Kroger's Moves Signal New Fiscal Flexibility

Kroger Co.'s long climb back to financial fitness reached a milestone last week when the company said it would no longer need to devote a third of its cash to servicing debt. Instead, Kroger officials announced a more shareholder-friendly financial strategy of using its free cash to fund the repurchase of up to $1 billion in company stock, and to fund a quarterly dividend. The move, which

CINCINNATI — Kroger Co.'s long climb back to financial fitness reached a milestone last week when the company said it would no longer need to devote a third of its cash to servicing debt.

Instead, Kroger officials announced a more shareholder-friendly financial strategy of using its free cash to fund the repurchase of up to $1 billion in company stock, and to fund a quarterly dividend. The move, which enhances Kroger's financial and strategic flexibility, met the approval of rating agency Standard & Poor's, which last week upgraded Kroger's corporate credit outlook to “positive,” citing lower debt and improvements in sales and earnings.

S&P had downgraded Kroger's corporate rating to “BBB-” — or one notch above junk status — two years ago. The positive outlook is seen as the first step toward a rating upgrade.

“We believe maintaining a solid investment-grade rating provides us with the best cost of capital and the flexibility to execute our growth strategy,” W. Rodney McMullen, Kroger's vice chairman, said in a conference call.

Analysts said the improved financial flexibility makes a large acquisition a stronger possibility for Kroger. “At its current leverage, Kroger could afford to make an acquisition in the range of $5 billion to $6 billion,” Perry Caicco, an analyst for CIBC World Markets, Toronto, said in a research note.

Standard & Poor's calculated Kroger's total debt at $6.6 billion as of the end of its fiscal first quarter May 26, down from $7.1 billion at the end of 2006. Its lease-adjusted debt to EBITDA ratio improved to 2.9:1. That level was around 3.5:1 when S&P cut its corporate credit rating.

Since the Fred Meyer merger in 2000, Kroger has reduced total debt by $2.2 billion while improving EBITDA by $522 million, McMullen added. The debt reduction was achieved after years of devoting one-third of its free cash flow to pay off its borrowings.

Kroger last week said its board of directors had authorized a $1 billion stock buyback, replacing a $500 million plan announced last May. The buyback “reflects the board's confidence in Kroger's customer-first strategic plan and management's belief that Kroger's shares represent an attractive investment opportunity,” McMullen said.

David Dillon, Kroger's chairman and chief executive officer, reiterated his position that small, in-market acquisitions tend to make the best investments for Kroger. “We aren't saying we wouldn't do a large or even midsize acquisition,” Dillon said. “We see lots of acquisition opportunities but very few of them hit the kind of criteria that we're after.”

PRICE INCREASES

Robust sales growth continued at a 6.7% clip during the first quarter as Kroger passed along product price increases only gradually against product inflation it estimated to be around 2%. The practice helped generate identical-store sales of 5.2%, excluding fuel, while sending profit as a percent of sales down to 23.7%.

“Typically, such inflation will eventually be passed along to customers, but in some cases we chose not to due to competitive situations,” McMullen said. “We are working hard to balance the current product cost environment with our strategy to provide everyday value to our customers. On an individual-quarter basis, that can affect our gross margin.”

Passing along price increases was “only a question of timing,” Dillon said, explaining the decision to hold the line against volatile spikes in the price of commodities such as milk helped the retailer maintain pricing perception and sales volumes.

Kroger overall reported net income of $336.6 million, or 47 cents per share, on sales of $20.7 billion for the period. Earnings, which were up by 9.9%, were negatively impacted by around $22 million when Teamsters struck Kroger's Louisville, Ky., distribution center as it transitioned to third-party management.

Though Kroger's performance, including the labor charge, was in line with most analyst estimates, its stock fell by around 6% after the earnings announcement. Analysts said the market had anticipated Kroger would exceed projections, as it had in the previous quarter.

“I think some investors had expectations that got ahead of themselves,” Meredith Adler, an analyst for Lehman Brothers, New York, told SN. “You had investors who got into the stock because Kroger beat its fourth quarter by a lot and who expected them to beat it every quarter.

“In my mind, they were excellent numbers,” Adler added. “They put up another 5% comp without fuel. If you add up their numbers from last year you see their two-year comp is improving every quarter. That's very unusual. That's amazing.”

Andrew Wolf, an analyst at BB&T Capital Markets, Richmond, Va., also considered the quarter a strong one for Kroger.

“Sales momentum is what Kroger's about now — it's their strategy,” Wolf, told SN. “The profit model they follow says to drive sales and the earnings follow. There are times where you do that and the earnings will leverage better than others.”

In other topics addressed by Kroger in its conference call:

  • Dillon said the company was pleased with the results at its large-format Marketplace stores and has plans to add the format to six existing markets in addition to Marketplace stores that already exist in Arizona, Salt Lake City, Cincinnati and Columbus, Ohio.

  • Savings derived from more efficient energy and health care strategies helped the company lower its operating, general and administrative expenses 76 basis points to 17.41% of sales.

  • The company invested $555.8 million in capital projects during the quarter, up from $449.9 million in the same period a year ago. The investments went toward 19 new, expanded or relocated stores and 71 remodels.