In this article, I will explain why took advantage of a recent price drop in the food giant Kroger (NYSE:KR) and explain my own process of looking at this company before I initiated a small position on Thursday.
I will argue why I believe the company is fundamentally undervalued with regards to its growth and future development prospects based on historical valuations and future expectations. I will show you why I believe that you, as a value-oriented investor, should take the opportunity to look at this massive company and why I believe exposure to its impressive portfolio, size and diversity could represent an increase in stability of your portfolio.
Kroger – Second largest in a nation of 325 million consumers
Only Walmart (WMT) is larger than Kroger with its ~$120B annual revenue stream. Kroger has 2,800 supermarkets across the nation, most with their own pharmacy, and over half with their own fuel center. The company has representation in over 35 states and serves 9 million consumers daily. Founded in 1883, it’s one of the oldest grocery stores in existence in the US.
Kroger as a company has a high degree of vertical integration, and much of its sales come from its own brands. KR owns its own manufacturing plants. As far as sales mix, as well as structure, goes, this increases the company’s profit margins and sales model and is also keeping with time, as many corporations both within and outside the US increasingly are moving towards their own private labels as an alternative to the more expensive labels that are sold in-store but not manufactured by the companies themselves.
Kroger has responded to a recent (2017) challenge from Amazon (NASDAQ:AMZN), which purchased Whole Foods Market and in its own way changing the shopping industry. This is reducing the already thin margins of not only Kroger but also its competitors. The “Restock Kroger” initiative helps the company to maintain a competitive edge by focusing on the technological developments and improving its existing line of service with new technologies as opposed to focusing entirely upon opening new stores, which is usually the way for a company its size to grow profits.
(Source: Investor Presentation Q2/Q3)
The way Kroger intends to transform itself is through self-driving grocery deliveries, automated warehouses, and data-driven alternative profit sources, among other things. The company already has experience in integrating different things in its own lineup, and it is also working on integrating with pharmacy giant Walgreens (NASDAQ:WBA). Unlike many other companies that seek to do the same, Kroger’s initiatives are already working, with the self-driving delivery service having served its first customers and the automated warehouses already being planned at 20 sites with online supermarket company Ocado (OTC:OCDDY).
It’s also important to mention the consumer sentiment, which is definitely in the company’s favor. Kroger is a company that seems to be loved by consumers more than other grocery stores, being ranked “most loved” with a favorable rating of over 50%. Whole Foods was the second in this survey (Source).
The company recently divested its convenience stores, and the sale generated a capital of $2.15B. This money will go towards paying down debt as well as funding a share buyback program.
Kroger also enjoys some excellent placements in terms of sales compared to its rivals in its home markets. Being first or second place in most of its primary and secondary markets based on sales gives it advantage in terms of economies of scale, enabling it to acquire more products at lower prices, which in turn helps Kroger survive where its rivals cannot in a world where consumers are increasingly focused on price.
Kroger also has an impressive lineup of initiatives in terms of sustainability and “green” projects. While I, as any person should, applaud these greatly, I leave them to others to analyze deeper, as I do not believe (or can find data) they meaningfully (at this point) affect the company or the investment thesis. One may argue that in doing so, they could affect logistics and margins – in my cold, calculating investor heart, I believe them to currently be window dressing. One they provide me with results, and I’ll get back to it.
Moving on to the bad and the ugly.
Trouble at the grocery store – Let’s talk risks
(Source: Seeking Alpha)
Yesterday, the numbers of a disappointing quarter came in. The company missed analyst targets in terms of both revenue and EPS, and the stock, which initially was up pre-market, dropped between 9% and 13% and settled on an almost 10% drop in a single day. A strong reaction to a mediocre quarter.
Short-term headwinds for the company are, in no particular order, changing customer preferences, increasing competition from both national grocery stores and rivals from outside the US, changing consumer confidence, fuel profit margins and margin compression in the grocery/food sector overall.
Long-term headwinds and risks are numerous, as the way people are buying food is changing. Kroger seems to be in a position to capitalize on its market position and share to shoulder away most competition. Over the past years, proving this, Kroger has grown its market share. What’s been missing from this development however is a corresponding increase in profit/EBITDA.
This indicates that the company has a problem with margin compression and capitalizing on its increase in market share – or that its increase in market share comes at the cost of lowering its own prices, which in and of itself may be referred to as a wicked circle that really has few winners in the end (as a result of lowering food quality to keep up with competitiveness).
It may of course also indicate that Kroger is simply spending increasing amounts of profit on CapEx and OpEx, investing in existing structures to improve them and, in doing so, muscling away further competition. While part of the company’s trouble may be related to this, we do know it’s trying to do this; grocery stores all across the western world are having trouble with their margins.
So, the bad is that despite increasing the market share, we haven’t been able to see the profit results due to this.
LEE-dil and the Krauts are coming!
(I can say it; I’m German!)
The US is facing some similar issues as that of Sweden in this department, in that Lidl (and Aldi) is expanding into the nation, bringing with it low-cost food alternatives in ways which Kroger hasn’t had yet. Lidl and Aldi focus almost exclusively on bare-bones stores with private-label food. In Sweden, this resulted in serious market share loss for the three largest chains, although not before Lidl compromised and included Swedish brands in its lines of products.
What Lidl found when trying to expand in Sweden is that Swedish people in general are quite brand loyal and store loyal. Despite having achieved some success here, ICA (OTC:ICCGF), Axfood (OTCPK:AXFOF) and Coop (cooperatively owned) have retained their dominant market position with Lidl, at best, being a niche player where people buy some of their daily groceries. Positive effects from this for the consumer have been a general price pressure/competition, which likely already exists in the US without a player like Lidl.
Regardless of how you view these new entrants, the fact remains that they will try to chew away at the already razor-thin margins of the food and grocery industry. Lidl and Aldi are privately owned in a traditional German fashion (many of the great companies in my nation of birth are not on the stock market).
They cannot be bought out, and looking at their history, they do not scare easily when they decide to kick down a door. Lidl alone is the largest discount conglomerate/company worldwide, with annual revenues creeping towards the €100B mark. The Schwarz Gruppe, which owns Lidl and other stores, has 400,000 employees and already owns grocery stores in most European countries. Its strategy, much like electronics store Media Markt, is to shoulder in and compete with aggressive pricing and what equates to (IMO) pretty competitive food quality. While Lidl failed to change the Swedish consumer patterns at their core (at least for ~15 years now), Media Markt succeeded through selling at loss (for years) in bringing down the entire Swedish consumer electronics market to where only one rival remains to date.
So, prepare for us Germans comin’ over. Tesco (OTCPK:TSCDF) in England knows well the horrors of battling with Aldi and Lidl on the home turf.
This affects the company’s future possibilities and potential
Kroger already has a strained balance sheet at a 4.0x leverage (including pensions). With investments in the pipeline and new rivals knocking on the door, the company’s ability to raise its dividend growth may be impeded due to the necessity of paying down its debt and decreasing its leverage.
The mature character of Kroger’s business means that most of its increases in EBITDA/profit come from expansion and not existing stores, which the company currently has slowed down in order to invest in the existing lineup. This requires a change in the mix, with online shopping alternatives demanding to generate a greater share of profit in order to bring Kroger forward to where it wants to be in terms of profit.
Between the company investing in its own lineup rather than expansion, German rivals entering the market, and the existing home market being plagued by already-present rivals such as the grinning giant Amazon, why should you consider this company at all?
Well, let’s talk valuation and positives
(Source: F.A.S.T. Graphs)
The company is BBB-investment-rated with a manageable, albeit above-sector leverage/debt. While the current market presents challenges, I’m convinced that Kroger will do what it’s done previously – adapt and survive. The company has already done this through many previous challenges. Although it seems in our nature as humans to assume that new changes and developments will be revolutionary, to think that Kroger will simply sit by and allow other companies to shoehorn it out of its own market is foolish. The company has already gone to steps to ensure that this is understood.
A current blended P/E of 11.9 makes the company appealing and undervalued from a historical perspective, though I hasten to add that there have been opportunities of even better valuation as little as 1-2 years ago. The current share price makes, I believe, for an excellent entry point, but one should watch and buy more of this company should the headwinds continue.
Analysts’ own expectations of Kroger are modest, forecasting roughly 3-7% of growth annually, and these analysts have a decent track record with this company. As a rule, they don’t miss.
(Source: F.A.S.T. Graphs)
When the company does miss estimates, it doesn’t miss it by far (with the exception of 2010), and while there are grocery stocks that are easier to predict, this in my mind cements the thesis that there’s a case to be made for investing in the second-largest grocer in the US.
The fundamental numbers in terms of earnings, FCF and payouts are solid. Kroger pays out no more than 25% of its earnings, giving it a sizeable safety margin both for increasing the dividend (as it has over the past years), but also using the capital for the CapEx-intensive industry that characterizes grocery shopping today.
(Source: F.A.S.T. Graphs)
An annual dividend growth rate of 13.1% since 2005 makes the company’s track record appealing in my book.
Metrics in terms of sector comparisons, price ranges, and P/E/Yield also make the stock a compelling subject for a thesis here. I do not believe that the analysts’ estimate of a historical blended P/E of 15.7 with estimated earnings growth of 6.4% is exaggerated, and as such, I’m going to be looking forward to using this number when it comes to forecasting.
A return to historical valuation would yield an almost 20% annual rate of return. My own preference is a minimum of 15% projected Ann.RoR, though I’ve invested in stocks forecasting less. Such a forecast assumes that Kroger, with its current initiatives and plans, manages to pull off most, if not all of them, and as a result of this, is able to keep raising its dividend at a pace that investors have gotten used to.
The fact remains, however, that you could invest in Kroger and have the stock drop to a historically low P/E of ~9 without losing money until 2022 – so I believe the downside and risk here to be well covered. We also need to consider the sector in which Kroger operates, which by its nature is a fairly low-growth low-risk industry. It’s recession resistant, due to the need it fulfills, and while the Germans are coming…
…I somehow foresee American consumer patterns to be challenging to change from the products, stores, and brands that they like. I don’t foresee the entry of German stores to be a quick or easy process.
So, wrapping up
Selling Kroger isn’t really a hard thesis to me – it’s the upside/reward that in its scale can be said to be, at best, modest for you as the reader and potential investor.
We’re talking a 2.2% yield in a sector where it’s not uncommon to find a lot better. The fundamental metrics and numbers in this case could easily sell a buy in this company compared to say Walmart which currently trades at a blended P/E of almost 20. You, as the investor, really have to put things into perspective. Valuation to me is absolutely central when I consider investing in stocks, and without the proper valuation, I don’t even go there (anymore). Yield is secondary, or I try to make it as secondary as possible (Though it’s hard for me to invest in a stock that’s below 1.5% yield).
I believe this thesis and article showcase my love for stock diversity in my portfolio. Not every position is the same, nor does every position have the same outlook. I invest in different companies for different reasons, and Kroger is a company I bought for its attractive history, stellar management, its scale, vertical integration, its focus on technology, and store experience. The company’s integration of other services can be said to be out of the norm for the sector. It’s stable, and its industry is stable.
In addition, Kroger owns its own dataset company and is expanding into fields that I consider to be central to future shopping patterns. KR is both aware of this and investing in the future. This can be said for most companies in the sector, but I believe that Kroger has better prerequisites than most, given its vertical integration and its already high degree of private label products.
Let’s say my situation was reversed. I was recommending or was recommended a stock where I’d have to pay 15-30% withholding on dividends without the possibility of getting it back (Swedish). I’d rarely expect anyone to expect in this sort of dividend stock, nor would I do it under those circumstances. But no withholding (despite coming from outside the US), an evident undervaluation (currently rare over here) that piques my interest, even from across the pond.
My exposure to this company is small, but it pinged my watchlist as it dropped to ~$25. I will keep looking at this company and once (as I believe it will), drops somewhat further, load up on more of Kroger shares.
My price target for this company begins now at ~$25 per share and a blended P/E of ~12. I expect we’ll be seeing lower numbers, and blended P/E values of 10 or even lower, in which case I recommend you visit Kroger for some shares.
Thank you kindly for reading.
Disclosure: I am/we are long KR, AXFOF, ICCGF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.