Adversely impacted by the continuing effects of deflation, Kroger earlier this month reported an 8.6 percent drop in its third quarter earnings from $428 million to $391 million for the period ended November 5.
The Cincinnati-based supermarket chain, the largest pure-play grocery retailer in the country, however did manage to keep its positive identical sales streak alive at 52 consecutive quarters, eking out a (non-fuel) 0.1 percent gain for the period.
“A silver lining of deflationary environments is that it reveals to us how we can run our business better by shining a light on areas we can improve. It is really tough when you are in it, but we’ll be in a position to benefit from changes we’re making today once we’re out of this cycle. We are firmly focused on our long-term strategy of improving our connection with customers and associates, and continuing to work on process changes to lower costs. We don’t change our strategy based on quarterly swings in results. We remain committed to delivering our long-term earnings per share growth rate target of 8-11 percent on a 3-to-5-year time horizon, plus an increasing dividend,” said Rodney McMullen, Kroger’s CEO.
During the conference call with financial analysts following the earnings release, McMullen stated, “We’re in the middle of the (deflationary) cycle now – and it’s not fun.”
The veteran Kroger executive compared the current cycle of deflation which is now nearly a year old, to a five-month stretch of lower prices which impacted retailers in 2002, adding that the beginning of both cases was gradual and supply-driven, as opposed to the stretch of 2009 deflation brought about by an overall recessionary environment.
Kroger CFO Mike Schlotman affirmed: “Deflation has not only persisted, but has increased with overall deflation, excluding pharmacy, growing from 1.3 percent in the second quarter to 1.5 percent in the third quarter. Additionally, pharmacy inflation declined to 130 basis points to 3.3 percent during the third quarter.”
McMullen and Schlotman also noted several positive indicators, including increased tonnage results and sales growth of items such as wine, Starbucks coffee, sushi and natural and organic products spearheaded by its fast-growing Simple Truth brand. “If you can drink it or snack on it, it’s selling,” McMullen disclosed.
Reviewing the third quarter numbers for Kroger revealed that total sales increased 5.9 percent to $26.6 billion in the third quarter compared to $25.1 billion for the same period last year. Total sales, excluding fuel, increased 7.1percent in the third quarter compared to the same period last year. Total supermarket sales, excluding fuel and Roundy’s (which the company acquired last year), increased 1.6 percent in the third quarter compared to the same period last year.
Gross margin was 22.2 percent of sales for the third quarter. Excluding fuel, Roundy’s, and LIFO, gross margin decreased 5 basis points from the same period last year.
Kroger recorded an $8 million LIFO credit during the third quarter, compared to a $9 million LIFO charge in the same quarter last year.
Total operating expenses – excluding fuel, Roundy’s and an $80 million contribution to the UFCW Consolidated Pension Plan in the third quarter of 2015 – increased 19 basis points as a percent of sales compared to the prior year; of which 15 basis points were related to depreciation due to increases in the capital program.
FIFO operating margin on a rolling four quarters basis decreased 12 basis points compared to the prior year, with the following exclusions: fuel, Roundy’s, the second quarter 2016 restructuring of certain multi-employer pension obligations, the 2015 and 2014 contributions to the UFCW Consolidated Pension Plan, and the fourth quarter 2014 contribution to The Kroger Co. Foundation.
Kroger said its long-term financial strategy is to use its financial flexibility to drive growth while also returning capital to shareholders.
The company’s net total debt to adjusted EBITDA ratio increased to 2.35 in the third quarter, compared to 1.99 during the same period last year. This result, Kroger noted, is due to the mergers with ModernHealth and Roundy’s, Inc. At year end, Kroger expects net total debt to adjusted EBITDA to be near the high end of the company’s targeted range of 2.00 to 2.20.
Over the last four quarters, Kroger has used cash to: repurchase $1.4 billion in common shares; pay $418 million in dividends; invest $3.8 billion in capital; merge with Roundy’s, Inc. for $866 million, and; merge with specialty pharmacy ModernHealth for approximately $390 million.
Return on invested capital, excluding Roundy’s, was 13.63 percent for the third quarter, compared to 14.16 percent for the third quarter of 2015.
For the fourth quarter of 2016, Kroger expects slightly positive identical supermarket sales growth, excluding fuel.
The company’s expected capital investments – excluding mergers, acquisitions and purchases of leased facilities – is $3.6 to $3.9 billion for the year.
In fiscal 2017, Kroger said it is currently completing its business plan process and will provide specific 2017 guidance in March. The big retailer said it anticipates both positive identical supermarket sales and net earnings per diluted share growth, excluding the 53rd week. Net earnings growth will likely be below the low end of the company’s 8-11 percent net earnings per diluted share long-term growth rate guidance.
Kroger noted that it expects the operating environment in the first half of 2017 to be similar to today. The second half of 2017 should show improvement as the company cycles the current environment.
“We are both clear-eyed about the challenges before us and optimistic about Kroger’s future,” McMullen said, “Transitions are no fun but they do create opportunities to improve the way we run our business. We will continue to focus relentlessly on our customers and our associates. We’ll continue to accelerate our adoption of technology to deliver additional value, to provide convenience for our customers, and take costs out as Mike mentioned. All of these things set us up to grow our business. We have a unique opportunity for explosive growth in the $1.5 trillion U.S. food market, and our best days are still ahead of us.”