Traditional grocers such as Kroger Co (NYSE:KR) and Delhaize Group SA (NYSE:DEG) are having an increasingly hard time dealing with competition from nontraditional grocers. Both of these firms have tried to adapt to the pressure stemming from rival discounters, with varying degrees of success. Whereas Kroger has been able to utilize its scale to leverage fixed costs, Delhaize has struggled to maintain margins, and is being forced to lower prices.
Fending off competitorsInvestment gurus John Hussman of Hussman Economtrics Advisors and Joel Greenblatt of Gotham Capital own considerable positions in Kroger, one of the largest retailers in the U.S. The firm currently operates over 2,400 supermarkets, 750 convenience stores, and 325 jewellery stores across 31 states. Shareholders have reason to be optimistic, as the company recently acquired Harris Teeter Supermarkets Inc (HTSI). The $2.44 billion deal means Kroger will be looking at an 8% increase in its store base and a 4% boost in revenue.
The purchase of Harris Teeter is part of Kroger’s strategy to fend off rival discounters, such as Wal-Mart Stores Inc (WMT), Costco Wholesale Corporation (COST)andTarget Corp(TGT). The firm intends to lower prices on items such as bread and milk, in order to attract more customers to the high-end products Harris Teeter has to offer. Thus, it will seek to drive traffic to its stores by using food as a loss leader, much the same way rivals operate. Reduced margins are expected, yet Kroger is still the best positioned traditional grocer to deal with the competition arising from non-traditional grocers. The firm’s 2,400 stores and $100 billion in annual sales, generate a scale which enables it to leverage fixed costs and thus compete with large rivals.
Kroger also offers gasoline at almost 50% of its locations, limiting the threat of competitors luring customers away with this service. In addition, the firm’s private-label products have achieved a 25% penetration rate. With 40% of this merchandise manufactured directly by Kroger, margins are amplified and profits increased considerably. The strong growth in same-store-sales, the firm’s acquired market share, and the 8.5% weighted average cost of capital estimate are indicative of the company’s solid business model. Finally, Kroger is trading at only 14.1 times its trailing earnings, translating to a 24.2% price discount to the industry average, which represents a good point for entry.
Crumbling under the pressure
The food retailer Delhaize operates over 3,400 stores across the U.S., Belgium, South East Europe, and Asia. The company operates 1,500 banners in the U.S., including stores such as Food Lion, Harveys, Bottom Dollar Food, and Hannaford. Despite reporting solid second-quarter financial results, increasing pressure from competitors could harm the firm’s U.S. margins and returns on invested capital.
Non-traditional grocers are challenging the food retailer by selling food at tiny or inexistent margins forcing Delhaize to lower its prices. The industry’s low customer switching costs and the company’s lack of cost advantages relative to rivals Wal-Mart, Costco, and Kroger leaves Delhaize in weak position. In order to counteract this pressure, the firm has plans to sell some of its smaller banners, such as Sweetbay, Harveys, and Reid’s for an estimated $265 million. Since the traditional grocer has no scale advantages over larger rivals, it will focus on the strong performing Food Lion banner, which should contribute to better results.
Delhaize’s European locations on the other hand are exposed to less competitive pressures, yet the hostile macroeconomic environment has put a lid on growth. Its market share of 25% in Belgium and 21% in Greece are significant, yet economic hardship has not allowed the firm to extract the margins it achieves in the U.S. With austerity measures looming and prolonged recession on the horizon, growth and profitability are threatened. With 20% of Delhaize’s sales stemming from Belgium and 8% of its stores located in Greece, this is certainly troubling.
The only investment guru to trade in Delhaize shares over the past years is David Dreman of Dreman Value Management. He has been adding shares to his portfolio steadily since 2009 and must trust the company to regain its foothold in the longer term. I personally feel bearish regarding this stock and believe the price tag is far too high regarding its current and projected performance. The firm is currently trading at 25 times its trailing earnings, entailing a 34.4% price premium relative to the industry median.
An easy choice
After looking at these two firms’ current and future prospects, I think Kroger represents the best investment option. It is the only traditional grocer with enough scale to compete with non-traditional rivals, and has been delivering positive returns on invested capital for years. The recent acquisition of Harris Teeter is an additional step in the right direction for the firm that has retained a large market share without falling prey to margin pressure.