Why I Still Consider Kroger as a Buy Recommendation

In this article, let's take a look at the supermarket operator Kroger Co (KR, Financial) and try to explain if this is an appealing investment opportunity or not, when shares of the company are trading nearly its 52-week high. Shares of the firm closed yesterday at $73.11, amassing a year-to-date return of 13.6%, which I consider attractive when compared to a market benchmark such as the SPDR S&P 500 ETF (SPY, Financial). Further, the past September I wrote an article recommending the stock, and I think it has done pretty good, with a 42% return in the period.

Company’s competitive environment

The company is one of the largest retailers in the U.S. based on annual sales; operating in retail food and drug stores, multi-department stores, jewelry stores and convenience stores. As of January 31, 2015, the company employed approximately 400,000 full- and part-time employees, and operates (directly and indirectly) 2,625 supermarkets and multi-department stores. Further, it operates through subsidiaries 782 convenience stores, 326 fine jewelry stores and an online retailer.

Kroger operates in a competitive industry that is suffering aggressive expansion. Other characteristics include the permanent fragmentation of retail and online formats, and the possibility for new competitors to enter. Although these factors constitute a risk in terms of future profitability, I think that the food retailing industry is promising, principally due to lower food costs and lower gasoline prices. Looking at the big picture, I anticipate a more dynamic consumer spending that it is critical for profitability and growth.

Management

In my opinion management team has a good experience which is reflected in its high ROIC of about 13% achieved in January, 2015. Due to performance-based compensation, conflicts of interest are minimized, because the decisions are aligned with shareholders' interests, avoiding the principal-agent problem. Rodney McMullen, who has worked more than 30 years at Kroger, is the new CEO, and he has demonstrated ability to make strategic decisions. Further, McMullen has 1,072,441 shares which align his interests quite well with retail investors.

Corporate strategy

The company applies its “customer first" strategy, which in simple words tries to convince buyers to return to the store. Behind this, several actions are taken, ones related to employees, and other tasks related to the study of consumers.

The aim is to promote consumer loyalty, knowing better their preferences and improving key aspects of the relationship with them, so that the price variable remains in the background. To enumerate some of them, accessibility, store cleanliness, security, reducing times, are the main factors in order to affect customer´s decisions.

The firm´s merchandising strategy is attractive, with approximately 13,000 private label items. Products are classified into 3 different categories:

- Private Selection® is the premium quality brand

- The “banner brand” (Kroger®, Ralphs®, Fred Meyer®, King Soopers®, etc.), which represents the majority of the private label items

- The Kroger “Value brand” is designed to deliver good quality at cheaper prices

As of January 31, 2015, Kroger produced in its manufacturing plants (37 plants, primarily bakeries and dairies) about 40% of the corporate brand units sold, the other 60% is produced by outside manufacturers but with strict specifications.

Performance and earnings outlook

In the first quarter of 2015, total sales increased by 0.3%, to $33.1 billion from $33.0, when compared to the same quarter one year before. Excluding fuel, total sales increased by 6.4%.

Looking forward, the company confirmed its net earnings guidance range of $3.80 to $3.90 per diluted share for fiscal 2015. This range of 8 to 11% is in line with long-term guidance. It also upped by 50 basis points its supermarket sales growth guidance, excluding fuel, to a range of 3.5% to 4.5% for fiscal 2015.

Financial strength

The financial strength of Kroger is something investors need to be aware of. When looking at the total debt and taking into account the current and long-term portions of capital lease and lease-financing obligations, we see an increase to $11.7 billion in 2014, compared to 2013. The increase came from $500 million of senior notes and an increase in commercial paper of $25 million, partially offset by payments at maturity of $300 million of senior notes. Further, the company has been issuing new debt. Over the past three years, Kroger issued $3.1 billion, but looking at the ratio of LT Debt / Assets, I think we should not worry about this debt.

In the next table we can see the evolution in a 10-year period:

The company´s liquidity needs for 2015 will be approximately $5.2 billion, including: requirements for working capital, capital expenditures, interest payments and scheduled principal payments of debt and commercial paper. At the end of the first quarter, the company had $1.25 billion on the books. Also, Kroger has a $2.75 billion unsecured revolving credit facility which terminates in five years. In addition, as of January 31, 2015, it was authorized by the SEC for issuance $2 billion of securities. Last but not least, cash flows from operating activities will be adequate to meet liquidity needs.

As an example, the firm returned more than $1.1 billion to shareholders through share buybacks and dividends over the last four quarters, showing its financial strength.

Relative valuation

In terms of valuation, the stock sells at a trailing P/E of 20.99x, trading at a discount compared to a median of 23.4x for the industry. To use another metric, its price-to-book ratio of 6.52x indicates a discount versus the industry median of 2.09x while the price-to-sales ratio of 0.33x is below the industry median of 0.54x. Kroger does not stand out as particularly cheap in P/B ratio. Both, P/E and P/S ratios show the company is cheap. These two metrics indicate that the stock is relatively undervalued and subject to a potential buy.

Risks

One of the company´s principal risks is gasoline, due to probable increase of its control and regulation, as well as a possible increase in prices, which could hurt the firm and have an effect on financials. No one is able to predict how customers could react in an adverse scenario, but we can say gasoline is always a risk for Kroger. Right now, prices are stuck in a range and it is fair to say that the company managed to survive in difficult times.

Final comment

It is difficult to predict what gasoline prices will do in the future. If conditions remain stable, I think Kroger will continue growing with its attractive portfolio. I expect the company will achieved good performance in the foreseeable future and outperform the industry.

Moreover, management expect net earnings per diluted share in the range of $3.80-$3.90 for fiscal year 2015, a growth rate in the range of 8 to 11%, from 2014 adjusted net earnings of $3.52 per diluted share. Further, the company expects more square footage and improving productivity from existing locations that would lead to sales growth in the range of 3.0% to 4.0% in FY 2015.

Furthermore, a long position of USD 10K five years ago today represents USD 39,041, which represents a 31.3% compound annual growth rate, assuming reinvestment of dividends.

To sum up, weighing the pros and cons I would recommend adding Kroger to your long-term portfolios, based on my conviction that it will outperform the market over the next years.

The fact that billionaire hedge fund manager Israel Englander has doubled his stake in the company in the first quarter of 2015, makes me feel more comfortable with my buy recommendation, as well as the new positions initiated by John Burbank (Trades, Portfolio), Lee Ainslie (Trades, Portfolio) and Joel Greenblatt (Trades, Portfolio) or Paul Tudor Jones (Trades, Portfolio)´ long position in that time frame.

Disclosure: Omar Venerio holds no position in any stocks mentioned