Following Amazon’s acquisition of Whole Foods and the big drop in supermarket stocks – especially Kroger (KR) – I’ve decided to do a series of re-posts of my analysis of the U.S. supermarket industry.
Today’s re-post is a roughly 1,300 word excerpt from the Village Supermarket (VLGEA) stock report Quan and I wrote back in 2014. This section focuses on how the moat around a supermarket is always local.
In the Grocery Industry: All Moats are Local
The market for groceries is local. Kroger’s superstores – about 61,000 square feet vs. 58,000 square feet at a Village run Shop-Rite – target customers in a 2 to 2.5 mile radius. An academic study of Wal-Mart’s impact on grocery stores, found the opening of a new Wal-Mart is only noticeable in the financial results of supermarkets located within 2 miles of the new Wal-Mart. This suggests that the opening of a supermarket even as close as 3 miles from an incumbent’s circle of convenience does not count as local market entry.
In the United States, there is one supermarket for every 8,772 people. This number has been fairly stable for the last 20 years. However, store churn is significant. Each year, around 1,656 new supermarkets are opened in the United States. Another 1,323 supermarkets are closed. This is 4.4% of the total store count. That suggests a lifespan per store of just under 23 years. In reality, the risk of store closure is highest at new stores or newly acquired stores. Mature locations with stable ownership rarely close. So, the churn is partially caused by companies seeking growth. Where barriers to new store growth are highest – like in Northern New Jersey – store closings tend to be lowest. Village’s CFO, Kevin Begley, described the obstacles to Village’s growth back in 2002: “…real estate in New Jersey is so costly and difficult to develop. New Jersey is not an easy area to enter. This situation also makes it challenging for us to find new sites. It’s been very difficult for us, and for our competitors, to find viable locations where there is enough land especially in northern Jersey and where towns will approve a new retail center. With the Garwood store…we signed a contract to develop that piece of property in 1992; it just opened last September (2001). So it can be a long time frame from when you identify a potentially excellent site and when you’re able to develop it. Finding viable sites is certainly a challenge that we face, as do our competitors.”
New Jersey is 13.68 times more densely populated than the United States generally (1,205 people per square mile vs. 88). It is about 12 times more densely populated than the median state. This means New Jersey should have about 12 times more supermarkets per square mile to have the same foot traffic per store. The lack of available space makes this impossible. As a result, the number of people visiting a New Jersey supermarket is greater than the number of people visiting supermarkets in other states. The greater population density in New Jersey has several important influences on store economics.
One, it encourages the building of bigger stores. This sounds counter intuitive. If there are a lot of people in a small space and land is difficult to develop, it would be logical to enter the market with a small format store. That is true. However, incumbent stores have big advantages over new entrants. Incumbents have leases in key locations. Their stores are highly profitable. As a result, store owners in New Jersey will favor expanding each existing store to the maximum possible square footage whenever renovation is a possibility. This is what most Shop-Rite members have done. Village does not operate especially large Shop-Rites. However, 58,000 square feet is huge by national supermarket standards. Whenever Village has renovated a store, it has tried to increase square footage. Village has sometimes relocated stores to larger footprints. And Village’s most recent new stores have been huge. For example, Village recently built a 77,000 square foot replacement store in Morris Plains. This store is almost as large as the Wegman’s superstores (80,000 to 140,000 square feet) that tend to be the biggest supermarkets in New Jersey.
Two, New Jersey supermarkets turn the product on their shelves faster. This changes product economics for the store and the experience for the customer. A Shop-Rite turns its inventory phenomenally fast relative to the grocery section of a Wal-Mart. As a result, stale inventory and lack of help – the two largest complaints from grocery shoppers at Wal-Mart – are unusual in New Jersey supermarkets. More customers per square foot means higher sales velocity. It is not possible to stack more inventory per square foot. It is only possible to restock inventory faster. High inventory turnover can increase customer satisfaction by increasing the freshness of the product without requiring the store to buy different merchandise than a competitor with stale product on its shelves. More importantly for the stores, gross margins can be lower at a high traffic location and yet gross returns can be higher. In fact, this is exactly what happens at Village. Village’s gross margins are 10% lower than Kroger’s (27% vs. 30%) while gross profit divided by net tangible assets is 2.32 times higher (290% vs. 125%). A New Jersey Shop-Rite generates much higher returns on capital than any other traditional supermarket around the country. Again, this encourages reinvestment in existing stores. This further raises the barrier to local entry. A new store would need to find an open location where it could put a 60,000 square foot location to rival the breadth of selection and the low prices of the incumbent supermarkets. In most of the country, land is more widely available and the incumbent supermarkets are only around 35,000 square feet. Nationally, the average supermarket does $318,170 a week in sales. In New Jersey, the average Shop-Rite does $1 million a week. The initial investment required to enter a local grocery market in New Jersey is higher because the industry standard is higher and the costs of developing anything are higher. It is important to remember that the barrier is not simply the roughly 100% more expensive real estate in New Jersey versus the country generally. Nor is the barrier simply the lack of available space in New Jersey. The final hurdle to clear is the simple fact that supermarkets in New Jersey have evolved into much larger, lower margin beasts than the competition elsewhere.
Large stores support wide selection, low prices, fresh inventory, and high customer service. A comparison of inventory turns (Cost of Goods Sold / Average Inventory) helps illustrate this point. Village’s inventory turns are 26, The Fresh Market 21, Whole Foods 21, Fairway 20, Kroger 12, Safeway 11, and Weis Markets 9. It is easy to imagine a division between two groups: the supermarkets focused on freshness and the supermarkets focused on low cost. However, Village – a low cost generalist – has higher inventory turns than the group of “fresh” supermarkets (The Fresh Market, Whole Foods, and Fairway). Village turns its inventory twice as fast as traditional supermarkets like Kroger and Safeway. Kroger is an especially good comparison because its store size is the same as Village’s and its business strategy (big stores, wide selection, low prices, and generalist) is virtually identical. The difference between inventory turns at Village and Kroger is that almost all of Villages’ stores are in New Jersey while none of Kroger’s stores are in New Jersey. As a result of this higher inventory turnover, Village can charge customers 3 cents less per dollar of sales than Kroger and have double the return on capital (33% vs. 17%). The moat around Village is its portfolio of big, established stores in New Jersey that would take a lot of time, money, and risk to duplicate. If Kroger controlled these locations it would have at least as good returns on capital as Village. But the only way Kroger will ever control key New Jersey locations is through the acquisition of a New Jersey supermarket chain. The time, cost, and risk of introducing a new banner – the Kroger name is unknown in New Jersey – makes entry by any means other than acquisition extremely unlikely. The moat around Village is entirely local and historical. It runs big, mature stores under the well-known Shop-Rite name. Most importantly, it runs them in the best locations in America for supermarkets.