KROGER PROFIT 'TAKING IT ON THE CHIN'

JON SPRINGER

CINCINNATI -- Kroger here is investigating ways to further trim costs after reporting robust sales, but is "taking it on the chin on gross profit," David Dillon, chief executive officer, told analysts in a conference call last week.

Kroger is three years into a strategic plan to grow sales by cutting its costs and lowering prices. Yet rising health care costs, combined with slow-to-no inflation, have prevented Kroger from cutting costs to a point where it could offset its margin investments as soon as it anticipated, Dillon said.

"I think we would have achieved that this year but for the fact that health and welfare costs saw such significant rises this year and last," Dillon said. "I think the story of the supermarket industry, and certainly the story of Kroger in the last couple of years, includes at least one chapter about the periods of deflation in terms of what our retails and margins were doing, overlaid on significant cost increases in health care that were impossible to avoid."

While Kroger has achieved some cost relief in the form of new labor contracts, "we have recently done a lot of work in our cost areas and, frankly, we see a lot of opportunity. So I'm optimistic we can bring our costs down over time, particularly in an environment where we can grow our sales," Dillon said. Total capital expenditures for 2004 will be between $1.7 billion and $1.8 billion, which is $200 million to $300 million less than Kroger anticipated, he added.

Kroger said total sales increased 5.9% to $12.9 billion, and same-store sales were up 3.2% (1.8% excluding fuel) for its fiscal third quarter ended Nov. 6. Gross margins of 25.16% fell by 67 basis points from the second quarter. While quarterly earnings of $142.7 million, or 19 cents a share, increased by 29.5%, they fell short of analyst estimates.

"While 19 cents falls well below our [26-cent] forecast, we view the overall results positively," Rob Campagnino, an analyst for Prudential Equity Group, New York, said in a research note. Prudential noted the quarterly sales increase was the highest since 2000 and indicates Kroger is ahead of competitors in that regard. "We expect to see Kroger's peers playing catch-up for at least a few quarters," Campagnino said.

Tight margins in gasoline during the quarter had the largest effect on Kroger's overall gross margins, Dillon said, but the company also made investments in profit to spark sales.

Dillon said he was pleased with sales growth during the quarter, given a competitive sales environment and cautious consumers. "You don't hear me say I'm pleased with sales very often because that's what we keep pushing ourselves on," he said. "Sales have been hard to get." He added Kroger's full-year goal of 1.3% comp growth, excluding fuel and stores affected by the labor dispute, will be "challenging."

Jason Whitmer, research analyst for FTN Midwest Securities, Cleveland, told SN he felt Kroger is on the right track but does not expect better results until it can reduce costs further.

"Kroger understands the business, and they were among the first in the industry to realize they had to lower their costs so they could lower their prices, and that's something that companies small, medium and large are doing now," he said. "But they're not there yet; and until more cost savings materialize, like Dave Dillon said, they'll be taking it on the chin."

Kroger also said it is evaluating whether to take an impairment charge for goodwill at its Ralphs division, which is still recovering from effects of the 141-day strike-lockout, which began last November.

Dillon noted that sales in Southern California as compared to the same period in 2002 were down by less than 1%, improved upon the comparison between this year's second quarter with 2002's second quarter, and accounted for one-tenth of the chain's comp increase. However, he noted those sales overall comprised an increase in Food 4 Less and a decrease in Ralphs, and that profits were lower in the third quarter than in the second quarter. Kroger compared the sales to 2002 because 2003 results were affected by the strike. "The market was a little more promotional. People were reaching for sales and trying to hold onto sales they gained during the strike," Dillon said.

Asked whether the possibility of a write-off rendered the labor dispute a "failure," Rodney McMullen, Kroger's vice chairman, said: "Any inference of a goodwill write-down would not be any kind of a reflection on whether the strike was a success or a failure because we wouldn't characterize that way."

In other issues addressed at the conference call, Dillon said Kroger had added 450 new items to its private-label assortment during the quarter, helping private-label sales account for 24% of dollar sales and nearly 32% of units sold.

For the nine-month period, Kroger sales were up 4.9% to $42.7 billion, while net income decreased 16% to $548 million.

3RD-QUARTER RESULTS

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

Sales: $12.9 billion; $12.1 billion

Change: 5.9%

Comp-store: 3.2%

Net Income: $142.7 million; $110.2 million

Change: 29.5%

Inc/Share: 19 cents; 15 cents

9 Months: 2004; 2003

Sales: $42.7 billion; $40.8 billion

Change: 4.9%

Net Income: $548 million; $652 million

Change: -16%

Inc/Share: 73 cents; 86 cents