Can This Grocer's Claims Be Trusted?

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I have returned from my first big grocery shopping trip since Kroger (NYSE: KR) stopped doubling manufacturer’s coupons.

It wasn’t pretty.

As an extreme couponer, losing the savings advantages of double coupons is a major hit to my grocery budget. Before the recent coupon change, I expected to save about 75% off my groceries. I still use coupons, but without the benefit of doubling, I am spending just as much money as before, but getting considerably less.

Rodney McMullen, the President and COO of Kroger, doesn’t seem to think I will mind too much. (He’s wrong.) “We invested the monies that were saved from double coupons into lower everyday pricing,” McMullen told investors. “So if you look in total, it actually had no effect on gross margin. What we found was there weren’t very many customers actually engaged with double coupons and we felt like it was better to give lower prices to all customers so all customers could get the benefit of that. So it really didn’t affect much.”

Kroger doesn’t expect to lose me, or other couponers, as a customer!

For Q1 2013, Kroger reported $30 billion in sales, a 3% increase over Q1 2012. But gross margins were down 15 basis points from a year ago. Sales at stores open at least a year rose 3.3% during the period, excluding fuel. For the quarter, Kroger earned $481 million, compared to $439 million a year earlier.

Kroger store brands now account for 26% of total units sold and 24% of total sales, excluding pharmacy and fuel. Kroger pushes store brands aggressively (those “everyday pricing” savings he mentioned above, are often on store brands). McMullen noted that once customers try store brands, they stick with them, and don’t tend to go back to name-brand products.

McMullen's claim poses an interesting question. What poses the biggest threats to a grocer? Loss of a loyal customer? Other grocers? Or the manufacturers/producers of the products on the grocer's shelves?

It's all about the brand name

If McMullen is right, that customers like store brands more than name brands, this claim would be a great boon to the chain. Why compete with other stores when you can find success with better sales within your own store?

But a defection from name brands to store brands doesn’t appear be reflected in the sales at some of the major manufacturers. Kellogg (NYSE: K) is the second largest global savory snack company. The company's strategy is to be the dominant company in both cereal and snacks - two areas Kroger store brands compete in.

For instance, Kellogg reported that first-quarter 2013 net sales increased by 12.2% to $3.9 billion. EPS growth was estimated to stay in the range of 5%-7%.  Kellogg is a commendably diverse international company, but still receives most of its revenue domestically. The company is doing well, and analysts expect to see Kellogg to grow at a rate of 7.8% in the coming years. Kellogg recently announced a $1 billion share repurchase plan, expiring in April 2014. 

Despite the indomitable presence of Kellogg's cereals, at the company's U.S. snack division, which includes Pringles, Keebler cookies, and Cheez-It crackers, internal net sales declined by 1.7%. And Kellogg's North America overall net sales were $2.6 billion in the first quarter, an increase of 8.1%.

The anticipated defection to store brands is not reflected at Procter & Gamble. The household products magnate earned $2.57 billion in the fiscal third quarter ended in March, up from $2.41 billion a year earlier. Procter & Gamble revenue rose to $20.6 billion from $20.19 billion a year ago, but fell short of Wall Street expectations. The company cited "heavy" competition taking a toll on net sales of hair care and skin products. But that competition isn’t coming from Kroger store brands- Kroger doesn’t offer a store brand in those categories!

Both Procter & Gamble and Kellogg offer solid dividend yields, in addition to strong growth potential and cash flow. Kroger also offers a nice 1.7% dividend.

At Campbell Soup (NYSE: CPB), which does make products in direct competition with Kroger store brands, there was an improvement in sales and soundly outperformed its competitors in comparable categories. The Campbell’s core U.S. soup business rose 14% in the fiscal third quarter, the largest quarterly gain in nearly five years. The company attributes the positive growth to improved taste in existing products, adding new products to their offerings, and cutting back on advertising. For the fiscal third quarter, Campbell reported a profit of $181 million compared with a year-earlier profit of $177 million.

Campbell has worked on improving flavor, expanding its product line, and has recently acquired other competitors and markets internationally. While other companies have increased ad spending, Campbell cut back, without losing sales. The improvement in Campbell's soup business, plus internal restructuring and changes, have contributed to nearly 40% rise in Campbell shares over the past year.The changes at Campbell have helped it regain lost market share, but it will still take a few more years to see how it all plays out before it can be truly determined how strong a company and strong a competitor the soupmaker really is.

Campbell’s Global Baking and Snacking, which includes Pepperidge Farm, were $568 million for the third quarter, an increase of 5% from a year ago. Did it steal sales away from Kroger? Maybe.

General Mills' U.S. retail segment, which makes several products in competition with store brands, sales grew 2% to $2.66 billion. General Mills Bakeries and Foodservices division (snacks and baked goods) sales were flat with the most recent net sales at $470 million, essentially matching year-ago results. It isn't losing sales to Kroger brands either.

All things considered, it does not appear that Kroger really has converted customers to store brands over the name brands. The name brands are not necessarily growing, but they are not losing either.

The real competition

Kroger clearly is not attracting customers away from the manufacturer name brands. With more and more grocers cutting double coupon offerings, Kroger does not need to worry that the couponers will defect to another store to get that benefit. Instead customers will go to the stores with the best prices and most convenience, and that means the real competition for Kroger comes from big box stores like Wal-Mart or Target. Kroger faces competition from these bigger chains that offer groceries at comparable prices, and draw in customers with the convenience of the other retail products and services that traditional grocers do not offer.

Traditional grocery chains have struggled in recent quarters as other stores become more specialized and diverse. Mass retailers such as Wal-Mart, Target, or SuperValu provide convenient one-stop shopping that grocers like Kroger and Safeway cannot compete with. But this is where Kroger stands apart from the competition. In some states the Kroger can compete against the big box stores with Smith's Marketplace, Fry's Marketplace, or Kroger Marketplace. The Marketplace models offer everything from eggs and milk to cocktail dresses and lawn mowers. The company is moving more and more to this model where applicable.

The grocery business is a difficult and complicated one. Not only are the companies in competition with other grocers, and the manufacturers, but they are vulnerable to the slightest shifts of the economy, and the weather. Nowhere is this seen better than at Wal-Mart. Groceries are a very important sector for Wal-Mart. Grocery sales accounted for 55% of its U.S. sales of $274.5 billion in the latest fiscal year.The company reported weaker-than-expected fiscal Q1 2014 results due to a 1.4% decline in US comparable store sales. Revenue of $114.19 billion fell shy of analyst estimates of $116.29 billion. The company attributed the decline in U.S. same store sales to weak consumer spending during the quarter primarily caused by payroll tax increase, and lower-than-expected price inflation of grocery items.

In the bag

In spite of Kroger’s claims, it just doesn’t look like the chain has the customer loyalty it says it has, nor does there appear to be a real impact made from a shift to store brands. Will customers return without the benefit or incentive of doubled coupons? Or will they flock to the one-stop shop, big-box stores? It is too soon to say. Sales may have been up in the first quarter, but it is the second-quarter results that will really tell the story.

Citing its stronger first-quarter results, Kroger increased its net earnings guidance for the year to a range of $2.73 to $2.80 per share, up from $2.71 to $2.79. Will the hopeful growth happen? Only time will tell. But for now, I’m a skeptic, and encourage investors to really take a look at the company’s claims before jumping too far in.

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Erin McBride has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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