Kroger's Value Plan Retains Consumer Appeal

MARK HAMSTRA

CINCINNATI — Kroger Co. continued to leverage its strong value image to drive sales and profit growth amid consumer caution in the second quarter, the company said last week.

On the day after stock markets were battered by the news of the Lehman Bros. bankruptcy, Kroger's report of strong first-half results and an upbeat outlook for the rest of the year helped buoy its share price and gave analysts reason for optimism.

“A very impressive performance compared with virtually any other retailer,” said John Heinbockel, an analyst with Goldman Sachs, New York, citing the company's same-store sales growth of 4.7%, excluding fuel. “Investors have been very concerned about two things: decelerating sales momentum and gross margin pressure. Kroger sidestepped both of these concerns in the [second quarter.]”

In a conference call discussing the results, David Dillon, Kroger's chairman and chief executive officer, said the company saw the highest grocery-cost inflation — about 5%-6% — in the quarter since the late 1980s, but for the most part was able to pass along increases in the form of higher retail prices, while contracting profit margins somewhat. Produce inflation was in double digits, he said, and overall product-cost inflation was 4.9% in the quarter.

He also said the company saw indications of the economic pressures on consumers, including strong private-label volumes and increased sales at value-oriented stores, a trend that he said has emerged in the last four to six months.

“Both of these changes would suggest that some shoppers are looking for ways to stretch their budgets,” he said, noting that Kroger also seems to be benefiting from the trend toward at-home dining. “While customer behavior continues to change, we believe there's an opportunity for Kroger to gain share in this environment.”

Although same-store sales slowed somewhat in the latter weeks of the second quarter, which ended Aug. 16, Dillon said the trend reversed in the first four weeks of the third quarter, which saw same-store sales above 5%.

Consumers also seem to be eschewing some discretionary purchases, Dillon said, noting that sales in drug and general merchandise categories were flat for the period.

Dillon credited Kroger's expansive, three-tiered private-label program — offering more than 14,000 items — with providing alternatives for budget-conscious shoppers and for giving the company pricing leverage in negotiations with branded suppliers. Private label now accounts for 26% of dollar sales and 33% of unit sales. Interestingly, the company's high-end private label, Private Selection, saw the most growth in the quarter, Dillon said.

“A little bit more than half of the increase in [private-label] items sold in the quarter were our Private Selection and Private Selection Organic products, and those are not targeted at value customers particularly,” he said. “We're seeing customers across all income streams interested in that product, so it suggests that there are several things going on here in our improved corporate brand mix, and it's not just the economy. In fact, I would argue it's actually more the marketing efforts that we've applied to it, and some effect by the economy.”

As the company continued its strategy of investing in price, overall gross margins for the quarter were down 51 basis points excluding fuel, compared with the second quarter of a year ago. Kroger was able to reduce its operating, general and administrative expenses in the quarter, however, by 28 basis points excluding fuel, to 16.37% of sales. Year-ago OG&A expenses included about $8 million for pre-opening costs at acquired Scott's and Farmer Jack locations.

Net income for the second quarter rose 3.4%, to $276.5 million, on an 11.9% increase in sales, to $18 billion. Same-store sales including fuel rose 9.7%. Through the first half, net income rose nearly 10%, to $662.5 million, on an 11.7% rise in sales, to $41.2 billion.

Kroger also narrowed the range for its same-store sales outlook for the year to between 4.5% and 5.5%, excluding the impact of Hurricane Ike, compared with previous forecasts of 4% to 5.5%. It confirmed previous earnings guidance of $1.85-$1.90 per share.

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., said he believes Kroger is “better positioned to generate decent earnings growth in an economic downturn than at any time since we have known the company.

“In the current slow consumer environment, we believe that many large, well-run retailers have ramped up market share-seeking tactics at the expense of less well-positioned chains. If we are correct that the environment will continue to remain inhospitable, then Kroger's apparent strategy of trading some near-term profit growth for market-share gains is appropriate.”