Squaring the Circle with ROUNDY'S

So far, the only sure answer is (d).

The $3.86-billion company, 37th overall among U.S. retail grocers by sales in 2013, is in transition–except no one seems sure where the transition is heading. Its Pick 'n Save banner, with 93 stores, still is the market leader in the Milwaukee area, but its share is eroding, and observers see no sign of gearing up to meet competition that will toughen up very soon. Roundy's has already pulled out of Minnesota, selling off or closing its 27 Rainbow stores in the Twin Cities area this year.

Roundy's two major banners are Pick 'n Save, the market leader in the Milwaukee area, and Mariano's Fresh Market, an upscale chain named after CEO Bob Mariano.

On the other hand, Roundy's is getting plenty of positive attention in and near Chicago, where its Mariano's Fresh Market banner–founded by and named for CEO Bob Mariano–took the city by storm in 2013-14. Mariano founded the banner in 2010, and it got a big boost when his company began snapping up shuttered Dominick's supermarkets, buying 11 of them beginning in late 2013 and converting them to Mariano's supermarkets that offer a Whole Foods-like experience–at much lower prices. Together with existing and newly built stores, Mariano's Fresh Market now has 27 outlets (one pharmacy-only for now) in the Chicago area, and Bob Mariano has said that he's thinking of expanding the banner beyond Illinois. (For a brief history, see "Roundy's: Wholesaler to Retailer, Co-op to Private to Public" on page 18.)

So how is Roundy's doing overall?

By standard metrics, not well. Roundy's reported a net loss of $13.5 million for the second quarter. Most of this was a $9.8 million charge for the Rainbow closings, but the company also admitted a $2.9 million loss from continuing operations. Roundy's has revised its earnings estimates downward twice so far in 2014. Overall sales rose, but that was attributable to the new Mariano's stores; same-store sales were down 2.2 percent, company executives acknowledged in the earnings call.

The quarter's performance is consistent with Roundy's overall recent history: its net income, as reported in its annual statements, fell steadily since 2009 to a loss of $69.2 million in 2012, before bouncing back to black with $34.5 million in 2013. Roundy's stock has lost more than half of its value since an IPO of $8.50 per share in 2012. Bank of America downgraded the stock from Buy to Neutral, and Standard & Poor's changed its credit rating from B to B-minus.

During the second quarter earnings conference call, held Aug. 6, Mariano and other Roundy's executives used phrases like "transition year" and "building-block quarter." But what are they building and transitioning toward?

CARRYING THE CORE?

It's an unusual situation, analysts say, in that a relatively small part of the business appears to be doing better than the mainstream core. (In addition to Pick 'n Save and Mariano's Fresh Market, Roundy's has two other active banners, both in Wisconsin: Copps, with 25 mainstream stores in Madison and points north, and Metro Market, with three upscale stores in or near Milwaukee and one in Madison.)

"Our strategy today is to focus our efforts where they will provide the most benefit for all of our stakeholders," says James Hyland, vice president for public affairs. "The Twin Cities divestiture is very strategic for us in that it allows us to focus our management, capital and other resources to grow our Mariano's business in Chicago, our growth market, and to stabilize and grow our core Wisconsin market where we have stronger market shares."

But the core Wisconsin market might not be enough.

"If they're telling the truth, then Mariano's is definitely carrying the core," says Karen Short, a Deutsche Bank analyst. "The core is really, really struggling."

In addition to the positive press in the Chicago area, Roundy's can point to initial sales figures for the newest Mariano's Fresh Market stores that are running up to 20 percent ahead of expectations in many locations. But there is little context. During the conference call, Roundy's execs deflected several requests to break out results for the Mariano's stores. Without that breakout, it's hard to see how well the stores truly are doing, says Short, who was in on the call.

"They give us economics of the Mariano's stores, and that's great that you read them out, but something doesn't add up with the numbers," Short says. With all of the openings and closings that took place this year, it's hard to get a firm handle on the company's true situation, she says: "Either the core business is just imploding at a much faster rate than I even was aware, or the Mariano's stores are not generating the margins they claim–although that may be a bit harsh."

Complicating the picture further is Roundy's heavy debt load. The company had a debt-to-equity ratio of 3.28 in 2013, compared with 1.7 for mainstream rival Kroger and 0.007 for upscale (and cash-rich) competitor Whole Foods, per their annual reports. Even with a debt restructuring last year, Roundy's is carrying more than $700 million in long-term debt.

The debt, combined with a drop in earnings, accounts for at least part of the poor stock performance, analysts say. But it may mask a deeper problem, according to David Livingston, a consultant who worked as Roundy's market research manager until 2002.

"The company has used debt to false-front their success," Livingston says flatly. "Nice new [Mariano's] stores, competitive pricing, strong service–it's all paid for with debt."

CONTRASTING STORES

The contrasts between Pick 'n Save and Mariano's Fresh Market stores are apparent on many levels. When Retail Leader visited a Pick 'n Save in Pewaukee, Wis., it was nearly deserted (although it was mid-afternoon on a weekday, not a prime time for grocery shopping). The store was clean and well-tended, but the stock on the shelves was riddled with gaps, and store personnel were few and far between on the floor.

On the other hand, the Mariano's Fresh Market in Hoffman Estates, a Chicago suburb, was bustling on a Sunday afternoon. Hungry customers could choose from a variety of hot and cold entrees, including a sushi bar and a grilling station, with a gelato booth for dessert. Live piano music tinkled near the door, and floor personnel were plentiful, cheerfully hustling around and looking sharp in white shirts with black neckties. Other Mariano's locations have attractions like oil and vinegar bars, oyster bars, BBQ spots and fully equipped kitchen classrooms. It's a marriage of luxurious amenities and affordable, mainstream groceries.

The fortunes of the two banners are definitely diverging. Pick 'n Save had about a 60 percent share of the Milwaukee market in the mid-2000s, Livingston says; that is down to about 45 percent today, according to the company's own estimate. That's still the biggest share, but the competition is about to intensify. Meijer is moving into town in a big way, with three stores planned for next year and three more for 2016, plus two others elsewhere in southern Wisconsin. Costco, Whole Foods and Fresh Thyme also are coming to the region.

Mariano and other Roundy's execs swear that the company is not planning to leave the Milwaukee market as it left the Twin Cities, where the Rainbow banner has been liquidated. (The nine stores that weren't sold were closed in July.) Livingston and others have speculated that the company is milking Pick 'n Save to subsidize Mariano's Fresh Market–a notion that Mariano "bristles at," according to an article in the Milwaukee Journal-Sentinel.

Mariano declined to be interviewed by Retail Leader, but Hyland firmly rejects the notion that Pick 'n Save is being neglected. "The Milwaukee renewal project, which started in 2013, is an ongoing multi-store project with the goal of positioning Pick 'n Save as the best conventional operator in our market," he says. "We have rolled the project out to 71 Milwaukee area Pick 'n Save stores. The renewal project is not static but rather a continuous rollout of product, merchandising and service initiatives supported by a brand positioning campaign. The renewal project was recently enhanced with the remerchandising [of] our vestibules, end caps and barges to sell more customer-critical items consisting of a mix of own and national brand items, and meaningful pricing adjustments have been made on a significant number of key items important to our customer base. All of these initiatives are being supported by a multi-media advertising campaign."

But critics are unimpressed.

"He named [Mariano's Fresh Market] after himself, he's directed all available capital, and he pretty much just focuses on those stores," says Livingston, who further speculates that the success of the Mariano's stores depends heavily on their giving excessive value for what they charge.

ON THEIR OWN?

Without a breakout of results for Mariano's Fresh Market, it's hard to prove whether they're standing on their own or are in fact subsidized, through debt or another means. But whatever they're doing to keep prices down, it's working, at least in the short term. Mariano's stores, which follow an EDLP strategy (Pick 'n Save uses Hi-Lo), often undersell competitors–and not just upscale ones.

According to a study of the Chicago market furnished by a major analyst who prefers to remain anonymous, prices at Mariano's Fresh Market, when calculated against a baseline of grocery prices at Walmart, fell steadily since December 2013. They rose slightly after hitting a low last March, but they still beat two of the four competitors in the study–and the two they didn't were discounters Walmart and Target.

Retail Leader's own analysis bears that out. Our market basket of 23 items shows that not only does Mariano's come out 34 percent cheaper than Whole Foods; it beats Jewel-Osco, a mainstream Chicago-area banner that now uses EDLP, by 15 percent. (Details are on page 16.)

If Mariano's Fresh Market is in fact being subsidized, through debt or other means, it raises the question of how long that situation can be sustained. And if the Mariano's stores are standing completely on their own, how long can they carry the rest of the company?

Hyland says there's no subsidy involved. "Our model for Mariano's differs from our core Wisconsin business model," he says. "The Mariano's banner leverages its fixed cost structure with sales of approximately twice the sales volume of our core Wisconsin stores. This allows for a more aggressive pricing structure. In addition, our overall perishable sales mix in our Mariano's stores is much higher than our core stores and thus, Mariano's is able to generate gross margin rates that are comparable to our core stores. Our pricing strategies are continually evolving and adjustments are made when appropriate."

Another possible concern is the recent departure of Darren Karst as Roundy's chief financial officer. His acceptance of the CFO position at Rite Aid, the nation's No. 3 drugstore chain, effective in August, raised some eyebrows. In Roundy's last 10-K, Karst was named, along with Mariano and one other exec, as a "key employee" whose loss "could negatively affect our business."

Livingston believes that Karst, who had been with Roundy's a dozen years, got out while the getting was good. "He does not want his last job to be with a bankrupt company and does not want the bankruptcy on his legacy," he says. "He was urged to take another position and not simply resign, making everyone look bad."

But Short cautioned against reading too much into Karst's departure. She noted that he took part in the Aug. 6 conference call, even though he was slated to leave a few days later: "The fact that Darren participated tells me [his departure] wasn't contentious."

SPINNING THE FUTURE

If Karst's future is settled, the company's is not as sure.

One alternative is obvious when one part of a company is notably outperforming the rest: a spinoff. Short, however, notes that spinning off the Mariano's stores wouldn't be easy.

"It's not unreasonable to think that that's possible, but I don't think you could do a spinoff of the jewel of the company and then saddle the core business with all of the problems," she says. Dividing Roundy's huge debt wouldn't be the only issue; if the Mariano's stores are spun off, they would need their own distribution center (although Short notes that they'll probably need that soon no matter what happens).

Livingston and others think there's a darker motivation at work.

"I suppose there will be a spinoff once they figure out how to stick Roundy's with all the debt and let Mariano's spin off with a free pass," Livingston says. "My guess is Roundy's will just sell Mariano's for pennies on the dollar to Bob."

No matter what happens, Roundy's and its divergent fortunes stand as a microcosm of market bifurcation. The fact that the upscale Mariano's stores are thriving while the mainstream Pick 'n Save stores are struggling, regardless of any subsidy, show how the extremes of the market–high quality or low prices–these days often have an inherent advantage over the middle.