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In this series, we discuss how an approach known as “managing for value” can help grocers develop a powerful reinvestment advantage. We’ll cover five steps in the process: aligning on a single measure of success; identifying internal and external concentrations of value; establishing management’s key priorities; creating differentiated strategies and resource allocation; and building a culture of ownership.
While the average profit margins in grocery are only 2%, that “average” hides what top performers know: that everywhere and always, value creation and value destruction are highly concentrated.
We have found that our clients, on average, generate ~80% of their value from ~20% of activities, ~40% of activities are roughly value neutral, and the remaining ~40% of activities ultimately destroy value.
Knowing where and why those concentrations exist in the company and in the competitive landscape is at the core of being able to separate yourself from the “average” of your peers.
Every grocer should be pursuing a more nuanced understanding of internal and external value concentrations — studying the business at a more granular level to unearth opportunities that will most significantly move the needle for the company.
In addition to “atomizing” the business from a segment standpoint, companies should also ensure that they have multiple lenses on profitability in each of those segments. Most grocery competitors focus on gross margin for individual products or categories. Instead, we have found tremendous value can be unlocked by understanding a “fully burdened” view of economics that includes an allocation of the capital employed required to generate that profitability (working capital, share of store fixed capital, etc.).
It is not that one metric is wrong and another right, but they each raise unique strategic questions that should be considered when searching for ways to drive as much profit growth from the business as possible.
Conversely, without this knowledge, management teams may unknowingly pursue strategies that consume value.
Similarly, many companies prioritize revenue growth above all, assuming that sales will drive profit. In reality, there is both “good” revenue and “bad” revenue, along with “good” costs and “bad” costs — where good and bad define whether or not they create or destroy value over time. But this general rule of thumb/commonly held belief that all growth is good, misses a key consideration: some segments inherently have better economics (i.e., profit and growth) than others, and therefore market profits are concentrated differently than revenues.
The most successful organizations identify and target favorable segments of the market and double down on granular areas where they hold a competitive advantage (i.e., capture better margins than others). Unsuspecting competitors chase those least profitable segments, thinking their peers are “under-investing,” when in fact the high performers are abandoning those value-destroying segments to competitors so they have more money to spend on areas that really matter.
In this article, we will elaborate on why every company should build this kind of understanding, how different grocers have successfully capitalized on concentrations of value within their markets, and how your company can do the same.
Do you know where your value is concentrated?
Most grocers understand where their profit is concentrated at a high level (e.g., by department), but we have seen many companies falter when making important business decisions at this level. For example, one of our clients regularly viewed profit by category, which seemed to indicate that most categories were profitable:
As such, the company’s strategy primarily focused on across-the-board growth – not realizing this was also driving value-destructive sales within categories.
Taking a deeper look into “Category J,” for example, revealed that nearly half of the products in this category were delivering negative profit. Building this understanding allowed management to fix or discontinue specific products (i.e., 19-23), while slowing growth investments until issues were resolved, which significantly increased category margins.
This review also gave management the opportunity to realize that value was more concentrated, even at a higher level, than they realized. Categories A and B comprised ~65% of total value but together received a similar amount of marketing spend as Category J and were effectively “starved” for resources.
Reducing marketing budget in Category J and reallocating that spend to Categories A and B fueled the intended growth and, combined with product improvements, drove total company EP growth (through more favorable mix) and resulting Total Shareholder Returns to outpace peers.
Similar concentrations exist at every company but may manifest differently for any given grocer. For example, value may be highly concentrated at the intersection of stores and customer segments. Without understanding this concentration, a company may choose to implement banner-wide changes – in an effort to be more cost-effective – rather than customize strategies for groups of stores that serve similar customers.
However, cutting costs across the board risks eroding the customer experience at profitable stores, driving margins down rather than up — i.e., it is important not to cut “good” costs. Differentiating strategies to fix stores that are less profitable due to their assortment or customer mix – while investing in top performers – may cost more up front, but it will pay for itself quickly through higher enterprise profits.
Developing this granularity is a key component to driving profit growth, but it’s not the whole picture. “Profit” can tell a very different story depending on how it is measured.
Unlocking profit growth through different lenses
Many grocers use gross profit as their key measure for products and operating income as their key measure for stores or banners. Both metrics provide valuable information.
For example, comparing gross margin across items may beg the question, “Can these lower-margin products fund the costs required to sell them?” This may lead a grocer to explore alternatives, such as private labels, that will provide greater leeway to account for future selling costs. Asking questions like this can drive high-level mix improvements that support necessary costs elsewhere.
Operating profit brings up a different set of strategic questions, likely including:
- Why does it cost more to sell in certain stores compared to others?
- Is my supply chain operating efficiently?
- Where will my marketing spend generate the greatest ROI?
Asking these questions can drive a swath of operational improvements, but looking solely at operating income still misses one critical question: “Is my capital deployed to the areas of my business that have the greatest potential to drive profit growth?”
This is where we have found a less common metric, Economic Profit (EP), to be a vital addition. EP measures earnings less a charge for the capital employed to generate those earnings. As we explained in our first article, growth in EP drives shareholder returns and is highly correlated with cash flows.
To understand the difference between these metrics, just look at one of the largest grocers in the U.S., Albertsons.
You will note that despite Albertsons having a higher gross margin than the average grocer (likely driven by mix), operating margins are similar. This may be due to Albertsons closing fewer stores in challenged geographies compared to competitors; for example, Kroger currently has ~40 fewer stores than 3 years ago, while Albertsons has ~15 more.
But Albertsons ultimately delivers above-average EP, as they are able to generate similar profit using fewer resources than peers (i.e., employ capital more efficiently).
However, the real power of these metrics comes into play when measuring each at a more granular level. For example, a grocer may find that two products with similar gross margins deliver quite different operating profit if one skews towards regions that incur higher marketing and selling costs.
Similarly, a slower-moving product that sits in inventory longer will deliver lower EP compared to a faster-moving product with similar operating margin. Without visibility into these metrics at a detailed level, grocers lack the information necessary to make decisions that will generate the greatest value within their company.
Real estate is another example – consider a grocer that has decided to close a number of underperforming locations, including some that have several years left on their lease. Looking only at EBITDA, buying out those leases would be an easy decision because every dollar spent would be immediately accretive to EBITDA. A grocer more holistically contemplating the best way to invest its precious capital, however, would think about the opportunity cost.
What other ways could it be spending that set amount of money required to buy out the leases? What would be the return on those other investments compared to the savings of buying out the leases now? It’s important for grocers to go beyond the basic metrics and think about the impact of their capital investments over a longer time horizon than one or two years.
There is one final piece to the puzzle; understanding why activities are generating or destroying value also requires knowing where your competitors are capturing profits.
Certain markets and subsets of markets are inherently more profitable than others, and this knowledge helps to put your company’s performance in perspective. Similarly, over time, some market profit pools will grow as others contract, which must be accounted for when choosing strategic areas of focus.
Where value is concentrated in the market
Within the broader grocery industry, profits are concentrated both by market and by individual company. Looking at the market as a whole, profits largely reside within mass players – despite chain grocers capturing a higher share of revenue – and profit growth is expected to be driven largely by these companies and warehouse clubs moving forward.
Companies like Walmart, Target and Costco capitalized on customers looking for a “one-stop-shop” during the pandemic and captured strong profit growth as more customers made larger purchases. These additional earnings were then invested into improving customer experience and growing profitable complementary markets. Investors expect the results of these investments (i.e., increased profits) to be realized soon, fueling future growth.
Chain grocers also enjoyed strong growth in sales – and a spike in profit – during a period of high inflation where significant price increases were passed to consumers. Since 2021, profit has pulled back as consumers have spent their pandemic stimulus and savings and are contending with higher interest rates. However, over the next three years, discretionary income is expected to begin rising again as inflation cools, driving some recovery in market profit.
On the opposite end of the spectrum, independent grocers benefitted somewhat from raising price but are expected to continue losing share of revenue and market profit due to limited scale and ability to invest. The convenience segment has struggled over the past couple years – largely due to declines in retail pharmacy and more recently in dollar stores – but is expected to recover some profit as consolidation (i.e., Rite Aid bankruptcy) and operational improvements take place.
As within any company, additional granularity drives deeper understanding of these trends. Looking at the larger players in the grocery market (for simplicity) reveals more nuance.
Note that the “mass” market is generally more profitable than warehouse clubs; for example, while run by the same management overall, Walmart delivers roughly twice the margins of Sam’s Club, as each market has different economics driven by distinct business models and consumer bases.
“Convenience” players deliver strong operating margins but require significant capital to do so, driving EP margins below average.
But averages do not tell the full story; within segments, individual companies have been able to outperform their peers by capitalizing on more granular concentrations of value.
How companies have capitalized on concentrations of value
Take Walmart for example. While not entirely driven by their grocery business (which does represent a healthy ~60% of total sales), Walmart collects a wealth of data on its large consumer base, their preferences, and trends. Analyzing this data uncovered granular pockets of growth opportunity at the intersection of product, geography, etc., by targeting profitable customers within categories that are stagnant or declining in aggregate.
Walmart has not only used this data to optimize mix but has also unlocked several highly profitable alternative revenue streams (advertising, data monetization, etc.). Understanding that significant market value is concentrated in these streams has led Walmart to focus heavily on these areas. While a small share of business today, capitalizing on these profit pools accounted for half of recent earnings growth and is expected to drive Walmart to capture market-leading margins over the next three years.
Of course, not every grocer has the scale necessary to employ similar tactics, but that does not mean smaller grocers cannot be successful. Sprouts targets profitable consumers who are generally wealthier and seek food options to fit their lifestyle. They match assortment (e.g., shifting produce mix to 40% organic and SKUs to 70% organic or vegan) to customer preferences at a local store level to drive more trips and larger basket sizes with these customers.
Additionally, Sprouts stocks products that are generally not found at other merchants, minimizing overlap and informing store placement near larger grocers to capitalize on complementary shopping trips. This has allowed Sprouts to maintain higher margins than the average grocer.
On the other hand, companies that have not acted upon concentrations of value have struggled. Dollar stores, for example, benefitted from consumers turning to discount options in the face of rising inflation, but companies like Dollar Tree focused on improving gross margins while underinvesting in other areas. This approach padded individual line items temporarily but eroded differentiation.
The Dollar Tree and Family Dollar banners compete for the same customers, and expansion has created a large overlap in stores with similar offers. Not understanding where EP is concentrated at a granular level has pushed the profitability of Family Dollar negative, resulting in the overall brand destroying value (-0.6% EP margin) last year.
However, the outlook for Dollar Tree is more positive. The relatively new management team has identified underperformance at the store and product level, resulting in ~1,000 planned store closures and a shift to more differentiated and profitable private labels targeting diverse consumers. Examining the business in even more granularity and accounting for all costs at the segment level would help Family Dollar banner turn around even more quickly.
Plan of Action
While the benefits of building a more comprehensive understanding of your business and market profitability should now be clear, it may sound like a daunting task. It can take over a year to develop a regular and automated process, but most companies are capable of getting started today and developing actionable insights within months.
We recommend grocers:
1. Build the capabilities to examine economic profit at a granular level.
Companies should strive to measure value creation and destruction at the intersection of products, channels, stores, etc., through financial reporting. To get started without an IT overhaul, finance or strategy teams can conduct this analysis ad hoc, starting from the top down and adding granularity as concentrations of value are revealed. For teams that do not have the bandwidth, the first iteration can be outsourced while resources are put into place to make this process repeatable.
2. Learn where and why value is concentrated in your market.
Focus competitive intelligence on understanding where your competitors make (or lose) money and what drives their performance. Extrapolate expectations for publicly traded companies, supplementing with your own intelligence, to build your market forecast. Consider not only your most direct peers, but companies that participate in your current (and future) markets, and segment them by granular market. Once these companies have been identified and an analytical framework has been developed, replicating this process will become significantly less burdensome to your organization.
3. Compare your performance to the market to highlight competitive advantages and gaps.
Armed with the insights from the above exercises, you will find markets where your company captures an outsized share of the profit pool compared to peers – but also areas of the market that are highly profitable where you may be falling short. You may even find areas where market economics are not strong enough to justify further investment. Putting this all together will reveal a long list of areas in your business to grow, fix, or begin to exit.
4. Use this knowledge to focus a short-list “agenda” of your top priority value growth areas.
Management teams only have so much bandwidth to tackle strategic issues, so “following the money” and narrowing focus to the areas where you have the greatest potential for profit growth is essential to achieving your intended outcomes. Strategies designed with the best of intentions but not informed by this understanding are just as likely to destroy value as create it.
Stay tuned for our next article, where we will expand further on how grocers should go about setting this agenda.
If you missed the first article in this series, Managing for Value, Part 1: A new way to think about winning in grocery, you can check it out here.
