KROGER: GROSS MARGIN INVESTMENTS TO HURT 2004 PROFITS

DAVID GHITELMAN

CINCINNATI -- Kroger Co. here said last week it intends to stick with its two-year-old strategy of investing gross margin to build sales, with the expected result being lower profits in 2004.

The company noted that this strategy excludes any lingering effects from the recently concluded Southern California strike-lockout.

At the same time, Kroger noted that the labor dispute will continue to impact its financial performance to such an extent that it could not offer guidance more specific than that of lower profits.

During a conference call with industry analysts to discuss results for the fourth quarter and fiscal year ended Jan. 31, Dave Dillon, Kroger's chief executive officer, explained that the company could give no additional guidance for the current fiscal year because of "inherent uncertainties" in the ultimate cost of the Southern California labor dispute, the time and investment needed to rebuild the business, and the funds necessary for continued "profitable sales growth."

Analysts told SN the prediction of lower profits was not expected by investors, but did not necessarily invalidate the company's strategic direction.

Andrew Wolf, an equity analyst at BB&T Capital Markets, Richmond, Va., said, "The announcement took the market by surprise. People had hoped that this would be the year when earnings would finally be up.

"But to Kroger's credit, they are generating sales momentum. Their strategy is not futile, but it has a price, and the price in 2003 was lowered earnings, and the price in 2004 will be lowered earnings."

Wolf noted that even excluding the effects of labor disputes and a variety of one-time charges, earnings were down 10% in the fourth quarter and the fiscal year.

Mark Wiltamuth, an equity analyst at Morgan Stanley, New York, predicted Kroger's margin will shrink still more. "I expect gross margin to continue to contract as Kroger makes further tactical price sacrifices and as discounting commences in the Southern California market," he said. "I believe the wave of discounting has already begun."

Kroger said the cost of the two labor disputes it was involved in during the fourth quarter -- the Southern California strike-lockout, which spanned the entire quarter; and a 36-week work stoppage in a tri-state region centered in West Virginia -- reduced its fourth-quarter earnings by $156.4 million after-tax. The company noted that 95% of this cost was a result of the Southern California dispute.

However, Kroger said the improved labor agreements that emerged from these disputes would benefit the company. "In Southern California, we expect that our fully loaded costs per labor hour over the term of this new contract will be lower than in the previous contract," Dillon said. "These contract changes were essential to improve the competitiveness of our cost structure in this market."

Wiltamuth said these benefits will not be immediate. He explained that the settlement calls for a two-tier wage/benefit system, in which existing employees will retain most of their benefits, but new hires "will receive lower starting pay, progress to a lower top rate at a slower pace, and receive less generous benefits."

He added, "As the cost savings will be primarily derived from the lower tier benefit packages for new hires, I see limited near-term improvements and believe it will take a number of years before the benefits of the negotiation will be fully felt by Kroger."

In the quarter, the company also reported a $444 million write-down in goodwill for its Salt Lake City-based Smith's Food and Drug subsidiary.

During the call, Rodney McMullen, Kroger's vice chairman, said, "The markets that Smith's operates in are very competitive, and have been made even more competitive by supercenters as they have grown."

The write-down lowered Smith's book value from approximately $600 million to roughly $150 million, according to Mike Schlotman, Kroger's senior vice president and chief financial officer.

Analyst Wolf said the write-down means Kroger "paid too much" for Smith's, at least in terms of Smith's current cash flow. Kroger acquired Smith's as part of its 1999 purchase of Fred Meyer Inc., Portland, Ore.

Kroger also said it took a $75 million after-tax asset write-down on 74 underperforming stores. McMullen noted that "some of these stores are likely to close in 2004."

Wiltamuth observed that both of these show how competitive the supermarket industry has become. "I believe both of these impairment charges are only further evidence of the difficult operating environment," he said.

4th-Quarter Results

Qtr Ended: 1/31/04; 2/1/03

Sales: $9.6 billion; $9.1 billion

Change: 4.5%

Comp-store: 2.3%

Net Income: ($337.4 million); $381 million

Inc/Share: (45 cents); (50 cents)

52 Weeks: 2003; 2002

Sales: $53.8 billion; $51.8 billion

Change: 3.4%

Comp-store: NA

Net Income: $314.6 million; $1.2 billion

Change: -73.9%

Inc/Share: 42 cents; $1.52