Kroger Is Facing Challenges

Unfortunately few awards are issued to companies outperforming within a difficult environment. If there were, I think Kroger $KR is worthy of a place on the short list.

The grocer finds itself challenged with reluctant consumer behavior and its markets are being encroached on by the big box retailers at the low end and an assortment of niche players at the higher end. Its management is doing all the right things in response, but is it enough to make it an attractive investment opportunity?

What Happened With Kroger?

As usual the immediate reaction of the media is to look at the falling share price and then quickly conclude that the market doesn’t like the results because net earnings fell slightly. I would like to think that investors are a little more discerning than that!

In fact pre-tax earnings were up 9.7% to $429 million. It was an increased tax rate that caused the net income decline but diluted EPS actually rose 10.8%. My view is that it is more to do with the continued fall in gross margin and the sluggish sales growth.

Sales growth excluding fuel was 3.8%, which is not great considering inflation in the food sector over the last year or so. Interestingly Kroger claims it is gaining market share in food but the market doesn’t seem to want to listen.

Challenging Markets

The thesis with Kroger is that its margins are falling thanks to increased competition. The structural changes happening with online merchants grabbing sales from traditional retailers are forcing them to expand into other categories, and one of them is food. Kroger finds itself challenged by Wal-Mart $WMT and its efforts to expand food and pharmacy sales, particularly via its increasing number of smaller box outlets.

As Kroger’s management points out, they have been doing a good job so far in countering Wal-Mart by reducing operating costs and initiatives designed to create loyalty by creating good customer influences.  Like I said, if anyone deserves an award…

Kroger also faces competition from discount retailers who are seeing an increasing amount of customers doing more marginal grocery shopping in their outlets. Moreover the likes of Family Dollar, Dollar General $DG and Dollar Tree  $DLTR are all aggressively rolling out new stores.  If the experience from Germany (where discount retailers like Aldi and Lidl began to expand aggressively after they went through an austerity period after reunification) this kind of shift in consumer habits can stay a long time.

Another challenge comes from specialty retailers like Whole Foods Market $WFM, which is managing to create enough differentiation in their product offerings to grab footfall from traditional Kroger customers, many of which are likely to be higher margin purchasers for Kroger. It is a challenging environment and lower end Kroger competitors like Supervalu (NYSE: SVU) are having to close underperforming stores in order to reduce costs.

Other Challenges and Opportunities

As if the increasing competitive challenges weren’t enough, rising food costs have eaten in to margins and higher gasoline prices always reduce lower income groups' discretionary spending. Putting all these aspects together demonstrates how well Kroger has been doing to keep profits rising over the last few years.

The company has also seen some benefits within its pharmacy sales from the Express Scripts/Walgreen dispute. Now that that dispute is resolved (they will start working together again next week) there are some concerns that Kroger has seen some kind of artificial boost, which will drop out in future quarters. We shall see.

Where Next for Kroger?

The company is very well run but as good as its management undoubtedly are, there is only so much they can do to fight a tough working environment. I think it is hard to argue that the stock is cheap on 21x earnings. Granted it deserves a premium to its sector (who will all be fighting the same conditions) but at this level?

I think cautious investors should wait for a more favorable macro-environment before chasing the stock higher. Moreover, if you share my view that the stock won't turn until gross margins do then why fight the trend? Better to wait until they start turning up or Kroger generates some stronger revenue growth.