Kroger Co. Earnings Show the Mounting Costs of a Pricing War

Kroger (KR -1.34%) recently announced earnings results for its fiscal second quarter. The nation's biggest grocery store chain showed a slight improvement in operating results. But its pricing battle with rival retailers is heating up and will push profits lower for the full year.

More on that earnings outlook in a moment. First, here's how the headline results stacked up against the prior-year period: 

Data source: Kroger financial filings.

What happened this quarter?

Kroger's sales growth pace improved for the second straight quarter, yet remained far below the 5% or better that shareholders enjoyed as recently as 2015.

Chart by the author. Data source: Kroger filings.

Here are some other highlights from the quarter:

• Comparable-store sales rose by 0.7% to mark Kroger's first expansion by that metric since the third quarter of fiscal 2016. That growth kept the retailer behind its chief rival Wal-Mart (WMT -2.28%), which boosted its comps by 1.8% in the most recent quarter while increasing its profit outlook
• Kroger's sales volume and customer traffic improved, suggesting minor market share gains.
• The digital sales channel more than doubled thanks to a recent e-commerce acquisition.
• Operating margin held steady at 2.5% of sales as the company benefited from cost cuts.
• Higher interest and tax payments pushed net profit down to $353 million, or 1.3% of sales, from $383 million, or 1.4% of sales, last year. However, Kroger's earnings decline was far steeper after accounting for the prior year's pension plan charges. Adjusted profit dove by 22% to $353 million as the company ramped up its price cuts to protect its market position.

What management had to say

CEO Rodney McMullen focused his comments on Kroger's improving operating trends. "We returned to positive [comps] growth in the second quarter," he said in a press release. "We had strong growth in both loyal and total households," McMullen continued. 

Image source: Getty Images.

Executives highlighted the direct connection they saw between low prices and rising sales volumes. "Traffic is up, unit movement is up, market share is up, and our customers' price perception is excellent and continues to improve," McMullen explained.

Looking forward

That price leadership is proving expensive to the business, with operating margin declining by half of a percentage point over the trailing 12 months.

Investors shouldn't expect a quick rebound, either. Executives have expressed their determination to win any pricing war, whether it comes from comparable peers like Wal-Mart or from Internet-based challengers. Kroger has spent billions on lowering prices over the past decade, McMullen said in June, and the management team has "no intention of giving up the momentum we've gained on low prices."

The good news for the business is that the strategy is delivering results in the form of rising customer traffic and sales volumes. And a lost customer is much more expensive to the business than reduced prices, over the long term.

This competitive approach assures that earnings will fall significantly this year, though. Kroger's confirmed outlook calls for adjusted profit of between $2 per share and $2.05 per share. That would mark a decline from last year's $2.12 per share result. Given the intense pricing pressure in the grocery industry, it's not clear when Kroger will be able to return to its long-term target of improving annual earnings by between 8% and 11%.