Grocers Won’t See Green for Long

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.