Kroger Has Bigger Problems -- Amazon Is Buying Whole Foods

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When The Kroger Co. (NYSE: KR) reported its recent financial results, increased competition and a decrease in same-store sales were already taking a toll. This forced the grocer to lower its profit forecast for the year by 10%. The company's stock fell 19% on its lackluster performance and reduced guidance -- then Amazon.com, Inc. (NASDAQ: AMZN) announced it would buy organic grocer Whole Foods Market, Inc. (NASDAQ: WFM). Kroger stock fell another 9%, to levels not seen in more than three years.

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The news sent shockwaves through the grocery industry, sparking a wholesale sell-off in all the major players. Kroger, as the leading grocer in the U.S., has the most to lose. Amazon, an e-commerce powerhouse, has disrupted a large swath of the retail industry and has been testing the waters in the grocery industry for nearly a decade with its Amazon Fresh and Amazon Pantry concepts, and its concept store without checkout lines.

A new paradigm

Website Quartz calculated that Whole Foods' 440 U.S. stores are within three miles of 75 million U.S. shoppers. The company struggled from growing competition in its core organic fare, but adding these locations to Amazon's already powerful arsenal of unrivaled pricing power and growing delivery network may create an indomitable force in the grocery arena.

Still, difficulties remain regarding fresh groceries. Items like milk, eggs, and frozen foods require refrigeration to keep from spoiling, and require shorter delivery times and a person available to accept delivery. Produce is tricky, and choice in the area is subjective. Consumers may want to consume that avocado today, or a few days from now, so the level of ripeness comes into play.

Dealing with increased competition

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Kroger was already facing increased competition on the home front, from German grocers Aldi and Lidl. Both discount grocery chains are well known in Europe and have been expanding their footprints in the U.S. Their operations are most comparable to Trader Joe's -- stocking a limited selection of items at lower prices. They rarely stock name brands, preferring to sell their own private-label products, instead. The locations are also typically smaller than comparable U.S. stores, with only six aisles versus 24 for their U.S. counterparts. 

Kroger's Chief Financial Officer Mike Schlotman said that competition is just part of the business:

This industry has always been highly competitive. I've been around Kroger -- it will be 32 years in October -- and year-in, year-out it's a competitive industry. Each year has been more competitive than the last. 

Down this road before

This may all seem like an eerie bit of deja vu to Kroger. Similar pressures occurred in 2002 when Wal-Mart Stores, Inc. (NYSE: WMT) first entered the grocery business. Investors feared that Walmart's state-of-the-art inventory management and increased pricing competition might make it difficult for Kroger to compete. In the 15 years since those dire prognostications, both have endured, and Kroger has even thrived.

Kroger has been preparing for the German invasion by cutting prices in competing locations. In its most recent quarter, Kroger reported sales of $36.3 billion, up from $34.6 billion, an increase of 4.9% over the prior-year quarter. Excluding fuel sales, revenue increased only 2.9% year over year. Net income fell to $546 million from $696 million in the prior-year quarter, while earnings per share fell to $0.58 compared to $0.72 year over year, excluding one-time items. 

Weighing on results

The headline, though, was the decrease in same-store sales -- which fell by 0.2%, excluding fuel -- the third consecutive quarterly decline. Kroger also lowered its guidance for the remainder of the year to a range of $2.00 and $2.05 from its previous estimates of $2.21 to $2.25, as the competition was already taking its toll. Prices on key items like milk and eggs were lowered to match those of competitors, temporarily depressing results.

The news wasn't all bad. Kroger has been beefing up its online sales capabilities and saw 30% in new digital customers and a 30% increase in online sales visits year over year. More importantly, digital revenue more than doubled over the prior-year quarter. 

Kroger has also been aggressively buying back shares for years. During the last 12 months, the company reduced its diluted shares outstanding by 3.5%, and by nearly 50% since January 2000. In the wake of its stock swoon, Kroger announced an opportunistic $1 billion share buyback, along with an increase in its dividend to $0.50 from $0.48, further benefiting shareholders over the long term. 

The bottom line

There's little doubt that the level of competition has escalated, but Kroger has been down this road before. No one really knows Amazon's plans for integrating Whole Foods into its operations. The future just became a bit more uncertain for Kroger investors, but it's still too early to call the game in Amazon's favor.

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John Mackey, CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Danny Vena owns shares of Amazon and Whole Foods Market. Danny Vena has the following options: long January 2018 $57.5 calls on Wal-Mart Stores and long January 2018 $55 calls on Wal-Mart Stores. The Motley Fool owns shares of and recommends Amazon and Whole Foods Market. The Motley Fool has a disclosure policy.