Kroger Plays Offense Amid Challenges

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Kroger (NYSE: KR) clearly isn't afraid of the future. While some might think that the largest U.S. grocer is an old-fashioned or boring business, there's actually a lot going on under the surface. Last October, the company launched its Restock Kroger program, centered around investments in product optimization, e-commerce, and employee initiatives.

Add in the recent purchase of meal kit provider Home Chef, a partnership with and increased investment in British online grocer Ocado, and a partnership with Chinese e-commerce leader Alibaba -- not to mention the divestiture of its convenience store business -- and the Kroger of today looks vastly different than the Kroger of just one year ago.

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Despite all the excitement, Kroger's recent second-quarter earnings report sent shares down, as the revenue growth missed analyst expectations and gross margins declined. The stock has had a nice recovery since it sold off when Amazon (NASDAQ: AMZN) announced it was acquiring Whole Foods in June 2017, but investors still appear to be skeptical.

Same old concerns

The big knock on the grocery industry is that margins are very low. Those fears were amplified when Amazon bought Whole Foods and as other low-cost retailers invest heavily in the grocery space.

Kroger's last quarter reflected those fears -- revenue rose only 1%, though 1.8% when adjusting for the acquisition of Home Chef and the sale of the convenience store business. Same-store sales increased a mere 1.6%, below Kroger's full-year target of 2% to 2.5%. The company continued to "invest in price," which means cutting prices in the face of competition.

In addition, Kroger also got hit with rising costs, both on fuel and on credit card fees from Visa. In fact, Kroger subsidiary Food Co. stopped accepting Visa cards entirely over the summer. Kroger's management said, "We're prepared to expand non-acceptance to other banners if that's what it takes to get a level playing field for negotiated interchange rates. It's also worth noting that we recently changed our Kroger Rewards credit card from Visa to Mastercard." It's rather unsettling to think Kroger might need to take such a drastic step with a major credit card distributor and potentially lose cardholders as customers.

These factors contributed to gross margins declining 36 basis points from last year, adjusting for fuel sales.

But reasons for optimism

The earnings call wasn't all doom and gloom, however. In fact, some of the gross margin decline could actually be viewed positively.

For one thing, Kroger decided to accelerate store optimization investments into the second quarter. When the company remodels a store to better give customers what they want, that work gets in the way of sales for the renovation period, but should pay off in the longer run. CFO Mike Schlotman said that without such store optimization, same-store sales would have been more than 2%, which is within the company's full-year guidance. Schlotman also said that these headwinds would turn to tailwinds in the second half of the year, as 600 stores finish renovations in time for the holidays.

Second, Kroger actually saw disproportionate growth in its specialty pharmacy business. That business has even lower gross margins than groceries, so the growth in that segment was actually a negative to the company's overall gross margin.

Expanding store brands

Finally, many of the aforementioned price cuts were centered on Kroger's private-label brands, including, Big K, Wholesome@Home, and Comforts for Baby. Private-label brands usually have higher margins for retailers than consumer packaged-goods brands, so cutting prices in private-label brands isn't necessarily bad if it spurs increased sales as a proportion of overall revenue.

That's exactly what happened -- the private-label brands made up 28.2% of Kroger's unit sales and 26.5% of Kroger's dollar sales in the second quarter, which was a record.

Not only that, Kroger inked a deal with Alibaba to sell Simple Truth–branded goods in China. Simple Truth is Kroger's organic private-label brand, which has been a huge hit with customers. Last quarter, Simple Truth grew 15%. In just five years, Simple Truth is already the second-biggest brand sold across Kroger, with more than $2 billion in annualized sales. Should Simple Truth resonate in a similar way on Alibaba's Tmall, that's another half a billion people Kroger could reach, all without having to open more stores.

Kroger shouldn't be counted out

While investors are skittish about Kroger's recovery, there's reason to believe. The company has built Simple Truth from nothing into a huge business in just five years and is building partnerships to help it improve. This gives me confidence management can succeed in newer initiatives such as store optimization, meal kits, and delivery, all of which are rolling out currently. In short, Kroger investors shouldn't panic as the company goes through this transition period. Its current investments are likely to pay off.

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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. Billy Duberstein owns shares of Alibaba Group Holding Ltd., Amazon, and Kroger. His clients may own shares in some of the companies mentioned. The Motley Fool owns shares of and recommends Amazon and Mastercard. The Motley Fool owns shares of Visa. The Motley Fool has a disclosure policy.