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County Line StoresStore Remodel and New Store Investment

Abstract

Athrough a combination of organic growth and through acquisitions. As part of its organic growth strategy, CLM needs to consider expanding or replacing some of its existing stores, with focus on 10 specific store locations. These stores are located in areas where the demographics, population, and competitive landscape have changed dramatically since the stores were last remodeled. The key capital investment trade-off decision facing CLM is whether to:

1.remodel or expand the existing stores now,

2.replace its existing stores now with new, larger superstores, or

3.wait five years and replace the existing stores with superstores.

The Chief Financial Officer (CFO), Ron Winston, thinks that it is premature to invest substantial sums of money in some existing locations because they are still in a state of flux and he feels that it is better to wait until the area stabilizes before committing large amounts of funds to this area. The Vice-President of Operations, Jerry Williams, and the various store managers think that CLM needs to invest in advance of market changes.

CLM Background

Michael Lloyd and his wife started CLM in Indianapolis, Indiana, in 1905. The couple started with one store, which grew to a chain of five stores within 10 years. Michael Lloyd operated CLM until 1940. At that time his son Marcus Lloyd became president of the company, while Michael served as chairman of the board. When Marcus took over the company,CLM had 15 stores located in the greater Indianapolis area. Marcus and his four brothers made up CLM's senior management, which undertook a major expansion of the business throughout the central portion of Indiana. By the time Marcus retired in 1980, CLM had 55 stores that stretched from north of Indianapolis to Fort Wayne, and south to Bloomington, with 47 stores located in the greater Indianapolis area. CLM also had six stores in Fort Wayne and two stores in Bloomington.

During his tenure as CLM president, Marcus bought out all his brothers' interests in the company. Marcus's son Harry took over CLM as president in 1980. Marcus's other children were not involved in the operation of CLM but remained as shareholders.

Harry Lloyd managed the family business from 1980 to 2002, during which time the CLM experienced not only substantial growth, but also tremendous growth in competition. All of the major discount retailers (i.e., Wal-Mart, Target, and K-mart) added grocery items to their retail offerings. In addition, several discount grocery "club" stores opened up in CLM's market area. This increased competition caused several of the independent grocery operations in Indiana to sell out to the national grocery retailers (viz., Kroger, Safeway, and Albertsons).

Because of CLM's organizational efficiency, competitive pricing, customer loyalty programs, and modern stores, CLM was able to increase its market share by expanding its product line as well as by building and buying store locations. CLM added bakery, delicatessen, floral, and seafood departments to its stores. CLM also built several new stores in central Indiana and bought out the five-store Midwest Markets Group.

When William Lloyd took over CLM from his father Harry in 2002, CLM had 67 stores throughout Indiana. CLM also had three manufacturing operations. CLM produced its own bakery items, meat, and milk at its respective plants.

Currently, CLM has 6,750 employees who work at its 67stores, three manufacturing operations, and the two warehouses. The corporate headquarters are located adjacent to CLM's largest warehouse in downtown Indianapolis. The 200 corporate employees are organized into seven departmental units, including: finance, store operations, manufacturing, marketing, purchasing, and legal.

Industry Overview

The retail grocery industry in the U.S. ranks only behind the motor vehicle industry in terms of retail sales volume. The three largest retail grocery operations are Wal-Mart, Kroger Company, and Safeway. These firms account for over 25% of all industry sales.

Typical store formats that exist in the retail grocery industry include:

Conventional supermarkets: this type of store offers a full range of dry groceries, canned goods, nonfood products, and perishable goods. These stores stock about 22,000 items and average 25,800 square feet.

Superstores: supermarkets that are larger than conventional supermarkets; typically, they average 50,000 square feet in size and stock approximately 30,000 items. Between 10-20 percent of a superstore's selling space is devoted to nonfood items, specialty departments (e.g., floral), and services (e.g., video store).

Combination stores: superstores that include a full-service drugstore with a common checkout area. The average store size is 55,700 square feet.

Supercenters: provide a mix of merchandize of both a discount store and a supermarket and drugstore. The average size of these stores is 190,000 square feet, with 40 percent of its selling space devoted to grocery products.

Other food outlets: may include grocery stores (small stores with a narrow selection of items); convenience stores (primarily dry goods with a limited selection of perishables, stocked with 3,000 items); warehouse clubs (retail/wholesale hybrid store with 60 to 70 percent general merchandise, and 30 to 40 percent health and beauty and groceries).

The grocery retailing industry in the U.S., as well as world-wide, is fiercely competitive, slimly profitable, and dominated by multibillion-dollar companies. Not only are grocery stores competing with each other, they also have to compete with restaurants and other prepared-food providers for a share of the consumers' food budget.

The U.S. population has become more diverse ethnically. This shift has changed the types and number of products that grocery stores need. In addition, the aging of the Baby Boomer population and the general interest in healthier eating has prompted the industry to provide natural and organic food items. This addition of the natural and organic food category has allowed grocery stores to compete with stores like Whole Foods, which specialize in natural and organic foods. The higher profit margin on this food category has allowed grocery stores to differentiate themselves as well as to enhance store profitability.

Industry-wide, the retail grocery industry has experienced some recovery in net profit after taxes following several years of decline. Net Profit after taxes increased from 1.4% of sales in 2005 to 1.6% in 2006. Even with this rebound, net margins are still considerably below the 2.5% achieved in 2002.

Current Situations

In the fall of 2006, Ron Winston, Jerry Williams, and Park Hill Acres store manager Lucy Smith met to discuss CLM's investment in its area of Indianapolis. The evaluation of the remodel or expansion of this store and its sister Webster Street location is the beginning of the CLM's investment analysis of its 10 area stores.

Although the specific circumstances of each location are different, the analytical and judgmental issues facing CLM's management are typical of other stores. The Park Hill Acres store is a 25,000 square foot space that was upgraded, remodeled, and expanded seven years ago. The store is located in a neighborhood near downtown Indianapolis. The neighborhood has had poor demographics: income levels were at a mid-to-lower range, housing prices had steadily declined, and there was a high transient population. Approximately three years ago, the Park Hill Acres neighborhood began to change. Several developers purchased older homes in the area and "scrapped" them to build upscale single-family homes and duplexes. Many upper-income professionals purchased older homes and restored them to their 1930s vintage. Several luxury condominium projects are now underway with several more under consideration.

Historically, the CLM Park Hill Acres store competed with an Albertsons that was comparable in size; two small, locally owned grocery stores; and several convenience stores. Several competitors are located within a six-mile radius of Park Hill Acres. Safeway replaced its similarly-sized store with a 60,000-square-foot superstore 18 months ago. CLM also runs its 20,000-square-foot Webster Street store, which is located between the CLM Park Hill Acres site and the Safeway store. In addition, 15 months ago Whole Foods opened a 75,000-square-foot store across the street from the new Safeway superstore.

Jerry Williams and Lucy Smith think that CLM should replace the Park Hill Acres store with a new 60,000-square-foot superstore. Their preliminary analysis, as illustrated in Exhibit 1, estimates that the Park Hill Acres superstore would increase sales by 2505 as a result of the expansion of some highly profitable departments, such as floral, deli, and bakery, attracting customers who shop at the nearby Albertsons and the two locally-owned grocery stores.

Williams and Smith estimate that a $9.95 million investment in a Park Hill Acres superstore will generate annual incremental free cash flow of $1.69 million and provide CLM a payback in 5.88 years. They view their analysis to be conservative because they have not built any anticipated growth into their revenue projections beyond the initial increase in revenue from $19.5 million to $48.75 million. Williams and Smith feel that their estimate of the gross margin of 25.8% for the

Park Hill Acres superstore is also conservative. As Exhibit 2 illustrates, the current margin of the Park Hill Acres is 24.7%. However, the additional space in the superstore would enable CLM to expand its high-margin departments (viz., produce, bakery, deli, and floral), and thereby drive overall profitability for the superstore.

The CFO (Ron Winston) thinks there are several things wrong with this analysis. First, he thinks their financial justification is flawed because it includes in the financial justification the total sales for the superstore, rather than incremental sales. That is, the CFO thinks some of the superstore sales will result from Webster Street customers shifting their purchases to the Park Hill Acres superstore. He considers this to be "double counting," where the shifted sales are considered incremental sales for the superstore. Second, Winston thinks that Williams and Smith's analysis, apart from the sales erosion from the Webster Street store, is aggressive rather than conservative. He feels that sales and the gross profit margin for the Park Hill area superstore will increase over time to the levels they projected. However, he does not feel this will happen until the demographics for the neighborhood change. Third, CFO Winston thinks Williams and Smith did not analyze all of the other investment alternatives available to CLM in the Park Hill area. In particular, Winston feels they should consider remodeling both stores, closing down the Park Hill Acres North store, or to take no action now and wait until the neighborhood transformation is complete before CLM invests significant funds in the Park Hill Area.

Winston, Williams, and Smith agreed to meet to discuss the data and analysis that has been conducted on the proposed Park Hill Acres superstore. All agreed that they would consider any and all options as well as do a rigorous financial and strategic analysis of the investment situation. In preparation for this meeting, the CFO prepared some baseline sales and profitability information for the Webster Street store. This information is presented in Exhibit 3.

Winston opened the meeting with Williams and Smith by elaborating on his concerns about the Park Hill Acres superstore. He said that he believes 30 percent or more of the superstore sales will be the result of current Webster Street customers shifting their buying to the superstore. He thinks these customers will find the broader selection at the superstore more appealing than the older, smaller Webster Street store. Winston underscored the fact that these consumers were already CLM customers, and as a consequence, should be excluded from the economic evaluation of the superstore. The CFO noted that the principle of "incremental analysis" in capital budgeting indicates that only the cash flows that are incremental to the company should be utilized in judging the viability of an investment. He went on to note that the application of this principle suggestions that CLM's cash flows without the Park Hill Acres superstore should be subtracted from CLM's cash flows with the superstore in order to determine the project's incremental cash flow. Winston emphasized to Williams and Smith that CLM runs the risk of over-segmenting the market by building too many stores too close together if they fail to apply incremental analysis to new store locations as well as superstore investments.

Winston told them that he had not reworked their analysis of the Park Hill Acres superstore with only the incremental sales, but his guess was that the investment would not meet CLM's investment criteria. In addition, the CFO indicated that he thinks the Park Hills Acres and Webster Street stores should be expanded or remodeled in the coming year. Winston's staff compiled the data listed in Exhibit 4, which details the specific costs and assumptions related to the remodel as well as the expansion of the two stores.

Winston indicated that he also wondered why the two did not consider the feasibility of a superstore location at the Webster Street location. He observed the competitive disadvantage of Safeway's and Whole Foods' major investment nearby. Winston theorized that maybe CLM's best strategy was to expand the Park Hill Acres store and to put in a superstore at the Webster Street location.

Williams said that he understood Winston's rationale but felt that the CFO was ignoring the dynamics and realities of the marketplace. Williams indicated that he had recently heard from several CLM vendors that the Albertsons store near the Park Hill Acres location was going to be expanded, and quite possibly converted into a 50,000-sq. ft. superstore. Smith observed that the Park Hill Acres store would be severely handicapped if Albertsons put in a superstore while CLM only invested in a store remodel or 12,500 sq. ft.expansion. Williams also thought Winston's estimate of a 30% cannibalization of the sales of the Webster Street store by a Park Hill Acres superstore was excessive. Williams reiterated the CLM's market research shows that the traffic area for a store in the area included within a 3 mile radius of the store, and reminded Winston that the Webster Street store was approximately 3.5 miles from the Park Hills Acres store.

Williams did not think a superstore at the Webster Street location was feasible, for the following reasons:

1.Not sufficient space in the Webster Street location to accommodate a 60,000square-foot store.

2. LM still has five years remaining on its lease for the Webster Street store. CLM will need to continue to make payments on this lease or to find someone to sublet the space.

3. CLM is at least two years late in making this investment. The company should have invested before Safeway upgraded its store and Whole Foods opened its new facility.

Williams and Smith were adamant in their opposition to Winston's store remodel idea for one or both of the stores. They indicated that a remodel would only represent a cosmetic face-life for the stores. The remodel would not allow the stores to significantly expand their more profitable departments nor add a deli operation at the Webster Street store. Both felt a store remodeled in the Park Hill Acres area would signal to consumers and competitors that CLM is a conservative market follower, rather than an aggressive market leader. Williams also felt that this remodel decision would accelerate Albertson's plans for a superstore in the Park Hill Acres area.

By the end of the meeting, all agreed that the store remodel or new store location decision was not as simple as it first appeared. They also agreed that CLM needed to establish some guidelines now for future store investment decisions. Winston agreed to set up a task force of finance and operations personnel that would consider all the possible investment options for the Park Hill Acres and Webster Street stores as well as to create investment guidelines for future store investment decisions. As a follow-up step, Winston provided the task force with the data contained in Exhibit 6, to help it develop its recommendations for CLM's senior management. He also reminded the task force that the projections in Exhibit 5 reflected CLM's inflation outlook of four percent for all items except utilities, which was projected at a 6% inflation rate.

Case 12-2 County Line Markets: Store Remodel and New Store Investment (by Ron Rizzuto and Lou D'Antonio, Journal of Financial Education, Vol. 35 (Spring 2009)

1. Determine the investment options that CLM should consider for the Park Hills Area.

2. Perform a detailed financial analysis of the Park Hill Acres superstore option assuming the Webster Street store remains open. In your analysis include your judgments and rationale for dealing with the 'sales erosion' from the Webster Street store.

3. Make a financial analysis of all of the feasible investment alternatives available to CLM in the Park Hill area. Identify two options that warrant serious consideration based on this financial analysis.

4. Recommend which option CLM should select for the Park Hill Acres area.

5. Recommend policies that CLM should adopt in evaluating other store remodel/expansion investment situations.