Kroger (NYSE:KR) is the largest pure-play grocery store chain in the country. This provides the company with considerable purchasing power and allows it to offer lower prices than many smaller chains. However, a couple of larger rivals with even greater buying clout continue to muscle into the industry. And ironically, an improving economy may now work in Kroger’s favor. To bearish investors, the current quarter offered a glimpse that these two factors may be in play.
Third Quarter Review
Total sales grew 5.9% to $18.7 billion as grocery sales rose 3.1%, primarily from a 2.4% rise in same-store sales. Fuel sales accounted for the rest of the top-line improvement. Cost controls helped lower corporate expenses but gross margins fell slightly on higher product costs. Commodity inflation is adversely affecting margins at Kroger as well as many food suppliers such as Kellogg (NYSE:K) and Kraft (NYSE:KFT).
Operating profit came in at $406.9 million after a loss in last year’s quarter due to the write-down of the value of the Ralph’s franchise in California as the state was particularly hard-hit during the housing bust. This worked out to 2.2% of sales and demonstrates just how low-margin Kroger’s business model is. Net income was $202.2 million or $0.32 per dilutes share. This met analyst expectations for the quarter.
Kroger increased the lower end of its full-year sales outlook and lowered the high end of its profit guidance but also raised the low end of its profit range. It now expects same-store sales to grow between 2.5-3%, which is up from a range of 2-3%. Earnings guidance is now in a range of $1.65 and $1.78; previous projections called for between $1.60 and $1.80.
The Bottom Line
The market was apparently spooked by the lowering of the high end profit range and sent the shares down as much as 11% after the earnings release. This has pushed the forward P/E to just over 11, if it hits the new high end of its guidance.
The good news in the company expectations was that it plans to lower capital expenditures for the full year. This will likely boost free cash flow generation. However, bearish sentiment on the name could continue for a couple of primary reasons. The first is that the economy is recovering from a recession and as a result people are eating out more and eating at home less often, which suggests lower overall demand for groceries.
Secondly, competition in the industry remains fierce and will only get tougher as both Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) have ambitious plans to add more grocery square footage to drive foot traffic. Wal-Mart has pushed its way into the space and is now the largest player and Target is just getting started with an aggressive campaign to add grocery items. Over the long term, this could hurt cash flow as Kroger will need to keep spending to stay efficient and keep its store base spruced up. (To learn more, check out Evaluating Grocery Store Stocks.)