4 Key Takeaways From Kroger’s Third-Quarter Earnings Report

Leo Sun, The Motley Fool

Updated Fri, Dec 7, 2018, 6:25 PM

Shares of Kroger (NYSE: KR) rallied 3% on Thursday after the grocery chain posted its third-quarter earnings before the bell. The supermarket operator's revenue dipped 0.3% year over year to $27.67 billion, matching analysts' consensus expectations. Excluding the impact of fuel sales, the divestment of its convenience store business, and its acquisition of meal kit maker Home Chef, its revenue rose 1.7%. Identical store sales (a metric that excludes fuel sales) grew 1.6%.

Kroger's net income fell 20% annually to $317 million, and its earnings per share fell 11% to $0.39. But excluding its investment in British online grocer Ocado (LSE: OCDO), Kroger's adjusted net income declined less than 1% to $394 million, and its adjusted EPS grew 9% to $0.48, clearing the consensus estimate by a nickel.

Image source: Getty Images.

The retailer reduced its full-year GAAP EPS guidance from a range of $3.88 to $4.03 to a range of $3.80 to $3.95, which would still amount to 82% to 89% growth from 2017. Kroger attributed the forecast cut to the volatility of its investment in Ocado, which has lost a quarter of its market value over the past three months.

On an adjusted basis -- which excludes Ocado, Home Chef, and other one-time benefits and losses -- Kroger reaffirmed its prior EPS guidance range of $2.00 to $2.15, compared to $2.04 a year ago. Analysts expect Kroger's revenue to decline 0.6% for the full year, and for its adjusted EPS to rise 4%.

Kroger's earnings report indicates that its results are stabilizing, but is it a worthy turnaround play yet? Here are four takeaways from the third-quarter report that will suggest an answer.

1. Stable identical store sales

Kroger's identical store sales growth of 1.6% slightly missed the consensus estimate of 1.7%, but indicated that its top-line growth remained stable.

Metric	Q4 2017	Q1 2018	Q2 2018	Q3 2018
Identical store sales*	1.5%	1.4%	1.6%	1.6%

Source: Kroger quarterly reports. *Excluding fuel. Chart by author.

Kroger expects its identical store sales growth in the second half of 2018 to be "similar" to the growth rate it achieved during the first half.

2. Declining margins

Unfortunately, Kroger's gross margin fell by 80 basis points annually to 21.6%, missing the consensus forecast of 22%. On an adjusted basis, which excludes fuel and a $12 million LIFO (last in, first out) charge, its gross margin fell 91 basis points annually, but improved sequentially.

Kroger attributed the year-over-year decline to higher transportation costs, the growth of its specialty pharmacy business, and "price investments" -- the industry term for accepting lower margins to remain competitive. That's worrisome, because Kroger still faces stiff competition from the likes of Walmart (NYSE: WMT) and Amazon's Whole Foods Market.

Kroger's FIFO (first in, first out) operating margin -- on a rolling four-quarters basis (excluding fuel, a pension contribution, and the 53rd week in fiscal 2017) -- fell 47 basis points annually. That was mainly due to the expenses incurred for its three-year "Restock Kroger" turnaround plan, which involves leveraging analytics to optimize prices and products, expanding the company's portfolio of private label brands, and adding more features to its digital ecosystem.

3. Robust digital sales growth

On the bright side, Kroger's digital investments -- which include its pickup service ClickList, the direct-to-consumer Kroger Ship platform, partnerships with courier services like Instacart, and its investment in Ocado -- boosted its total digital sales by more than 60% year over year in Q3. That's an acceleration from the more than 50% growth rate it posted for Q2.

A shopping cart icon on a smartphone app.

Image source: Getty Images.

Kroger also noted that the "seamless" coverage area between its brick-and-mortar and digital services now reaches over 90% of Kroger households, compared to 80% in Q2. However, as it invests more in logistics solutions and competes more aggressively against its online rivals, the costs of that digital expansion could throttle Kroger's profit margin.

4. A cheap stock with a decent dividend

Based on its Friday closing price of $29.17, Kroger stock trades at 14 times the midpoint of its adjusted EPS forecast for this year. By comparison, Walmart trades at about 19 times this year's earnings. However, Walmart is also posting stronger growth, with analysts expecting its revenue and earnings to rise 3% and 10%, respectively, this year.

Kroger currently has a forward dividend yield of 1.9%, and it has raised its payout annually for nine straight years. With a payout ratio of less than 30% (based on its projected adjusted EPS for fiscal 2018), it has plenty of room to hike those payouts further. However, investors looking for a higher dividend might instead consider Walmart stock, with its forward yield of 2.2%.

An uncertain future

Kroger's top-line growth is stabilizing, but its margins are contracting, and it's relying heavily on a costly ecosystem expansion to hold Walmart, Amazon, and other rivals at bay. Therefore, I'd stay away from Kroger stock until the company reports stronger sales growth and returns to margin expansion.

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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. Leo Sun owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.

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