Kroger Outlook Gloomy

JON SPRINGER

CINCINNATI — The sluggishly rebounding U.S. economy took its toll on Kroger Co. last week.

Stock in the retailer here fell more than 8% after the company said continued consumer caution led to lower margins in the third quarter, and that annual earnings would come in below the top end of previous guidance.

“Some say the Great Recession is technically over. For Kroger, it's not over until our customers say it is, and many of our customers continue to be cautious in their spending,” David Dillon, chairman and chief executive officer of Kroger, said in a conference call discussing results for the third quarter.

“Overall, the economic recovery is slower and weaker than we anticipated it would be at this point in the year,” he added. “Job growth remains elusive and fuel prices have risen. These factors affect consumer confidence and grocery budgets. Many of our customers remain cautious in their discretionary spending. We continue to manage our business with the expectation that this economic environment will persist through the end of fiscal year and throughout next year.”

Quarterly sales and earnings met analyst expectations, but a continued emphasis on sharp pricing and a subsequent decrease in margins helped to draw a negative reaction on Wall Street, analysts said. The stock sell-off followed a period of anticipatory buying that had raised prices near 52-week highs.

“The market was unrealistically optimistic going into results, so there was an expectation that earnings would be well ahead of consensus, there was an expectation that the comp would be better, there was an expectation that selling gross margin would be up,” Karen Short, an analyst for BMO Capital Markets, told SN. “There's been a lot of building momentum, and the chatter out there was unrealistic.”

Kroger narrowed its annual earnings guidance, to a range of $1.65 to $1.78 per share, vs. previous expectations of $1.60 to $1.80. “We're striving for a result in the upper half of this range,” Dillon noted.

Rodney McMullen, Kroger's president and chief operating officer, said Kroger experienced inflation in some perishable categories during the quarter, but deflation in dry grocery, driven in part by promotional spending by branded goods manufacturers. Kroger said it is passing along grocery price increases but has to be cautious of competition and other factors.

“We have every reason to believe CPG vendors want to increase their [prices],” Dillon said, “but very few of them are actually doing it.”

Much of the discussion in the conference call centered on volatility in Kroger's gross margin investment, with analysts noting a 13-basis-point reduction in selling gross margin in the third quarter vs. a 109-basis-point reduction in the same period a year ago. Michael Schlotman, Kroger's chief financial officer, said, the company desired a less “lumpy” pattern and would be comfortable with an investment in the 50- to 60-basis-point range, but he said Kroger was ultimately looking to increase operating margins over time.

“Some people seem to be appalled by the concept of a 40- to 60-basis-point average decline in selling gross margin,” Short noted. “But Kroger has never talked about their strategy with regard to selling gross margin; they've talked about strategy in terms of overall operating margin. And that strategy has not changed: Comps drive leverage and slight operating margin expansion in a normal environment. And that's still their goal.”