American retailers are facing a very interesting predicament: the price of food is simply too low. Deflation of food is starting to eat into the profits of grocers and discounters in the United States.
America’s largest grocer; Kroger (NYSE: KR), reported a free cash flow of just $24 million (€21.35 million) on revenues of $112.41 billion (€99.99 billion) for the second quarter of 2015. Kroger also reported a profit margin of 1.44% on July 31, 2016; which is actually high for the grocery business.
Sprouts Farmers Market (NASDAQ: SFM); a discount organic grocer, reported a negative free cash flow of -$950,000 (-€845,045) on revenues of $3.858 billion (€3.19 billion) on June 30, 2016. Sprouts’ negative free cash flow came in spite of a profit margin of 3.61%.
Supervalu (NYSE: SVU); which operates supermarkets and distributes food to other grocers reported a profit margin of just .89%. Disturbingly Supervalu reported a free cash flow of $62 million (€55.15 million) on $17.32 billion (€15.41 billion) in revenues for the second quarter of 2016.
The low profit margins came after nine straight months of falling food prices between December 2015 and 2016. Data from Bloomberg indicates that American food prices fell by 4.9% over the summer of 2016.
The rate of the price decrease is accelerating; a clear sign of deflation. Food prices fell by 1.5% in June 2016, 1.6% in July and 1.8% in August. News reports of the deflation were followed by widespread speculation about lower earnings at grocers.
The rate of deflation was highest for some of supermarkets’ most profitable offerings; including eggs, beef and pork, data from the US Bureau of Labor Statistics’ Consumer Price Index indicates. The fear is that prices might drop so low, retailers will not make enough to cover their operating expenses.
How Walmart and Kroger profit from the Death Spiral
The situation is made worse by a brutal price war launched largely by Kroger; which is trying to gobble up as much of the American grocery market as it can. Kroger is deliberately trying to drive down prices and profits in the grocery sector in order to force smaller competitors into the death spiral.
The death spiral occurs when the cash a retailer generates cannot cover its operating expenses. Giant retailers like Kroger and Walmart (NYSE: WMT) use the death spiral to gain market share by keeping prices so low competitors cannot match them.
Retail behemoths achieve this with their vast resources. Kroger uses profits from its other businesses; such as 1,387 filling stations, 2,231 pharmacies, 784 convenience stores and 323 jewelry stores, to cover losses from grocery discounting. It and Walmart are also in a position to force manufacturers and suppliers to lower prices on popular name brands.
Low food prices serve as a loss leader to get customers into Kroger’s stores to buy higher priced items such as liquor, wine, prepared meals, deli foods, gourmet foods and organic items. To this mix we can add higher-priced name brand-name products such as laundry detergents.
In recent years, Kroger has also been competing directly with Walmart by adding higher-priced dry goods to the inventory at some stores. These include electronics, furniture, housewares, clothing and shoes.
How the Death Spiral Helps Kroger Grow
The strategy pays off in another way by forcing the management at other grocers to sell their brands to Kroger, often at a discount. In December, 2015; Kroger was able to buy Roundy’s a Wisconsin based supermarket operator; with around $4 billion (€3.56 billion) in revenue, for $800 million (€711.62 million).
Roundy’s gave Kroger 35 coveted locations in America’s third largest city; Chicago, and entrance to two new metropolitan areas; Madison and Milwaukee, Wisconsin. Not to mention 9.5 million square feet of store space, four supermarket brands and 151 stores, 100 of which contained pharmacies.
At the time of its acquisition, Roundy’s reported a negative profit margin of -.15% and $656 million (€583.53 million) in debt it could not pay. Roundy’s was not able to make money; or remain competitive, even though it controlled 39% of the grocery market in Milwaukee – a city of 599,164 people.
Nor is Roundy’s alone at least one supermarket A&P collapsed completely in 2015 and another; the Fresh Market, sold itself to a private equity fund to survive. Kroger’s also purchased Hiller’s; a privately held chain of seven grocery stores in the Detroit area, in July 2015.
Even more expansion is possible during the current cycle of deflation. There has also been speculation that Kroger will try to buy Supervalu which owns 230 supermarkets. Supervalu is certainly very cheap; its’ stock was trading at $4.99 (€4.44) a share on September 30, 2016.
Food Deflation Threatens More than Just Supermarkets
Food deflation is a threat to a wide variety of American retailers because many stores in the United States sell food. Drug stores and dollar stores sell a wide variety of groceries, while large discounters like Walmart and Target (NYSE: TGT) are major players in the grocery market. The Progressive Grocer actually lists Walmart as America’s largest grocer and Target as the nation’s third biggest food retailer.
Target in particular is very vulnerable to food deflation because its revenues fell by $1.26 billion (€1.12 billion) between April and July 2016. Also threatened are dollar store operators like Dollar General (NYSE: DG) which rely on selling times at very low prices; for example 70¢ (€0.62) for a can of tuna. Family Dollar, a subsidiary of Dollar General’s archrival Dollar Tree (NASDAQ: DLTR) has signs advertising 2,000 food products in its stores.
Some retailers may have to dramatically change their business models in order to survive. A strong possibility is that some dollar stores may reduce their grocery sales or stop selling food. Another is that the number of supermarkets in the United States will simply fall. A major problem is that grocers might pull out of lower income areas and smaller towns because of the limited profits.
Food deflation might change the entire landscape of the American retail landscape. If it continues, many retailers will have to rethink their business plans. Investors might be well advised to stay away from American retail for the foreseeable future.