Defending Against Competitive Trade Channel Encroachment

1. Defending Against Competitive Trade Channel Encroachment May 6, 2003 www.hoytnet.com 8912 East Pinnacle Peak Road • Scottsdale, AZ 85255 Phone (480) 513-0547 • Fax (480) 513-0548 • E-Mail: chrishoyt@hoytnet.com • nancyswift@hoytnet.com

2. Welcome to Our Mini Workshop On Defending Against Competitive Channel Encroachment • This is your meeting – feel free to interrupt at any time with questions • If you have a question, don’t be shy – it’s probably the same question everyone else has too • Take the best and leave the rest • Feel free to disagree with anything we say – but if you do, you must speak-up • Feel free to get up and move around • The benefits you derive from this workshop will directly reflect the time and effort you put into it: • Workshop participation • Proactive participation will bring happiness and deep inner satisfaction • Use us! – we are here to answer your questions and clarify points to the best of our ability

3. Today • Key issues facing supermarkets in the current competitive environment • Price • Supermarket strengths and weaknesses vs. consumer expectations • Creating value beyond price

4. To kick this off, we have a few questions… • Whom do you see as your most serious competitive threat over the next five years? • What’s most threatening? • How are you trying to compete?

5. Now let’s see if our perceptions are the same as yours… The Key Issues Facing Supermarkets In The Current Competitive Environment

6. The U.S. Supermarket industry is under siege and, to date, has not been able to develop an effective response to competition from Value Discounters • Earlier this year, USA Today reported one one analyst’s forecast that supermarket’s share of the grocery business will drop to 34% by 2010 from its current 53% with the bulk lost to Wal-Mart. • The BLS just reported that Club Stores’ and Supercenters’ share of Food At Home sales catapulted from 1.8% in 1991 to 7.4% in 2001.

7. Competition from Value Discounters (cont’d) • Value Discounters have forced Supermarkets to lower prices repeatedly over the past five years, thereby reducing profits, driving down stock prices and further limiting Supermarkets’ financial ability to compete effectively. • Location can no longer be relied-upon as a passive Supermarket advantage because all those folks shopping at Supercenters and Clubs are obviously driving around Supermarkets to get there.

8. On top of all this, we have… • Trip loss • No increase in transaction size • Category hijacking • Consumer shopping patterns that have morphed into regular “Big Shops” at Value Discounters, supplemented by “fill-ins” at Supermarkets for commodity-type center-of-the-store items • A continual share loss trickle to Value Discounters – defined as Supercenters, Clubs and now Dollar Stores – with no let-up in sight

9. Trip loss • One trip = 105.5MM visits • Shopper Trips By Channel (1996 – 2002)(Avg. # Trips/Household/Channel/Year) • Trip Losers • Trip Gainers Total Trips • Down 2.3 Billion Trips Annually in Seven Years 180 167 Source: AC Nielsen Homescan, 2003

10. No increase in transaction size • Annual Shopper Dollars Per Trip By Channel Source: IRI Consumer Shopper Panel Database, Custom Analysis

11. Category Hijacking • Dry Grocery Sales Trends In Drug Chains vs. Food Stores Food ‘95 to ‘99 Drug ‘95 to ‘99 Snacks - Health Bars & Sticks Spaghetti - Canned Water - Bottled Cereal – Ready-to-Eat Ravioli – Canned Soup - Canned Snacks – Potato Chips Coffee - Ground Soft Drinks - Carbonated Dry Dinners - Pasta Jelly Dog Food - Dry Type Cat Food - Dry Type Granola & Yogurt Bars 387% 6% 77% -8% 35% 13% 16% -16% 30% 21% -2% 24% 16% -9% 681% 183% 160% 159% 128% 119% 68% 60% 59% 58% 50% 48% 41% 29% Source: AC Nielsen

12. Anyone want to guess what Grocery Store this is?

13. Did you guess Osco Drug?

14. $37.00 Using Clubs vs Supermarkets as an example, for some consumers the shopping pattern appears to have morphed into something like the following: • Annual Trip Frequencies & Transaction Size:Clubs vs. Supermarkets Avg.TransactionSize $84.00 Source: AC Nielsen Homescan, 2003 and 2001; IRI Consumer Shopper Panel Database, 2003

15. Daily Defections to Non-Food Trade Channels • Share/Share Chg of Supercenter Shopper $ by Channel -0.6 -1.2 +0.1 +0.0 -0.2 +0.3 -0.5 +2.1 Source: ACNielsen Cross Outlet*Facts 2000; Total US

16. Bottom line: Steady erosion of total share to Value Discount formats • Percent Share of Total Annual Shopper Dollars -4 pts +5 pts +1 pt +1 pt Source: IRI Consumer Shopper Panel Database, Custom Analysis

17. No let-up in sight • One analyst predicts that Wal-Mart will open over 3,000 Neighborhood Markets by 2010: • Now building 25 in Florida as we speak • Over the next five years Costco plans to buckshot the landscape with 200 – 300 60K sq. ft. versions of its 10 – 14% margin Club Stores. • Dollar Stores are planning an explosion of new outlets between now and 2010, mainly in a pincer movement with Dollar General, Dollar Tree and Family Dollar moving west and 99¢ Only Stores moving east.

18. Over the years, Supermarkets have responded to threats like these with a variety of epidemic-like initiatives, mostly without much success: • 1980 – Direct Product Profitability (DPP) • 1985 – Category Management • 1989 – “Partnering” • 1991 – Activity-Based Costing (“ABC”) • 1993 – “ECR” • 1995 – Prepared Take-Home Meals • 1997 – “Club Packs” • 2000+ – “Meal Solutions”

19. The fundamental problem with the way in which these initiatives have been implemented is that they have focused the attentions of both Supermarkets and Suppliers on the relationships they have with each other instead of on the relationships Supermarkets ought to be building with their customers.

20. The “net” as far as Supermarket shoppers are concerned: • Don’t care about: • DPP • Category Management • ABC • ECR (etc.) • Lack compelling reasons to shop a particular store other than location and price: • “84% of consumers think all Supermarkets are alike.” (American Research Council) • Have strayed from the channel by the millions and allowed to become habituated to shopping for groceries in other formats

21. Price

22. No Fast Food No Mass Merchandisers No Clubs No Supercenters Independents Dominated Drug A&P Dominated Food Most CPG-type Products Sold Through Supermarkets Most Meals Prepared and Eaten at Home In the 50’s and 60’s Supermarkets competed mainly with other Supermarkets and used price, location and assortment as their principal weapons. This worked well as long as Supermarkets competed with other Supermarkets. • The Supermarket Competitive Environment – 1950’s & 60’s

23. Today 120K Convenience Stores 32K Supermarkets 6K Mass Merchandisers 20K Drug Stores 1K Club Stores 12K Dollar Stores McDonaldsBurger KingWendy’sJack-in-The-Box 48% of Food DollarsSpent Away From Home 1950’s + 60’s No Fast Food No Mass Merchandisers No Clubs No Supercenters Independents Dominated Drug A&P Dominated Food Most CPG-type Products Sold Through Supermarkets Most Meals Prepared and Eaten at Home Today, Supermarkets are faced with an entirely different environment characterized by outlet saturation and a huge excess of selling space

24. % Buyers In In addition, Supermarkets no longer have a lock on “traditional” grocery items which were formerly almost exclusively theirs to sell • SuperCenters • Grocery • Mass • Clubs • Drug • C-Stores • Non-Choc. Candy • Chocolate Candy • Artificial Sweeteners • Ground Coffee • Dried Fruit Snacks • HH Cleaners • Toilet Tissue • Paper Towels • Liquid Soap • Soft Drinks • 79.4% • 83.6% • 80.2% • 90.2% • 83.2% • 78.6% • 86.4% • 77.8% • 55.4% • 97.5% • 62.0% • 58.0% • 21.8% • 30.0% • 22.8% • 42.9% • 50.3% • 25.1% • 45.0% • 44.7% • 18.0% • 16.6% • 8.1% • 11.3% • 7.2% • 12.1% • 16.5% • 6.6% • 11.6% • 16.9% • 12.6% • 10.4% • 11.9% • 15.5% • 12.7% • 11.4% • 10.4% • 10.0% • 10.3% • 9.2% • 43.5% • 5.1% • 5.2% • 7.7% • 4.2% • 14.7% • 19.8% • 9.5% • 9.9% • 24.1% • 9.5% • 1.5% • 0.4% • 1.0% • 0.8% • 0.8% • 1.6% • 0.6% • 0.2% • 20.4% Source: Scarborough Research, 1999-2000

25. On top of this, Supermarkets are now confronted with competition from Value Discounters whose business models deliver higher net incomes than Supermarkets at significantly lower retails. For example: • Wal-Mart Operating Costs vs. Leading Supermarket: Impact on Margins – 2002/2003 Operating Profits 5.2% 4.9% 5.1% 5.2% Wal-Mart Kroger Albertson’s Safeway Sales $81B* $53B $36B $32B Operating Costs 16.6% 22.1% 24.1% 25.9% Net Income 3.3% 2.2% 1.4% (2.5%) Gross Margins 22.2% 27.0% 29.2% 31.1% Source: Company SEC filings, Kroger & Albertson’s through 3 quarters, Wal-Mart & Safeway reflect full FY2002 *Food Only, Total U.S.

26. Question: How many of you are thinking at this point that Wal-Mart and other Value Discounters have acquired this advantage because suppliers sell to these companies at lower net prices than they sell to Supermarkets?

27. Answer: You are 100% correct! • Suppliers do sell to Wal-Mart, Clubs and Dollar Stores at lower net prices than they sell to Supermarkets BUT: • This is not due to these retailers’ clout or size or to favoritism by suppliers • It is due to the fact that these retailers have different business models and buying protocols than Supermarkets which makes them inherently more efficient from a pricing standpoint • Bottom line is that suppliers offer no better pricing or deals to these accounts than they do to Supermarkets – only they structure them differently • Want to know how this works?

28. First thing to understand is what suppliers have available in terms of discretionary spending: • This is known as the “Advertising & Promotion budget”: 2002 Supplier Discretionary Advertising & Promotion Spending Category Spending Type Net Sales Consumer Advertising Consumer Promotion Trade Promotion Total Adv. & Promotion $100.00 $7.00 $5.00 $17.00 $29.00 TV, Radio, Print, Etc. FSIs, Coupons, On-Packs, Etc. Slotting, O/Is, Accruals, Bill-backs, Etc. Avg. Industry A&P Spending* *All numbers have been rounded to the nearest dollar Source: Cannondale Associates, Inc.; Trade Promotion spending and Merchandising 2002 Industry Study, 2003

29. Next thing to understand are the buying protocols of Value Discounters. For Example: • Wal-Mart: • Does not want slotting • Does want trade promotion but is willing to accept less providing the supplier uses the balance to reduce net prices • Does not want any consumer promotion that would in any way increase prices • Works with every supplier to achieve the right “balance” between discretionary funds available and net pricing to Wal-Mart • Works equally hard on the supply-side to keep operating costs as low as possible

30. Buying protocols (cont’d) • Clubs: • Require suppliers to strip-out all slotting, trade promotion and consumer promotion and reduce prices accordingly • Are willing to accept up-charges for packaging changes and use of packaging sub-contractors • Provide full disclosure on promotion costs and require suppliers to promote only using retailer-developed promotion vehicles • Pricing is always a negotiation • Structure supply requirements to keep handling and labor costs at absolute minimums

31. How Value Discounter buying protocols translate vs. Supermarkets Supermarkets Wal-Mart Clubs Net Sales Consumer Advertising Consumer Promotion Trade Promotion Total Advertising & Promotion Add-Backs For Packaging Net Pricing vs. Supermarkets $100.00 $7.00 $5.00 $17.00 $29.00 – $29.00 –0- $100.00 $7.00 $2.50 $8.50 $18.00 – $18.00 ($11.00) $100.00 $7.00 – $2.00 $9.00 $2.00 $11.00 ($18.00)

32. Impact on retail prices: Supermarkets Wal-Mart Clubs Standard case price Budgeted A&P investment Actual A&P costs Balance to price Net case cost to retailer Avg. gross margins (2002) Retail per case Per SKU (12 unit case) % difference vs. Supermarkets $100.00 $29.00 $29.00 $0.00 $100.00 29.1% $129.05 $10.75 – $100.00 $29.00 $18.00 ($11.00) $89.00 22.2% $108.93 $9.08 15.5% $100.00 $29.00 $11.00 ($18.00) $82.00 11.1% $92.23 $7.69 28.5%

33. Channel Pricing Index on Selected Consumables(Scottsdale, AZ, 8/7/2002) Translation into real world pricing differences • Food • Supercenters • Clubs • Formula 409 • Pine Sol • Pledge • Lysol Disinfecting Spray • Windex • Arrowhead Water • Tea Bags • Maxwell House Coffee • Sweet ‘n Low • Equal • Hershey’s Kisses • M&M’s • Bath Tissue – 36-48 Roll • Bath Tissue – 12-24 Roll • Napkins • Towels (roll) • 100 • 100 • 100 • 100 • 100 • 100 • 100 • 100 • 100 • 100 • 100 • 100 • 100 • 100 • 100 • 100 • 61 • 92 • 68 • 66 • 59 • 92 • 49 • 71 • 92 • 72 • 66 • 65 • 54 • 73 • 60 • 77 • 53 • 58 • 57 • 54 • 37 • 65 • 45 • N/A • 43 • 48 • 67 • 54 • 41 • 57 • 39 • 73 • Source: Hoyt & Company Store Checks w/o 8/7/2002. • Largest sizes carried indexed to Food on a per unit (oz/sheet/count) basis.

34. It is because the consumer intuits these differences that she has become habituated to shopping different formats • In 2002: • 100% of U.S. HH shopped Supermarkets approximately 1.5x’s per week and spent an average of $37.00 per trip. • 92% of HH shopped Mass Merchandisers about every other week and spent about $41.00 per trip. • 86% of HHs shopped a Drug chain about every three weeks and spent an average of $24.00 per trip. • 63% of HHs shopped a Supercenter about every 3 weeks and spent an average of $54.00 per trip • 62% shopped a Dollar Store about once a month and spent about $12.00 per trip. • 52% shopped a Club about once every 5 weeks and spent a whopping $84.00 per trip. • 46% shopped a Convenience store about 1X per month and spent about $14.00 per trip.

35. Key Message #1 • Supermarkets mustcompletely revamp their go-to-market strategies in order to remain viable in the 21st century: • The 1950’s and 60’s model built on price, location and assortment is no longer working effectively • Fact is that Supermarkets cannot compete on price alone with Value Discounters and continue to grow profits on a sustainable basis • By continuing to attempt to compete with Value Discounters on price, Supermarkets are allowing these channels to dictate the way they (Supermarkets) do business • On the other hand, there is a way to create a low price impression without digging one’s grave in the process

36. How to create a Low Price impression • Top 15 Supermarkets Items Ranked in Order of “Pulling Power” HHPenetration PurchaseFrequency PullingPower Index ToMedian %of Sales X = 1. Baked Goods (Fresh) 2. Milk 3. Soft Drinks-carb. 4. Snacks 5. Paper Products 6. Candy 7. Juices/drinks-ss 8. Meat & Seafood-fresh 9. Produce 10. Packaged Meats 11. Cereal 12. Condiments/sauces 13. Cheese 14. Pet Food 15. Vegetables-canned 99.4 97.8 97.7 98.7 99.3 97.9 94.7 99.9 99.9 96.7 96.1 98.3 97.5 71.1 95.4 35.5 34.3 30.3 25.7 23.5 21.8 20.9 19.1 18.5 18.9 17.8 17.2 17.2 19.6 14.6 3529 3355 2960 2537 2334 2134 1979 1908 1848 1828 1711 1691 1677 1394 1393 698 663 585 502 461 422 391 377 365 361 338 334 332 276 275 3.20% 2.96% 3.22% 2.33% 2.05% 1.03% 1.60% 14.38% 9.75% 2.49% 1.99% 1.43% 2.13% 1.29% 0.87% 50.72%

37. Question Just how important is “price” relative to the other factors that influence the consumer’s decision on where to shop?

38. Based on a 2003 FMI Study, not nearly as important to Supermarket shoppers as everyone seems to assume: • FMI Study results: • Only 20% of shoppers compare prices on every trip • 23% compare “fairly often” • 32% compare “only occasionally” • 25% “never” compare • In other words, price is not the magnet it used to be with 57% of shoppers and is only marginally important to another 23%. • Larry Johnston, CEO of Albertson’s, recently affirmed these findings when he told analysts that although Albertson’s was again lowering prices, Albertson’s research indicates that price is a determinant for only about 35% of grocery shoppers Source: FMI “Spending and Saving Money”, 2003

39. Because price is such an important – and controversial – issue, Hoyt & Company conducted its own (informal) survey on this subject during the week of March 24 in Scottsdale, AZ • Approximately 100 parking lot shopper intercepts • Albertson’s, Fry’s (Kroger) and Safeway • Wal-Mart Supercenters and Costco • Objectives: • Determine why consumers shop supermarkets versus alternate outlets • Likes/dislikes/expectations versus alternate outlets • Purpose of trip/what they buy • Other channels at which supermarket shoppers regularly buy groceries and why

40. Hoyt & Company Survey Results – Question #1 • Are you shopping today to fill-in or do a major shop? Supermarket Shoppers Supercenters Shoppers Club Shoppers Major Shop Fill-in 12% 88% 36% 64% 0% 100%

41. Hoyt & Company Survey Results – Question #2 • Is this the only store where you buy groceries? Supermarket Shoppers Supercenters Shoppers Club Shoppers Yes No 8% 92% 7% 93% 0% 100%

42. Hoyt & Company Survey Results – Question #3 • In what other channels do you buy groceries? Supermarket Shoppers Supercenters Shoppers Club Shoppers Other supermarkets Supercenters Clubs Drug Chains Food Specialty (Oats, Joes, Whole Foods) Other 63% 33% 56% 21% 50% 13% 57% 0% 71% 29% 50% 7% 100% 27% 0% 0% 27% 0%

43. Hoyt & Company Survey Results – Question #4 • Does this store carry all of the items, or brands or sizes you want to buy? Supermarket Shoppers Supercenters Shoppers Club Shoppers Yes No 52% 48% 57% 43% 0% 100%

44. Hoyt & Company Survey Results – Question #5 • What items do you buy mostly at this store? Supermarket Shoppers Supercenters Shoppers Club Shoppers Fruits & Vegetables Meats & Fish Dairy & Frozen Soft Drinks, Juices, Coffee Cereals, Cookies, Chips, Canned Goods Detergents and Paper Goods (Dry Grocery, Non-Food) 88% 83% 88% 75% 73% 42% 64% 57% 57% 64% 64% 64% 36% 36% 27% 64% 36% 100%

45. Hoyt & Company Survey Results – Question #6 • Why did you choose this particular store? Supermarket Shoppers Supercenters Shoppers Club Shoppers Close by Prices Service More choices Other 75% 13% 6% 2% 0% 21% 71% 0% 0% 7% 50% 50% 0% 0% 0%

46. Net on Supermarkets and price: • Consumers no longer perceive Supermarkets as grocery price leaders and do not shop the channel primarily for price savings: • Only 13% of supermarket shoppers said they shop Supermarkets for price versus 71% of Supercenter shoppers • Location, Service and “More Choices” are the three most frequently-cited reasons why consumers shop Supermarkets versus other channels • Consumers have “0” expectations of both Supercenters and Clubs to provide either “service” or “more choices” • Based on these findings, continuing a 24/7 fixation on price is counter-productive relative to focusing on other ways of meeting shopper expectations that would add genuine value to the overall Supermarket shopping experience.

47. Key Message #2: • Supermarkets have unique strengths which clearly set them apart in the consumer’s eyes from other trade channels selling similar products. • Supermarkets have failed to leverage these strengths by imitating rather than leading. • The extent to which Supermarkets can learn to leverage these strengths is the extent to which Supermarkets will be able to move away from price-based merchandising and create value that aligns with shopper expectations of what a Supermarket should deliver.

48. Supermarket Strengths and Weaknesses versus Consumer Expectations

49. Despite higher overall prices, 100% of U.S. households continue to shop the Grocery channel with no drop-off in sight: • % Household Penetration By Channel Per Year: 1996 - 2002 + Ptsvs. ‘96 Channel 1996 1997 1998 1999 2000 2001 2002 Grocery Convenience and Gas Drug Chains Traditional Discount Warehouse Clubs Supercenters Dollar Stores 100 52 90 95 49 N/A 39 100 52 89 94 48 N/A 45 100 52 86 94 49 47 47 100 50 87 95 50 52 52 100 48 86 94 49 54 55 100 45 86 93 50 60 59 100 46 86 92 52 63 62 – -6 -4 -3 +3 +16 +23 Source: AC Nielsen, Channel Blurring Studies, 1998 - 2002 inclusive

50. In addition, consumers shop Grocery far more frequently than any other channel and 3.5 Xs more than lower-priced Supercenters • US CPG ChannelsTrip Frequency – Annual # Trips/Household/Year/Channel, 1996 - 2002 + Ptsvs. ‘96 Channel 1996 1998 1999 2000 2001 2002 Grocery Mass Merchandise Drug Supercenters Dollar Warehouse Clubs Convenience and Gas Totals 95 29 16 13 6 8 13 180 85 28 15 14 9 9 18 173 83 26 15 15 10 9 13 171 78 25 15 17 10 10 14 169 75 23 15 18 11 10 15 167 73 22 15 21 12 10 14 167 (22) (7) (1) 8 6 2 1 (13) Source: AC Nielsen, Channel Blurring Studies, 1998 - 2002 inclusive