No matter what, people need to eat.

This essential truth has long made grocery stores the gold standard for real estate investors and strong anchors for shopping centers.

Over the last several years, however, the industry has had to withstand a barrage of corporate bankruptcies, including the collapse of the A&P and Haggen Food & Pharmacy chains and recent bankruptcy filings from Southeastern Grocers, LLC and Tops Markets, LLC.

While the grocery business is not looking at the same existential threat that the electronics and office supply sectors have faced, the landscape is unquestionably changing. The key shift underway is a bifurcation of the market that favors large format discount stores and smaller specialty stores, adding to the pressure mid-market chains have already been feeling.

So far, the closures that have rocked the industry have been concentrated in chains that have carried high levels of debt. These chains have often lacked the resources to invest in their physical stores and expand their offerings. But the challenges may spread across the industry.

Traditional grocers must now contend with competitors that have consumed demand for higher margin products--such as Trader Joe's, Amazon's (AMZN) - Get, Inc. Report Whole Foods Market, and Sprouts Farmers Market (SFM) - Get Sprouts Farmers Markets, Inc. Report --while discounters like Aldi U.S. and Smart & Final Stores, Inc. go after the more affordable generic segment of the market. At the same time, Walmart Inc. (WMT) - Get Walmart Inc. Report and the warehouse chains Costco Wholesale Corp. (COST) - Get Costco Wholesale Corporation Report and BJ's Wholesale Club Inc. have continued their assault on the business, maintaining pressure on pricing in the industry.

Amazon is a holding in Action Alerts PLUS.

Online shopping adds another wrinkle to the concerns of the industry. Before Amazon acquired Whole Foods, the grocery business may have believed that online retailing was less of a concern. After all, consumers might still show resistance to buying fresh meat, eggs, and produce sight unseen. However, grocers cannot live by bread alone.

Purchases of dry goods online might increase as shoppers seek the convenience of home delivery. The aisles of a traditional grocery display dry goods from toothpaste and paper towels to spices and breakfast cereal that consumers can purchase online or from drug stores and mass marketers. With Whole Foods now part of the Amazon fold, we see online sales of these products increasing as the company makes more items available through its shopping platform and expands home delivery and in-store pickup. This could also affect slotting fees that food and consumer goods manufacturers pay to grocers for shelf space.

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With profit margins that can be as low as 1%, traditional grocers will either need to reduce their space, or seek out new ways to use the space that they have to maintain or increase those margins, such as expanding into higher end prepared food offerings, meal kits, and organics. According a 2017 article in the Houston Chronicle, adding prepared foods, delis, and bakeries helped increase margins for Weis Markets, Inc. to 2.5%, compared with normal aisle section margins of 1%.

Progressive Grocer reported that in 2016, in-store bakery margins were over 45% and that sales of those in-store bakeries could increase to $18.4 billion by 2020, a 45% increase from 2010.

Grocery Margin Compression

The chart below illustrates the tightening of operating margins across some of the major grocery retailers as Walmart expanded its grocery operations. The Kroger Co. (KR) - Get Kroger Co. (KR) Report and SuperValu, Inc. (SVU) have recovered somewhat over the past few years. While SuperValu shifted out of retail and expanded its wholesale operations, Kroger has worked to change its product offerings to accommodate higher margin goods.

Walmart has hurt rivals.

Size Matters

The chart below shows the average size of grocery store footprints across the various chains. Walmart's average size of 178,000 square feet is for its supercenter store, which includes a full grocery department. The Kroger Value and Marketplace stores, both of which the chain has expanded in recent years, show an increasing average size.

The grocery store base has gotten smaller.

Going to Extremes

Our research suggests a bifurcation of the industry. At one end are mass marketers and warehouse clubs that use large format stores of over 100,000 square feet. These stores will still operate with lower margins but will have a large national footprint for high volumes and scale, while investing in best-of-class supply-chain management to maintain lower costs. They perform well in densely populated areas that can drive demand and volume.

At the other end of the market are smaller stores of 25,000 to 40,000 square feet that focus on higher margin or specialty foods. While supply chains will still be important in cost control, these stores will rely on superior data to better target their offerings to their clientele. Such stores are likely to continue to expand in urban locations, as well as in more affluent suburbs. Expanded services such as delivery and in-store pickup of online orders could also help push sales higher.

Who gets left behind? Those middle-market chains in secondary locations with smaller stores of less than 50,000 square feet. Midsize stores without sufficient scale or specialized offerings will be unable to generate scale across their footprints, which will put pressure on costs. In addition, the loss of some sales to online outlets and discounters like Aldi will add to the pressure on already-low margins. Unless traditional grocers can adapt to the changing landscape, over the next 10 years, we expect owners of shopping centers anchored by these chains to endure the most pain.

By: Edward Dittmer, Senior Vice President, Morningstar Credit Ratings

Edward Dittmer, CFA, is senior vice president and head of CMBS Credit Risk Services for Morningstar Credit Ratings, LLC. Dittmer has more than 15 years of experience in commercial real estate, including 10 years at GMAC Commercial Mortgage and Capmark Investments, and he has experience in ratings analysis for both CMBS new issuance and surveillance. Previously, Dittmer was an acquisitions underwriter for Capmark Investments' private equity platform.

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