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Kroger a New 'Buy' at Citigroup

The No. 2 food retailer is taking aim at Wal-Mart by sacrificing margins.

Citigroup initiated coverage of supermarket chain operator

Kroger

(KR) - Get Kroger Co. Report

with a buy rating Tuesday, citing the company's potential for growth in a rapidly changing marketplace.

Analyst Deborah Weinswig said Cincinnati-based Kroger, the No. 2 food retailer in terms of sales behind

Wal-Mart

(WMT) - Get Walmart Inc. Report

, has regained some lost market share "by tailoring its product and service offerings to customers' purchasing behaviors and patterns."

Weinswig said Kroger is sacrificing margins so that it can compete with Wal-Mart. She said a pricing survey found an average price gap of 8% between Kroger and Wal-Mart, compared with a 27% gap for

Safeway

(SWY)

and Wal-Mart.

Kroger's "secret weapon" is its partnership with Dunnhumby, a British database management and analytical services company, Weinswig said. This is the same data-mining tool Tesco used to climb to the top of the U.K. food retailing industry, giving Kroger "the key to the treasure chest filled with Dunnhumby's data-driven tactics to gain a larger share of its customers' wallets," she said.

"Since 2003," Weinswig wrote, "Dunnhumby has converted management's approach to decision making that is data-driven as opposed to instincts driven. Consequently, Kroger has improved financial returns while reducing risks ... we see tremendous opportunity ahead for Kroger as it continues to extract new insights from its loyalty card database."

Kroger owns a 50% stake in Dunnhumby U.S.A., making it the only food retailer in the U.S. the firm can work with. Weinswig said that based on its experience with Dunnhumby, Kroger sales per square foot have increased more than 20%.

"With the help of Dunnhumby-driven insights," Weinswig wrote, "Kroger has also developed new products, such as Kroger Personal Finance, which offers services such as mortgages, home equity loans, pet insurance and identity theft monitoring ... we have witnessed a trend for retailers (such as discounters and clubs) to branch out into diversified financial services, not so much from a revenue or margin perspective, but rather to provide the consumer with added convenience (of) a one-stop shop."

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Weinswig said the competition in the $483 billion food retailer sector is intensifying.

Supervalu

(SVU)

took a big step when it acquired Albertsons, and

Target

(TGT) - Get Target Corporation Report

is "moving toward the self-distribution of food (vs. third-party distribution), which we believe could fuel its future food sales."

Also,

Whole Foods

(WFMI)

announced the acquisition of

Wild Oats

(OATS)

and Tesco will be entering the U.S. market in the third quarter of 2007. Weinswig noted that Tesco will not be able to use Dunnhumby's data in the U.S.

"Companies that were unable to compete either for the lower end or higher-end customer have found it difficult to survive," she wrote. "Kroger and Safeway represent two of the traditional grocers that have survived the transition phase."

Shares of Kroger gained 60 cents, or 2.1%, to $29.15 in recent trading.