WALL STREET REACTS TO KROGER'S LOWER EARNINGS

CINCINNATI -- Kroger Co. here said last week it is lowering its earnings growth estimate for the year to 5% to 7% -- a move that drove the company's stock price down in what securities analysts told SN was an overreaction.Kroger had previously forecast an earnings growth of 10% to 12% annually. Last week's estimate of 5% to 7% for the year excludes one-time items and goodwill expense.Joseph A. Pichler,

CINCINNATI -- Kroger Co. here said last week it is lowering its earnings growth estimate for the year to 5% to 7% -- a move that drove the company's stock price down in what securities analysts told SN was an overreaction.

Kroger had previously forecast an earnings growth of 10% to 12% annually. Last week's estimate of 5% to 7% for the year excludes one-time items and goodwill expense.

Joseph A. Pichler, chairman and chief executive officer, said the lower forecast results from a combination of factors, including unexpectedly severe deflation, overly exuberant promotional levels in some Kroger divisions, and a high degree of shrink.

The stock market reacted negatively to the news, with stocks for Kroger, Safeway and Albertsons all taking a beating on the day of the announcement, falling 2.25, or 12%, to 15.76; 2.17, or 7.9%, to 25.22; and 2.98, or 11%, to 24.05, respectively.

Meredith Adler, managing director for Lehman Brothers, New York, told SN she thinks the market's reaction had less to do with Kroger than with its own misunderstanding of the retail food industry. "The market's perception is that discounters like Wal-Mart are taking over the world, and it's impossible to change that view in the context of a difficult economy and a weak sales environment," she explained.

"So I don't think the market is really reacting to what Kroger said as it is reacting to its own fears about what is happening to competition over the long term, and nothing seems to be able to convince the market its fears are unjustified because all the data points seem to support its negative view."

Gary Giblen, director of research and senior vice president for C L King Associates, New York, said the market "grossly overreacted" to the Kroger announcement. "Everybody in the Western world knows the supermarket business is facing its toughest challenges in recent memory and they all know Kroger is trading profitability for sales, and although its numbers were slightly less than projected, they were certainly within an acceptable range.

"But the company got penalized and its stock was oversold because it was honest about the challenges it's facing instead of trying to gild the lily, as some of its competitors are doing, and that's a shame. The fact that its 2002 numbers are soft should be obvious to anyone, but Kroger has the integrity not to overemphasize the positives that are there, nor has it changed its outlook for the 2003 numbers."

Lisa Cartwright, director at Salomon Smith Barney, New York, told SN she expects Kroger to lower its long-term expectations later in the year. "It's not a surprise Kroger lowered its growth rate for this year, and as it begins talking about next year and beyond, it will probably lower its forecasts again, and while that's negative for the group and the stocks, I think it's the right thing to do.

"The fact Kroger is investing in lower prices and that same-store sales were positive suggests that what it's doing is working and is the right course to pursue. But although it's making the right moves, I think there will probably be some downside before there's an upside."

Kroger discussed its reduced earnings guidance last week during a conference call with securities analysts following the release of financial results for the second quarter and first half ended Aug. 17, which showed sales rising 3.8% to $11.9 billion for the quarter and 3.8% to $27.6 billion for the half, while comparable food-store sales, excluding fuel, rose 0.9% for the quarter, reflecting product cost deflation of negative 0.7%, the company noted.

Net income -- excluding restructuring charges and other items -- rose 1.7% to $267.1 million, or 35 cents per diluted share, during the quarter, and 13.3% to $652.8 million, or 83 cents per share, for the half.

Pichler said he expects sales comparisons in the third quarter to suffer because of the increased spending that followed Sept. 11 last year. "People were at home more so they bought more food, and it was a very noticeable trend," he explained.

In addition, he said Kroger expects earnings per share to be "flat to slightly positive for the balance of the year," resulting in the lowered expectations.

Explaining why earnings will be lower going forward, Pichler offered the following comments:

On deflation. Product cost deflation of negative 0.7% was "greater than we expected, particularly in meat and produce. In fact, I can't remember a time in the past 22 years when deflation affected beef, pork and poultry at the same time.

"As a result, we may have underestimated the strength of identical-store sales as the quarter went on and reduced gross profit to accelerate sales increases without taking deflation into account. And we may have overinvested in promotions in some markets, though we're correcting that."

Deflation in the first quarter was flat, he pointed out.

On promotional efforts. Kroger overinvested in some markets during the quarter, Pichler said -- "there's no question about it. Maybe it was a result of overconfidence from our strong first quarter. But we're taking actions to deal with it.

"There's no question we got caught off-guard by deflation. But with that deflation in perishables, particularly meat, the temptation was to provide red-hot prices, though in some cases it was too much. And there's no question we overheated [prices] in some markets.

"But we've had a lot of discussions about that, and we're making mid-course corrections where necessary because we need to do a better job balancing sales increases with EBITDA production.

"We want to be sure we're more disciplined going forward than we were in the second quarter. We haven't pulled back on our promotions, but we are making adjustments."

On shrink. An increase in shrink is not uncommon during a recession, Pichler said, "but we've seen a particular problem in health and beauty care items, and we have some efforts under way to address shrink that involve changes in systems, planning and additional training, and it's taking longer to execute those programs than we'd planned."

Pichler said the efforts to reduce shrink may not pay off immediately. "We want to be careful we're not so forceful that we run into out-of-stock problems, and we want to make sure the systems we're putting in and the associate training we're providing produce the results we want."

Shrink control is also impacting Kroger's efforts to cut procurement costs, Pichler said, noting the company had hoped to reduce those costs by $500 million over two years, with two-thirds of the savings anticipated this year. "But we fell slightly short of that goal" -- cutting costs by $175 million in the quarter, he noted -- "because shrink reduction has proven more difficult than anticipated."