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Our Top Three Grocery Picks

These picks are faring well in the recession and trading at attractive prices.

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Over the last few decades, the landscape of the grocery store industry has changed considerably. Grocery retailers, once bullied by the large consumer products companies they depended on, used consolidation as a means to fight back, only to face heightened competition from newer and different types of food retailers. Now, with consumers tightening their belts and changing the way they spend their food dollars in reaction to the recession, grocery stores are finding a renewed opportunity to take share of the consumer's food dollar. However, given that consumers are more price sensitive than ever, grocery stores must strike the right balance of low prices that drive foot traffic without sacrificing too much in profits.

In this article, we will take a brief look at the changing landscape of the grocery store industry and review our top three picks.

The Evolving Landscape of the Grocery Store Industry
Once upon a time, most consumers did nearly all of their grocery shopping at traditional supermarkets. In the past few decades, however, the grocery landscape has changed considerably, and consumers now have a myriad of choices: from low-price mass merchants such as  Wal-Mart (WMT) to high-end natural and organic specialty chains such as  Whole Foods (WFMI) to convenience locations such as  Walgreens (WAG). Even fuel retailers like  Casey's General Stores (CASY) have boosted the number of food offerings and prepared meals they offer to consumers. Because most supermarkets can't win against these retailers on such dimensions as price, quality, or convenience, they have been losing volume on foot traffic, which is crucial to profitability.

Although grocers have faced heightened competition from nontraditional operators, they have at least been successful in wielding some power away from their suppliers. Up until the early 1990s, consumer-products companies enjoyed a significant amount of power, and they could protect margins and increase business by pushing steady price increases through to willing retailers, who depended on these products to drive traffic to their stores. However, consolidation among U.S. grocers shifted that influence into the retailers' hands, making price increases more difficult for consumer products companies.

Currently, the recession has created some interesting dynamics in the industry. First, consumers are spending more of their food dollars at home instead of at restaurants, which benefits grocery stores. Second, consumers are more focused on price, and the private-label programs that many grocers have invested in over the years are paying off. Private-label products were at one time a retailer's best attempt to develop a copycat product and gain some extra profit margin. However, these products have emerged as a way to help a retailer build its brand image, and with the quality of many private-label offerings as good as or better than certain branded products, grocers are reaping many benefits from their investments in these private brands in today's economic environment.  Costco's (COST) Kirkland brand and O Organics for grocer  Safeway (SWY) are two examples of strong private-label brands.

Despite these favorable tail winds, not all is positive for today's grocery retailers. Consumers' laser focus on price means more discounting and special offers are needed to drive foot traffic, which affects profitability. As a result of consumers' shifting behavior in the recession, grocers are more and more touting their "investments in price." Also, retailers that had positioned their stores as upscale and premium, such as Whole Foods, are feeling the pain as they struggle to compete with more price-focused competitors. We expect these types of retailers to experience ongoing weakness until the economy recovers.

 

Three Picks at Reasonable Prices
Overall, we think there are a few standouts in the industry that are trading for attractive prices. For those investors looking for some exposure to the domestic grocery retail industry, we would recommend a closer look at the following stocks. As the grocery industry tends to be characterized by very stable growth, these companies have medium uncertainty ratings, and we do not foresee any financial distress in these cases.

 Kroger (KR)
Uncertainty Rating: Medium | Price/Fair Value Estimate Ratio: 0.66 | 5 Stars
Kroger is reaping the benefits of an evolving strategy that began a little over five years ago to cut costs in order to combat the assault by discounters and give itself a leg up on other conventional operators. We believe the firm today is positioned to increase its top line faster than the broader supermarket industry and be an effective consolidator. What Kroger has done really well in recent years, in our view, is to effectively identify all the large and small things that drive customer visits and loyalty and make targeted investments. The firm has also developed what is today a best-in-class private-label program. Kroger has been quite resilient in recent quarters, something we believe is being underappreciated by the market.

 Safeway (SWY)
Uncertainty Rating: Medium | Price/Fair Value Estimate Ratio: 0.69 | 5 Stars
While Safeway is not positioned particularly well in the current economic environment, we believe it is taking the right steps to correct this problem. For years, Safeway spent heavily in remodeling its stores into what it called a lifestyle format and tried to position itself as a premium operator. Now it is reversing course and trying to play catch-up with operators like Kroger in terms of cutting costs. However, we think its private-label offerings are a positive for the firm. Overall, we think Safeway's robust free cash flows, which remain at an average of 13% to 15% of the firm's total market capitalization, are being underappreciated by the market.

 Delhaize Group (DEG)
Uncertainty Rating: Medium | Price/Fair Value Estimate Ratio: 0.68 | 5 Stars
Since acquiring a 22-store chain in the Carolinas around 35 years ago, Delhaize Group has built a formidable East Coast presence. With low-cost operations in the U.S. and strong market share in Belgium, Delhaize earns some of the highest margins in the supermarket industry. Delhaize's Food Lion banner has smaller stores (averaging less than 35,000 square feet) and low overhead (resulting from a nonunion labor force and a cost-conscious culture), which have enabled the company to position the stores as more convenient and lower-priced than comparable supermarkets.

Ann Gilpin does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.