Analysts have aired concerns over Kroger’s decline in gross margins during its third quarter, leading to shares in the US retailer falling as far as 11% yesterday (2 December).

During the quarter to 6 November, Kroger’s FIFO gross margin declined by 56 basis points to 22.14% of sales. Meanwhile, supermarket selling gross margin declined 13 basis points without fuel.

Kroger’s stock plummeted as far as 11% yesterday, closing the day down 9.4% at US$21.63 a share.

Speaking about the results, Barclays Capital analyst Merdith Adler said: “Investors will likely be disappointed with the weakness in gross margin and that the top end of the FY10 EPS guidance was lowered. We expect the stock to be weak today based on these results.”

Analysts have been looking for Kroger to find a balance between increasing market share while, at the same time, improving gross margin. However, Adler said that a “highly promotional competitive environment did not allow [Kroger to do] this in the third quarter”

UBS analyst Neil Currie questioned the retailer’s ability to eke back margin lost at around the same time last year, when he said Kroger admitted that it “over-invested in pricing margin and operating margin declined quite rapidly”.

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Currie said there had been some improvement in Kroger’s operating margin this year but insisted it was “way below two years ago and third-quarter margins previously”.

“Can we safely assume that over investment really is somewhat lost because you don’t seem to have the appetite to recover that lost margin?” questioned Currie.

Kroger CEO David Dillon remained confident of the success of the retailer’s long-term strategy.

“Look at the recession we’ve just gone through and think about the results of many of our competitors that had some rather serious declines from where they had been running in profit and operating profit. We didn’t have such a serious decline and as things begin to recover, that means our recover, at least back to the par, isn’t going to snap back quite as abruptly,” Dillon said.

“But our potential for the future, I think, is much greater because we have something to work with. We’ve got identical sales to work with, we’ve got customers who are rather permanently loyal customers at Kroger that continue to grow, and that gives us something to work with to which you can apply that operating profit margin.”

Dillon told analysts the improvement the retailer has seen in customer traffic and behaviour will “actually does give you the recovery that we’re seeking”.

While the retailer may have been able to sacrifice margin for lower prices in a deflationary environment, this looks set to become more difficult as food costs begin to rise.

Kroger COO Rodney McMullen said the company has already seen inflation in some of its perishable departments, particularly meat and produce. However, McMullen added that deflation is persisting in its grocery department due to high promotional activity from national brand suppliers, which, he said, is “masking some of the list price increases we have received”.

McMullen acknowledged that analysts have questioned Kroger’s ability to pass along product cost increases to consumers, particularly when shoppers are spending cautiously” but said the retailer is passing along product cost increases “depending on the product”.

“Kroger is passing on product increases from national brand suppliers in the grocery department today, and will continue to do so,” McMullen added.

However he said that inflation in the perishable departments “affects our business differently”.

“In these areas, product costs are typically driven by short-term factors such as seasonality and product supplies, so product costs can vary from quarter to quarter,” he explained.