KROGER'S PROFITS PLUNGE AFTER 'OVER-PROMOTION' 2004-09-20 (1)

ELLIOT ZWIEBACH

CINCINNATI -- Kroger here said last week it would continue to promote heavily if market conditions warrant doing so after the company reported a sharp drop in profitability in the second quarter due to aggressive competition in some markets.

Part of Kroger's strategy is "to be more competitive on price," said David Dillon, chairman and chief executive officer. This will reduce gross margin trends "somewhat downward."

"Looking ahead to the second half, we expect the decline in gross margin to be less than in the second quarter, but individual market competitiveness will ultimately determine that," he said in a conference call discussing results for the 12-week second quarter ended Aug. 14.

Analysts contacted by SN said they were pleasantly surprised by the company's 5.1% sales increase during the quarter that generally exceeded expectations, but were disappointed by a 25.2% drop in net earnings that was partly the result of the heavy investment in pricing.

"Kroger is trying to argue that the gross margin declines were the result of over-promotion in a couple of markets, but the depth and breadth of those declines were much greater than anticipated," Jason Whitmer, an analyst with Midwest Research, Cleveland, pointed out.

"About half the decline probably came from Southern California, which is not surprising, but a lot of the weakness on the margin line most likely came from activities in Colorado, Texas and possibly the Pacific Northwest -- every place where Kroger bumps into Albertsons and Safeway.

"Albertsons' management has said margin pressures should be less problematic in the second half. Safeway has already backed off. Now Kroger is saying it doesn't expect the same degree of promotional efforts in the second half. So I expect the next few quarters to get better.

"But it's all a reflection of an inability by the chains to find the right balance between sales and margins, and obviously none has found it yet."

Mark Wiltamuth, an analyst with Morgan Stanley, New York, said he does not anticipate any let-up in pricing pressures. "While margin investment may moderate somewhat in the third quarter, the sluggish retail environment and continued efforts to win back lost sales in the strike-damaged Southern California market will keep Kroger on its current price-reduction path," he said.

"Until the drumbeat of price reduction ends, investors will continue to face the risk of downward earnings reductions."

Steve Chick, an analyst with JP Morgan Securities, New York, said Kroger's strategy of boosting sales at the expense of near-term profits is "likely the best for the long run for market share and long-term viability."

"Nonetheless, gross profit investments in the end mean selling food products at lower levels of profitability, [which] is what traditional food retail private companies do. With lower costs of capital, some appear to be successful."

Kroger's decision to contract margins did produce better sales, Chick admitted, "[but] incrementally, sales were costly."

According to Rob Campagnino, an analyst with Prudential Equity Group, Boston, the margin deterioration at Kroger resulting from price investment meant "strong top-line results did not reach the bottom line, as Kroger struggles to find the right balance in terms of pricing relative to competitors."

The economic outlook does not suggest an easy answer is likely to materialize anytime soon, he added. "Given the company's results and recent economic data, there is very little good news on an industry level. Competition remains tough, and there doesn't seem to be any help from slightly better employment numbers.

"Basically, improvements in the economic environment that would benefit conventional supermarkets do not appear to be materializing. Though if trends were to improve, Kroger appears to be in many ways best positioned to take advantage," Campagnino said.

Speaking with analysts during the conference call, Dillon acknowledged the company has not been precise in projecting margins. "We said margin in the first quarter was a little higher than what we had expected because we were a little slower getting our plans in place than we had planned. In the second quarter, our margins were a little bit lower than what we had expected."

Gross margin fell from 26.39% in the first quarter to 25.21% in the second, the company said. Excluding fuel and stores in Southern California, which are recovering from a 141-day strike, the decline was 60 basis points, he pointed out.

"We do think we over-invested just a little bit in the quarter," Dillon said, "and I don't want to create the impression that there's lots more of that to come because that's certainly not our current intent. Ultimately, it's up to what happens in the competitive markets that we operate in that will determine where we end up."

That's not something Kroger can always predict, he added.

"We're dealing with individual markets, and we don't always know before the fact when an investment is going to be prudent or produce value," Dillon explained.

"We're saying there was some over-investment in the [second] quarter. But at the time we made it, we didn't think it was an over-investment or else we wouldn't have made it. But that's Monday-morning quarterbacking. Looking back, it wasn't a good use of money.

"But we had a couple of markets that were pretty competitive, and in that environment we found we spent some money for which we don't have a lot to show, which sometimes happens.

"Some [analysts] have said we have some examples of over-investment every few quarters. But each is different and, I think, a little less significant than some of the ones we've had in the past, and I believe we've actually gotten a little better and learned something each time."

Financial results for the 12-week second quarter showed net income down 25.2% to $142.4 million -- a decline the company said was due in part to recovery costs of $23.4 million, or 3 cents a share, from the labor dispute in Southern California, and a premium of $15.3 million, or 2 cents per share, paid on early redemption of the chain's $750 million 7-3/8% notes due in March 2005.

Sales for the quarter rose 5.1% to $13 billion, and identical-store sales, excluding fuel, rose 0.6%; IDs excluding fuel and stores affected by the Southern California labor dispute increased 1.1%.

For the first half, net income fell 25.2% to $405.3 million, including a total of $110.3 million, or 15 cents per share, for recovery costs in Southern California and the redemption premium, and sales climbed 4.4% to $29.9 billion.

Dillon said Kroger would not achieve its full-year ID target of 1.3%, exclusive of fuel and stores affected by the dispute.

In other comments during the conference call:

Dillon said Kroger hopes to drive sales in the future by investing labor savings from reduced health care costs. To date, however, it hasn't been able to invest those savings "[because] our labor costs were not competitive in markets when you compare them to all the other places people buy the same products we sell. But as those costs get more competitive, it's our intent that our pricing and other sales initiatives will become more competitive as well," he explained.

Asked how Kroger assesses customer price perceptions of its stores, Dillon said, "It's probably more intuitive than anything else, but the best measurement actually comes from the kind of response we get to sales in markets where we have changed pricing, and what response we get on individual items. We are in the process of evaluating that.

"I think some of our sales improvement is clearly the result of some of our pricing strategies. As for how long those perceptions typically take [to develop], it doesn't take very long to lose a [positive] price perception, but it takes quite a long time to actually build one.

"If all we wanted to do is drive some simple sales burst, we could do that by being much more promotional. But we are attempting to get to a price level where we can afford to stay and to push and to capture the loyalty of customers over time and have them recognize that we are the place to shop for a lot of reasons, not just price.

"This is not just about price. It's about sales initiatives that include price, but also include investment in training and capital and other areas."

Dillon said he believes Kroger has come "a long way on the journey" to narrowing the price gap with discounters, "but we still have a ways to travel. And some of the ways to travel in the future will come from savings we find from [reductions in] benefits or labor or other operating, general and administrative expenses or on total costs.

"We look at total costs, which include advertising, logistics and shrink, along with OG&A costs, as the ticket to be able to narrow that gap further and further. We have made the first cut, and as we look at comparing our prices to everyone who sells similar products, we clearly have made progress."

Kroger is moving ahead slowly with expansion of its Marketplace stores, Dillon said, "[because] we want to make sure it is successful and know for sure that we have our plan together."

The company operates 17 Fry's Marketplace stores in Phoenix and five Smith's Marketplace units in Salt Lake City, with plans for three Kroger Marketplace locations in Columbus, Ohio, "and we are working on some additional sites," Dillon said.