Investors were clear about their perception of the second-quarter earnings results that Kroger (KR 0.48%) reported last week -- they didn't like them. Shares fell 7.5% on Friday in response to last quarter's shrinking gross margin, and have since given up a bit more ground. Rising wholesale costs and (of all things) theft are taking a toll.

This pullback, however, is ultimately a buying opportunity. Last quarter's cost increase is not only out of the ordinary, but it's projected to be temporary.

Person standing in a grocery store aisle, comparison shopping.

Image source: Getty Images.

There's seemingly little room for this cost increase

The good news is, Q2's top and bottom lines were better than expected as well as better than year-ago figures. The grocery store chain turned $31.7 billion worth of revenue into an adjusted per-share profit of $0.80, versus expectations for sales of $30.4 billion and earnings of $0.64 per share. In the same COVID-disrupted quarter a year earlier, Kroger earned $0.73 per share on revenue of $30.5 billion.

The bad news is, Kroger's cost of goods sold grew from 77.2% of sales in the second quarter of 2020 to 78.6% of Q2's revenue.

On the surface, this increase in wholesale costs seems modest; plenty of other corporations are dealing with worse. Besides, Kroger was able to offset its rising food, shipping, and shoplifting costs by lowering its selling and administrative costs.

The problem, however, lies in the grocery industry's pricing power. Margins in this business are paper-thin, leaving little wiggle room when it comes to a grocer's biggest expense -- the aforementioned total cost of goods sold. Of last quarter's $31.7 billion top line, only 2.7% of it was turned into operating income.

All of a sudden, last quarter's wholesale cost increase to 78.6% of sales is a big concern, made even more concerning by the fact that at 78.6%, Q2's cost of goods sold rate is not only above average, but it's the highest it's been since the second quarter of 2018.

Fortunately, that's apt to only be a temporary swell in the company's total inventory costs.

Not as bad as it seems

Calling a spade a spade, the market lost a little perspective on last quarter's increased cost of goods sold.

The graphic below puts things in perspective. Q2's wholesale costs were admittedly higher than the year-earlier rate. But, relative wholesale costs were below average during the second quarter of 2020, when the impact of the pandemic was at its greatest, and when eating at home rather than at then-shuttered restaurants was the norm. For a much-needed perspective, Kroger's average wholesale inventory costs for the past five years is 77.5%, which of course is higher than the Q2 2020 figure.

Kroger's revenue breakdown by four different cost types by quarter from October 2016 to July 2021.

Source data: Thomson Reuters. Figures are in millions of dollars. Chart by author.

And perhaps more important right now, the analyst community expects these rising costs to cool off sooner than later. The current quarter's wholesale costs are projected to pull back to 78.4% of sales en route to consistent sub-78% levels next year, before moving back toward the 78% mark!

Chart of Kroger's cost of goods sold as a percentage of revenue by quarter from October 2016 to January 2024.

Data source: Thomson Reuters. Chart by author.

These are only projections, of course; and they're somewhat in question after producer inflation jumped to a shockingly high annualized pace of 8.3% in August. Even stripping out the volatile prices of food and energy, the nation's factories are now paying 6.3% more for inputs than they were in August of last year.

Again though, some perspective has been lost. Current prices are being compared to prices recorded when the disruption stemming from the pandemic was still fresh. That hurt overall pricing power then, making current prices look and feel exaggerated now. The producer price index measuring these costs on an absolute basis currently stands 8.1% higher than it did in August of 2019 -- before the COVID-19 contagion had materialized -- which is more in line with long-term inflationary norms.

The Federal Reserve Bank of New York further estimates that while closely related consumer inflation will roll in at levels above long-term norms for the foreseeable future, it's still expected to ease from 5.2% a year from now to 4% three years from now. Both figures are lower than July's multi-year high inflation rate of 5.4%. And wages are expected to increase in step with these price increases, ultimately translating into more pricing power for grocers like Kroger.

The point being, analysts' suggestions that there will be a tempering of Kroger's rising inventory costs are credible. One can presume the company will also figure out a way to curb the shoplifting that has quickly turned into a serious challenge.

Think bigger picture

It's also worth noting that Kroger shares were already pretty frothy headed into Friday's second-quarter report, up 45% year-to-date. It's arguable the stock was going to sell off regardless of the numbers the company posted, with profit-takers primed to pull the trigger. Indeed, despite the 9% pullback since the Q2 results were published, there may be more profit-taking to come.

On balance though, most of any selling that was in the cards has likely run its course, leaving shares of this grocer closer to a bottom than a top.

Remember, despite the uptick in last quarter's costs, the company also just upped its full-year profit guidance to a range of between $3.25 and $3.35 per share versus a forecasted range of only $2.95 to $3.10 three months ago. That's not a tough idea to digest either. This company continues to refine its overall revenue-bearing operations with things like ghost kitchens, dedicated customer delivery warehouses, scan-and-go tech, advertising on its website, and more. Higher wholesale costs don't stand in the way of any of these efforts. A growing understanding that last quarter's increased cost of goods was a temporary anomaly will only beef up the bullish case.