Kroger Bullish On Sales

CINCINNATI — In the wake of strong second-quarter results, Kroger Co. here is optimistic about sales for the rest of the year, Dave Dillon, chairman and chief executive officer, said here last week — a position with which several analysts said they agreed.

“Sales improvements have really been broad-based, in all senses and in every possible direction,” Dillon said. “Essentially all but one division had positive identical-store sales, and that one had flat sales.”

All store departments showed improvements in the number of units scanned at checkout, which is how the company measures tonnage.

“Plus, we had growth in total households, and growth in loyal households that was greater than the growth in total households,” Dillon said. “So from almost every vantage point I can think of, we're seeing really positive trends, and I'm very optimistic about the future.”

He made his remarks in a conference call with analysts to discuss financial results for the second quarter and first half, which ended Aug. 14.

Net income for the quarter rose 2.8% to $261.6 million, while sales were up 6% to $18.8 billion with fuel included and 3.3% excluding fuel. Identical-store sales, excluding fuel, increased 2.7%. For the half net income fell 5.3% to $635.3 million, while sales were up 7.5% to $43.6 billion with fuel included and 3.2% excluding fuel, and ID sales rose 2.6%.

Dillon said Kroger has seen the same kinds of ID sales growth through the first four weeks of the third quarter, “and we anticipate ID sales for the full year will be pretty much down the center of the 2% to 3% guidance we've given.”

Analysts were generally optimistic as well, though some were not sure it will be all smooth sailing ahead for Kroger.

Meredith Adler, senior research analyst for Barclays Capital, New York, said attributes Kroger's positive ID sales results to the chain's “long-running efforts to improve the value it provides to customers on price, service, selection and promotions, [which] are clearly paying off.”

She said she believes Kroger's second-half will be better than the first “[because] gross margin and earnings-per-share comparisons are very easy as Kroger was highly aggressive on price and promotion last year; and Wal-Mart, its single largest competitor, has said it is returning to its traditional EDLP merchandising approach, which will lead to an environment that is less intensively promotional and at times irrational.” (See Page 1 for more on Wal-Mart.)

In a report titled, “We Like What We See,” Scott Mushkin, managing director of Jefferies & Co., New York, said he believes there has been “a fundamental shift at Kroger — to grow market share but to now do so profitably” — a shift he said should lead to EBITDA growth that eclipses sales growth.

Andrew Wolf, managing director for BB&T Capital Markets, Richmond, Va., said he anticipates solid profit margin expansion for Kroger during the second half “[based] on our outlook for normalization of the operating environment.”

However, Karen Short, director with the New York office of BMO Capital Markets, Toronto, had a more guarded tone.

“Given ongoing cautionary comments [from Kroger] on the economy and competitive environment; no visibility on when or if we will see stable, broad-based inflation; and the sentiment-driven investing environment, [we see] strength in the business model [but] are less certain on the investment thesis on the stock.”

Mark Wiltamuth, executive director for Morgan Stanley, New York, said he believes Kroger will need comp sales to accelerate beyond 3% for the company to get operating leverage, “and given the difficult operating environment, we do not see sales accelerating.”

“While current ID sales excluding fuel of 2.7% are impressive vs. the negative comps being delivered by Safeway and Supervalu, the economy remains sluggish, the grocery backdrop remains promotional, and we believe it is hard to make the case for a sales acceleration from current levels.”

Although noting that selling gross margins fell 12 basis points in the second quarter, compared with a drop of 71 basis points in the first and 128 in last year's third quarter, Wiltamuth said, “[Kroger's] insistence on further price cuts will likely continue to hurt margins in the near term.”

During the conference call, one analyst suggested the increase in ID sales indicated Kroger was taking market share from competitors — a thesis Dillon said isn't that clear.

“We look at our ID sales not so much as taking market share from others as growing the share we have with our very best customers,” he explained. “If you look at traditional competitors and compare their ID sales with ours, the difference could simply be that we're growing our business by connecting better with what customers want today while they haven't connected quite as well.”

According to Dillon, overall product cost inflation, excluding fuel, was roughly 1% during the second quarter, despite deflation of 1.6%, excluding milk, in the grocery department, which he said he attributed primarily to increased promotional spending by vendors.

“Earlier in the year we expected grocery deflation to moderate, but it hasn't,” Dillon said.

While some investors view food inflation as a positive indicator and deflation as a negative indicator, “the experience in our grocery department illustrates why this relationship is not that simple,” Dillon added. “Gross profit dollars for groceries were higher this quarter, despite the deflationary trend.”

Q3 RESULTS