Supermarket giants Albertsons and Safeway (SWY) made news last week by agreeing to merge, creating a combined company that will fall just shy of Kroger (KR) in terms of store count. Cerberus Capital, the private equity firm that owns Albertsons, has offered to pay $40 per share for Safeway.
But naturally, whenever a large merger like this is announced, it raises questions.
I have two particular questions at the front of my mind: Will there be more industry consolidation to come? And more importantly, who are the winners and losers?
A Brutal Industry
The biggest winners in the Albertsons-Safeway merger are, of course, the Safeway shareholders. Belief that a buyout was imminent was a major factor in Safeway’s share price rising about 20% year-to-date.
Given the size of the remaining players, large consolidation is unlikely, though given the competitive dynamics of the business, it would be welcome.
The mass-market grocery store space has been saturated for years. Kroger currently is the second-largest grocery chain in the United States after Walmart (WMT), though WMT, of course, sells much more than groceries.
Outside of premium or specialty grocers — think Whole Foods (WFM) or Trader Joe’s — growth in grocery sales is essentially limited to population growth, which has averaged less than 1% for the past decade. All jokes about Americans getting fatter aside, we’re really not eating more, and the grocery business is something of a zero-sum game for existing competitors. Again, outside of specialty or premium stores, new grocery store construction is mostly limited to new neighborhood construction.
Click to Enlarge This is reflected in profitability, measured here by return on assets (I used return on assets over the more commonly used return on equity because it is less sensitive to differences in capital structure, i.e. debt level).
Safeway’s return on assets shot up last year due to one-off asset sales, but over the past two decades the company has struggled to generate returns much better than 5%. The same is true of Kroger.
Walmart, aided by its scale and ruthless efficiency, has been consistently more profitable, though Whole Foods has recently taken the lead.
Safeway’s merger with Albertsons should improve its competitive prospects, as the larger economies of scale and bargaining power with food manufacturers should allow the company to squeeze out slightly higher margins. But it’s worth noting that so far, over time, Kroger has had roughly similar levels of profitability as Safeway. (The spike in Safeway’s RoA was in part due to divesting Canadian stores.)
As with the rest of American retail, there are two models to higher profitability in the grocery business:
- Compete on cost
- Go upscale and compete on quality
You’re not going to beat Walmart on cost. Some smaller, niche stores — such as Aldi — can be competitive with WMT on price, though they generally lack its brand selection and variety. Kroger can’t beat Walmart on price, and it’s hard to see Albertsons-Safeway being any more effective.
Going upscale is an option, of course. Even WMT offers a limited selection of organic and premium produce, and offering a wider selection might make it less worthwhile for a neighborhood shopper to drive across town to a Whole Foods or Trader Joe’s store. But transformations like that are not particularly easy to pull off.
A more likely scenario is that Albertsons-Safeway finds itself, like Kroger, a lower-margin also-ran that is “stuck in the middle” between low cost and higher quality.
Aisle 5 Is Now Online
Then, of course, there is the elephant in the room: online grocery shopping.