$1B Charge Hammers Kroger's Q3

CINCINNATI — A massive goodwill charge at the Ralphs banner, aggressive price investments and lingering deflation helped drive Kroger Co.'s third-quarter profits off a cliff.

“Based solely on our tonnage, we had a solid quarter,” David B. Dillon, chairman and chief executive officer, told industry analysts during a conference call last week in an effort to put a positive spin on the results. Tonnage was up more than 8.5%, he noted.

The loss for the quarter, which ended Nov. 7, was $874.9 million, which the company said was due primarily to a non-cash asset impairment write-down of $1.05 billion for the chain's Ralphs operation in Southern California. Sales for the quarter fell 0.3% to $17.7 billion, and identical-store sales, excluding fuel, increased 2.2%. For the year to date, the loss was $185.4 million, with sales declining 1.1% to $58.2 billion and ID sales up 2.4%.

Dillon said challenges from the weak economy, deflation of negative 0.8%, increasing competitive activity and a more cautious consumer have prompted it to cut back on capital spending by a third over the next three years, with plans to spend $2 billion rather than $3 billion, as originally announced.

The company also said it was reducing its financial guidance for the fiscal year, lowering ID sales growth to a range of 2% to 2.5% — compared with a range of 3% to 4% in earlier forecasts — and earnings to a range of $1.60 to $1.70 per share, excluding the Southern California impairment charge — down from the $1.90 to $2 per share previously forecast.

Price investments during the quarter resulted in a decline of 26 basis points in overall gross margin and a drop of 109 basis points in gross margin in non-fuel sales, the company noted — a point of concern for industry observers.

Karen Short, a New York-based analyst with BMO Capital Markets, Montreal, said Kroger's third-quarter results indicate that “it is not yet evident that price investments are resulting in permanent share gains, [and] given Kroger's overlap with Wal-Mart and slightly lower-income demographics [compared with Safeway], Kroger may have no choice but to continue investing in gross margin.”

Short said the decline in selling gross margin was “alarming,” adding: “At this stage, we can't help but wonder if the company is only encouraging the cherry picker — a strategy that has yet to demonstrate it will result in sustainable and profitable market-share gains.”

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., said he anticipates that, despite what he called “disappointing” third-quarter results, “Kroger's profit growth will return and earnings visibility will strengthen as the operating environment eases in 2010.”

Wolf said he was basing his optimism on the fact real sales for the industry turned positive in September, rising 0.8%, after a 12-month run of negative growth, followed by a boost of 1.5% in October; and on predictions by the U.S. Department of Agriculture that steep deflation in food prices will turn to inflation of 2.5% to 3.5% next year.

“Deflation in the fourth quarter will be about as severe as for the third quarter for the sector, but will ease considerably in the first quarter and turn to modest inflation in the second quarter,” Wolf said, “[so] improved volume and pricing trends should lead to an eased competitive environment as 2010 unfolds.”

John Heinbockel , an analyst with Goldman Sachs, New York, expressed more skepticism — downgrading Kroger shares last week to “neutral” from “conviction buy” — because of “clear signs that the transition to a moderate inflation/stronger consumer environment from the current deflationary/weak consumer one is not going to be as smooth or fast as we thought.”

Even if a return to moderate food inflation accelerates Kroger's sales and earnings, Heinbockel said, “the shares are likely to tread water for the next three to six months, given a meaningful decline in [anticipated] fourth-quarter earnings per share [which will be reported in March] and a tough first-quarter comparison [in June].”

During the conference call, Dillon said one miscalculation Kroger made over the last few quarters was committing itself too quickly to some pricing strategies “that didn't leave a lot of gunpowder for later in the year if the market got more competitive. So I think you could argue that maybe there was too much investment in the quarter.”

Asked whether more prudence in pricing and less tonnage growth would have been a more reasoned response to competitive activity, Dillon replied, “We make a judgment call in each case, [and] we've found that with customers it's really important to make sure you protect your franchise.

“But Thanksgiving sales and results were softer than we would have liked,” he added, “and I'm not bullish about where Christmas is going to come in for the industry.”

According to J. Michael Schlotman, senior vice president and chief financial officer, the write-down on Ralphs — which reduced earnings per share by $1.62 — was due to several factors, including the weak California economy, high unemployment rates in the state, population declines and real estate valuations falling to historic lows.

Asked whether the impairment charge means the Ralphs division is in worse shape than other Kroger divisions, Schlotman said that is not the case.

“I wouldn't characterize it as any worse than anywhere. There is no more [financial] goodwill in the books for Ralphs, [but] there are a lot of places where we do not have any goodwill.”

Dillon added, “We're quite bullish on Ralphs, and we believe that, in the last six months, Ralphs' market share has actually grown slightly. But we think the market itself has shrunk a little, and that's actually what creates a lot of the problems.

“So I wouldn't read anything into the write-down having to do with how pleased we are with Ralphs. In the long run, we believe Southern California is going to be a good market for us.”