Is The Traditional Grocery Store Dying?

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Safeway (NYSE: SWY) has been increasing its dividend on an annual basis over the last few years despite recently difficult market conditions. Although reasonably strong financially, its yield of 3.8% is now more than a full percentage point above industry leader Kroger (NYSE: KR). With the demise of Supervalu's dividend not too long ago, Safeway could become just another casualty of the shift away from traditional grocery stores. This is a shift that investors need to consider carefully before investing in the grocery space.

A history of poor performance
Supervalu is the most recent cautionary tale in the grocery industry, as it had to cut its dividend because of poor performance. Prior to the cut, it was yielding well above the industry norm without a financial reason to suggest it could sustain such a high payout. However, this isn't the only case of a traditional grocery chain suffering.

Albertson's, for example, was a model of growth for decades, making it a beloved option for dividend investors seeking regular dividend increases. Until, that is, it found it increasingly hard to compete in a crowded field. The company eventually sold itself. Winn-Dixie's trip through bankruptcy is a more recent example of the troubles that traditional grocery stores are having, as the company simply had too many problems to take care of while still attempting to pay its creditors.

Who's destroying grocery stores
The really big problem in the grocery store space is that well-heeled competitors have entered the fray at the same time that buying habits are shifting. This has increased competition in an already competitive industry.

Wal-Mart (NYSE: WMT) and Target (NYSE: TGT) are probably the biggest new entrants. Both have made aggressive moves to add grocery items to their stores in an attempt to increase the frequency of their customers' visits. In fact, in a very short period of time, Wal-Mart has taken material market share in the grocery space. The problem for traditional grocery stores is that the business is very low margin. So, while Target and Wal-Mart may be able to make up for that by selling more within their other retail operations, benefiting from more frequent customer visits, grocery stores don't have that luxury.

Another problem category for traditional grocery stores is the wholesale club format that has become increasingly popular. Wal-Mart's Sam's Club and specialist Costco are examples of the leaders in this space. Basically, these clubs look to provide lower prices by allowing customers to buy in bulk. So, instead of selling three rolls of paper towels at a time, they sell twenty. Clearly, the more a customer stocks up on a product, the less they have to go to the grocery store.

The fee that's associated with a wholesale club membership is also an important hurdle. Costco knows its customers are going to show up because they paid for the “privilege.” This creates a loyalty that grocery stores can't replicate. In fact, generally speaking, the main differentiation for traditional grocery stores is price, which only makes profitability that much harder to maintain.

Changing tastes
There is one “traditional” grocery store that has taken a completely different approach: Whole Foods (NASDAQ: WFM). This company has been able to benefit from its focus on organic and “healthy” foods, taking advantage of the trend toward more healthy eating habits. This has allowed it to expand and charge higher prices than traditional grocery chains. Although grocery stores have tried to fight back with their own healthy food options, Whole Foods hasn't missed a beat. This is partly a result of its image and partly a result of the shopping experience at its stores, which are generally more appealing than those of regular grocery chains.

In fact, Safeway's future likely rests on its plans to overhaul its stores to provide customers a better shopping experience, moving more toward the Whole Foods model. A successful transition is no sure thing, and that's a good reason to avoid the stock despite its relatively enticing yield. Another risk that can't be dismissed is the recently announced retirement of Safeway's CEO. While a new CEO can often come in and make changes that his or her predecessor couldn't, or didn't, make, such changes don't always lead to improved performance.

Some old hands doing well
Privately held Publix is beloved by its customers because of the selection it offers and the pleasant shopping experience. Although it isn't like a Whole Foods, the company has taken its cue from such upscale competition. Smaller chains have also begun to make similar shifts, focusing on services like high-quality pre-made meals.

Kroger (NYSE: KR) is an industry giant that has been able to take on some of the tactics of wholesale clubs to gain market share on companies with less financial heft. One notable example is its use of gasoline sales as a loss leader to draw customers through its doors. With a 2.3% yield, the company isn't going to satisfy most dividend investors, but it is one of the better positioned of the old guard.

An industry in transition
The grocery industry is still in transition. The companies here have been trying to figure out how to survive with new players taking market share and customers' changing desires. It hasn't been an easy shift. Most investors would probably do better avoiding grocery stores and sticking to the companies that are expanding their way into the grocery isle like Wal-Mart, Target, and Costco.

ReubenGBrewer has no position in any stocks mentioned. The Motley Fool recommends Whole Foods Market. The Motley Fool owns shares of Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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