Kroger—and entire U.S. grocery sector—hurtling towards a ‘day of reckoning’

We have mixed views about Kroger and this latest set of numbers does very little to change our position. Overall, the results are far from fantastic and continue to show pressure on top line growth and a significant drag on the bottom line. That said, the company is innovative and is putting in place a number of plays - from digital solutions to meal kits - that will allow it to generate some market share growth over the medium term.

The question is whether such growth will be profitable or whether it will come at the expense of the bottom line. For all Kroger's enthusiasm around the online market and its crowing about 60% digital sales growth, we remain very skeptical about whether this push will be margin enhancing. In our view, online grocery has yet to prove itself as a viable business model. Even in the U.K. - where the market is far more advanced and where the higher population density is more favorable to distribution - online has not been particularly helpful to the bottom line. If anything, it has eroded profits and put margins under severe pressure.

This does not mean that Kroger is wrong to invest in digital. Indeed, we see its partnership with Ocado as appropriate and necessary. There is no doubt that consumer interest in online grocery is growing and Kroger needs to play strongly in this space if it is to defend its market share. However, given the unfavorable metrics around online, we believe that Kroger needs to counterbalance its digital efforts with growth strategies in other, more profitable parts of the business.

One area in need of desperate investment is stores. While Kroger has a very strong network of shops, we remain broadly unimpressed by the quality of its estate. Many stores, especially regional banners, feel run down and dispiriting. They are not great places to shop and they do little to showcase Kroger's range in an effective way. As more and more money goes into digital we fear that investment in stores will fall further and further behind. Given the importance of stores to the consumer and the investments of other players - like Aldi, Lidl, Target, Walmart, and Amazon - in physical grocery, this position is simply not viable. Longer term, it will create pain on both the top and bottom lines.

In this regard, we are particularly worried by the statement from CEO Rodney McMullen that he sees Kroger moving to a company with more “asset-light" partnerships. This mantra was also one peddled by Eddie Lampert, who used it to justify the deterioration in stores. This did not work well for Sears and ultimately, we do not believe it will work out well for Kroger unless the company comes up with a more balanced growth strategy.

To be fair, these issues and dilemmas are not exclusive to Kroger. In our view, the entire U.S. grocery sector is hurtling towards a day of reckoning. Changing shopping habits, the rise of digital, more competition, and increased price pressures are all going to crimp margins, store productivity, profits, and will reduce returns on investment. There is simply no avoiding this pain and ultimately the battle will be about surviving rather than thriving. Kroger will survive, but we question whether it will thrive.