Rising gross margins are almost always cheered by market price action, but a myopic focus on this figure can get a company and its investors stuck in a short-term mentality. Yes, increasing gross margins can signify pricing power or cost advantages, but higher prices and lower costs can also make short-term profits look good while actually hurting the business in the long run. For example, a company could cut its service levels, raising gross margins now, but resulting in customer losses in future periods. Consider SuperValu (SVU), which is using this phenomenon to its advantage.
SuperValu is a bit of a turnaround story. For years, its efficiency has lagged that of the competition (e.g. Wal-Mart (WMT)). As a result, its prices are higher relative to the competition, which has caused many of its customers to migrate away.
Often a company in this position can shrink its way out of trouble, closing unprofitable stores until it is generating normal returns on investment. In this case, however, previous management took on a lot of debt; shrinking revenues would only make the debt loom larger. As such, the only option here was to turn the company around.
New management has done an exemplary job in this regard so far. Many of the initiatives that have been completed or are on-going include:
- Increasing its private-label SKUs so customers can trade down.
- Reducing stock-outs.
- More emphasis on catering to store-specific customer tastes.
- Promotional spending the emphasizes profitability over traffic.
- Reducing shrinkage.
A number of these initiatives required investments in software and systems over the last couple of years, but some of them are already yielding positive results. Yet one wouldn't know it from looking at the company's gross margin levels, which are down. This is because management is re-investing the returns from these initiatives into product prices. In order to bring back customers, SuperValu is investing in price. This lowers the gross margin in the short-term, but should reduce customer attrition over the next several periods. As management makes further progress on the initiatives above, further price reductions are planned. Eventually, customer traffic should start to tick up as SuperValu levels the playing field by reducing the price gap between it and its competitors.
Rising or falling gross margins don't tell the whole story of how well a company is performing. Investors need to dig into the details (through financial releases and quarterly conference calls, for example) to truly understand how well a company is doing. As discussed elsewhere, SuperValu stock offers retail investors the opportunity to invest like a private equity firm in a leveraged buyout.
