Inflation is at the top of everyone’s minds today, and one of the most important industries that is facing inflationary pressures is the grocery store industry.
Against expectations, The Kroger Co. (KR, Financial) seems to be holding up remarkably well even in this high-inflation environment. The company is one of the largest food retailers in the U.S. with over $137 billion in annual sales. With a history dating back to 1883, the company operates approximately 2,723 stores in 35 U.S. states under a variety of brands, including iconic names such as Kroger, Ralphs, Fred Meyer and Food 4 Less.
Recent financial results
In the inflationary environment that began rapidly forming in spring 2022 as a result of monetary policy decisions and market forces over the past couple of years, Kroger's results were not a disaster. Same store sales increased 4.1% and gross margins only declined 26 basis point to 21.6%. Adjusted operating profit increased to $1.6 billion from $1.4 billion in the prior-year period.
Despite the inflationary environment, the company continues to generate good free cash flow, which totaled $357 million in the first quarter, despite high levels of inventory purchases. Kroger has stated is is committed to investing in the core business to drive long-term sustainable profit growth, maintaining its current investment grade debt rating and returning excess free cash flow to shareholders through share repurchases as well as growing dividends.
Kroger's leverage ratio is 1.68 times, compared to 1.79 times a year ago. The company's net total debt to adjusted Ebitda ratio target range is 2.30 to 2.50. During the first quarter, the company repurchased $665 million shares of common stock.
Digital results
Although in-store grocery purchases are still the substantial majority of total sales, the company has been an industry leader in digital or omni-channel experiences. During the quarter, Kroger opened two new Kroger Delivery facilities in Dallas, Texas and Pleasant Prairie, Wisconsin, which were powered by grocery technology leader Ocado (LSE:OCDO, Financial), allowing Kroger to serve products directly to more households.
The company also expanded the Kroger Delivery network by opening three new spoke facilities (last-mile cross-dock locations) in Columbus, Louisville and Miami.
Lastly, Kroger introduced a national e-commerce experience that expands Kroger Home and Baby offerings by selling several thousand new products on Kroger's Ship Marketplace in collaboration with Bed Bath & Beyond Inc. (BBBY, Financial).
Valuation
Company guidance for this fiscal year, which ends on January 2023, calls for same store sales growth of approximately 3.0% and earnings per share in the mid range of $3.90. More importantly, free cash flow is expected to be over $2.0 billion. Consensus analyst EPS estimates are calling for $3.84 this year and $4.00 next fiscal year.
That puts Kroger stock selling at 12 times current year estimates and only 11.5 times next year's earnings. The enterprise-value-to-Ebitda ratio stands at 9.5 times this year's average estimates an 9.0 times next year's estimates.
The company’s annual dividend payment is $0.84, which equates to a below average dividend yield of 1.82%. However, that dividend payment represents a payout ratio of only approximately 20%, so dividend increases are possible.
Guru trades
Gurus who have purchased Kroger stock recently include Ray Dalio (Trades, Portfolio) and Joel Greenblatt (Trades, Portfolio). Gurus who have reduced their positions include PRIMECAP Management (Trades, Portfolio) and Jim Simons (Trades, Portfolio).
Conclusion
Kroger remains a well-managed and quality blue chip retailer that appears to be undervalued at this time, in my view. Although the inflationary environment creates gross margin headwinds, long-term investors may appreciate the strong balance sheet, low valuations and possible material dividend increases going forward. The company maintains a long-term growth plan to create total annualized shareholder returns in the 8% to 11% range through a combination of earnings growth, dividend increases and share repurchases.
