Kroger Is Falling into the Diworsification Trap

Were you hoping to pick up some yoga pants the next time you go to the grocery store? Apparently that's what Kroger Inc (NYSE: KR) thinks.

The supermarket giant said last week it would launch its own modern lifestyle apparel brand as part of its Restock Kroger initiative. The new clothing line will include "elevated basics and fashionable highlights," and management says the launch of Our Brands will reinvigorate its apparel line. It's set to debut at 300 Fred Meyer and Kroger Marketplace locations next fall.

The announcement follows news in September that Kroger would open its first restaurant, called Kitchen 1883. The eatery, which is expected to open this fall, will offer a "New American Comfort" menu and will be located inside a Kroger marketplace in Union, Ky.

If you're wondering what's going on here, why a supermarket chain is branching off into seemingly unrelated businesses, famed fund manager Peter Lynch has an answer for you. Lynch dubbed such diversifying moves "diworsification" and bemoaned the impulse that CEOs often have to spend money on tangential businesses that don't improve the company's core operations. Kroger's diving into restaurants and apparel looks like a classic example of diworsification.

Just bad strategy

It's clear why Kroger is looking to shake up its business: the stock has fallen 38% this year, its financial results have disappointed investors, and the company has come under threat from Amazon following the latter's acquisition of Whole Foods. Kroger's streak of 52 straight quarters of comparable sales growth came to an end this year amid competitive pressure and lower prices from food deflation, and in its most recent quarterly report the company stepped back from a long-term goal of 8-11% annual EPS growth. Analysts now see earnings per share falling this year and next.

Management is clearly looking for new ideas to reinvigorate the company, but opening a restaurant or launching an apparel line isn't the right way to do it. Not only do those businesses not play into the company's core strengths as a grocer, but there are significant macroeconomic challenges in both industries. They simply aren't attractive businesses, especially for a stodgy supermarket chain.

According to research firm TDn2K, comparable restaurant sales have fallen nearly every month for the last year and a half as the industry suffers from oversaturation and a decline in mall traffic. Meanwhile, brick-and-mortar apparel is widely declining, with a few notable exceptions such as fast fashion and off-price. Hundreds of department stores are closing, Nike is pulling back from retail partners, and Amazon is expected to become the biggest clothing retailer in the U.S. this year, a sign of the rapid growth of online apparel retail.

In that kind of environment, launching an apparel line or opening a restaurant makes little sense.

A better way

Instead of grasping at tangential revenue streams, Kroger would be better off investing in businesses that have real growth ahead of them. For example, digital revenue led by Clicklist, its grocery pickup program, jumped 126% in its most recent quarter. Rival Wal-Mart (NYSE: WMT) has seen its stock approach all-time highs as it's invested in grocery pickup stations and made a big bet on e-commerce with its acquisition of Kroger would be mindful to follow suit by expanding Clicklist and considering acquisitions in online retail.

In fact, for a long time Kroger's acquisition strategy was the key to its success. Unlike most of its competitors, which have expanded by opening their own stores, Kroger has largely grown through acquisitions, snatching up banners like Harris Teeter, Roundy's, and Murray's Cheese in recent years. Growth through acquisitions like this allows the company to avoid oversaturating local markets, and lets it use its expertise and scale to drive increased profits out of those businesses.

Returning to that strategy and focusing on acquisitions and e-commerce is the best way for the company to leverage its strengths and return to profitable growth. It doesn't need to be Amazon or even Wal-Mart to succeed -- and anyway, both of those companies are focusing now on groceries, which has been a relative strength for brick-and-mortar retailers.

Adding new businesses like a restaurant and an apparel line is a waste of money, and won't help the company's core business. Peter Lynch would surely label it diworsification.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Jeremy Bowman owns shares of Kroger and Nike. The Motley Fool owns shares of and recommends Amazon and Nike. The Motley Fool has a disclosure policy.