Kroger (NYSE:KR) barely extended its streak of 53 consecutive quarters of same store sales growth in Q3 2016 on December 1st. The company reported identical same store sales growth of just 0.1%, earnings per share of $0.41 (vs $0.43 a year ago) and reduced full fiscal year earnings guidance range to $2.03 - $2.08 from $2.03 - $2.13. Yet Mr. Market responded positively and Kroger's share price rose by 3% the day of the earnings announcement.
After listening to the earnings call and reviewing data from Bureau of Labor Statistics, I found numerous signs of growth in the latest earnings release that are discussed below.
Cheese, eggs and milk
Deflationary food prices have been the main story for grocers the past six months. CFO Michael Schlotman stated that price deflation (ex fuel, ex pharmacy) not only persisted but increased by growing to 1.5% in Q3 vs 1.3% in Q2. Schlotman also stated deflation in cheese, eggs and milk had an almost 50 basis point effect to ID sales in Q3.
The positive news for investors, according to the US Bureau of Labor Statistics, is that the worst may be over for price deflation.
In the first six months of 2016, milk prices were on average $0.20 cheaper than the same period year ago. In August, September and October the price difference has been narrowing and is now almost at parity versus year
In Aug/Sep/Oct 2015, the average price of a dozen eggs was about $2.90. For the same time period in 2016, the average price of a dozen eggs was $1.43. Eggs are $1.47 per dozen cheaper this year than last year. It is highly unlikely that eggs will drop by another $1.47 cents; they would then have a negative cost. Eggs prices will likely soon bottom out or have slower deflation.
Price stabilization in eggs, milk and cheese will have a positive effect on comparable sales growth. Based on the Bureau of Labor Statistics data referenced above, price deflation looks to be slowing.
Private label and gross margins
During the analyst Q&A portion of the earning call, Ed Kelley of Credit Suisse asked how gross margins have remained consistent during a deflationary cycle. With increased promotions caused by price deflation and a strong competitive environment, gross margins would likely decrease.
In his response, CFO Michael Schlotman stated that the expansion of corporate brands helped as they have higher gross margins. In Q3 2016, corporate brands accounted for 28.1% of total volume (ex-fuel, ex-pharmacy). CEO Rodney McMullen also stated that Simple Truth, Kroger's natural and organic brand, continues to have double digit growth in units sold.
I highlight the role of private label products for two reasons.
First, Kroger has consistently increased the volume share of private label goods over the past three years. In 2013, corporate brands accounted for 27% of total volume. In three years, corporate brands gained 101 basis points in volume share.
Second, in a deflationary environment, with prices dropping for cheese, eggs and milk, it could be assumed that name brands would increase in sales. If shoppers are purely buying Kroger's private label brands based on price and name brand prices are trending lower due to price deflation, consumers may switch back to the now cheaper then before name brand products. Kroger's ability to grow volume share of private labels with deflationary prices shows shoppers have loyalty to Kroger's private label goods.
Increasing volume share and brand loyalty for high margin private label products is a positive sign for investors.
Resumption Of Growth
In the earnings release, Kroger also announced:
- Total and loyal households grew
- Tonnage and market share improved
- Average number of diluted common shares decreased to 953 million from 959 million versus Q2 2016.
By combining the two paragraphs above with the three preceding bullet points, its easy to see how Kroger will continue to grow.
- Higher numbers of total and loyal households together with stronger high margin private label sales will lead to stronger profit growth.
- Less price deflation and higher total and loyal households will increase earnings and revenue as price deflation ceases.
- Improved market share and less shares outstanding will increase earnings per share.
Price deflation and the impact it has on comparable sales, earnings per share, and revenue has masked how Kroger is growing with households, market share and tonnage.
In conclusion, even with a deflationary pricing environment, Kroger is continuing to grow. Comparable sales which are impacted by lower prices for milk, eggs and cheese will likely improve as prices stabilize for these commodities. The company continue to grow the volume share of high margin private label goods. Finally, total and loyal households along with market share all increased.
My advice to long term investors is to stay the course. As price deflation begins to wane, as it is for milk and will for eggs, Kroger's strength in private label goods, loyal households and market share will lead to strong profit growth.
Disclosure: I am/we are long KR.
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.