Kroger's Margins Get Boost From Inflation

ELLIOT ZWIEBACH

CINCINNATI — With inflation in core grocery “at a level not seen in several years” during the second quarter, and with more of the same anticipated in the third quarter, Kroger Co. here said last week it will continue to pass through higher product costs to ease pressures on gross margins.

In a conference call with analysts discussing its results for the second quarter, in which sales and profits surged, the company said inflation was 2.6% during the period, compared with 2% during the first quarter.

Analysts said last week they doubt Kroger will be able to sustain gross margin gains during the rest of the year, though stronger sales of perishables and private-label products could help strengthen earnings.

Asked what impact ongoing inflation may have on margins through the rest of the year, David Dillon, chairman and chief executive officer, said, “You may see some unusual fluctuations in margins at different times, depending on what happens with inflation, in what items it occurs and what the market conditions are.

“Mostly, what we are trying to do is make sure [investors] understand not to expect growing gross margins. Based on what we know today, the third quarter looks like it will be similar to where we've been in the second quarter in terms of product cost increases, primarily in dry grocery.”

Rodney McMullen, Kroger vice chairman, told analysts during the call that the chain will continue to make strategic price investments.

Kroger said its second-quarter gross margin increased 47 basis points to 23.94% of sales, with 23 basis points attributable to lower costs in shrink, distribution and advertising. It was the chain's first gross margin increase since the second quarter of 2002.

Kroger made a strategic decision during the first quarter of the year not to reflect all inflationary costs in retail prices immediately, he said, “[but] second-quarter market conditions allowed for a general pass-through of cost increases.”

Net income for the quarter rose 27.9% to $267.3 million on sales gains of 6.6% to $16.1 billion and identical- store sales growth, excluding fuel, of 5.1%. For the half, net income increased 17.2% to $603.8 million, with sales climbing 6.7% to $36.9 billion and ID sales, excluding fuel, up 5.1%.

Dillon said ID sales were positive in all regions, “and certainly inflation in the quarter caused or helped our IDs to be more positive than they otherwise would have been.”

With performance through the first half exceeding its expectations, Kroger said it was raising corporate guidance on annual sales and earnings, with ID sales anticipated in the range of 4%-5% and earnings per share of $1.64-$1.67, up 12%-14% from the previous range of $1.60-$1.65.

Beyond 2007, the company said it expects to grow ID sales by 3%-5%, excluding fuel sales, with slightly improving operating margins.

John Heinbockel, an analyst with Goldman Sachs, New York, said the strength in Kroger's earnings “puts to rest the food inflation concerns its first-quarter results had spawned. The notion that food inflation is bearish for [supermarket] gross margins has been dispelled, [though] there was never a question that cost increases would be fully passed to the consumer within months and render any margin pressure short-lived.

“However, that does not mean food retailers are out of the woods in terms of inflation's impact on demand,” he pointed out. If consumers come under greater pressure, “[Kroger] will probably increase its price investments in the second half of the year, [leading to] a return to flattish gross margins over the next few quarters, along with a moderation in comp momentum.”

Perry Caicco, an analyst with CIBC World Markets, Toronto, also said he doubts Kroger will be able to boost gross margins going forward, “though third-quarter gross margins may be at least flat [in comparison to] last year [and] are forecasted to still decline in the fourth quarter.”

He said margin investments are moderating as the sales mix shifts to perishables and private label. “But if, in any quarter, management feels its competitive position has eroded, it will come back with guns blazing,” Caicco said.

According to Meredith Adler, an analyst with Lehman Brothers, New York, while some investors may view Kroger's gross margin investment as incremental to its other pricing initiatives, “we see a lag in raising prices as one part of Kroger's entire effort to improve its price image in many markets. That's why management indicated it was best to look at the first and second quarters together, with combined selling gross margin down 11 basis points in the first half, [and that] is probably a reasonable expectation for the future.”

Deborah Weinswig, an analyst with Citigroup Global Markets, New York, said she expects selling gross margins to continue to be pressured as Kroger pursues its commitment to price investments. However, “private-label initiatives should offset some of the negative impact to gross margins expected from those investments,” she pointed out, and any pass-through due to higher food inflation “is a positive to top-line sales,” she added.

According to Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., one risk of rapid product-cost inflation is slowing sales growth, “[though] Kroger is [well-] positioned to generate decent earnings growth in the face of an economic downturn.”

Kroger faced a very lenient year-earlier comparison on gross margins — a contraction of 112 basis points, he pointed out — “[but] with gross margin comparisons more challenging in the second half, we do not anticipate more of the same,” Wolf said.