A Grocer For Hungry Investors

By Kristin Graham | September 21, 2009 AAA

Generally speaking, the grocery industry is a risky business in which to invest. The low-margin business models don't allow much pricing flexibility and ultra-competitive nature among rivals requires lean cost structures. Overall, grocers in the past haven't made very appealing investments.

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However, the nature of the industry is changing. Consumers are transitioning from eating out at restaurants to eating at home to save money, and big consumer product giants like Proctor & Gamble (NYSE: PG) and Kraft (NYSE: KFT) are losing their pricing power as grocers are creating their own private-label products to rival higher priced brand names. Both trends are quite favorable to grocery stores and are improving my outlook on the industry in general.

Grocers' Moat
From a cosmetic perspective, it's difficult for grocers to distinguish their store from their rival down the street, except in pricing. Sure, cleanliness, layout and service can go a long way, but those attributes can be easily copied by any competitor. The real advantage that builds a competitor's moat is internal logistics. It's key for grocers to creatively and strategically structure their operations in order to gain a competitive advantage, because those with lower costs ultimately offer lower prices without killing margins.

Based on this notion, Kroger (NYSE: KR) stands out as my top pick among the most prominent public grocers, including Whole Foods (Nasdaq: WFMI), Safeway (NYSE: SFY) and SuperValu (NYSE: SVU).

Kroger operates an impressively efficient distribution system that has resulted in noticeable expense control. The company's automated supply chain process is revolutionary in the industry. This is key, because it allows Kroger to leverage its lean business model to offer very competitive prices to its customers in these tough times.

A Distasteful Quarter
Of course, even a superior operational structure can't fully shield a retailer from the impact of sluggish sales and heavy promotional activity. For the second quarter, total sales slipped 1.98% - though excluding fuel, revenue rose 3.5%. Margins also contracted from price cutting, which ultimately led to profits dropping 8%.

Operational performance may have been less than desirable, but that's to be expected in poor economic times. I'm more focused on the company's ability to gain market share and grow its customer base. During the quarter, Kroger increased both the number of households it serves and the number of items people are buying. This is key, because it means that Kroger is increasing its market share; a feat not easy in such a competitive space.

Evolving Consumers
As management addressed in the conference call, consumers are continuing to evolve their shopping habits as the recession drags on. The major change is the continuous trading down to lower-priced private label brands. And while alteration in pricing mix surely impacted margins, it is favorable for Kroger because the company offers one of the most extensive and well established private label product lines. By lining its shelves with cheaper alternatives stamped with a Kroger label, the retailer is essentially branding itself. In the long run, this can build strong loyalty among customers.

Bottom Line
Missing earnings estimates can provide great buying opportunities, and I think investors' reaction to Kroger's earnings presents this opportunity for a company that is emerging as a leading competitor in the industry. (Read Analyzing Retail Stocks to learn about the most important metrics to look at when analyzing retail stocks.)

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