Kroger: The Model For Competing With Wal-Mart And Target?

| About: Kroger Co. (KR)

Grocery giant Kroger (NYSE:KR) reported strong second quarter results, proving it is possible for a traditional retailer to do battle with Wal-Mart (NYSE:WMT) and Target (NYSE:TGT). Revenue increased 4.6% year-over-year to $22.7 billion, modestly exceeding consensus estimates. Earnings per share jumped 18% year-over-year to $0.60, a penny above consensus expectations. Free cash flow year-to-date was solid at $1.5 billion, equal to 2.9% of revenue.

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Source: Company Filings

As one can see from the chart shown above, Kroger has dramatically outperformed Safeway (NYSE:SWY) during the past two years as competition from the likes of Wal-Mart, Target, and Meijer has intensified. Kroger's same-store sales were 3.3% higher than a year ago (ex-fuel) in the second quarter (6.9% 2-year stacked comp), and management believes positive growth will continue going forward. CEO David Dillon added some commentary on the conference call, saying:

"And I think the most important fact that demonstrates that we believe this can continue for a very long time is the fact that roughly half of the business our best customers can give us, they are giving someplace else. And Rodney addressed that in his comments earlier. I think that's the best evidence. Now there's plenty of other evidence, too. Just the fact that we have 39 quarters in a row of positive identical sales illustrates that there continues to be room to grow. And so we think that the future is still bright and that we see very good opportunity to grow our market share ahead."

The 39 consecutive quarters of positive comps is incredible, in our view, especially since even Wal-Mart has dealt with negative comps in the U.S. Management believes the company's continued focus on price and product selection can help the firm win additional wallet share from its best customers-meaning it won't take a grandiose advertising campaign or drastic promotional activity to drive store traffic and additional business.

FIFO gross margins, which management contends is a better way of looking at the business than LIFO gross margins, declined just 11 basis points year-over-year to 20.46%. This decline is mostly attributable to the company lowering prices to maintain market share. Though it is never advisable to get into a price war with Wal-Mart, Kroger's strategy has clearly worked well over the past 10 years.

Kroger also did a great job of keeping operating, general, and administrative expenses constrained, with costs declining 17 basis points as a percentage of revenue on a year-over-year basis, excluding fuel. Though cost cutting hasn't been as consistent as comparable sales growth, it did mark the eighth consecutive quarter of cost leveraging-crucial for any grocer's success.

Looking ahead, Kroger raised the low-end of its fiscal year 2013 same-store sales growth guidance to 3%-3.5% from 2.5%-3.5%. However, the company maintained its full-year guidance of $2.73-$2.80 per share as margins will likely remain under pressure going forward.

Valuentum's Take

If your name isn't Whole Foods (NASDAQ:WFM), it can be incredibly difficult to be a grocery retailer. Competition is fierce, margins are thin, and consumers tend to not be all that loyal. Nevertheless, Kroger continues to demonstrate stronger performance than Safeway, Roundy's (NYSE:RNDY), and SuperValu (NYSE:SVU) by driving traffic and providing its stores with adequate capital investment. Though we aren't fans of Kroger as it trades above our fair value estimate, we think it has the best management team in the traditional grocery business.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.