CEO Dave Dillon doesn’t seem a bit worried, but Wall Street is increasingly concerned about penny-pinching consumers cutting into Kroger’s profits.

The Cincinnati-based supermarket chain’s gross margins declined by nearly a full percentage point in its latest quarter that ended in August. Net earnings also slipped. Those results were announced in mid-September, and since then at least two analysts have pulled their buy ratings on Kroger’s stock, citing supermarket pricing and margin trends.

For consumers, that could mean it’s a good time to shop at Kroger. Analysts generally rate Kroger as the best-positioned big supermarket chain with respect to pricing. It has the lowest prices—though not as low as Wal-Mart—and it’s still increasing its profits.

But, for investors, it could mean slower earnings growth and a stock price with nothing on the horizon to push it higher.

In an interview on October 7, Dillon said the recent margin decline was largely caused by a sudden drop in wholesale prices.

That hurt margins because even though sales were lower, the number of units or tonnage sold still increased, and the costs of handling the products don’t decline in line with prices.

Competitive Pricing

Competitive pricing is something Kroger’s strategy is designed to accommodate, and it continually adjusts to market conditions, Dillon said. In the long term, that benefits Kroger as it increases market share and allows it to leverage higher sales, he said.

“Kroger has certainly benefited from our reduced prices,” Dillon said, noting it has been a leader in price-cutting for five years.

Kroger’s shrinking gross margins—a measure of the percentage difference between sales and the cost of goods sold—are not new. They’ve been in decline for most of the past decade as it has implemented its “Customer 1st” strategy focusing on building customer loyalty and market share. The strategy has successfully countered the inroads made elsewhere by Wal-Mart.

Wal-Mart has gained market share in grocery sales, but so has Kroger. And even while margins are slipping, Kroger’s earnings per share have grown by a double-digit annualized rate since 2005.

Now, competition has intensified in a tough economic climate, and Kroger and other supermarkets are cutting prices further to keep customers. Some Wall Street analysts think that’s eating into profits and sales growth. And they see little chance of the trend moderating soon.

Several recent developments point to more pricing pressure ahead.

In a conference call last month, Dillon cited noticeably softer sales toward the end of the month in recent months. He interpreted that as a sign that shoppers “just run low on money by the end of the month.” That’s cutting into discretionary purchases and prompting them to buy less per trip.

Kroger’s lineup of more than 14,000 store-brand products—primarily sold under its Private Selection, Kroger, and Value labels—give it an advantage as consumers trade down from more expensive national brands. Those sales are growing, accounting for 35 percent of units sold in the latest quarter. Overall, Kroger’s store brands generate higher profits than comparable national brands, but that doesn’t apply across the board.

Growing sales of its bargain-priced Value products are reducing overall margins because that line has lower margins than national brands, according to a recent research report by Citigroup analyst Debra Weinswig.

Unplanned Adjustments

Weinswig visited with Kroger’s top management in late September and reported there has been heightened competition in the grocery industry, driven by supermarkets rather than Wal-Mart. Several of Kroger’s national and regional competitors have been very aggressive, prompting Kroger to make some unplanned price adjustments, she said. She maintained her hold rating on Kroger stock.

Morgan Stanley analyst Mark Wiltamuth cited heightened price competition in downgrading Kroger from overweight to equal-weight. With all the major grocers cutting prices at once, it will take longer for the cycle to turn around, he said.

“While Kroger is out-executing its peers, margin sacrifice is limiting earnings growth,” he said.