The calendar may have turned, but the challenges impacting the Food Retail and Food Producers industries remain unchanged. The groups are marred by slow sales growth, higher costs, falling returns and subpar balance sheets. We do not believe 2019 will see any deviation from these difficulties as they appear largely systemic and, as such, we continue to advise investors to underweight Food Retail and Food Producers. In our opinion, while a sharp economic slowdown would clearly hurt if it were to materialize, the Hardlines Retail industry still appears poised to see robust sales growth fueled by a strong consumer, stable margins, and higher ROIC. These companies also have solid balance sheets and a penchant to return cash to shareholders. With valuations reasonable, we continue to suggest investors overweight Hardlines Retail. Finally, the Broadlines Retail industry is seeing sales grow rapidly, in part due to the strength of the economy, but with labor expenses increasing and with the need for omnichannel investments, EBIT growth and better ROIC remain elusive for some. While this causes us to advise market weighting the Broadlines Retail industry, we do believe there are opportunities for outperformance (AMZN, DG) and underperformance (BJ) within the group.
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The Kroger Co. (KR, Underperform) today (01/07/19) announced a partnership with Microsoft, using Kroger technology and Microsoft’s cloud service, Azure, to pilot two “connected stores” (in Monroe, Ohio and Redmond, Washington), and jointly market a commercial Retail-as-a-Service (RaaS) product to the broader retail industry. The goal is to combine Kroger’s EDGE (Enhanced Display for Grocery Environment) Shelf technology and Azure to help customers with a unique, guided shopping experience, use video analytics to improve employee insight and productivity, and leverage the EDGE Shelf to generate new advertising revenue from CPG manufacturers through personalized offers.
Our latest three surveys in December showed mixed results with the Chicago market continuing to deteriorate, while Philly and D.C. remain relatively calm. Overall, sequential and year-over-year pricing throughout the U.S. appears to be largely deflationary, with a couple exceptions, signaling that the tough competitive environment of flat to falling prices and rising costs for operators is unlikely to ease anytime soon. The biggest takeaway for us is whether Walmart will need to increase its price investments, or whether the company is taking profits by allowing prices to remain flat in deflationary categories such as coffee. With this note, we are removing our industry rating on Drug Retail (previously Market Weight) following the transfer of coverage of WBA to Justin Lake (see his note here). We are also separating our rating on Food Retail / Food Producers as well, though we continue to rate both industries as Market Underweight.
KR reported its third quarter this morning before the market opened, with ID sales (ex-fuel) and gross margin below expectations offset by a decline in OG&A dollars, leading to an EPS beat of $0.48 vs. our $0.43. The lackluster comp sales of 1.6% and gross margin decline were largely in-line with our research of a highly promotional pricing environment recently. Our top questions for management are 1) Whether investors should expect OG&A to decline y/y going forward 2) If gross margin declines are likely to continue in order to drive volume 3) Why are “alternative revenue streams” not yet benefiting gross margin 4) Whether the digital business will require more investment and continue to be a headwind next year and 5) What is the cadence of earnings growth next year and is there potential for it to be back half loaded given ongoing investments that are likely to continue into the first half of next year.
Our latest round of pricing surveys in Houston, Atlanta, and Southern California in November showed the pricing climate to have deteriorated further, led by traditional supermarket operators Kroger and Safeway/Albertsons. With price gaps to Walmart narrowing again in certain markets, the question in our mind is what will Walmart do? Walmart’s business became troubled near the beginning of this decade as a result of a need to fund its growth ambitions by milking its U.S. operations. This led to an erosion of its low-price advantage and a failure to adequately invest in its labor force. Fast forward to today and we wonder whether the financial pressure from Flipkart and the e-commerce losses prevent Walmart from lowering prices further in the U.S. to thwart resurgent competitors. Clearly, letting people back in the game would be a long-term negative for Walmart but a godsend to other retailers as well as consumables manufacturers, in our opinion.
Kroger hosted its 2018 Investor Conference in Cincinnati on Monday and Tuesday (10/29/18 - 10/30/2018) highlighting its plans to transform the business and the customer experience to address the changing consumer landscape under its Restock Kroger plan. While the company is pulling costs out of the enterprise, investing for the future, and re-packaging vendor funding into alternative streams of revenue, it is hard to look past the hurdles the company faces as competition ramps-up to provide consumable goods to consumers whenever and wherever they want. The bottom line is that sales so far are coming in below expectations, and our research suggests more competition ahead, rather than less, which is likely to weigh on sales and profits. We are reiterating our Underperform rating on the equity.
Investors are anticipating that higher pricing rolls through the consumables complex. However, outside of household chemicals, we are not seeing evidence this is truly taking hold. In fact, looking at our pricing work across the country suggests the opposite may be taking place. A combination of Walmart’s increasing market power, falling farm product prices, ALDI’s aggressive stance on fast-turning items, and a seemingly more promotional stance of late from operators such as Kroger and Meijer appear to validate the notion put forward by Walmart U.S. CEO Greg Foran that the environment has gotten more competitive lately. Given our research, we are reiterating our Market Underweight stance on Food Retail/Food Producers and our Underperform ratings on Kroger, Campbell Soup, and Smucker’s.
Your business weaknesses come to light and your equity is likely down. Indeed, to continue to channel Billy Squire, there’s no one left to call and the writing is on the wall. The latest PPI and CPI numbers from the government do not bode well for the pricing environment in Staples Retail, with PPI for Farm Products and Processed Foods falling y/y in September (-5.1% and -0.6%, respectively) and now seemingly CPI Food at Home wants to follow (September growth of 0.4% slowing from August growth of 0.5%). Our latest pricing survey work in our Notes from the Road (Fooling Yourself) shows that Walmart is continuing to press down on price and take market share. We fully expect that this strategy will continue and we’re likely to hear as much at the company’s analyst day next week. But it’s not just Walmart that is pressuring more traditional consumable retailers, such as Kroger.
Indeed, our research is increasingly showing a heightened level of competition in private label items. In our note yesterday evening (Fooling Yourself), we highlighted Walmart’s price reductions in private label products, with our basket having fallen to approximately $66 currently (down from $80 in July of 2017). Pictured below is a Kroger endcap display from Atlanta prominently displaying more savings with its private label brands. We would also note that Treehouse on its latest earnings call acknowledged an intense price war in condiments on the East Coast. While some of this is due to the incursions from the deep discounters, particularly ALDI, the actions by Walmart and Kroger suggest that competition in private label is escalating.
Our latest research from around the country shows a further escalation in the competitive climate in consumables retailing. Following our significant pricing survey work over the summer that Walmart was maintaining its aggressive pricing stance on branded consumables, our latest round of surveys continues to show this pattern. Walmart is also continuing to drop pricing on private label items. However, it’s not just prices where Walmart is getting more competitive. The company is enticing consumers to use its free click-and-collect service through trial discounts, while also providing special click-and-collect promotions. Not to be outdone, Target has also become quite aggressive in its omni-channel efforts in consumables, with many of the services offered at low or no cost. In our opinion, this is causing a significant share shift in the consumables industry to mass merchants from the supermarket channel and is reminiscent of what happened in the late 1990’s and early 2000’s.
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