Coriolis Chart Watch Q2 2006

Chart Watch is an online publication featuring a brief view into our latest thinking on the evolving food and fast moving consumer goods industry. It is sent to subscribers four times per year.

The Warehouse Group has achieved strong sales growth, primarily driven by the New Zealand "Red Shed" discount operations. The Warehouse has had three operational divisions:

However, with the sale of the Australian business and stalling growth at Warehouse Stationery, The Warehouse "Red Sheds" are now left as the only remaining engine of meaningful sales growth for the group.

The Push into Grocery/FMCG

Unfortunately, it does not appear that the "Red Sheds' offer as it currently stands has enough "gas in the tank" to support additional meaningful sales growth, making a move into new categories, such as grocery, liquor and pharmacy crucial for the group.

Average sales per store per year have flattened following a decade of strong sales growth. In the period between 1991 and 2005, the "Red Sheds" grew at a compound annual growth rate (CAGR) of 12.5%. However, this growth is clearly slowing and in the most recent year (FY2005) this actually fell.

In addition, this strong sales growth has been driven by building bigger boxes, not through increased efficiency (in the form of higher sales per square metre).

As a result of this strong sales growth, the "Red Sheds" now capture 44% of total New Zealand department store sector sales.

However, the "Red Sheds' appear to be approaching saturation in the "New Zealand market for their current format and with their current range.

The Response

In March 2006, The Warehouse finally announced that it was opening the first of many Warehouse Extra hypermarkets at Sylvia Park in Auckland.

While this was no surprise to Chart Watch (see our newsletter from 2003) or anyone in the New Zealand FMCG industry, it was the first public admission by the company that it harboured ambitions in grocery retailing.

Before the store opens, it is difficult to evaluate the strength of their offer and the likelihood of success. However, we can look at the experience of another retailer in a similar situation and see what lessons this highlights for The Warehouse.

Lessons From Wal-Mart's move into Grocery

In 1986 Wal-Mart was a regional discounter with sales of US$11.9b through 940 discount department stores and 49 warehouse club stores across 23 states. In it's FY1986 annual report, Sam Walton announced:

"New retail concepts, presentations and formats will be tested. The first of two Wal-Mart SuperCenters, a combination food and general merchandise retailing center in excess of 220,000 square feet, is planned to open in late 1987. These Super Centers, a joint venture of the company and Cullum Companies, are a result of our continuing interest in the experimentation with and understanding of what we believe to be significant new retailing vehicles. The Super Centers will be a modification of the European "hypermarket" concept."  Sam Walton, Jan 31, 1987

Lesson 1 - You don't get it right the first time

Wal-Mart opened a range of different store formats, with very different strategies, including different ranges, pricing, merchandising and decor before it settled on a successful format. It initially opened stores under the Hypermarket*USA banner, then additional stores under the name Wal-Mart Supercenter.

As the above chart clearly shows, Wal-Mart went through a rapid learning curve in terms of store size, range, branding, space allocated to food, location and suitable catchments. The company quickly abandoned the Hypermarket*USA format, converting these to Wal-Mart Supercenters, and reduced store sizes and space allocated to foods, while at the same time increased the range of general merchandise. However the 97,000 sqft store was also considered a failure as food did not have sufficient space. As then Wal-Mart CEO, David Glass said:

''When you start something new like a Hypermart or a Supercenter, in the beginning the stores don't look alike. The thing we needed to do was to put one in, get one open and tinker with it... We believe this concept has great merit... they [the Hypermart USAs and SuperCenters] generate tremendous sales, and we're pleased with that." David Glass, CEO, Wal-Mart, March 1988

Through the learning phase, Wal-Mart evolved from a high capital cost, high customer count, medium transaction model to a lower capital cost, lower customer count, higher transaction value model.

At the time, many in the supermarket industry and the press ridiculed the offer, criticising the quality of perishables, the prices or store standards. Execution, especially in perishables was a key:

"We've still got a lot to learn about supercenters. Bigness is not the key. Quality is more important than quantity, so the issue is not how many supercenters we can open; it's what does the supercenter do for the customer? For example, we opened hypermarkets, four of those beauties, and learned something. We looked at Europe where hypermarkets have done very well and at our friends Carrefour and Auchan. But we tried to do it a little differently, and still we built in too many costs and made it too big... The big debate seems to center on neighborhood convenience vs. one-stop shopping. I think there's a need for a combination of both types of shopping. Having it all under one roof is not a detriment, it's a plus." Don Soderquist, Vice President, Wal-Mart Stores, June 1993

However, the strength of the existing general merchandise offer gave the company the time required to learn and refine with every new store and eventually they got it right.

The Warehouse: No matter how much homework they have done or how many stores they have visited around the world, we expect The Warehouse will have a similar experience and tinker with its concept on an ongoing basis as it develops more experience with the concept in the New Zealand market.

That said, we are generally positive on the ability of The Warehouse to eventually get it right. Unlike, for example, a new market entrant or a start-up into the supermarkets space in New Zealand, The Warehouse, like Wal-Mart before it, has many of the needed components for success in place:

• Sites and stores, many of which were build to accommodate food (e.g. Te Rapa)
• Systems, including buying, warehousing, and retail information technology
• An existing grocery range and sales with a turnover of about NZ$150m that provides a starting point
• An existing business which can subsidise the grocery business
• An existing customer base already visiting the stores

Lesson 2 - The Right Concept Has Huge Potential

Wal-Mart opened its first combination general merchandise and grocery store in December 1987. It opened a total of 9 stores over the first five years of operation while the concept was being perfected.

In 1992, once they had the concept right, Wal-Mart went on a massive expansion that continues to this day.

"The ROI [Return of Investment] has been not only better than regular Wal-Mart's or Sam's, but beyond our expectations." David Glass, CEO, Wal-Mart, May 1993

To date (June 2006) they have opened over 2,000 Wal-Mart Supercenter stores across the country. In addition, Wal-Mart has exported the Supercenter format to other countries, with (somewhat mixed) success.

For Wal-Mart much of the growth of the supercenter store format in the United States came from conversion of existing stores.

The success of the concept and this massive roll-out has led to Wal-Mart now being the largest supermarket retailer in the United States. It has also led to market share losses among the poorer retailers in the market and increasing competitiveness among the stronger retailers. One analyst described the growth of Wal-Mart into supermarket space as "The Black Death" saying "It either kills you or it makes you stronger."

The Warehouse: As we mentioned above, we expect the Warehouse to develop a number of successive concepts as it gets the offer right.

We also expect that - if and when it gets everything working - it will be able to expand the concept rapidly and take share from weaker existing supermarkets. However, we expect that conversion of existing stores to a supercentre concept will be even more important for The Warehouse than for Wal-Mart, given their current relative saturation in the New Zealand market.

We believe the effect of The Warehouse Extra will be felt unevenly by existing supermarkets, with those most focused on a price offer in a big box (i.e. Countdown and Pak'n Save) most at risk in the medium term. The Box Warehouse store format, of which Pak'n Save* is the key New Zealand example, was effectively stopped in its tracks in the US market by the supercenter (c.f. Cub Foods). We believe that once The Warehouse gets to scale and is able to lower prices, it will have a similar effect here. Another likely victim is mid-market supermarkets in smaller regional towns, where drive time and distance are less of an issue and where The Warehouse already has relative strength.

* Countdown started life in 1982 as a box warehouse store, but has since drifted into being a large conventional supermarket.

Lesson 3 - Have a Joint-venture partner

Running a full-line supermarket is difficult, especially for one store. The average grocery store stocks in excess of 20,000 lines and involves multiple product categories across three temperature states (ambient, chilled and frozen). In addition, pricing and ranging are highly complex activities that require a dedicated team of experts and strong corporate disciplines.

Wal-Mart, which at the time (1986) had 900 discount stores and 38 wholesale club stores, opened its first two Hypermarkets as a joint-venture with Cullum Corporation, which (at the time) had turnover of over US$1 billion and operated more than 30 supermarkets stores under the Tom Thumb/Page name in the Dallas, Texas market where it was the market leader. Cullum ran the grocery store component of Hypermarket*USA and Wal-Mart ran the general merchandise component.

Following this, the company bought Cullum out of the joint-venture and used the services of Malone & Hyde, a regional grocery wholesaler and later Fleming Co, then the second largest grocery wholesaler in the United States. Once it had achieved sufficient scale it built its own grocery distribution center. In parallel with building its own grocery distribution capability, in 1990, the company purchased McLane Co, a well respected grocery distributor, partially to leverage its skill base.

The Warehouse: The Warehouse does not have a joint-venture partner in its move into grocery retailing. In addition, as there is no independent grocery wholesaler in the New Zealand market, The Warehouse has to handle its own ranging, sourcing and distribution. While the company has hired a number of people with supermarket experience, this can only take the group so far, and it will lack the existing economies-of-scale a partner or wholesaler would have brought. As a result, we believe The Warehouse will struggle initially (1) achieving a wide range (2) being regularly in-stock (3) and at having competitive prices.

Update: Today's news that Foodstuffs, New Zealand's largest supermarket group, is acquiring 10% of The Warehouse may change this situation.

Lesson 4 - Initially Open Away From The Strongest Competition

Excluding the two Hypermarket*USA stores, where Wal-Mart was in a joint-venture with the local market leader, the company opened all its early Supercenter stores in small towns far away from the leading competitors in US supermarket retailing. Washington, Missouri - the town where the first Wal-Mart Supercenter opened - had a population of only 10,800 and only 20,000 in the catchment. In addition, Missouri was not at the time - and is still not - a hotbed of supermarket competition with minimal national chain presence.

The Warehouse: The Warehouse is opening its first hypermarket in Sylvia Park, a major mall in the centre of Auckland, the largest city in New Zealand. In addition, the mall will also have as tenants both a new Pak 'n Save (Foodstuffs) and a new Foodtown (Woolworths Australia); the site is also less than a kilometre from a large Countdown (Woolworths Australia). While we would have advised them to open their first store in a more remote town away from the competition, we admire their bravery. However, we believe the Sylvia Park store will be hit with very aggressive pricing from the two main players in the New Zealand grocery industry. As a result, The Warehouse will be unable to achieve pricing leadership in the catchment around Sylvia Park and will therefore underperform in that location relative to what it could achieve elsewhere.

Lesson 5 - Expect Others to Enter The Market

In parallel with Wal-Mart's early development of a hypermarket/supercenter offer, numerous other retailers also launched similar formats. Key concepts launched in the United States market during the same period include:

While a number of groups tried to develop a successful hypermarket concept for the United States market, there were more losers than winners. The winners were clearly those groups with a strong existing business with strong operational disciplines (Wal-Mart and Target)

The Warehouse: Unlike the U.S. experience, we do not expect global entrants, other than the possible outsider of Pick"N Pay from South Africa, who entered the Queensland market with a single hypermarket in the early 1990's (an interesting story beyond the scope of this newsletter). However, we do believe that The Warehouse Extra will not be the only experiment in hypermarket retailing in New Zealand. We believe that Woolworths Australia, with its existing New Zealand supermarket business in New Zealand and general merchandise experience, through its Big W chain in Australia, is the most likely to succeed. On the other hand, international experience suggests that any attempt by Foodstuffs to make the leap to a full general merchandise offer will be difficult as franchise independents have very limited success in this space (cf. Supervalu, Leclerc).

Conclusions

The Warehouse clearly has a huge opportunity to become the third force in New Zealand grocery retailing after Foodstuffs and Woolworths Australia. Supermarket retailing in New Zealand represents a NZ$10 billion market and even a relatively small market share would have a huge impact on the NZ$1.5 billion sales of the Warehouse. Clearly the company has studied the global leaders in hypermarket retailing and appears to have learned many lessons.

However, the success of the venture will not come easily. The group is opening in a highly competitive site without a joint-venture partner. Execution will be the key to the success or failure of this bold venture. The company will go through a steep learning curve as it attempts to develop a wide range of operational disciplines that are unfamiliar to a general merchandise retailer.

Part II

Part two brings you an evaluation of the first Warehouse Extra store once it opens.

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