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Edible Profits: Grocery Stores

September 23, 2013 | About:
Low customer confidence due to an adverse economic environment has affected supermarket operators, and tighter market competition over pricing has further eroded margins. However, as the economy slowly recovers, grocery stores are presented with an opportunity to improve performance and deliver profits. Let us look at the Safeway (SWY) and Kroger (KR), two supermarket operators, in order to discern which one offers better investment prospects.

Improvements Continue

The second largest supermarket operator in the U.S., Safeway, has sold its operations in Canada. To support its stores, the firm has developed an integrated network of manufacturing, processing and distribution network. The latest news indicates the firm has had a weak second quarter due to soft fuel sales, and ID sales remain weak.

Right now, Safeway has improved its performance thanks to the introduction of the loyalty program Just for U. The program has allowed the company to increase market share and total sales. Also, the firm has invested significant capital in the Lifestyle upgrade, given another push to market share growth. The upgrade means less capital investment and the opportunity to generate a higher cash flow. Additionally, the company has made increasing efforts to reduce cost with a focus on cost of goods sold and supply chain efficiencies, which is expected to improve its margins in the upcoming quarters.

Safeway’s sale of its Canadian operations has been mildly accepted by analysts due to the lack of clarity on management plans to gain momentum in the domestic market. At the same time, given the nature of the industry, constructing an economic moat is very difficult if not impossible. Hence, today’s market share winnings can quickly turn into tomorrow’s loss. At last, analysts are concerned about the generous cash flow and lack of debt reduction.

The balance sheet for Safeway is moderate. Revenue entered an upward trend but so has debt. Trading at 12.5 times its earnings, carrying a 44% discount to the industry average, the stock is undervalued. Among the 10 gurus who made moves within their holdings, there are two increments and a new buy. The rest has shrunk their positions by over 30%, among them Charles Brandes the guru with the largest holding, while Joel Greenblatt opted out completely. I share the pessimism displayed by these last two gurus because management has not proposed a long-term strategy for growth.

Improvements on the Way

Operating more than 3,500 stores nationwide, Kroger is the largest grocery store operator in the U.S. Additionally, the firm manufactures and processes food while managing drug, department, jewelry and convenience stores. Lately, the company has recently caught the analyst's attention due to a change in high management, expected to be completed Jan. 1, 2014. The announcement has been well received since it is expected to continue performing above average.

At the moment, Kroger`s attention is on higher competition. Analysts, however, remain very optimistic about the company’s strength to confront price competition from rival who go at a loss in order to increase store traffic. Also, management sat clear guidelines for opening new stores, expansion and relocation of existing assets, and remodeling of over 100 branches. At the same time, private-label products have penetrated the market above the industry average, allowing for greater margins.

On another note, Kroger’s Customer 1st business strategy augmented identical supermarket sales, while alleviating gross margin pressure, at the same time that operating margin and return on invested capital improves. Management expects to continue growing through the acquisitions of Axium Pharmacy Holdings Inc. and Harris Teeter Supermarkets. The acquisitions mean a strengthening of the drug offered and geographical expansion into high-growth markets.

The balance sheet for Kroger is strong. Revenue continues to improve, debt levels are on the downtrend, and cash flow remains high. Currently trading at 14 times its earnings, packing a 37% discount to the industry average, the stock is undervalued. At last, the largest guru, Charles Brandes has reduced his holding. But John Hussman and Jeremy Grantham have taken important new positions below Brandes. I share their optimism because the firm holds a dominant position, is well prepared to counter the race-to-the-bottom proposed by competitors, and amid high management changes, the successful business strategy will remain in place.

Hungry for profits

I prefer Kroger for several reasons aside from the ones mentioned above. Although it offers a lower yield and dividend than Safeway, the investment is sure to be safe. Also, the firm holds a history for customer care and improving shareholders’ positions.

Disclosure: Vanina Egea holds no position in any of the mentioned stocks.


Rating: 2.8/5 (4 votes)

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