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Challenging the Competition: Mega-mergers and Supply Chain Technology

Written By: Predrag Jakovljevic
Published On: April 19 2005

Market Impact

In the face of the mega-retail stores, like Wal-Mart and Target, some of America's oldest retailers have joined forces to remain competitive. Late 2004, Kmart Holding Corporation (NASDAQ:KMRT) and Sears, Roebuck and Co. (NASDAQ:S) signed a definitive agreement to merge. Following suit, Federated Department Stores, Inc. (NYSE:FD) and The May Department Stores Company (NYSE:MAY) announced February that they also entered into a merger agreement.

Part Two of the Retailers Join Forces for a "Make or Break" Attempt Their Competitive Landscape series.

On paper and in terms of numbers, these acquisitions look like idyllic marriages of convenience—they will, theoretically, create more powerful revenues players in the retail industry with their respective $55 and $30 billion (USD). Points of distribution and renowned proprietary home and apparel brands will be expanded and significant opportunities for improved scale and operating efficiencies will surely emerge. In the short term, by combining supply chains and aggregating their purchasing powers by, for example, consolidating shipments or leveraging volume deals with carriers, Sears and Kmart, estimates at least $300 million (USD) in savings. In theory, the merger could produce a new layer of competitive challenge to two undisputed mega-retailers, Wal-Mart and Target, by giving Sears Holdings a combined total of nearly 3,500 stores and by creating a service organization capable of a major expansion to serve the needs of existing Kmart and Sears customers.

The merger should generally enable the combined businesses of Sears and Kmart and of Federated and May, respectively, to produce higher profits or profit margins than any of these companies could achieve on their own. This may particularly be true for Kmart, for whom this merger is a virtue made out of necessity and likely the only way it could continue its long-term existence. While Kmart has improved its financial performance and operations since coming out of bankruptcy in 2003 to the point where it even become a buyer, it has not been able to distinguish itself from Wal-Mart and Target, not to mention an army of boutique specialty stores, catalog retailers, and Internet-based sellers. Without this merger, its stand-alone, long-term survival is difficult, at best.

The Kmart's conundrum has long been its inability to position itself clearly within the retail market. It was caught in a twilight zone between an extremely efficient low-cost retailer, Wal-Mart, and a fashion-oriented brand-name discounter, Target. At the same time, the company appeared to be oblivious to customers' voices of dissatisfaction as seen in its poor customer service, run-down stores, and indolent merchandising and outdated product lines.

Thus, Sears might provide a better corporate foundation, brand tradition, and more demand-driven growth strategy that can better leverage Kmart's extensive real estate assets more effectively in the highly competitive retail marketplace. Namely, the amalgamation might make the Sears and Kmart franchises stronger by accelerating Sears' much needed off-mall growth strategy by using existing, convenient Kmart locations.

As a proof of concept for the off-mall model, Sears is experiencing early positive results with three "grand" store formats. Instead of taking the time-consuming approach to assess a new site location and to build a store, Kmart's current store assets, distribution, and logistics infrastructure allows for a relatively immediate set of options that can be re-brand into Sears Grand and be broadened into new geographies. In fact, the idea for the merger was born during the recent sales transaction of several dozens stores between Sears and Kmart when they were independent.

Ultimately, the savings from the merger should certainly bolster Sears and Kmart's competitive strength, since their combined purchasing clout and streamlined supply chain capabilities is projected to result in $300 million (USD) of financial improvements. This may be cost equivalent to Target and somewhat improve costing against Wal-Mart. The volume of this combined portfolio can increased the opportunities for new private-label product development. According to some calculations, if improved process flows like stock availability, promotion planning, and price management are combined with (though not yet fully fleshed out) supply chain improvements, the combined entity could produce nearly $1 billion (USD) in cost and operational efficiencies. Still, these advantages, coupled with potential savings from workforce wages spiraling down across several industries, may reflect an emulation of Wal-Mart's practices rather than any sort of differentiation.

In the case of Federated and May, the cost efficiencies from their merger may not necessarily reverse the protracted decline in their department store sales, given its scale is much smaller than the behemoths like Wal-Mart and Home Depot. In fact, the merger might even increase the risk of brand equity erosion, given that in the future, their presence will no longer be as geographically dispersed, and that there will be a subsequent, reduced distinction between the stores' brand recognition.

This is Part Two of a three-part note.

Part One detailed the event summary.

Part Three will cover technology and make user recommendations.

Demographic Challenges

The Sears-Kmart merger should "beef up" their brand portfolios, since each will benefit from the other's distinctive merchandise assortment. On one hand, as Sears continues to fine-tune its merchandise strategy, successful product lines like the Kmart's Martha Stewart Everyday or Jaclyn Smith should become viable options to include in the Sears mix. Conversely, Kmart's remaining branded locations could see the introduction of longstanding Sears product lines, including Craftsman, Kenmore, or even the new Lands' End apparel products. Merchandising is to retailers what rosters of pitchers and hitters are to baseball sport clubs: the broader assortment of options should, in principle, allow each retailer to fine-tune products to the appropriate target customer demographics for each of the remaining product lines.

However, one should note that though Kmart and Sears are large retailers, they do sell to different groups of consumers— Sears sells mainly to married men in their late thirties and early forties who are looking for Craftsmen tools. Kmart targets largely senior citizens with lower incomes. This might impair future cross-selling. Moreover, Sears has not proven its proficiency with apparel. Its 2002 acquisition of Land's End, which pioneered the virtual fitting room back in 1999, has been poorly exploited.

The Land's End customer profile seemed to be a good fit with the demographics of buyers of Sears appliances and tools, and Sears attempted to use the preppy brand to lure well-off shoppers to its combined apparel and home appliances department stores. However, with apparel being a stocking nightmare with nearly a gazillion styles, sizes, and colors that completely change every three months or so (see Intentia: Stepping Out With Fashion and Style; Part One: Characteristics and Trends of the Fashion Industry), Sears often had meager selections at each locations, discouraging its middle-class clientele. Thus, the merger with Kmart provides both an opportunity and challenge of how Sears should handle the popular Land's End brand. However, one should note, that Sears may have already decided as there are early indications that it is seeking a buyer for the Land's End division .

In general, Sears Holding will have to force customers through a new learning curve with significant advertising campaigns to increase market share and customer loyalty to certain product brands. Customers will have to change their perception from discount mass merchandise stores to more upscale stores. However, Sears Holding will have to make sure that customers are not pressured by too aggressive sales associates trying to push the new retail image, because customers need to feel they are making informed decisions about their purchases. If not, customer loyalty may be compromised.

Developing a Competitive Strategy

Moreover, these potential benefits come with a number of significant "ifs and buts." The main question is whether Sears Holding can develop a successful, competitive strategy. At this stage, most consumers have different perceptions of merging parties. Kmart is still associated with low prices, boring store layouts, and mediocre services, while Sears, despite losing market share to equivalent general stores like Target, Lowe's or Kohl's, is synonymous with higher-quality merchandize and above-average customer service.

If Kmart is going to remain a mass discounter, how will it succeed in the long term if its prices remain even 15 percent higher than those of Wal-Mart? On the other hand, how will Sears, with its aura of a genuine North American retailer, differentiate from its competitors in terms of its product categories and the way its stores will be arranged, located, and stocked? In other words, the combined parties will have to figure out, first of all, what (or, if still diversified, in which ratio) they want to be. Do they want to be a mid-size retailer in the malls or a mega-store operator in the suburbs or rural areas? Once decided, they need to devise the merchandizing, pricing, payment, and other processes to back up their strategy.

The decisions the future Sears Holdings makes in the area of a coherent merchandizing strategy will not only have an impact on its future brand recognition, revenues, and margin, but also on the performance of its supply chain and downstream business processes. It must first figure out and then bring into line the capabilities and goals of merchandising, supply chain management (SCM), and its accompanying IT assets. It is expected that Sears Holdings will build its SCM capabilities around efficiency like Wal-Mart, but, for the sake of some differentiation, these competencies should also envelop speed and flexibility to compete with more versatile competitors.

Even if the two retailers merge their different corporate cultures, store formats, working procedures, and target demographics, perhaps the biggest challenge will be instilling a pervasive culture that embraces IT as an enabler.

Comparison to Wal-Mart

To see what the new entities will be up against, let us look at the undisputed retail leader—Wal-Mart, which is not just a ferocious competitor because of its size. As both Sears and Kmart have already painfully discovered, being huge is a short-lived advantage if one does not have the infrastructure and the intelligence to leverage it. When Sears opened its headquarters more than a century ago, it quickly became the nation's top retailer. Ironically, Kmart took Sears' title in the mid 1980s, only to surrender it to Wal-Mart a few years later. Though the combined Kmart-Sears endeavor will be much larger, giving it the ability to beat upon suppliers price-wise, it is a small comfort when Wal-Mart not only has the same means, but can do it better.

The problem with competing with Wal-Mart is that, besides being huge and relentless, it is amazingly smart. It is not just its constant "Always low prices. Always." hymn that has made Wal-Mart the top retailer. Wal-Mart first opened stores in places that no reputable national retail chain ever did. With its growth mostly being organic and not having bought a direct competitor in recent memory, Wal-Mart has a uniform culture. In fact, most of the same people are running the company today. It has created and maintained a way of life that does away with business process uncertainty and inefficiency. Moreover, in the commodity market, where Wal-Mart rules, the lowest-cost provider wins, and Wal-Mart tracks its expense-to-sales ratio meticulously.

Wal-Mart's well-known purchasing and supply chain operations extort price concessions from the largest suppliers. Its supply chain stretches back from thousands of stores all the way to littlest production facilities across Asia and the Americas. Most of this infrastructure is specified, supervised, and controlled, if not owned completely by the retailer. Its operations are crown examples of true and virtual vertical integration.

SCM and IT Are Key

In retail, Wal-Mart might be the best example of a company paying attention to its supply chain planning (SCM) and IT operations, and it shows. One only has to scrutinize how Wal-Mart introduces new technology to see its true attunement and strategic goals and objectives. Namely, any new technology must be with a view of lowering costs and improving customer service. Stock-outs must be reduced or eliminated. Once initially approved, every level of the organization that is effected by the new technology, from headquarters personnel to store associates, is responsible for testing it in a live, applied setting. If approved, the technology is standardized across the board and becomes compulsory.

Despite negative sentiments towards a bullying, giant company, its alleged labor practices, and arm-twisting of suppliers to outsource manufacturing to cheaper labor markets that are well outside of North America, Wal-Mart should at least be credited with embracing technology to optimize business processes within its supply chain. Its use of the waste-eliminating concepts of vendor managed inventory (VMI), cross-docking, direct shipment, and radio frequency identification (RFID) (see RFID—A New Technology Set to Explode?) are notable.

Consequently, Wal-Mart is the leader in global sourcing and in tracking demand and providing visibility to sales and inventory throughout its humongous supply chain. Systems are updated with the latest sales in fifteen minutes at the store level and within an hour back at the home office in Bentonville, Arkansas (US). The Wal-Mart organization is fanatically focused on reviewing and reacting to the latest sales trends with unmatched strictness, paying attention to details that often go to the granularity of the store to the SKU level.

Core Necessary Technology

So what technology is suffice to enable these complex processes? SCM can be definitely put at the core, given that the traditional model of "company versus company" competition has long been superseded by the "supply chain versus supply chain" model. SCM is defined by the APICS Dictionary, (11th edition) as

"The design, planning, execution, control, and monitoring of supply chain activities with the objective of creating net value, building a competitive infrastructure, leveraging worldwide logistics, synchronizing supply with demand, and measuring performance globally."

Although SCM software may look like a shipshape category on the charts of industry pundits', and one which has two subcategories of planning and execution, in reality, it is an unusual hodgepodge of packages from a variety of vendors. Few of these vendors are large and stable players that have a broad coverage of SCM. On the other hand, some leading retailers like Wal-Mart tend to not invest in packaged applications tailored to their needs, since it could take away their competitive edge. This further problematizes the already-complex SCM applications picture with many in-house legacy systems.

The foundation application of this system is advanced planning and scheduling (APS), which offers a mix of design and planning tools that use mathematical procedures to optimize the flow of goods across the supply chain. It generally includes separate planning modules for managing demand, distribution, production, material requirements, purchasing and fulfillment, all of which have some overlap with the modules of back-office enterprise resource planning (ERP) systems.

APS systems were originally designed as bolt-ons with the idea of plugging into an ERP system's database to download information and then create a feasible schedule within identified constraints, such as finite capacity. The new schedule can then be uploaded into the ERP system thereby replacing the original material requirements planning (MRP) results, which are based on infinite capacity. These APS systems typically offer simulation ("what if") capabilities that allow the planner to analyze the results of an action before committing to that action to ERP system. Some of these systems go even one step further by offering optimization capabilities. They automatically create multiple simulations and recommend changes in the supply chain within the existing constraints. For more information, see Advanced Planning and Scheduling: A Critical Part of Customer Fulfillment and Advanced Planning and Optimization Software: Myths, Facts, and User Perceptions).

Linking an APS system to an ERP system, although simple in principle, is nonetheless a major integration project. Further, APS is a subset of supply chain planning (SCP) applications that are designed to provide forward-looking options for the future, by sitting on top of a current transactional system (most often ERP) to provide planning scenario analysis capabilities and real-time demand commitments. SCP typically deals with activities such as developing demand forecasts, establishing relations with suppliers, planning and scheduling manufacturing operations, and developing metrics to ensure efficient and cost-effective operations. It also determines marketing channels, promotions, respective quantities and timing, inventory and replenishment policies, and production policies. Thus, the typical SCP modules includes network planning, capacity planning, demand planning, manufacturing planning and scheduling, and distribution and deployment planning.

Particularly important for retailers is warehouse management and fulfillment, which starts with traditional warehouse functions (such as receiving, put-away/stocking, picking, shipping, and cross-docking), but also includes non-traditional functions such as gift wrapping. Many retailers' warehouse operations are still designed for wholesale shipping to stores rather than retail-to-order picking and shipping. Therefore, retailers, especially those dealing with multiple channels, must either redesign their warehouse operations (and the IT systems that support them) or outsource the operation, as Wal-Mart has done with Fingerhut.

Other relevant applications include multimodule systems for managing customer relationships and supplier relationships, while there are also newer systems for monitoring the chain as a whole and responding to problems as they occur. In other words, at a high level, the SCM software scope can be segmented into SCP and supply chain execution (SCE). Strategic sourcing, procurement, spend management, supplier relationship management (SRM), and product lifecycle management (PLM) components are still considered the extension of the SCM rather than its constituents.

As supply chains become more dynamic and operate in near real-time, the lines between planning and execution continue to blur, which bodes well for their functional convergence. For a more extensive discussion of the integration of these systems, see Linking Planning and Execution Systems For Retailers' Nirvana Improved Visibility and Fulfillment.

Weakness of Wal-Mart System

Consequently, even Wal-Mart is not without drawbacks, and the company openly admits to being paranoid and watching carefully for the competition—not only from its fellow general merchandisers, but also from food and drug stores like Kroger, Walgreen, and Albertson's or specialty retailers like Amazon.com, Ann Taylor Stores, and Foot Locker. Indeed, while its supply chain visibility capabilities have driven industry-leading supply chain efficiencies, it still features a reactive process that cannot adequately anticipate any sales shortfall in the nick of time.

For example, for the recently finished holiday season, Wal-Mart surprised many by announcing that November's same-store sales barely increased (less than one percent) over last year. It was significantly below the 2 to 4 percent growth previously anticipated. More surprising was how self-inflicted the result was, given the decision by the giant to skimp on holiday discounts, which flew in the face of more aggressive competitors' actions, and outwitted Wal-Mart's early holiday season pricing strategy. Also the retailer failed to consider significantly higher energy costs, which have affected disposable income spending among the lower income consumers it relies upon.

Thus, one should expect that in the future, Wal-Mart will embrace pertinent predictive analytics combined with broader demand and market intelligence coming from suppliers, store employees, and consumer research. This should allow it to more proactively profile demand and squeeze out every available, profitable revenue dollar from consumers. For more information on modern technologies retailers might use, such as advanced retail planning that synchronizes merchandise management with demand, or more sophisticated retail life cycle pricing, see Retail Market Dynamics for Software Vendors.

Further, although Wal-Mart competes through supply-chain and IT mastery, it poorly caters to a growing market segment—the personalized, specialty markets, thus leaving these sizable, profitable, and budding opportunities for more agile competitors. Namely, Wal-Mart's efficiency requires uniformity, and thus, it cannot feasibly alter what and how to sell to customers as individuals. For instance, Wal-Mart's recreational, entertainment, and technology products are uniform, single-box commodity solutions, ready-to-go off the shelves. They are low-priced and are items with disputable quality or appeal. These are by no means the so-called "flexible-but-complicated system" solutions that need additional product information, programming assistance, technical support, accessories inventory, and install, repair, return options.

This concludes Part Two of a three-part note.

Part One detailed the event summary.

Part Three will cover technology and make user recommendations.

 
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