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The Science of Hitting
The Science of Hitting
Articles (597) 

Some Thoughts on Kroger

A quick look at Kroger after the stock fell more than 25% in a week.

June 18, 2017 | About:

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.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 5.0/5 (7 votes)



Swnyc2 - 2 years ago    Report SPAM

Thank you for sharing your thoughts. Nice article. But, I think things for Kroger will get worse, much worse.

Take a look at what Lidl and Aldi have done to Tesco in the U.K.

For the forseeable future, Kroger will be in a price war with Lidl and Aldi, and a technology / fulfillment war between AMZN and WMT. The U.S. consumer will benefit, but the retailers (all of them) will do poorly for a good while.

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Swnyc2 - There's no dobut Aldi and Lidl have ambitious plans. There's also no doubt that they've hurt traditional grocers in the UK (the most recent data I could find had the combined share for Aldi and Lidl at ~12%). What's happened to consumer perception of private label is pretty amazing. Look at this study from Bain; the fourth graphic shows that roughly 50% of consumers across retailers "agree" or "strongly agree" that private label products are as good or better than national brands:


In what’s already a fiercely competitive industry, things are about to heat up even more. Kroger must continue to improve if they plan on holding / gaining share. Thanks for the comment!

Swnyc2 - 2 years ago    Report SPAM

Thanks for the Bain reference. In the U.S. the grocery business is highly fragmented. Even if Aldi and Lidl have only a 12% market share, they can still have a profound effect on prices across the entire U.S. market. One Lidl or Aldi store can force many nearby competing stores to lower their prices in an attempt to maintian market share. This is what is happening in the U.K. where Tesco, Asda, Sainsbury, and Morrisons are all having a tough time with declining market share and profit margins. By seilling their own private label products, Lidl and Aldi have essentially vertically integrated. They are substantially increasing the number of their U.S. stores and are offering a better value proposition to those consumers who are not married to national brands. Kroger's same store revenue will drop, and they will lose share. I think there is little that they can do in response. Perhaps if some of the weaker traditional grocery stores close, that will help Kroger.... This future does not bode well for Proctor and Gamble either....

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Swnyc2 - I largely agree with what you've said, but caution that some may be overreacting just a tad. It's worth remembering that Aldi already has ~1,600 stores in the United States and has been in the market for 40 years. They will remodel much of the existing base (some of the one's I've been to need it badly) and add another ~900 stores. It's a great value for the consumer that's happy with private label goods and no frills shopping (bring your own bags, pay to "rent" a cart, etc). Thanks for the comment!

Rrurban - 2 years ago    Report SPAM

The paradigm has shifted for Kroger and there will be competitive headwinds going forward. This means intense price competition and a need to increase reinvestment into their business. I would not expect growth in operating income but would expect capex to increase. The stock is worth no more than $25/sh on a stagnant valuation moving forward.

Praveen Chawla
Praveen Chawla premium member - 2 years ago

I think Kroger will compete aggresively as ususal and even more aggresively now. Competition tends to bring out the best in organization. KR's moat is really the network they already have. They can / are building the digital network on top of that (as is WMT). AMZN is really now doing the opposite - by buying WFM they are essentially buying physical distribution points. The future is clearly moving towards - online ordering and physical pick up.

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Thanks for the comments Rruban and Praveen. You both make good points that are worth consideration. One thing is for sure: intense competition is great for us consumers!!!

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

For what it's worth, here's Goldman's take on Lidl pricing after visiting a few stores in Virginia Beach (Lidl opened its first 10 U.S. stores last week): "Our own pricing study found meaningful discounts to Kroger's Harris Teeter on private label goods, but similar pricing to WMT, and above ALDI."

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