Source: Kroger
Can Kroger offset its margin headwinds?
Shares of Kroger fell nearly eight percent on Friday after the grocer reported that gross margins in the second quarter came in lower than expected due to higher food prices, theft and supply chain costs.
On the positive side, the supermarket chain raised full-year earnings guidance as its sales topped expectations. Same-store sales dipped 0.6 percent against the pandemic-fueled 14.6 percent gain a year ago. CEO Rodney McMullen told analysts, “Food-at-home trends remain sticky.”
Gross margins were down 60 basis points from the 2020 quarter, however, and 120 basis points versus the first quarter.
The higher shrink experienced by the chain, which reflects about a quarter of the margin impact, is believed to be driven by organized crime.
The chain said it lost another quarter of its margin due to the same increased warehouse and transportation costs facing other retailers. Kroger is securing increased shipping capacity and augmenting retention programs at warehouses to offset these cost pressures that are expected to be temporary. Supply chain expenses are expected to remain elevated in the second half of the year.
Finally, Kroger saw higher inflation in some categories in the second half of the quarter. Officials reiterated they expect inflation for the full year to be higher than originally contemplated in its 2021 business plan. For the second half, inflation is expected to range between two percent and three percent.
“We are continuing to invest in price where we think it makes sense,” said CFO Gary Millerchip. “Sometimes that might be in areas where we’re seeing inflation, sometimes it might be where we’re investing because we believe it’s the right thing to do to grow customer long term loyalty and other places through our personalization strategies.”
In a note, J.P. Morgan analyst Ken Goldman said he believes price elasticity is moderate enough for Kroger to raise prices more broadly to offset the varied cost pressures.
Mr. McMullen said Kroger has proven it can operate successfully in “low or negative inflation and high inflation” with the ideal rate being between three to four percent. He said, “So far, costs are being passed through in an organized way for the most part.”
- Kroger Reports Strong Second Quarter Results and Raises Full-Year 2021 Guidance – Kroger
- The Kroger Co (KR) Q2 2021 Earnings Call Transcript – AlphaStreet
- Kroger Reports Second Quarter 2020 Results and Updates Full-Year 2020 Guidance – Kroger
- Kroger gets hit by higher costs, theft — even as shoppers fill up grocery carts – CNBC
- Shipping woes, discounts bite into Kroger’s margins, shares fall – Reuters
- Will American consumers push back against higher grocery prices? – RetailWire
Discussion Questions
DISCUSSION QUESTIONS: How much room does Kroger have in the current climate to raise prices to offset cost pressures? What advice do you have around passing through unusually high operating costs?
Poll
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As inflation and supply chain costs impact the cost of products, all grocers need to increase prices to protect margins. Inflation and much of supply chain costs are uncontrollable expenses that affect all grocers and there is no choice but to adjust prices. Shrinkage, on the other hand, is somewhat controllable and varies from location to location.
All grocers, not just Kroger, will come under margin pressure. There are a cocktail of cost increases: rising raw material prices, increased labor costs, higher shipping prices, and so forth. On top of this are the investments needed to drive online growth, and the margin erosion that higher digital sales create. Increase prices to compensate? Sure, that can be done. But, with a lot of expansion coming from the value sector – Aldi, Lidl, dollar stores, and even Mere toying with a U.S. entry – retailers are constrained for fear of losing market share. There are some very difficult balancing acts ahead in grocery.
There’s a bit of room for Kroger to raise prices considering all retailers are facing the necessity to do so for one reason or another lately. That being said, the retailer that figures out the way to pass on the least amount of charges to the consumer will prevail in today’s price-sensitive world.
The best way to navigate price hikes with the consumer is to be as transparent as possible. Attempting to do this in a subtle way will only lose trust with shoppers.
Kroger has a lot of tools to help offset margin erosion but those take a little time to take effect, which may translate to gross margin pressure in the short term. All grocers are facing increased cost pressure and supply chain issues. However this also creates opportunity to retain or gain more market share. So it may be in the interest of some grocers to take a short-term gross margin hit to invest in keeping low prices and defending or gaining share. That long-term loyalty could be worth it in the long term.
Given today’s market dynamics Kroger has a good deal of elasticity to raise prices, and it’s interesting they’ve taken an investment mindset for certain categories/products. Layering in the odds of beating last year’s numbers makes the financial decision making even more interesting. Don’t misunderstand me. I think it’s great Kroger has the financial wherewithal to make these decisions, but for how long? Inflation is and will continue to be a drag on the economy and will drive prices higher, faster for the balance of the year, and likely at least until end of Q1 ’22. No one relishes in this — consumers, retailers, suppliers, but it’s the unfortunate situation all companies are facing today. I predict – and soon – Kroger will raise prices across the board for nearly all products and categories.
It’s not about how much it should raise prices, but understanding which items it should be raising prices on and which ones it should continue to invest in to maintain its competitive position. Having a balanced pricing approach to offset cost increases is the only correct solution and has helped numerous retailers establish a win-win approach during inflation by raising profits while offering better prices on the key items most essential to consumers. Having a price optimization platform and the right analytics can definitely help define this balance and I’ve seen some really fantastic balanced results coming out of high inflation/cost pressure markets from retailers who have done this. The worst solution is to raise prices to hit a margin target without listening to your customer and understanding the long-term impacts of those increases.
All companies are facing lower profit margins on e-commerce sales, the infrastructure and logistics erode sales margins. But no industry is hit harder by this than grocery. It typically costs a grocer about $7 per basket for customers to fill their own baskets and check out in-store. The cost soars to $20 per basket if the employees are doing the filling for curbside pickup, and even more if delivery is involved. The grocery model doesn’t work using today’s e-commerce positioning.
Interesting that Kroger is calling out shrink as a major component of its margin challenges. But I suspect the problem is more than just organized teams. Go into a typical Kroger after 6 on Saturday: there’s a line for self-checkout and no open checkstands with cashiers. It’s an open invitation to “just walk out.”
There is a bit of room for Kroger to selectively raise prices. There may be some backlash with the end of certain COVID-19 related unemployment benefits, but with the right positioning Kroger can create a win for itself by holding firm on staple and basic care items. The typical consumer doesn’t really care if there are labor shortages up and down the supply chain, what they care about is if they can take care of their families. If Kroger appears to be looking out for itself at the expense of families that are struggling, they may very well lose some loyalty. If on the other hand they are seen as making a commitment to be there for customers during the difficult times, they’ll build long term fans.
Retailers (in collaboration with CPG manufacturers) will need to rely on revenue growth management principles to offset cost inflation. Through RGM they can look at the product, price, promo, and trade spend from the eyes of the consumer and increase prices for some existing products (or launch new products) that are valued higher by consumers while retaining prices for others – all in a way that they are able to increase the gross margin of their entire portfolio.
Retailers can only absorb cost and other increases for so long. Raising prices requires a thoughtful strategy and transparent communications to customers.
Price elasticity is there for Kroger to offset the losses from shrink, transport, and possibly inflation. Typical price adjustments can rise to ~5% and in certain cases with higher demand goods up to 10%. Kroger will easily manage this. The largest threat is actually transportation and warehousing costs, with shipping costs for parcels rising and transport costs increasing as well. The push in higher warehousing costs are unhelpful, but these might not be longer term changes. Shrink by organized crime has limited recourse, while high inflation rates have yet to materialize.
Operating costs will be baked into the product prices for consumers and those who must have their special food items will pay a premium.
Other factors that will impact are a bit longer term. A great study shows the grocery industry as it is at the end of 2020 — where new entrants and competition from convenience, gas, and drug stores impact the most. See here.
The current conditions are transient, and the general trend for the past few years have seen over 2% growth. For Kroger, their growth spurt from 2020 has slowed down, but they’re still pulling in similar sales (0.6% less). The importance of grocery hasn’t waned, and there is expected increased disposable income across the board this coming year. Price will not be their driver.
There is some room, but Kroger must strike a balance across items to ensure only items that are experiencing cost increases and/or supply chain issues are the ones experiencing price changes. Other products should hold the line as long as possible to avoid customers deciding they need to look for alternate brands. I wonder how much of the cost increases are coming from their national brand partners versus their own private labels. They may need to evaluate which they wish to promote more with customers depending on where those increases are hitting the hardest.
Kroger has a lot of tools in its box to deal with various cost pressures, including any flexibility built into its loyalty program and substantial private label business. If organized crime has become a significant factor, then they will want to look into advanced technologies for detecting exception patterns. While there aren’t as many opportunities in grocery (vs. fashion, for example) to use RFID technology to help out with the supply chain and loss prevention, there may be a few areas to consider. Otherwise, Kroger is probably looking to its micro-fulfillment capabilities via Ocado to increase its profitability in the long run—reducing its vulnerability to these types of margin pressures.
And how are other retailers dealing with these (very same) issues? Hard to answer the Kroger question(s) — at least in any meaningful way — without dealing with this one first.
What Kroger needs most of all is more securities analysts who truly understand the grocery business. Kroger is firing on all cylinders, yet securities analysts keep badmouthing the stock when someone farts. It’s a mystery, much like parakeet menopause. Neil Saunders, by the way, nailed this one.
In case no one has noticed, the prices in grocery stores have already gone up, and no doubt will continue to fluctuate based on costs. Grocers in particular are not profligate spenders and therefore there are not hidden buckets of expenses ready to be reduced to keep retail prices low.
Passing on costs to consumers is always risky. Once you take price and consumers react negatively, many don’t stick around and wait for retailers to course correct.
Supply chain pressures are going to continue. Grocers are in a delicate place because food is not discretionary, cost of goods keep rising and consumers are only concerned about feeding their families.
Kroger has to take a strategic approach. Where can price increases be most equitably distributed without making consumers feel their dollar is not stretching as far on grocery essentials? Likely easier said than done.