KROGER SEEKS SALES GROWTH WITHOUT MARGIN SACRIFICE

CINCINNATI -- Kroger here said last week it expects to emphasize non-price initiatives to build sales this year as part of an effort to halt overly aggressive pricing investments that hammered the company's margins in 2004.

Kroger said its gross margins fell to 25.08% for the fiscal year ended Jan. 29, compared with 26.43% in the prior year. This is a decline of 135 basis points, which was double the investment it had anticipated. The company reported a loss of $128 million for 2004 after taking a fourth-quarter goodwill write-down of $884 million for its Southern California operations, compared with net income in the prior year of $314.6 million.

Analysts contacted by SN said Kroger's decision to concentrate on non-price initiatives to control margins should help, with several noting ongoing concerns with the chain's margin levels for the last few years.

David Dillon, chairman and chief executive officer, said Kroger is committed to keeping gross margin investments under better control this year.

Speaking with supermarket analysts to discuss financial results for the year, Dillon said, "We obviously achieved sales benefits for the price of investment, but the cost of that investment was higher than it should be or needs to be. We should have been able to achieve the same sales growth without that kind of a gross investment." He added, "Our intent this year is to prove that point. We are really focused hard on non-price initiatives to improve sales and take some of that pressure off margins."

Among those initiatives, he said, are better in-stock conditions and picking the right items to put out for sale.

Dillon said other factors contributed to last year's gross margin declines, including inflation in some commodities, particularly cheese and meat; merchandising for the New Year's holiday that "wasn't as good as it might have been"; and pricing decisions, "which I wouldn't characterize as just local decisions. Some of it has to do with decisions we made in a coordinated fashion, and either didn't recognize what the cost would be, or didn't properly plan for it."

Mark Husson, New York-based managing director and global head of consumer research for HSBC Securities, London, questioned whether Kroger gives too much pricing autonomy to its divisions. "[Kroger has] coordinated buying, coordinated distribution. [Its] private brands [are] going in the right direction. [It has] a handle on shrinkage. The area that looks like it lost all the gross margin was the divisional presidents going out and spending it on price like sailors on shore leave. Sales did respond, but it sounds like [management] was surprised. This isn't the first quarter it's been surprised by that gross margin hole."

Perry Caicco, an analyst with CIBC World Markets, Toronto, told SN he's puzzled by some of Kroger's pricing strategies.

"While Kroger is probably the best-positioned grocery company against alternative formats, it keeps talking about investing more deeply in gross margins than it intended, which begs the question: Does it really have an overall pricing strategy, or is management abdicating that responsibility to the division level? The bigger question is: Once pricing investments have been made, is there strong corporate control by market? It's beginning to look like there isn't -- that pricing is a more decentralized, less sophisticated process."

Besides the non-price initiatives Dillon mentioned to control margins, Caicco suggested Kroger could pursue a bigger push on perishables, "which alternative formats cannot match," or place more emphasis on private label.

Steve Chick, an analyst with JP Morgan, New York, said margin investment is necessary to drive sales. "Ultimately, lower pricing has meant that chains simply sell items at lower gross profit dollars per unit," he said. "While this creates a detrimental effect to bottom-line earnings, it is necessary for traditional food retailers to regain competitive traction and drive sales dollars, as a private company would."

Chuck Cerankosky, an analyst with KeyBanc Capital Markets, Cleveland, told SN he believes Kroger can get a better handle on gross margins "by looking to increase the amount each customer spends. As long as it has the bodies in the stores, it should be able to get people not only to grab promotional merchandise, but also to add more items to their carts, or occasionally trade up in a category.

"It's hard to say if Kroger has been lax in pursuing those kinds of opportunities, or if it has an out-of-stock problem. But it is pursuing stronger customer relationships, making better use of point-of-sale data," Cerankosky noted. "It has a great array of store formats serving a variety of demographics that should make it possible to offer a product mix that complements margins. Improvements in the U.S. economy are on its side as well."

Dillon said Ralphs and Food 4 Less have confronted "promotional battles, store conditions, personnel changes and morale issues," with the result that sales in Southern California are not yet back to the levels they were before the 20-week strike that ended last March.

Sales for the year rose 4.9% to $56.4 billion. Sales for the quarter rose 5.1% to $13.7 billion, with a loss of $675.9 million, compared with a loss of $337.4 million a year ago.

For the quarter, comparable-store sales, excluding fuel and Southern California food stores, rose 2.3%. Identical-store sales at all food locations rose 0.8%, excluding fuel, and 1.9% excluding food stores in Southern California. With fuel included, ID's rose 2.1% at all food stores and 3.3% excluding Southern California.

4TH-QUARTER RESULTS

Qtr Ended: 1/29/05; 1/31/04

Sales: $13.7 billion; 13.0 billion

Change: 5.1%

Comp-store: 2.3*

Net Income: ($675.9 million); ($337.4 million)

Inc/Share: (93 cents); (45 cents)

52 Weeks: 2004; 2003

Sales: $56.4 billion; $53.8 billion

Change: 4.9%

Comp-store: Not available

Net Income: ($128 million); $314.6 million

Inc/Share: (17 cents); 42 cents

*Excluding Southern California food stores