By Bob Ciura
If you were to base your investment decisions solely on the news headlines, you might be convinced that Kroger Co (NYSE:KR) is going out of business.
In fact, Kroger stock lost one-third of its value… in two trading days.
First, Kroger announced lower 2017 earnings guidance in its first quarter results. This caused the stock’s price to tumble.
The next trading day, Amazon announced its $14 billion pending takeover of organic grocer Whole Foods Market which caused Kroger’s stock price to fall further.
Investors fear that what Amazon did to department stores—undercutting them on price to take market share—it could soon do to grocery stores.
But Kroger isn’t going away any time soon—it is the largest supermarket in the U.S., and rewards shareholders with rising dividends each year.
Since 2006, Kroger has grown its dividend by 13% each year, on average. It is a Dividend Achiever, a group of stocks with 10+ years of consecutive dividend growth.
On June 22nd, Kroger increased its dividend by 4%, and also approved a new $1 billion share repurchase.
This article will discuss Kroger’s business model, and why it is now an attractive stock for value and dividend growth investors.
Underneath the scary headlines predicting the imminent death of the grocery store, Kroger is performing quite well.
Kroger owes its strong performance to its “Customer First” policy, which is more than 10 years in the making.
Source: 2016 Investor Presentation, page 23
The three pillars of its management strategy are low prices, high-quality products, and making the customer the No. 1 priority.
This has worked very well—in fiscal 2016, Kroger’s total sales increased 5.0%. Excluding fuel, total sales increased 6.7% in 2016, year over year.
Comparable-store sales, which measures sales at locations open at least one year, rose 1% in 2016.
In addition, last year was the 12th in a row in which Kroger claimed market share in the U.S.
Net earnings were $1.98 billion, or earnings-per-share of $2.05 for the year. This was a fractional decline from the previous year.
Kroger’s sales growth last year was very impressive, thanks to a number of strategic investments.
Added costs from these investments kept earnings flat last year, but going forward, this will help Kroger maintain and expand its leadership position in the grocery industry.
Kroger has invested heavily in several various growth initiatives over the past few years, and has proved that Internet retailers aren’t the only ones that can innovate.
The first is acquisitions—in 2016, Kroger acquired supermarket chain Roundy’s, which has several banners including Pick ‘n Save and the popular Mariano’s specialty grocer.
Source: 2016 Investor Presentation, page 16
Kroger stated the Roundy’s deal added to growth last year, by giving the company a stronger foothold in the Midwest, especially from Mariano’s success in Chicago.
Separately, Kroger has invested heavily in technology, and has embraced a multi-channel approach.
Kroger merged with Harris Tweeter, to access its technological platforms. This gave rise to ClickList, which gives customers the ability to order online and pick up items in-store.
Kroger ended 2016 with 640 ClickList locations.
E-commerce investments are growing robustly: Kroger’s digital revenue more than doubled in the first quarter.
Separately, Kroger has significantly boosted its own lineup of natural and organic products. Thanks to its scale, it can offer its signature organics line Simple Truth, at far lower prices than shoppers will find at Whole Foods.
Kroger’s own signature products represented 25% of total sales last quarter.
Last year, Kroger also invested in Lucky’s Market, a specialty natural and organics store, which has 22 locations.
These investments have fueled Kroger’s growth to start 2017. First-quarter sales increased 4.9%, to $36.3 billion.
Competitive Advantages & Recession Performance
Kroger has several competitive advantages that will allow it to fend off the Amazon threat. First, is its scale.
Kroger operates 2,792 stores in the U.S., which give the company the ability to lower costs, which it passes on to customers through lower prices.
Kroger’s strong financial position lets it invest significantly in advertising, which is critical to maintaining and growing its customer base.
The company’s advertising expenses over the past few years are as follows:
- 2014 advertising expense of $648 million
- 2015 advertising expense of $679 million
- 2016 advertising expense of $717 million
These competitive advantages have resulted in a very high level of customer loyalty for Kroger.
Source: 2016 Investor Presentation, page 18
This results in strong financial performance. Last quarter, Kroger generated a healthy 12.75% return on invested capital.
Kroger’s competitive advantages have led to strong profitability, even when the economy enters recession.
Its earnings-per-share held up very well during the Great Recession:
- 2007 earnings-per-share of $0.85
- 2008 earnings-per-share of $0.95
- 2009 earnings-per-share of $0.87
- 2010 earnings-per-share of $0.87
- 2011 earnings-per-share of $1.00
The company benefits from a very simple truth, which is that everyone needs to eat, even during recessions.
And, Kroger’s low prices help protect its market share when the economy deteriorates.
Valuation & Expected Total Returns
Kroger stock trades for a price-to-earnings ratio of 11, based on 2016 results. This is a significant discount to Kroger’s valuation.
The S&P 500 Index, on average, trades for a price-to-earnings ratio of 26.
Kroger itself was trading for a price-to-earnings ratio over 20 as recently as last year. It seems the widespread fear over Amazon’s entry into groceries is causing Kroger’s valuation to contract.
However, this could be a good buying opportunity, as Kroger shares now appear to be undervalued.
Kroger holds a long-term forecast of 8%-11% earnings growth. Based on the following factors, the company could reach that goal:
- 5%-7% sales growth
- 3%-4% share repurchases
This takes the company to an expected earnings growth rate of 8%-11% per year.
Share repurchases will play a large role in Kroger’s earnings growth. The recently-approved $1 billion share repurchase represents approximately 5% of the company’s market cap.
This is the benefit of having a strong cash-generating business, combined with a cheap stock price.
Including the 2.2% dividend yield, investors can reasonably expect double-digit total annual returns from Kroger stock moving forward.
Companies that benefit from positive headlines can see their valuations rise, while companies viewed as old or boring are tossed in the trash bin.
Seeing the massive rally in Internet stocks over the past year may tempt investors to jump in, for fear of missing out. But investors that still value profitability and dividends, should give Kroger a closer look.
Consider that Amazon is paying nearly $14 billion for Whole Foods, which has 444 stores in the U.S., and generated $15.3 billion in sales last fiscal year.
Meanwhile, Kroger has a market capitalization of just $20 billion, but it has nearly 2,800 stores, with annual sales in excess of $115 billion.
And, keep in mind that Kroger’s sales growth was more than double Whole Foods’ growth in fiscal 2016.
As a result, Kroger stock appears to be significantly undervalued, with the added benefit of a rising dividend.