Kroger's Solid Second Quarter Not Enough to Squelch Wal-Mart Fears

 |  Includes: KR, SWY, WMT
by: Mark Krieger
Kroger (NYSE:KR) reported better than expected second quarter results when it generated earnings of 58 cents (beating my estimate by a penny) versus expectations of 55 cents and was initially rewarded with almost a 10% spike in its share price, but that entire gain has already abated and then some, thanks to a surprising downgrade by an overly worried analyst, apparently consumed by Wal-Mart's (NYSE:WMT) threat to the entire grocery sector.The fact that the downgrade came despite a very good quarter is perplexing to say the least, especially when the following highlights are illuminated:
  • Earnings were aided by a jump in sales, lower SG&A costs, reduced interest expense and fewer shares outstanding ( a 1% drop).
  • Sales rose 8.7% to $24.8 billion, while interest charges fell 20% from $163 million to $132 million.
  • The company also deserves some kudos for slashing expenses, as it was able to minimize its SG&A outlays, 72 basis points from 17.67% to 16.95%.
The only flaw in the report was a hit to the grocer’s gross profit margin, and it’s a big one! It fell 168 basis points, from 24.34% to 22.66% primarily due to aggressive price promotions needed to combat WMT’s relentless advances.
Conflicting Analyst Views
On Friday, B of A cut its opinion on KR from a hold to a sell, citing Wal-Mart’s aggressive pricing reductions and food commodity pricing deflationary pressures, while Citibank actually did almost the opposite, by raising its price target from $21 to $23. For some strange reason, Mr. Market definitely put more emphasis on B of A’s spin, as the shares lost over 3% the same day both analyst opinions were rendered.
Sometimes I think downgrades are actually a good thing for investors, because it enables potential buyers an opportunity to buy on a dip, and to capitalize on the benefits of lowered expectations down the road. I often wonder if firms actually downgrade to make it easier for their best clients to accumulate shares and upgrade to facilitate the distribution process (for you conspiracy theory enthusiasts).
Fiscal 2010 Guidance Maintained
The largest traditional supermarket operator still expects to earn $1.60 to $1.80, while producing identical store sales gains of 2.5%. If you do the math, the low end of the spectrum computes a modest forward multiple of 12.5 (coincidentally the exact same multiple of Safeway (NYSE:SWY)) This relatively low valuation is a compelling reason to contemplate purchase. Sooner than later the environment for grocery retailers will begin to improve. The problem is, if you wait for that to happen, you will likely miss out on the lion’s share of price appreciation. Translation: Buy now!

Disclosure: long swy,kr