(Published by Bob Ciura on June 23)
If you were to base your investment decisions solely on news headlines, you might be convinced Kroger Co. (KR, Financial) is going out of business.
In fact, Kroger stock lost one-third of its value in two trading days.
First, the grocery store chain announced lower 2017 earnings guidance in its first-quarter results, causing the stock price to tumble.
The next trading day, Amazon.com Inc. (AMZN, Financial) announced its pending $14 billion takeover of organic grocer Whole Foods Market Inc. (WFM, Financial), which caused Kroger’s stock price to fall further.
Investors fear that what Amazon did to department stores—undercutting them on price to take market share—it could soon do to grocery stores.
But Kroger is not going away anytime soon—it is the largest supermarket in the U.S. and rewards shareholders with rising dividends each year.
Since 2006, Kroger has grown its dividend by 13% each year on average. It is a Dividend Achiever, a group of stocks with at least 10 years of consecutive dividend growth.
You can see the entire list of all 264 Dividend Achievers here.
On June 22, Kroger increased its dividend by 4% and also approved a new $1 billion share repurchase program.
Despite the current uncertainty, Kroger is an attractive stock for value and dividend growth investors.
Business overview
Despite the scary headlines predicting the imminent death of the grocery store, Kroger is performing quite well.
The company owes its strong performance to its “Customer First” policy, which is more than 10 years in the making.
Source: 2016 Investor Presentation, page 23
The three pillars of its management strategy are low prices, high-quality products and making the customer the number one priority.
This has worked very well—in fiscal 2016, Kroger’s total sales increased 5%. Excluding fuel, total sales increased 6.7% year over year in 2016.
Comparable store sales, which measures sales at locations open at least one year, rose 1% in 2016.
In addition, last year was the 12th in a row in which Kroger claimed market share in the U.S.
Net earnings were $1.98 billion, or earnings per share of $2.05 for the year. This was a fractional decline from the previous year.
Kroger’s impressive sales growth last year was due to a number of strategic investments.
Added costs from these investments kept earnings flat last year, but going forward they will help Kroger maintain and expand its leadership position in the grocery industry.
Growth prospects
Kroger has invested heavily in various growth initiatives over the past several years, proving internet retailers are not the only ones that can innovate.
The first is acquisitions—in 2016, Kroger acquired supermarket chain Roundy’s, which has several banners, including Pick ‘n Save and the popular Mariano’s specialty grocer.
Source: 2016 Investor Presentation, page 16
Kroger said the Roundy’s deal added to growth last year by giving the company a stronger foothold in the Midwest, especially from Mariano’s success in Chicago.
Separately, Kroger has invested heavily in technology and has embraced a multi-channel approach.
Kroger merged with Harris Teeter to access its technological platforms. This gave rise to ClickList, which allows customers to order online and pick up items in store.
Kroger ended 2016 with 640 ClickList locations.
E-commerce investments are growing robustly: Kroger’s digital revenue more than doubled in the first quarter.
Separately, the grocer has significantly boosted its own line of natural and organic products. Due to its scale, it can offer its signature organics line, Simple Truth, at far lower prices than shoppers will find at Whole Foods.
Kroger’s own signature products represented 25% of total sales last quarter.
Last year, Kroger also invested in Lucky’s Market, a specialty natural and organics store, which has 22 locations.
These investments have fueled Kroger’s growth to start 2017. First-quarter sales increased 4.9% to $36.3 billion.
Competitive advantages and recession performance
Kroger has several competitive advantages that will allow it to fend off the Amazon threat. First is its scale.
The company operates 2,792 stores in the U.S., giving the company the ability to lower costs, which it passes on to customers through lower prices.
Kroger’s strong financial position lets it invest significantly in advertising, which is critical to maintaining and growing its customer base.
The company’s advertising expenses over the past several years are as follows:
- 2014 advertising expense of $648 million.
- 2015 advertising expense of $679 million.
- 2016 advertising expense of $717 million.
These competitive advantages have resulted in a very high level of customer loyalty.
Source: 2016 Investor Presentation, page 18
This results in strong financial performance. Last quarter, Kroger generated a healthy 12.75% return on invested capital.
Kroger’s competitive advantages have led to strong profitability, even when the economy enters recession.
Its EPS held up very well during the Great Recession:
- 2007 EPS of 85 cents.
- 2008 EPS of 95 cents.
- 2009 EPS of 87 cents.
- 2010 EPS of 87 cents.
- 2011 EPS of $1.
The company benefits from a very simple truth, which is everyone needs to eat, even during recessions.
Additionally, Kroger’s low prices help protect its market share when the economy deteriorates.
Valuation and expected total returns
Kroger stock trades for a price-earnings (P/E) ratio of 11 based on 2016 results. This is a significant discount to its valuation.
The S&P 500 Index, on average, trades for a P/E ratio of 26.
Kroger itself was trading for a P/E ratio over 20 as recently as last year. It seems the widespread fear over Amazon’s entry into groceries is causing the company’s valuation to contract.
This could be a good buying opportunity, however, as Kroger shares now appear to be undervalued.
Kroger holds a long-term forecast of 8% to 11% earnings growth. Based on the following factors, the company could reach that goal:
- 5% to 7% sales growth.
- 3% to 4% share repurchases.
This takes the company to an expected earnings growth rate of 8% to 11% per year.
Share repurchases will play a large role in Kroger’s earnings growth. The recently approved $1 billion share repurchase plan represents approximately 5% of the company’s market cap.
This is the benefit of having a strong, cash-generating business combined with a cheap stock price.
Including the 2.2% dividend yield, investors can reasonably expect double-digit total annual returns from Kroger stock moving forward.
Final thoughts
Companies that benefit from positive headlines can see their valuations rise, while companies viewed as old or boring are tossed in the trash bin.
Seeing the massive rally in internet stocks over the past year may tempt investors to jump in for fear of missing out, but investors that still value profitability and dividends should give Kroger a closer look.
Amazon is paying nearly $14 billion for Whole Foods, which has 444 stores in the U.S. and generated $15.3 billion in sales last fiscal year.
Meanwhile, Kroger has a market capitalization of just $20 billion, but has nearly 2,800 stores with annual sales in excess of $115 billion.
The grocer's sales growth was more than double Whole Foods’ growth in fiscal 2016.
As a result, Kroger stock appears to be significantly undervalued, with the added benefit of a rising dividend.
Disclosure: I am not long any of the stocks mentioned in this article.
