Kroger Eyes New Markets

NEW YORK — Declaring confidence in its momentum but fed up with a stagnating stock price, Kroger last week detailed a plan to boost its annual earnings growth in part by increasing capital spending and growing square footage in new and existing markets.

Speaking at an investor conference here, David Dillon, Kroger’s chairman and chief executive officer, said the company has raised its long-term, fully diluted earnings-per-share growth target from current levels of 6% to 8% to a new goal of 8% to 11%. To support that growth, Kroger expects to increase capital spending by an incremental $200 million annually and increase its focus on improving its return on invested capital and on expanding gross margins.

Kroger has long resisted Wall Street’s calls to grow earnings more aggressively, preferring to invest in price and service — often at the cost of margin — as part of its “Customer First” strategy. Dillon last week said that discipline has produced its intended results for Kroger’s shoppers and employees — and built a foundation for a growth profile more attractive to investors.

“We’re ecstatic about how well our associates have done and the job they’ve done in connecting with our customers, but we’re not happy about our stock price,” Dillon said. “And our conclusion was that we weren’t stepping out intentionally and growing our business in a way that produced shareholder value, and that was holding us back.

“We decided that we have to be counted on, we decided that if you’re ever going to believe that our stock price deserves to be rewarded, we have to step out and say, ‘We can do this,’” he added. “This is not based on wishing and hoping, it is based on our track record, the last three years in particular, but I’d argue the last 10 years show what we are capable of doing. We’re stepping out today to be counted.”

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Kroger’s stock, languishing for years despite consistent sales and market share gains that paced the industry, saw an immediate bump concurrent with the news.

“This is the culmination of a little more than 10 years of work and the Customer First strategy,” Andrew Wolf (pictured left), an analyst at BB&T Capital Markets, Richmond, Va., told SN. “Since taking those first steps in 2001, they’ve really become confident enough and the evidence is definitely there that they are a strong enough company to grow.”

“Management’s confidence in its ability to grow margins and returns while nudging up investment spending were noteworthy,” Scott Mushkin, an analyst at Jefferies & Co., said in a research note. “The company has clearly been a significant share gainer over the last several years, but returns and EBITDA generation have lagged.”

Kroger officials said they would track progress toward earnings goals quarterly by emphasizing return on invested capital as well as non-fuel identical-store sales and gross margin figures. Michael Schlotman, Kroger’s chief financial officer, said the company intends for margins to increase “slightly” over time. “It’s not going to double,” he said. “It’s not going to go up 100 basis points in any particular year. Slightly is slightly.”

According to Wolf, Kroger since beginning its program of price and service investments has won enough credibility with shoppers — and an edge on conventional competitors — to ease up on price aggressiveness.

“If you don’t have to invest as much price on the margin, then your margins are going to grow up,” Wolf said. “If they’ve been investing 25 basis points in price the last three years, now maybe they only invest 15. Guess what? The margins are going to go up.”

A 10% annual increase in capital spending beginning in fiscal 2013 — or $200 million in new spending — will fund a program of new-store development in existing markets and expansion to “one or two” new major markets in coming years, officials said.

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Investments in existing markets will focus on those where Kroger has the most room to grow — particularly those where its current market share is less than 21% — said Rodney McMullen, Kroger’s chief operating officer. He said Kroger is currently evaluating potential expansion markets, saying only that the company would expand where it could use existing distribution infrastructure and would likely enter using its Marketplace supercenter format, which will help establish a strong value image.

John Heinbockel, an analyst for Guggenheim Securities, in a research note last week said expansion behind Marketplace stores would be more “psychologically significant” than financially significant in the early years because it sends a signal that Kroger is prepared to battle Wal-Mart more directly than ever before while opening up opportunities for higher profits.

“Not only does this represent incremental growth off a healthy base, but there is potential for substantial growth in high-margin categories where the company’s market share is tiny,” Heinbockel said. “It is a reverse supercenter — it can be argued Kroger can do general merchandise at least as well as Wal-Mart does food, given [Kroger’s] Fred Meyer expertise, and it can price general merchandise aggressively since it is a completely incremental business.”