarket concept to date has been the Australian market, where both Coles Myer's Super Kmart and Pick'n Pay from South Africa failed, which could be a concern as the Australian market is the closest structurally, economically and culturally to New Zealand.

SuperKmart in Port Adelaide, 1987

However, in both cases, we believe the reasons for failure do not apply to The Warehouse Extra. In Coles case, from talking to people involved at the time, we believe the problem was internal politics between the Coles Supermarket management and the Kmart management and the inability of IT systems to talk to each other across the group. In Pick'n Pay's case, the chain was boycotted by Australian unions due to (at the time) apartheid in South Africa and as a result was unable to roll-out the concept beyond one store. However, the one store they opened is still in operation in Queensland, though it is now owned by Coles.

3. The Warehouse has delivered on a strong initial offer and has shown an ability to learn rapidly

It is very easy to walk around the Sylvia Park Warehouse Extra and pick holes in what is on offer. A classic example on the first day was the cross-merchandising of toilet cleaner and a pallet of dog food in front of the fresh meat case. But this ignores what the group has achieved. The have delivered on a complete 10,000 sku supermarket offer with a wide range of perishable and grocery lines that creates the minimum critical mass required for a customer to make a "shop."

Looking at the rate of improvement by the group, from Whangarei to Te Rapa to Sylvia Park shows that The Warehouse can and has demonstrated an ability to rapidly learn supermarket retailing. We expect that they will continue to learn at a similar or faster rate and that the next store will involve a similar step change again in terms of execution.

4. The existing business can afford to cross-subsidise the food and grocery offer until it reaches critical mass

In 2005, The Warehouse "Red Sheds" had turnover of $1.5 billion across 85 stores and an operating profit of $139m and a 9.3% operating margin. This business can afford both the start-up costs and the ongoing low margins until the grocery business reaches critical mass, which we would estimate at between 6 and 8 stores.

How big will they grow? How much market share can they capture?

The question on everyone's mind is how big can they grow and how much market share can they capture. To answer this question we built a simple model to analyse the key variables for The Warehouse Extra.

The two most important variables for The Warehouse Extra, or any retailer, are customer count and average transaction. The Warehouse needs to achieve high average transactions and high customer counts to achieve critical mass in its supermarket offer.

For comparison, the average mid-market supermarket in New Zealand (Woolworths or New World) achieves weekly sales of about $400,000/week and the average Pak'n Save achieves over $1.2m (with some Pak'n Save stores, such as Albany regularly breaking $2m/week). In the first instance the biggest determinant on this will be perceived pricing relative to the competition.

Based on potential weekly sales volumes we can project annual sales volumes as the number of stores in operation increases:

So, for example, if the grocery offer averages $400,000 a week in incremental sales and they open ten stores, total annual supermarket equivalent sales will be $208m. This is a good result for a chain doing $1.5b, but a long shot from the $6b+ achieved by Foodstuffs.

Then, assuming no real (inflation adjusted) growth in supermarket retailing to simplify analysis somewhat, we cross these sales values with total supermarket turnover in New Zealand ($10,123m in 2005), we can project The Warehouse's potential supermarket market share as follows:

There are two immediate conclusion from this simple model:

1. The most important variable for The Warehouse is achieving high weekly grocery sales/store. The average New Zealand household makes 8-12 trips per month to the supermarket (2-3/week) but only 1-3 trips to the Warehouse and other department stores. To succeed The Warehouse Extra must convince a significant percent of their shopper base to instead make one of those grocery shopping trips at the Warehouse Extra. In addition, the Warehouse must continue to offer inducements to its customers, especially low prices, to drive up average transaction.

2. The major supermarket groups will really only start to feel the pain once The Warehouse reaches ten stores, by which point the concept will have reached critical mass and be somewhat unstoppable. However, as the groups clearly realise this, we believe they will do everything possible to limit the growth of the Warehouse. Key tactics will likely include:

- Pressuring suppliers whose products regularly appear in the Warehouse at good prices. While we understand this has already commenced, the ability of Woolworths/Progressive to achieve this is constrained by its current Trans-Tasman pricing negotiations and the ability of Foodstuffs to achieve this by their recent partial ownership of The Warehouse.

- "Zone pricing" Warehouse Extra stores by lowering prices in stores in the same catchement. The number of supermarket employees in the Warehouse Extra on its first day doing price checks was an indication that this has already commenced.

Conclusions - Be Afraid, Be Very Afraid ...

New Zealand's two major supermarket groups - Foodstuffs and Woolworths Australia - should be afraid, very afraid. The Warehouse Group is well on its way to re-running the "Wal-Mart gets into grocery retailing" scenario and we all know how that ends. Based on what we saw during our visit, Chart Watch projects that The Warehouse will achieve 10% of the New Zealand supermarket market share within ten years (and thereby replicating Wal-Mart's achievement, though on a much smaller scale).

We were pleasantly surprised by how good the Warehouse Extra's grocery offer was relative to their previous attempts. They've really come a long way in a short period of time. If you look at Whangarei, then Te Rapa, now Sylvia Park, there is a constant improvement and evolution. They seem to be picking up grocery very quickly. It the old saying: "It's not how good you are, but how quickly you can learn."

One way to look at it is The Warehouse seems to be picking up food faster than the two supermarket groups are picking up general merchandise. If you go into a New World or a Foodtown and look at the general merchandise, it isn't a solid, coherent offer, it's bits and pieces. The Warehouse Extra had a solid credible offer in food. Basically, what The Warehouse needs to do to succeed is to continue its current rate of improvement.

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