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Competition Challenging Kroger Strategy in the Recovery

As noted earlier in this blog, Kroger (KR) had a rough time in the latest completed quarter, and during a conference call, executives admitted they had underestimated the effects of deflation and competition when they prepared its guidance for the period.

Yet, throughout the call's prepared remarks, Kroger executives avoided discussing the competition. The competitive factor still was a shadow over the presentation. Troubles that resulted in Kroger's taking an impairment charge against its Ralph's chain in California certainly resulted from the state's poor economy but compounded by a fierce price war there. The California turf battle didn't factor into Kroger's presentation.

When Citigroup analyst Deborah Weinswig asked a question about the intensity of the competition, though, CEO David Dillon admitted, as transcribed by SeekingAlpha:

Well, the environment itself, I would characterize as a new game. I have not ever seen anything like this or if I have, my ability to understand what was going on around me was so long ago that I maybe didn't perceive what was happening.
He soft-pedaled afterwards, saying:
But put that aside, and I think just use conventional knowledge of what typically happens, and I think what we saw from a competitive point of view is pretty simple. As you've seen, many of our competitors, in fact most of our competitors, have reported negative sales, negative IDs, and when you are in that position, it is pretty normal to try and reach out to say what can I do to try to change that? That automatically makes a market a little bit more promotional and a little more focused on price. So we shouldn't have been really surprised that that occurred, but it did occur clearly differently and a little more pronounced in the last half of the third quarter than what we had experienced earlier in the year. So I think that the behavior you are seeing is actually pretty consistent with patterns in past cycles, but I think the environment is a clearly different environment than what we have experienced before.
No matter the spin, that fact that Kroger has been hit by competition in ways it didn't expect comes through, and its troubles didn't begin in the third quarter. Identical store sales -- sometimes refered to as IDs and arising from stores open for at least a year discounting remodels and relocations -- have fallen from just over three percent in the first quarter to about two and a half percent in the second to one and a third percent in the last completed quarter.

What's more, a fourth quarter rebound doesn't seem imminent. In the conference call, UBS analyst Neil Currie questioned Kroger executives about the company's need to respond to competitive price pressure versus maintaining sales margins and profits. He noted that the company earnings per share for the third quarter came in almost 10 cents below what was posted in last year's period and that the company had taken its full year guidance down by at least 20 cents. Then he asked if the company's guidance was overly cautious or if reduction meant Kroger was planning on additional price cuts to keep pace with rivals. In answer to the question, Dillon said:

Well, I won't say we are being over-cautious, but I will indicate that we felt that we did not properly read the market in the second quarter release when we were telling you where the third quarter and the rest of the year would come out, and I fault myself...We are trying to stand back from it now and read it more accurately for you and to try to describe all the factors that we know about. And given that the two major holidays in the fourth quarter, one of them has already passed, we already know the data, and we can share with you that it was a soft holiday for us in sales, and the earnings results were softer than what we would have liked to have. And so when we take those things into account and look at how unpredictable this environment has been, we had to leave a lot more room than we might ordinarily have.
Take into consideration that non-traditional competitors such as Walmart (WMT) supercenter and Save-A-Lot were offering deals that provided $20 Thanksgiving dinners for eight in the aforementioned holiday. The real question Kroger faces is: Does this all shape up as a cyclical problem or as something more? Vice chairman Rodney McMullen suggested that the supermarket industry lags the economy by six to 12 months and so currently would be around the peak of recessionary effects. Still, if the selling environment has shifted to favor its competitors, particularly non-traditional competitors including alternative supermarkets such as Save-A-Lot, supercenters and warehouse clubs, then Kroger faces a different kind of challenge.

Kroger has proven competitively resilient in the past. It made hard choices, squeezing profit margins to develop a market position relative to Walmart that helped it build sales and profits earlier in the decade. As Dillon noted, the company is doing better than many of its major competitors. It has developed loyalty card and private label programs that allowed it to sell more product tonnage in the past quarter even if at lower prices that hurt its results. Yet, Kroger's position has deteriorated and that bears watching, particularly if the company doesn't rebound with the economy. Kroger may need to rethink its market approach again to pursue a consumer that has explored a range of food purchasing options and no longer is as satisfied with traditional supermarket shopping.

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