By Ronald Thomas, CFA

I have always thought that too many investment analysts, at least where the consumer sector is concerned, do not pay enough attention to marketing and marketing strategy, and spend too much time playing with financial ratios. Many analysts overlook the relative prices companies charge consumers versus their competitors. They then do not sound an alarm for potential future market share losses and the effect that will have on stock valuations. In the food retailing area, Safeway (SWY) and SurperValu (SVU) are examples.

Safeway's prices are about 18% higher than Walmart's (WMT), and 11% higher than Kroger (KR).

The price differential range that consumers notice and act on has typically been 5%-8%, though I believe that level is probably lower, given the consumers' present state. Safeway has had flat to down EBIT for about three years as sales have just not come in this environment, while Kroger has had expanded sales. (I know they only overlap in certain markets, but the price differential is appropriate for positioning throughout the U.S. in my opinion.)

Safeway's heretofore-strong urban/suburban California has been relatively protected from Supercenters because the company could not acquire space or had to fight zoning hostility for large stores. But Family Dollar (FDO) will be expanding strongly into California over the next few years. And it has decided to rev up growth of its neighborhood markets as the return on assets on new Supercenters has declined. 

Just assuming Safeway implements a 5% across-the-board price cut to halve the price differential with Kroger, which would probably result in a relatively static market share, I cut a projection of 2011 revenue by 5% (analysis here can be extremely rough, and still impart the concept). 

The result is a reduction of $594 million of gross profit dollars against and an operating income estimate of $1,137 million, or a 52% hit before any SG&A offsets. If Safeway wanted to gain some market share, as Kroger has done over the past few years, it would have to cut prices by 11% to Kroger's level. That would more than wipe out all operating income before SG&A offsets. 

That does not give me the warm and fuzzies about Safeway or about SuperValu, which has followed the same sort of strategy, except that it opened its own grocery discounter. I have to wonder if it is too late to reverse course for these companies.

Looking back, this piece of corporate strategy was like the old story of the bear (Walmart, then the dollar stores, and finally the overextended consumer that would have to retrench, if anybody saw that far into the future 10 years ago) going after the campers.

Kroger reasoned something along the lines, 'We do not have to beat Walmart. We just have to put on our running shoes (lower prices) and beat the other supermarket chains.'

As for Safeway's and Supervalu's managements, well, I do not know what they were thinking, but I'm sure it had something to do with protecting margins.