Currently all retailers are doing their best to navigate the unprecedented changes resulting from COVID-19, but the world will not return to a new normal until a vaccine is widely available, likely by mid-2021. Nobody knows exactly what that new normal will look like, but we have a strong sense that grocery prices will remain a strong driver of choice. has consistently shown over the past three years that the best predictor of financial and emotional connection performance is price perception.
In spring 2020, the U.S. Census updated the average gross margin (GM) as a percent of total grocery sales for 2018 (yes, there is a bit of a lag). These number surprised us and reinforced the notion that price is still very important. We also think it speaks to the post-COVID period, where price will be as important or even more important than it was pre-COVID.
We expected the 2018 GM to rise for 2018 due to the healthy economy, but it dropped compared to 2017. One of the key reasons we expected GM to rise was a slight uptrend over the past three years driven largely by increases in real income (see chart below). The orange line is real household median income versus our GM line from above. The income line has been a leading indicator for grocery gross margins since the 1990s. From 1993 to 1999, real incomes were rising along with grocery gross margins. With higher incomes, households were demanding higher quality fresh foods.
We see a flattening and slight divergence between the two lines from 2000 to 2007. Over that period, household incomes fell somewhat, but gross margins grew marginally. The reason for this gap was the $200 billion to 300 billion in equity extracted from mortgages, according to the Center for Economic Policy Research (CEPR). These equity withdrawals made households feel wealthier than they were, so their shopping behaviors did not change much even though their real household incomes were falling.
Then the Great Recession hit in 2008, and real incomes fell significantly. It was the beginning of the great hangover and the beginning of what Bank of America Merrill Lynch analyst Robert Ohmes labeled the “discount store decade.” The analysis found that low-income households were growing faster than middle- and high-income households, and that trend gave price-focused retailers a nice tailwind. In addition, the (NBER) found shoppers saved money during the Great Recession by taking advantage of coupons, sales, private brands, larger pack sizes, making more trips and shopping more at discount stores. All of these factors led to the decrease in gross margins for grocery stores from 2008 to 2014. During these six years, there was fundamental behavior change as people realized that credit and removing equity from one’s home was not a sustainable solution.
In 2013, real household incomes started to rebound and grew rapidly from 2015-2018. The rate of growth was like 1993-1999, which was accompanied by a significant increase in grocery gross margin. Based on that, we expected gross margins would grow with the healthy economy. But gross margins did not grow. Instead, gross margins have largely been flat since 2014, even though real household incomes have risen.
Why is 2014-2020 different from 1993-1999? In the 1990s, consumers were willing to spend that extra income on higher quality food. Canned green beans were no longer good enough. Retailers responded by building up perishable categories and the store perimeter: meat, produce, bakeries and delis. This all resulted in higher costs and higher prices for consumers, but they were willing and able to pay for the incremental quality.
Conversely in 2014, real household incomes were rising but gross margins remained flat. Some of the possible reasons include:
- Even with rising median household income, a large percent of the population did not see income gains. In 2018, the Federal Reserve reported that about 40% of households were living paycheck to paycheck—and this before the coronavirus.
- Costco and Trader Joe’s were just beginning to expand in the 1990s, with few retailers focused on both price and quality, so consumers had fewer lower-priced options.
- Walmart had just begun to sell groceries in 1988. In 2020, they are a dominant force with U.S. revenue over $330 billion, with food sales representing about 56%.
- Dollar stores were just starting out in the 1990s, and today, there are more than 30,000.
- Consumers found that discount retailers and private brands are not as bad as once thought. They trialed these products and retailers during the Great Recession, and in many cases, have stuck with them. Since the recession, private brand penetration has grown every year except one.
- Shoppers went from being loyal to a retailer in the 1990s to being loyal to a retailer and a category. Thus, they buy their commodity paper and household products at Costco, their organic frozen and packaged goods from Trader Joe’s, and their perishables from their local supermarket. In 2019, the average shopper hit four to six different stores in a month.
- Natural and organic items were dominated by one large retailer and dozens of smaller regional players in the 1990s, but today, almost all supermarkets carry natural and organic items, and they are offering them at lower prices. See Kroger, Costco, Trader Joe’s and Sprout’s to name just a few.
So, what does this mean for the grocery industry? Currently, we are working through a pandemic and most shoppers have returned to one-stop shopping to limit their exposure to the virus. But once people return to more normal behaviors, we expect consumers will once again shop at multiple retailers to find their ideal combination of price and quality. And if the economy continues to struggle after the vaccine is available, there is a reasonable chance that gross margins will fall again.
The gross margin trend reflects the consumer’s willingness to pay for groceries and it suggests that price is more important than it has been historically. People are simply less willing to pay price premiums, particularly for commodity items, and this trend should continue beyond COVID. So how should grocery retailers plan for the post-COVID or recovery phase?
- For the more traditional banners, they must find ways to improve value perceptions by carefully balancing prices and quality perceptions. They no longer have the luxury of engaging in bad promotions or inefficient operations. It will be increasingly important to upgrade technology and leverage customer and operational data to make better decisions and improve efficiency. For years, CPGs have paid for shelf space and influenced what is on the shelf—at the retailer’s and customer’s expense. Retailers must leverage their customer data to understand what customers want—not what CPG’s want to sell. CPG payments may mean dollars in the retailer’s pocket in the short run but results in too much complexity and inefficiency at the shelf in the long run. This category management disconnect, coupled with poor price perceptions, are the key reasons why shoppers have been leaving traditional banners over the last decade.
- Current macro trends suggest that premium grocers are out of step with a large proportion of U.S. households. Moreover, traditional grocers have brought more premium, natural and organic products onto their shelves, and in many cases they are priced lower than in premium stores. The price premium was warranted in the 1990s with differentiated items and a superior store experience, but that does not appear to be the case today. The quality gap between premium and traditional has lessened, and shoppers are simply savvier when it comes to finding the quality they desire at the price they are willing to pay. As such, real estate and targeting these stores are more important than ever. Premium retailers will still have a strong presence in higher income markets, but it will be increasingly difficult for premium stores to compete against limited SKU value banners like Trader Joe’s, Costco and Sprouts or strong traditional banners such as Kroger, H-E-B and Market Basket in middle- and lower-income markets.
Eric Karlson is head of customer strategy, North America, for dunnhumby, a global customer data science company.
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