Kroger reported FQ3 EPS of $.71 vs. consensus of $.67. ID sales ex.-fuel grew 10.9%, above consensus estimates of 9.3%. Digital sales grew 108% and contributed 4.6% to ID sales. During the current wave of lockdowns, the company is seeing further traffic declines offset by larger baskets. The week of Thanksgiving decelerated compared to the first two weeks of November. Taken together, November tracked at similar levels seen in FQ3 despite the new round of lockdowns.
Gross margins, ex. Fuel contracted 2bps despite robust sales growth. Management said price investments and mix changes offset sourcing efficiencies, sales leverage, and growth in alternative profit streams. Management explained that price investments were in the form of personalized promotions in categories like fresh food rather than broad discounting. Sales leverage, lower shrink, and the growth in alternative profit streams should be meaningful, while lower sales of prepared foods and targeted prices through loyalty plans seem limited. Until the company can explain the magnitude of the headwinds and tailwinds better, the lower margins from e-commerce are the obvious answer. Management said, “digital profitability improved” and “digital sales are incrementally profitable today,” but they were not cited as a margin drag. Adding to the mystery, payments to third party delivery providers like Instacart flow through OG&A on the P&L and not through gross margins. Management’s obfuscation on digital margins is one of our largest concerns.
Fuel margins were 37 cents per gallon compared to 30 cents in the prior year. Fuel margins have been a tailwind for an unsustainable period of time, as seen in the table below.
Management also does not disclose much about their alternative profit business, except for the accolades. The profit growth from the segment will add more than $100M in growth this year. Kroger Precision Marketing grew over 190%. More CPG companies are finding it more effective to advertise close to the point of sale rather than on social media or other digital advertising. Being able to track the marketing spend to the checkout holds a lot of appeal to vendors. The unit sounds as promising as Safeway’s Blackhawk Network did more than a decade ago. The company would do well to provide more details about the business at its March investor day.
Management raised EPS guidance for the year to $3.30-3.35 from $3.30 previously, which was in line with consensus. The company will host an analyst day in March, which is well-timed to preview the difficult comparisons the industry will face. Management said they expect the two-year stack comps to be stronger than they would have anticipated pre-pandemic – a low bar. The company generates significant amounts of cash during the pandemic, and leverage has dropped to 1.7x EBITDA.
Kroger is on our Best Idea Short list. Kroger is the best operator in a very competitive industry. However, it is coming up against difficult comparisons; various departments have cyclical and structural challenges (fuel, pharmacy, prepared foods). It is spending enormous amounts to prepare for a structural shift in how consumers shop while facing several headwinds margins. On the other side of these challenges, it is difficult to see when it can ever match its 2020 EPS.
