Wall Street Strategies'  Instablog

Grocery giant Kroger (KR) recently reported a second quarter earnings report that fell handily below expectations. Sales were half a billion dollars below consensus and earnings fell shy by $0.05 per share, sending shares down more than 8% the same day. For the average investor in the market these are tough numbers to swallow and indeed they were a disappointment. For most, it could easily be seen as another victim of our defunct economy, but Kroger’s story is not that straightforward. At first glance of those numbers, one might expect to walk into a Kroger store to see shopping carts rusting in the corners overtaken with cobwebs. Yet, in fact, walk into a Kroger market and you will see an energized operation abuzz with customer traffic.

 

So why then did earnings fall short? Put simply, food costs came down during the quarter leading to lower ticket prices and squeezed profit margins. Kroger was surely dented by product deflation, but it would be wrong to assume it has lost its pricing power. Make no mistake.  When it comes to the grocery business, Kroger is still the 800 lbs. gorilla and it is indeed still throwing its weight around. Sure, it was set back by pricing but you can be sure the competition is feeling the heat even more than Kroger. In fact, I suspect Kroger used deflation as an opportunity to exercise its economies of scale and point out that it can offer more value to its customers than the competitor down the street or a restaurant.

 

Consequentially, traffic trends and sales volumes are strong, and market share is expanding. Kroger will gladly engage in a price war, especially in tough economic times like now when the customer is more likely to go to one of its stores to seek value. As an end result, identical store sales (sales at equivalent stores open five or more quarters without expansion) were still up 2.6% year over year excluding fuel sales, while the likes of Safeway (SWY) and Supervalu (SVU) were -5.6% and -3.2%, respectively.

 

Price deflation mostly came from dairy and produce, but it is unlikely the trend will continue much further. Livestock farmers are becoming increasingly fed up by the dairy business which has become unprofitable in many cases and closed shop, while the USDA has even stepped in and added incentives to get millions of pounds of milk out of the market. As a result, supply is being lost in the dairy sector. Recent reports also suggest a cold front is likely to hit the Midwest and slow crop yields (some crop futures prices spiked in the expectation of a frost that would damage the fall harvest). These factors sit alongside producer and consumer price indices that showed increases in prices of food and other goods in August, as well as a diving U.S. dollar.

 

If food prices don’t reverse course all is not lost either, as Kroger is a mammoth business that rakes in large sums of cash each quarter. In the second quarter, Kroger generated $2.2 billion cash from operations; approximately $600 million was used to pay down debt (will reduce interest expense for quarters ahead) and $60 million was used to repurchase shares. Meanwhile, other capital is still being spent to refurbish stores and make them more customer-friendly. And you can bet it will gain more market share the more prices fall. Sales and earnings are also comparable to those of 2Q07 and 2Q08 when the stock traded at nearly $30 (it’s now $21). It’s a long term Buy whichever way you slice it.


David Urani is a research analyst with Wall Street Strategies (www.wstreet.com). He actively covers the homebuilding, staffing, and supermarket industries. For more information about Mr. Urani, refer to the company's website, wstreet.com.