Megafoods Stores Inc.

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Megafoods Stores Inc.

1455 South Stapley Drive
Mesa, Arizona 85204
U.S.A.
(602) 926-1087
Fax: (602) 926-1237

Public Company
Incorporated: 1987
Employees: 3,500
Sales: $409 million
Stock Exchanges: New York
SICs: 5411 Grocery Stores

Megafoods Stores Inc. operates a chain of 50 grocery stores in Arizona, Nevada, and Texas. Following its inception in 1987, the company expanded at a rapid pace by catering to value-oriented shoppers. Its chain peaked at more than 70 stores before Megafoods filed for Chapter 11 protection from its creditors. The grocer was struggling to emerge from bankruptcy going into the mid-1990s.

Dean Miller founded Megafoods in 1987. Although he was only 30 at the time, Miller had more than 15 years of experience in the industry. In fact, both his father and grandfather had worked in the grocery business, and Miller himself had started to work at age 13 in the back room of a grocery store in Spokane, Washington. Miller gradually worked his way up to store manager before deciding to go into business for himself. At the age of 25, he opened a specialty food store, which developed into a chain of outlets in Lodi, California. After a few years, Miller sold this business and moved to Arizona, where he launched a few other grocery-related ventures before devising the Megafoods concept. Joined in the venture by Jack J. Walker, a 52-year-old associate of Miller’s with a background in real estate, Miller opened his first Megafoods store in Phoenix, Arizona, with about 50 employees.

Miller faced an uphill battle with his tiny Megafoods operation. He was entering a hyper-competitive industry which was dominated by giant regional and national grocers. Most of those organizations had either acquired or forced the mom-and-pop and local grocery store operators out of business years earlier. The big grocery chains, aside from having relatively easy access to investment capital, enjoyed wide economies of scale that helped them to keep costs low. For example, they had greater purchasing power over their suppliers than small grocers and they benefitted from efficiencies related to distribution and marketing. Although his venture was thinly financed, Miller believed that he could undercut his competitors and steal market share through savvy management and aggressive cost controls. His basic concept was to create an unusual hybrid grocery store that had the look and feel of a mainstream supermarket but sported warehouse prices.

During its first year of operation, Megafoods captured $33 million in sales and lost about a half million dollars. Despite this inauspicious start, Miller believed that his new concept was viable and he was eager to expand. Further, his financing problem was diminished by Fleming Foods West, a major regional grocery supplier. Besides financing and supplying much of the inventory for Megafoods, Fleming also provided loans to back the chain’s expansion, sometimes accepting ownership in the company as compensation. Drawing on Fleming’s resources as well as internally generated cash, Miller was able to add three new Megafoods stores to his burgeoning chain by the end of 1988. Megafoods’ revenues in that year jumped 52 percent to $50 million while net losses tripled to $1.5 million.

Still confident in his long-term strategy, Miller was unfazed by the 1988 losses. In fact, Megafoods doubled its number of stores to eight and grew its assets to more than $20 million during the next year. Revenues nearly doubled in 1989 and Megafoods netted income of $222,000, it first annual profit. With continued support from Fleming—Megafoods entered into an agreement ensuring that Fleming would be its primary supplier through 1997—Miller tapped cash flow to add six more stores to his growing chain during 1990. In that year, Megafoods’ receipts bolted to an impressive $180 million. Miller spent 1991 regrouping and enhancing his existing stores, although he did add one store to the chain. By 1991, Megafoods was operating 15 stores in Arizona and California. Sales soared to nearly $250 million as net income bounded to $627,000. Meanwhile, Megafoods executives were formulating an even more aggressive growth stratagem.

Megafoods’ expansion in the midst of heated competition and an economic downturn in the early 1990s was largely attributable to its unique discount strategy. For example, Megafoods offered the lowest prices in its service areas by monitoring competitors’ prices, feeding them into a computer on a weekly basis, and then adjusting its own prices accordingly. The overall pricing scheme, which Megafoods referred to as “price impact,” was designed to undercut supermarket competitors by an average of five percent. The company made sure that consumers were aware of the low prices by displaying pricing labels that compared the Megafoods’ price with the competitors’ prices. Furthermore, customers entering Megafoods’ stores were greeted by a “Wall of Values,” a wide aisleway stacked floor-to-ceiling with shipping cartons full of deeply discounted, national brand, “shocker” items. From there, shoppers entered into an area with bright, fully stocked shelves and produce counters which looked more like a typical supermarket. The effect was designed to reinforce the company’s advertising theme of “Shop Us Like a Supermarket. Save Like a Warehouse Club.”

While at the same time simulating the look and feel of supermarkets, Megafoods was able to achieve its low-cost advantage by utilizing certain warehouse tactics. For instance, the company carefully analyzed customer service activities to determine which were the most cost effective. In addition, Megafoods offered several inexpensive services not offered by the warehouse clubs, but did not provide others such as bagging groceries. The company also sustained an intense focus on analyzing and managing costs. For example, its warehouse configuration allowed Megafoods to construct new store building shells at capital costs approximately 20 percent lower than typical supermarkets. Likewise, labor costs were minimized by using a high-tech computerized time and attendance system that analyzed chain-wide productivity on a daily basis.

Megafoods also reduced costs by stocking a significant amount of prepackaged bulk merchandise, which eliminated in-store preparation costs on such products as baked goods and meats. Similarly, most goods were displayed on warehouse racking systems or in their shipping containers as a means of lowering costs related to double handling and back-room storage. In contrast to warehouse stores, Megafoods stocked a selection of goods roughly equivalent to the assortment stocked by mainstream supermarkets. Megafoods also differed from club warehouses in that its stores were conveniently located in highly visible shopping areas. The outlets were slightly smaller than warehouse stores, but larger than most supermarkets. In addition, Megafoods stores charged no membership fees and were open 24 hours, seven days a week. One result of Mega-foods’ overall strategy was that sales per employee-hour stood at nearly $150 in the early 1990s, compared to about $96 for the average supermarket chain.

With its recipe for success seemingly in place by 1991, Megafoods stepped up its expansion initiative in 1992. The company’s basic strategy was to boost market share in existing markets and to open new stores in areas where its price impact program would be most effective. To fund the growth effort, Miller took Megafoods public on the over-the-counter market in July of 1992. Another stock sale in December brought additional cash into Megafoods’ coffers. The grocery chain used that money to crack into the Las Vegas, Nevada, market with two new stores and to expand in Arizona for a year-end total of 22 outlets, a sum which included the closing of an unprofitable store in California. The Megafoods organization showed healthy growth in 1992, with sales of $292 million and net income of about $300,000. Contributing to this rising profit margin was an innovative venture initiated in one of Megafoods’ California stores: an in-store, take-out food court. Miller planned to implement the successful concept throughout the chain through agreements with Kentucky Fried Chicken, Pizza Hut, and Taco Bell.

Although Megafoods’ expansion and sales increases in the early 1990s seemed encouraging to many observers, the gains masked serious underlying problems. In fact, by 1992 Megafoods was in heavy debt to Fleming. While the chain used part of the money raised through public offerings to reduce the $10 million bill, Megafoods still owed Fleming well over $5 million going into 1993. For this and other reasons, the relationship between Miller and Fleming executives began to erode. Evidencing the friction was Miller’s effort during 1992 and 1993 to reduce Megafoods’ dependence on Fleming as a supplier. Although Megafoods had signed an agreement with Fleming to purchase more than 50 percent of its stock from them through 1997, Miller began to pursue a contract with Safeway that would significantly reduce Fleming’s role as a supplier. However, the contract was contingent on Fleming releasing Megafoods from their original agreement. In addition, Miller’s co-founder, Walker, was relieved of his duties as chief financial officer of Megafoods in August of 1992 when outside accusations arose regarding questionable business dealings. Ultimately, Miller denied that these accusations had anything to do with Walker’s demotion to senior vice-president in charge of real estate.

As Megafoods’ potential problems were becoming increasingly apparent in 1993, the company continued to push its program for rapid expansion. Indeed, Megafoods outpaced even its own 1992 growth projections, taking over 15 Kroger stores in San Antonio, Texas. Megafoods remodeled the stores and partially converted them to its warehouse format and operated the refurbished outlets under the name “Texans’ Supermarkets.” Megafoods also added new stores in California, Nevada, and Arizona. By the end of 1993, Megafoods was boasting a chain of 46 stores spread throughout the southwestern region of the United States. The huge expansion boosted Megafoods’ work force from 1,950 people in 1992 to more than 5,000 employees, most of whom had to be trained quickly in order to work within the Megafoods organization.

While the 1993 store additions rocketed Megafoods’ revenues past $400 million for that year, the company began to show signs that it had overextended itself with acquisitions. In particular, the Kroger buyout proved to be a poor strategic move in that inadequate market research and unexpected competitive response in San Antonio, among other factors, stifled the cash flow that the Megafoods executives were counting on from the deal. To cut costs, Megafoods began pressuring Fleming to renegotiate their supply contract while at the same time reaching a tentative agreement with Safeway to begin buying more than 50 percent of its stock from the supplier. Armed with the Safeway agreement, Megafoods gave Fleming three months to come to terms with them or risk termination of the Megafoods/Fleming contract. While Fleming eventually backed down and agreed to renegotiate the contract, the supplier was less than overjoyed with Megafoods’ tactics.

Although Megafoods posted a staggering $19.5 million net loss in 1993, Miller optimistically attributed the sharp decline to temporary setbacks related to the Kroger acquisition and to various one-time costs related to overall expansion expenditures. In the Megafoods annual report, Miller insisted that the losses were the result of an investment in the company’s long-term profitability and he urged Megafoods to expand even more aggressively in 1994. In April of that year, Megafoods assumed control of 28 Handy Andy stores in San Antonio. Subsequent acquisitions during the next few months boosted the total number of Megafoods outlets to 71. Even before the Handy Andy takeover was finalized, however, critics were beginning to question Miller’s acquisition strategy. “I think its a bad time for Megafoods to be buying anything,” related one analyst in the April 8, 1994, Arizona Republic.

By late 1994, the Megafoods chain had become so unwieldy that profit margins slipped sharply, the 36-store San Antonio operation noticeably languished, and Megafoods experienced severe cash flow problems. Importantly, the long-running dispute with Fleming came to a head in mid-1994 when Fleming charged that Megafoods was failing to live up to the terms of their contract. Incensed, Fleming’s CEO Bob Stauth verbally condemned Miller and Megafoods in a public statement, saying “I don’t want your business.” Fleming threatened to halt shipments to the company, but Megafoods finally reached a tentative truce with the supplier by promising to pay cash for all deliveries. This resolution was of little comfort to either party, however; two days later, on August 17, Megafoods announced that it was filing for Chapter 11 bankruptcy.

When Megafoods filed for bankruptcy protection from its creditors, it was operating 71 stores in four states and employing a work force of about 5,500. During the next few months, Megafoods executives and directors labored to cut costs and maximize the value of their assets. By November, the Megafoods chain had been pared down to 58 stores and the number of employees on the payroll had been cut to 4,400. Following meetings in which shareholders expressed their displeasure with existing management, both Walker and Miller announced their resignations. By February of 1995, the company was employing 3,500 people and operating 50 stores in Arizona, Nevada, and Texas, having shut down all California operations. Under new management, Megafoods was laboring to develop an official plan of reorganization which would allow the company to pay off its debts and emerge from bankruptcy.