Kroger (KR +2.57%) has a profit problem that will take more than a single fiscal year to overcome. That much was clear from the supermarket chain's most recent quarterly report. After marking its fourth straight quarter of accelerating sales growth, Kroger's forecast suggests 2018 will be a third consecutive year of sluggish earnings growth, and may even result in a slight contraction.
In a conference call with Wall Street analysts, CEO Rodney McMullen and his executive team described fiscal 2017 as "one of the most complicated" years in Kroger's history. Below are a few comments management made in that presentation to put the latest results into perspective for investors.
Image source: Getty Images.
Meeting (lowered) expectations
"We are proud to share today that we delivered on those revised commitments for the year, finishing 2017 with strong sales and business momentum." -- McMullen
Revenue growth sped up to its fastest pace of the year in fiscal Q4, which ended Feb. 3, and the 1.5% comparable-store sales gain allowed it to modestly exceed the reduced expectations management issued back in June 2017.
Chart by author. Data source: Kroger.
As a result, its market share rose for the 13th consecutive year, ticking up by 21 basis points -- slightly better than last year's 16 basis point improvement.
Keeping prices low
"We saw an opportunity at the beginning of the quarter to invest in the shopping experience and price while still delivering on our annual [earnings] commitment. This is why our results reflected a gross profit rate decline." -- CFO Mike Schlotman
Kroger gave up a bit of profitability -- mainly through aggressive price cuts -- to achieve that faster sales growth. This is a trade-off that management says it will continue to make, since lower prices drive market share gains and enhance customer loyalty.
Ultimately, strength in these metrics should deliver improved earnings over the long term. "This is where the incremental profit margin will come over the next three years," Schlotman predicted.
Store brand wins
"In 2017, our brands achieved [their] highest ever unit share. We reached $20.9 billion in total sales and reached $2 billion in annual Simple Truth sales, which to me is even all the more remarkable when you consider that the brand is only 5 years old." -- McMullen
Store brands including Private Selection, Kroger, and Simple Truth continue to provide a major competitive advantage for the retailer. They accounted for just under 30% of sales volume in the quarter, executives said, and customer satisfaction with these exclusive products was on par with, or above, their comparable national-brand rivals. This bodes well for Kroger's plans to lean on store brands as a growth driver over the next few years.
Elevated debt for now
"Our financial strategy is to use our free cash flow to drive growth while also maintaining our current investment grade debt rating and returning capital to shareholders. We continually balance the use of cash flow to achieve these goals." -- Schlotman
Kroger's debt burden has climbed above management's target range recently thanks to big contributions it made to shore up its pension plans. These expenses sapped $1.6 billion from free cash flow in fiscal 2017.
Management is aiming to get its debt level back down into their goal range as a multiple of earnings, and the recent sale of the company's convenience store business represents an important step in that direction.
Looking ahead
"We expect 2018 identical supermarket sales growth, excluding fuel, to range from 1.5% to 2%. We expect net earnings to range from $1.95 to $2.15 per dilute share for 2018." -- Schlotman
Kroger is calling for its expansion pace to at least double to as much as 2% this year, even as adjusted earnings are expected to be flat due to elevated spending on price cuts and a bulked-up e-commerce infrastructure. Achieving that forecast would require healthy market share gains in a challenging sales environment. But it's still a far cry from the 5% comps gain -- and 20% profit increase -- that Kroger posted in 2015, before growth trends slowed to near zero.
