Markets

Profits, Aisle 4

Supermarket chain Kroger benefits as cash-strapped consumers eat out less and watch what they buy.

A recession means more dinners at home in front of the TV and fewer nights on the town at the swankiest eateries. With more people trading their dinner menu for a bag of groceries, Kroger (symbol KR), the nation's largest supermarket chain, is reaping the benefits.

"Supermarkets are the ideal retailers right now because they're taking market share from so many different areas," says Jeff Auxier, manager of the Auxier Focus fund. "Discretionary dollars are going to food."

Food inflation is running higher than it has in more than 17 years, but that actually helps Kroger. The company is able to pass increases to its customers yet remain less expensive than its competitors because of a price-slashing program it implemented five years ago. That allows it to compete capably with Wal-Mart (WMT) on price.

That foundation helped Kroger post an impressive 15% profit increase in the quarter that ended May 24 from the same period a year ago. The company earned 58 cents per share, beating analyst estimates of 55 cents per share. Net sales rose by 11.5% to $23.1 billion. Based on those positive results, Kroger revised its fiscal year 2009 guidance to a range of $1.83 85 to $1.90 per share (from $1.80 83 to $1.90 per share).

Investors like Auxier expect the tough economic times to last for a while, ensuring Kroger a steady stream of budget-conscious shoppers.

Aside from its attractive food prices, Kroger also benefits from the high cost of gasoline. With some 700 gas stations (at about 30% of its stores), Kroger offers incentives at the pump. The company noticed a trend among its customers to combine gas and grocery trips to save on fuel. Kroger now offers a discount of 10 cents per gallon on gas for every $100 spent at the store. "That's gone a long way toward improving its value image," says Mitchell Corwin, a Morningstar analyst who follows the stock.

Kroger is also pushing its private-label products as more of its shoppers trade down. The private label segment has increased its market share for 12 of the past 15 quarters. Seeing the greatest jump are Kroger's highest-quality items sold under the brand Private Selection. "The private-label products have gone from being copycats to a more premium position, so they're offering premium products at a good price," says Corwin.

Of course, Kroger isn't immune from the weak economy. The company has seen slipping sales in nonfood items such as jewelry, apparel and home furnishings sold most heavily in its Fred Meyer stores. "But it's still mainly groceries," says Pat Becker Jr., co-manager of the Becker Value Equity fund. "The majority of its inventory is consumer-staples items."

With so many pluses on Kroger's side, it's a wonder that its valuation hasn't seen a lift. The shares, which closed at $29 July 2, trade for 15 times the $1.93 per share that analysts, on average, estimate the company will earn in the 2009 fiscal year.

However, Kroger's growth opportunities are limited by the fact that it's purely a domestic operator. Its chief competitors, Wal-Mart and Costco (COST), have stores overseas that are growing much faster than the saturated U.S. food market. Tesco, the U.K.'s largest grocer, has recently arrived in the U.S. and is seeing fast growth here.

Kroger hasn't been an acquisition animal, either. Its growth comes largely from same-store sales. "They've bought a number of grocery stores in the past year," says Corwin. "That's accretive, but they're small, so it only adds a little bit to company earnings over time."

But in today's tough economic climate, slow and steady looks pretty good. "A double-digit grower can look like an absolute hero in a declining market," says Auxier.

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