For 25 years, the traditional supermarket has been sliding toward oblivion. Once responsible for almost two-thirds of food sales, its share in recent years has fallen to just above 50%. Busy consumers, more adventurous in their eating habits, have turned to the thousands of new restaurants that crowd city corners and suburban boulevards.

Now the battle for the American stomach is being joined. Led by small regional companies, supermarkets are building prepared-food sections and starting to make inroads. "The wake-up call has been heard," says Ron Paul, president of Technomic Inc., a Chicago-based food consultancy. Sales in the prepared-food section of supermarkets are likely to grow by about 7% in real terms this year, while the restaurant business will expand by just 2%, forecasts Technomic. Granted, supermarkets are starting from a much smaller base than restaurants, but even a small shift in spending is a big deal in the $700 billion food industry.

In 1998, supermarkets will not only have to win back old customers but also make more of a profit from those they have. Setting up new aisles filled with barbecued chicken and pasta primavera must be more than a loss leader. The new prepared-food sections, says David R. Sisk, head of Deloitte & Touche consulting group's food retail practice, "have created a lot of [traffic in stores] but often haven't helped the bottom line."

SEAT CHECK. And restaurants are not standing still--though they're not without problems. Chief among them is the massive buildup that started in the early 1990s. "There's more capacity coming into the market than the growth will accommodate," says Michael R. Quinlan, chief executive of McDonald's Corp., which just scaled back its U.S. expansion plans. Across the industry, restaurant seats will grow about 4% in 1998, while customer spending increases just 2%.

That's a recipe for further consolidation. The past two years have seen more than 300 mergers or acquisitions, and the number is likely to accelerate, says Everen Securities analyst Dean T. Haskell.

The survivors are likely to be chains that focus on taste--such as Papa John's International Inc., which caught pizza rivals off guard with its emphasis on ingredients rather than delivery time or discounts. In 1998, the fast-food behemoths will try to follow that lead and get away from their 99 cents sandwich discounts. Already, a few large chains are testing higher prices.

Casual dining is likely to continue prospering, too--particularly chains with cheaper menus and those that combine entertainment and food. Walt Disney Co., for example, will expand its ESPN Grill theme restaurant beyond Orlando. But however the restaurant business grows, it now has to worry about competition from those formerly stodgy supermarkets.

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