Shares of
Kroger (NYSE:
KR
)
rose a smart +4% today as the nation's largest standalone grocer
beat profit estimates by 8% for the quarter ended May 22. Yet once
you dig deeper into the numbers and get a sense of industry trends,
it becomes apparent that shares could move sharply lower in the
weeks and months ahead.
It's easy to look good when little is expected. Analysts were so
bearish about the grocer's rising cost picture that they lowered
their profit forecasts well below management guidance. So earnings
were seemingly robust, but really only not as bad as feared. More
important, earnings were more than 10% below year-ago results due
to a sharp drop in gross margins. And gross margins are the real
story here.
If you've shopped for groceries at a
Wal-Mart (NYSE:
WMT
)
store in the last year, you've probably noticed that produce was
the one category that seemed unusually pricey. Yet as we
noted earlier this week
, Wal-Mart is rolling back prices thanks to a renewed emphasis on
securing locally grown produce.
The mega-retailer is actually rolling back on prices on a wide
range of goods, but it thinks the most notable impact for consumers
will be found in the produce aisle.
That's not good news for Kroger,
Safeway (NYSE:
SWY
)
, and
SUPERVALU (NYSE:
SVU
)
. All three of these firms are struggling with anemic sales, rising
labor costs, and an "in-between"
business model
. High-end grocers such as
Whole Foods (Nasdaq:
WFMI
)
are appealing to quality-conscious consumers, while Wal-Mart is
stealing away the value-conscious foot traffic.
At first, Kroger and Safeway sought to emulate the Whole Foods
model by heavily investing in store remodelings. Those efforts
petered out when they realized that they couldn't beat Whole Foods
at its own game. Since then, they've vowed to protect the other
flank by lowering prices to retain customers. That's not helping
much either. Top-line growth stalled even as expenses rose. In its
most recent
fiscal year
, Kroger posted a 1% sales gain, but a 60% drop in
operating income
. Safeway's sales actually dropped -8% (excluding the impact of a
divested set of
stores) last year.
GE's (NYSE:
GE
)
Jack Welch once noted that an industry leader often has twice the
operating margins of the number two player, and the number two
player has twice the operating margins of the number three player.
That led to his famous quote: "Lead, or get out of the way" (a
slight twist on an old axiom from Thomas Paine). In this case,
Wal-Mart is doing exactly what you'd expect: using its massive size
to wring out costs to lower prices to the point where rivals feel
real pain.
And that's just what's about to happen. Wal-Mart's price rollback
strategy began in March but really picked up speed in recent weeks.
Kroger's just-announced results aren't yet a reflection of the
counter-moves it will need to make to keep Wal-Mart from stealing
customers. But it's only a matter of time. As Kroger, Safeway, and
SUPERVALU parry back, look for analysts to cut their profit
forecasts.
For investors, the impact is unlikely to be felt on shares of
SUPERVALU, which already trade at very low
price-to-earnings ratio (P/E)
multiples. But Kroger and Safeway will likely feel the pinch as
earnings estimates are revised downward.
Action to Take -->
If you are comfortable shorting stocks, then this is an ideal pair
trade: Go long Wal-Mart and short Kroger. Thursday's rally for
Kroger shares sets up a perfect entry point.
-- David Sterman
Staff Writer
StreetAuthority
Disclosure: David Sterman does not own shares of any security
mentioned in this article.