The Long and Short

Robust demand fuels a better outlook for Kroger

| December 2, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The Kroger Company’s (KR) third quarter results came in better than expected as robust demand for private label and digital orders fueled the outperformance.  KR’s private label growth outpaced identical sales growth, while digital sales witnessed a double-digit increase.  The results prompted management to raise both full year identical sales and adjusted EPS guidance. Although the better-than-expected performance should be a positive for spreads, the company’s pending acquisition of Albertsons is likely to keep spreads range bound until we get further clarity surrounding the deal.

Exhibit 1. KR Curve vs. Consumer Staples BBB Curve

Source: Company Reports; APS

KR’s Private Label Value Proposition Resonates with Customers

Identical sales (excluding fuel) for the quarter were up a strong 6.9%.  This compares favorably to the year-ago quarter when KR witnessed 3.1% growth in identical sales.  The strong quarterly growth was fueled by increased engagement with the company’s private label line as customers look to stretch food budgets. Private label growth was an impressive 10.4% in the quarter, with management focused on increasing their fresh private label offerings amid tremendous growth in their private label pet products.  Private label is margin accretive and remains a key pillar in KR’s strategy to grow profitability.  The company recently rolled out a budget priced private line “Smart Way”, which has also provided a boost to private label sales.

KR reported a gross margin of 21.4% in the quarter, which decreased 5bps from the year-ago period.  Management noted that they were able to effectively manage higher cost inflation and increased shrink through better product sourcing while keeping prices competitive.  KR’s operating profit margin of 2.5% declined roughly 20bps from 3Q21.  While the operating margin benefitted from strong cost savings initiatives, it was not enough to offset wage increases for associates.

Digital Strategy Paying Off

KR’s focus on digital growth initiatives is also paying off as digital sales grew 10% yoy, with the option for delivery still a major driver of growth, up 34%.  KR noted that customers are increasingly downloading digital coupons via the KR app, with coupon downloads up 32% versus last year.  Additionally, management noted that they launched their first in-app flash sales this quarter which helped to increase customer engagement.  These coupons and flash sales provide for additional savings to regular rewards programs and are generating a higher degree of customer loyalty.  KR is also expanding its delivery network in new and existing geographies after rolling out a new customer membership program “Boost” earlier this year.  KR noted it is the most affordable membership program and is foundational to expanding its delivery service.

Guidance Revised Upward

Given the better-than-expected quarterly results, KR upped its identical sales and adjusted EPS guidance for the year.  KR now expects identical sales (ex-fuel) to be in the 5.1%-5.3% range, versus previous guidance of 4.0%-4.5%.  Adjusted EPS is now expected to be in the $4.05-$4.15 range, up from $3.95-$4.05 provided last quarter. We note that KR has suspended share buybacks ahead of its potential deal with Albertsons (ACI), to build excess cash on the balance sheet that can be used for debt reduction post close.

All Eyes on Albertsons

While KR announced that it would be merging with ACI in October of this year, the merger is not expected to close until early 2024, given the regulatory scrutiny surrounding the deal.  As part of the transaction, and in an effort to gain regulatory approval, the companies will spin off 100-375 stores to ACI shareholders prior to the deal closing.  However, speculation abounds that they will be required to spin/sell more stores than previously announced in order to get the transaction approved. While management was not able to provide much of an update on the call, they did note that they had the opportunity to testify before the Senate Judiciary Subcommittee on Antitrust Competition Policy in Consumer Rights earlier this week.

With over a year for the deal to be consummated, investors will be keeping a close on eye on any updated transaction details to determine bond valuations.  Should KR/ACI be forced to spin more stores than previously announced, debt reduction efforts could be extended, keeping leverage higher than previously estimated.  While KR’s net leverage of 1.6x remains below their target range of 2.3-2.5x, the deal will bring adjusted leverage to just over 4.0x.  Both Moody’s and S&P put KR’s ratings on negative outlook when the deal was announced, given the increased leverage.

Meredith Contente
meredith.contente@santander.us
1 (646) 776-7753

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