Kroger: No Easing Up On Pricing

CINCINNATI — Kroger Co. here said last week it believes 2010 will be “an uncertain year” with a difficult first half that will require it to be cautious and flexible with its gross margin strategies — an approach that sends a mixed message to the rest of the industry, Wall Street analysts said.

“It is still our objective to reinvest what we can save,” David B. Dillon, chairman and chief executive officer, told investors during a conference call to discuss financial results for the fiscal year that ended Jan. 30.

Dillon acknowledged that it might be difficult to make changes in some pricing initiatives that are already in place. “You get customers to a point where they like the everyday prices, and to take that away runs the risk of derailing the very process you got started,” he said.

Going into last year's third quarter, Dillon said Kroger recognized “that we needed to be careful about making adjustments. We've made some minor adjustments and continue to make some adjustments in our tactics, but the strategy itself is the same we've been describing — and we believe it would be a long-term mistake to change course.

“So we have not pulled back from that, but we've not gotten more aggressive.

“We've attempted to learn the lesson from 2009, and we would apply whatever investments we plan in a more measured way. We would be cautious and ready to change through the year, and we will leave room in our plans to enable us to do that. But we recognize it will be an uncertain year, and it will be a little hard to predict what the back half is going to look like.”

Many Wall Street observers had expected Kroger to pull back on margin investments, according to Gary Giblen, executive vice president of Quint-Miller & Co., New York.

“But now the company is sending a mixed message,” he told SN. “On the one hand, it said things are getting minimally better in terms of consumer demand and deflation, while on the other, it's saying it won't back off on investing margin as an offensive and defensive strategy.

“If that's the case, then it kills any thoughts of margin expansion for the rest of the industry.” (See related story on Page 14.)

Selling gross margins at Kroger are running at 22.5% of sales, Giblen noted.

Karen Short, an analyst with BMO Capital Markets, Toronto, said she expects Kroger to drop gross margin 65 basis points this year and 10 basis points next year.

“The environment remains uncertain, although it appears to have stabilized from the very volatile environment experienced in the third quarter,” she said. “However, Kroger remains focused on investing in gross margin, and this strategy could pressure earnings this year, given the lack of visibility on the top line or the competitive environment.”

Andrew Wolf, managing director at BB&T Capital Markets, Richmond, Va., said he sees the possibility of margin expansion by Kroger in the second half.

“Despite Kroger's arguably overly cautious 2010 guidance, we anticipate profit growth will return and earnings visibility will strengthen as the operating environment eases.

“Recent industry data points suggest the prevailing negative macro trends of the past 18 months to two years have bottomed for grocers. With an inflection point now reached, earnings visibility should improve as the intensity of the competitive environment gradually eases.”

For the fourth quarter, net income at Kroger declined 26.9% to $255.4 million, while overall sales rose 7.2% to $18.6 billion and identical-supermarket sales, excluding fuel, increased 1.2%. Net income for the year fell 94.4% to $70 million — reflecting the effect of a $1.05 billion asset impairment charge for its Southern California operations in the third quarter — while sales were up 0.8% to $76.7 billion and non-fuel ID sales climbed 2.1%.

The company said it anticipates ID sales gains, excluding fuel, of 2% to 3% for fiscal 2010, with earnings in the range of $1.60 to $1.80 per share, compared with $1.71 per share in fiscal 2009, excluding the asset impairment charge.

Dillon said fiscal 2009 was an anomaly “once the economy went off the rails,” and the chain's financial results “don't fully reflect the progress we had for the year.”

Kroger's identical-store sales trends through the first five weeks of the first quarter are slightly ahead of the corporate guidance as a result of the timing of the Super Bowl and snowstorms in some regions, Dillon said.

“While I'm sure you won't see improvements in the first or second quarters, you may be able to see some by the third and fourth quarters, and the full year should not end up being quite like the first and second quarters might imply.

“When we talk about the prospects for a better second half, we mean we expect sales dollars to become stronger because of the change to inflation from deflation, and we would expect to get the benefit of cost reductions.”

Dillon said several factors are contributing to the uncertainty of Kroger's outlook, including inflation and deflation; the competitive environment; fluctuating fuel margins; and the pace of the economic recovery. “We expect trends in these areas to influence our results throughout fiscal 2010,” he noted.

One area in which Kroger is making significant progress is building customer loyalty, Dillon said.

“We've seen growth in the number of households that shop with us more often, and we have seen it now for some time. Over the course of a month, those customers are buying more items, which is a healthy sign that as the world improves, you'll begin to see it in our financial results.”

Future success may be highly dependent on Kroger's ability to reduce costs, he said. “Our objective is not to drive gross margin down. Our objective is to balance that out and depict the areas that matter to the customer.”

Kroger is seeing “a few small glimmers of hope” that the economy is strengthening, Dillon said, with sales in its floral and jewelry businesses up, along with some improvements in basket size, “though it's very early in that process. But if you look at things over six to 12 months, there's quite a bit of headwind.”

Kroger said it plans to allocated $1.9 billion to $2.1 billion to capital programs this year, with plans to open 40 to 50 new stores and remodel 150 to 160 units.

Q4 RESULTS

* ID SALES EXCLUDING FUEL.

** NET INCOME FOR THE MOST RECENT YEAR INCLUDES OF THIRD-QUARTER ASSET-IMPAIRMENT CHARGE OF $1.05 BILLION.