On Friday, the grocery retail chain Kroger (KR) reported its second quarter earnings. On the face of it, the report card was good. Kroger delivered a beat on the top line while EPS came in line with expectations. The company had reported an EPS of $0.39 on revenues of $27.6 billion (a beat of $110 million). And as we had discussed in our earnings preview, the company reported positive identical sales. Same store sales grew by 0.7%, after consecutive quarters of decline. Identical sales were helped by improving Food at Home CPI. Digital sales more than doubled from a year earlier, albeit from a low base. Moreover, the company maintained its FY 17 EPS guidance range of $1.74 to $1.79 per diluted share. Given the rising threat of competition, many were expecting the guidance to be revised downwards. But in spite of this, Kroger stock tanked by over 7% on Friday.
Rising uncertainty takes a toll on the stock price.
So what explains the market's reaction? Well, there were a couple of reasons. Firstly, Kroger removed the long term growth target of 8%-11% from its 8-K filings. “In this dynamic operating environment, we will continue to provide annual guidance as we have done for many years but will no longer provide longer-term guidance,” Chief Executive Officer Rodney McMullen said during the conference call. This might have been a prudent thing to do, given the challenges the retail industry, on the whole, is facing. Growth is slowing and margins are falling. However, investors viewed the removal of growth target as a lack of confidence in the company's future. Many expect the future growth to be subdued. It has also increased the uncertainty in the stock. Growth and risk (uncertainty) are two important determinants of a company's stock price. The stock price is an increasing function of growth and a decreasing function of risk. Lower growth prospects and increased risks generally lead to a drop in the stock price.
Investors are worried about a price war.
Investors are also worried about the company's profit margins. In the second quarter, gross margin fell 30 basis points from a year ago to 21.7%. Operating and net margins also experienced marginal drops. Kroger's net income margin came in at 1.3%, leaving a very thin margin for error. For the first six months of the year, Kroger's net profit is down by 39% and GAAP EPS is down by 36%.
Kroger has been slashing prices to fend off competition. And the strategy seems to be showing some results. Kroger's sales volume and customer traffic improved, suggesting market share gains. However, it also impacted its profitability. Moreover, as we had discussed in our earnings preview, Kroger intends to continue fighting this pricing war. "We have no intention of giving up the momentum we’ve gained on low prices. These investments enable us to connect with our customers in a deeper way and increase our market share over time," management said during the Q1 earnings conference call. Pricing war is generally not good for any company, especially when you have very thin margin, high debt burden and are trying to fend off the likes of Amazon (AMZN) and Walmart (WMT). The continued price war will weigh heavily on the grocer's profit margins.
To some extent, cost cutting and investment into technology will absorb the impact of price cuts. During the earnings call, Kroger said it will slash $600 million in capital spending over two years. It has also reduced the number of new stores it plans to build. But cut down in capital spending will also impact its growth prospects. Moreover, Kroger is not the only one investing in keeping the prices lower. Its competitors like Walmart have also been investing billions of dollars to keep prices low.
Amazon had slashed prices just after acquiring Whole Foods. And according to a report by Foursquare Labs Inc, the price cuts led to an increase in customer traffic at Whole Foods by 25% in the days following the acquisition.
Kroger stock is not a good buy right now.
Kroger stock is down by over 39% for the year, compared with a 24% fall in the S&P food retailers index. The stock fell by over 7% during Friday's trading session. Of course, to some extent, market's reaction was also amplified by the overall bearish sentiment in the retail industry. The stock may see some recovery in the next few trading sessions. However, the competitive pressure from Amazon, deep-discounting European chains like Aldi and Lidl and more importantly, Walmart, will keep the growth and profitability in check. Also, Kroger has not taken into account the impact of Hurricane Harvey while reiterating its FY 17 guidance. The Houston area is Kroger’s third-biggest market with 115 stores. Rising uncertainty and margin pressure will also continue to weigh heavily on Kroger stock. Investors must wait for the competitive landscape in the retail industry to become more clear before considering to invest in this stock.
Disclosure: I/we 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.
Additional disclosure: This article was written by Kumar Abhishek, an equity analyst at Amigobulls. Neither Amigobulls, nor any members of its staff hold positions in any of the stocks discussed in this post. The author may not be a certified/registered investment advisor, and the opinions expressed should not be treated as investment advice. Buying and selling of securities carries the risk of monetary losses. Readers/Viewers are advised to carry out their own due diligence and consult their investment advisors before making any investment decisions. Neither Amigobulls, nor the author have any business relationship with any of the companies covered in this post.