I wrote an article about Kroger (KR) in March after the company reported fourth-quarter results for fiscal 2016 (link). Here was the premise of that article:
“In the face of these challenges, Kroger hopes to achieve long-term EPS growth of 8% to 11% per year. On the fourth-quarter conference call, management reaffirmed its belief that this is a sustainable target, even though it fell well short in 2016 (EPS increased 3%) and projects another shortfall in 2017 (5% EPS increase at the midpoint, inclusive of the benefit from the 53rd week). Personally, based on the experience of Kroger’s peers, I think there’s reason to be skeptical.”
On Thursday, Kroger reported first-quarter results for fiscal 2017. Comparable store sales were roughly flat, with lower gross margins and EBIT margins driving a large year-over-year decline in profitability. Management cut the adjusted EPS target for FY17 by roughly 10%, to $2.00 to $2.05 per diluted share. The stock got crushed on the news, falling 19% on Thursday.
On Friday, Amazon (AMZN) announced their proposed acquisition of Whole Foods (WFM). Concerns about what this means for brick-and-mortar grocery stores in the U.S. led to another dive for Kroger on Friday (down 9% for the day). In the past week, KR stock has fallen from $30 per share to $22 per share, knocking off more than 25% of the company’s market cap.
So let’s set the stage: we now have one of the nation’s largest grocers trading at a low double digit earnings multiple. The dividend, which is easily supported by a payout ratio of less than 25%, is currently 2.1% (comparable to the current yield on the ten-year Treasury bond).
One last word on valuation: Kroger did $115 billion in revenues in 2016 – nearly 8x higher than Whole Foods. By comparison, Kroger’s current market cap is only ~50% higher than the price tag Amazon just agreed to for Whole Foods. It seems like there’s a bit of a disconnect here.
As you might expect, there’s some hair on this one: after years of consistently reporting solid comp store sales (with the two-year stack usually in the high-single digits), Kroger has fallen on hard times. My bet (as outlined in my last Kroger article) is that better performance from Walmart has been the primary factor. I’ve been very impressed by Doug McMillon, and don’t like the idea of betting against him. I don’t think this becomes easier for Kroger anytime soon.
In addition, emerging competition will likely take its toll. Aldi and Lidl are planning to expand their U.S. presence, with rock-bottom prices on private label goods placing them in competition with Kroger. They probably have their sights on Kroger’s roughly 10% share of the U.S. grocery market. In what’s already a fiercely competitive industry, things are about to heat up even more.
Finally, we have Amazon. As I’ve contended for some time, I thought Amazon’s strategy in grocery would be to go after the high-end, urban customer (those willing to pay for convenience, with Amazon benefiting due to the geographic concentration of these customers in cities like New York, Boston and Seattle). The Whole Foods customer seemed right in their wheelhouse. I assumed Amazon would organically attack this opportunity; I did not think they would buy Whole Foods (for $13.7 billion). This is by far the largest acquisition Amazon has ever made. Despite my doubts, I’m smart enough to know that doubting Jeff Bezos is a bad idea.
I find it interesting that John Mackey will stay on as the CEO of Whole Foods. Consider some of his commentary in a recent interview with Tom Foster of Texas Monthly (link):
“We’re going back to being a little bit more niche than we were. We are not going to be the supermarket that everybody’s going to want to shop at.”
That doesn’t sound like the Jeff Bezos approach. Long-term, he wants to be a major player in grocery. I question whether or not Whole Foods (as we know it) will be the vehicle to achieve that goal. If they try and make it everything for everyone, I think they risk damaging the brand. Maybe Bezos is willing to invest aggressively in price, taking hundreds of basis points out of gross margin. That would blow up the P&L in the short-term, but he might be okay with that.
I’d love to shop at Whole Foods if the value proposition was the “better” products they’re known for (cage-free, organic, etc.) at slightly higher prices than what you find on organics at Walmart (WMT), Kroger, or Costco (COST). A premium experience and premium products at a slight mark-up. This seems reasonable to me (it wouldn’t destroy the brand image). If that’s the plan, I wonder if Mackey is the guy for the job (which makes me wonder why he’s staying). Even then, the target market would grow – but it doesn’t eliminate traditional grocers. I need more time to think about this, but I’m skeptical this marks the end for traditional grocers in the United States.
That doesn’t mean Kroger (or anybody else) can stand still. They need to be a step ahead of the competition. As Warren Buffett (Trades, Portfolio) noted in his 1995 shareholder letter, retailing is a tough business:
“During my investment career, I have watched a large number of retailers enjoy terrific growth and superb returns on equity for a period, and then suddenly nosedive, often all the way into bankruptcy. This shooting-star phenomenon is far more common in retailing than it is in manufacturing or service businesses. In part, this is because a retailer must stay smart, day after day. Your competitor is always copying and then topping whatever you do. Shoppers are meanwhile beckoned in every conceivable way to try a stream of new merchants. In retailing, to coast is to fail.”
As Warren also noted in that letter, retailing is a business where management matters a lot:
“Buying a retailer without good management is like buying the Eiffel Tower without an elevator.”
I don’t have any issues with Kroger’s management team. What I do know is that the guys running Walmart and Amazon are two people I have absolutely no interest competing with. One of them is already my direct competitor, with more than 20% share of the U.S. grocery market; the other is getting closer to being a direct competitor with each passing day (especially after Friday). This is a real concern if I’m a Kroger shareholder.
The stock seems reasonable at 11x earnings. I’m comfortable assuming revenues can grow a few points per year, with repurchases bringing the per share number to the mid-high single digits. Margins are a bit of a wild card, but I’m not sure I buy the argument that significant, sustained margin compression is on the horizon. If that’s accurate, you’re buying a business that can grow EPS at a reasonable clip for a low double digit multiple. You could do worse in this market.
And yet, with all that said, I don’t think I’ll be buying Kroger. The beauty of investing is that even when the pitch looks pretty good, you don’t have to swing. It’s not enjoyable standing at the plate with the bat on your shoulders, particularly when others keep knocking it out of the park; but it’s still better than striking out. Outside of a quick jump in the multiple (which would result in a nice return for short-term shareholders), I’m not sure I want to own Kroger for the next 5-10 years. For me, that’s usually a good sign to stay on the sidelines. I don’t think things get demonstrably worse for the business from here, but I could be wrong. I’m open to your thoughts.
