Kroger's (NYSE:KR) business is in a tough spot. The supermarket chain lowered its outlook last week as its revenue growth slumped. Kroger managed to improve comparable-store sales for the 51st consecutive quarter, but by its smallest margin in years.
CEO Rodney McMullen and his executive team held a conference call with analysts to put those results into context. Here are the key points that management wanted to get across in that chat.
Industry headwinds are a pain
The transition from inflation to deflation creates a difficult operating environment.
By far the biggest factor influencing Kroger's results this quarter was falling grocery prices. By management's count, prices on products like dairy, eggs, and meat plunged by 1.5%, which lowered sales results and increased costs as a percentage of revenue. This is an industrywide challenge, though, brought on by the market's first bout of deflation since 2009.
Other industry participants are feeling the pain, too. Sprouts Farmers Market, for example, recently halved its growth forecast due to what it described as "significant ongoing deflation." It's likely that Wal-Mart (NYSE:WMT), Kroger's chief competitor, will also complain about falling prices when it posts its next quarterly update.
Fundamental metrics are still improving
Our core business remained strong as we continued to increase market share, improve tonnage, and grow loyal households.
Deflation helped lower comps to a 1.7% pace, marking a sharp deceleration from the 5%-plus level investors had enjoyed through 2015. It was about even with Wal-Mart's growth as well, although the retailing titan's second quarter ended a few weeks before Kroger's
However, Kroger still improved the volume, or tonnage, of sales while at the same time gaining market share. Those gains are good for the long-term health of the business as they should power stronger growth when the industry picks up again.
We're pulling back on our investment plans
Consistent with our long-term financial strategy, we are maintaining flexibility with our cash flow to invest in the business, repurchase shares and maintain a growing dividend.
-- Chief Financial Officer Mike Schlotman
Kroger has been ramping up its capital spending plan since 2012 but this week pulled back those goals in light of the negative industry dynamics. Executives were aiming to spend as much as $4 billion adding stores and investing in new technology this year, but lowered that forecast by $500 million.
They still plan to make growth investments, but believe the cash will be handy to have around in case deflation worsens or persists for many quarters. The company may also dedicate much of those savings toward share repurchases, which could pay off given that the stock is down nearly 30% this year.
Economic conditions aren't favorable
Our customers tell us they are less confident about the economy now than they were three months ago, and they expect the economy to get worse in the next three months.
Kroger's customer polling is pointing to tightening budgets throughout the industry. Combined with lower overall prices, that trend threatens growth in all sales categories, but especially those at the premium end of the industry.
Still, the supermarket chain should do better than many rivals in this situation because it carries a wide selection of both premium and value-based products categories.
Deflation will hurt results at least into 2017
We expect continued deflation and tough year-over-year comparisons for the remainder of this year -- and even into the first quarter of next year.
Kroger lowered its sales growth guidance as executives now see comps stopping at 1.5%, -- about half the level they projected back in June and just one-quarter of 2015's growth pace. McMullen and his team believe their long-term financial targets of roughly 10% annual profit gains plus a rising dividend aren't threatened by this disruption, even though the company will fall short of that figure this year.
They are also confident that industry trends will eventually improve, maybe as early as the second quarter of 2017. "As we know from past experience," McMullen said, "the environment won't be deflationary forever."