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The Science of Hitting
The Science of Hitting
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An Update on Kroger

A look at the retailer's 1st-quarter results

June 23, 2019 | About:

On Thursday, Kroger (KR) reported financial results for the first quarter of fiscal 2019. Revenues for the quarter increased 2% (adjusted for fuel and the sale of the convenience store business), with same store sales (what Kroger calls identical or ID sales) up 1.5%. As CEO Rodney McMullen admitted on the call, “we know we can do better when it comes to identical sales results.” As shown below, Kroger’s comps have slowed significantly as of late:

In addition, they’ve reported results that have lagged retail peers like Costco (COST) and Walmart (WMT) by a wide margin (I use two year stacked comps in this chart to reduce the noise around short-term events that can impact results like weather or the timing of SNAP benefits):

While overall comps were weak, Kroger continues to see outsized growth for its own store brands (which account for more than 30% of its grocery business add typically have margins that are 600 to 800 basis points higher than national brands). In the quarter, revenues for the own store brands increased more than 3%, with Simply Truth and Private Selection climbing double digits. In addition, the company’s digital revenues increased by more than 40%, with the company’s pick-up and delivery locations now able to serve more than 90% of its customer base. (As a reminder, Kroger exited 2018 with run rate digital sales of $5 billion.)

Moving down the income statement, gross margins contracted by 40 basis points in the quarter, with management pointing to industry wide gross margin pressure in the pharmacy business. Based on what I’ve read, it sounds like this could persist CFO Gary Millerchip alluded to this on during the question and answer sessions). As Walgreens (WBA) CEO Stefano Pessina noted in April, “The pharmacy trends are not only impacting our business. They are impacting the overall market and will likely continue to do so over the coming months.”

Kroger was unable to offset the gross margin headwind, with operating income declining 6% in the quarter to $957 million. After accounting for a lower share count (-5% from the year ago period to 805 million shares), diluted earnings per share (EPS) declined 1% to $0.72 per share.

Over the past year, Kroger has spent $589 million on investments in Ocado and Home Chef, $216 million on repurchases, and $400 million on dividends. These outflows were partially offset by the sale of YouTech (for $565 million) and the Turkey Hill dairy business (for $215 million). Kroger’s net debt to adjusted EBITDA ratio is at the high end of management’s target range (2.3x to 2.5x).

Conclusion

At $22 per share, Kroger currently trades at a roughly 10x guidance (management reiterated their target for 2019 EPS of $2.15 to $2.25 per share). In addition, management continues to guide to meaningful operating profit growth in the years ahead (roughly $400 million of incremental EBIT from fiscal 2017 to fiscal 2021, largely due to the “alternative” businesses of Personal Finance, Advertising and Data Analytics). Combined with share repurchases, that could setup the company for meaningful EPS growth, which could come with a rerating on the valuation as well. (By my math, hitting those targets would result in roughly $2.6 per share of adjusted EPS in 2021.)

On the other hand, management’s stated optimism does not appear to align with their actions. As shown below, insiders have only completed two open market purchases over the past three years (for 15,000 shares, which are currently worth $330,000). Considering how poorly the stock has performed over that period of time, I think the unwillingness of management and board members to step up and make meaningful personal investments in the company speaks volumes.

In addition, I’ve become convinced that management is way too focused on short-term results. With time, I think that misguided focus could be detrimental to strategic decision-making and long-term value creation. As an example, consider a few comments from a recent J.P. Morgan (JPM) analyst note following a series of meetings with Kroger’s management team (bold added for emphasis):

“We doubt that Kroger will miss its bottom line guidance because it has many other levers to pull (it can always contribute less to pensions, et al).”

“Following our meetings, we are increasingly comfortable in Kroger’s ability to hit EPS guidance ($2.15 to $2.25) even if sales disappoint.”

“The company explicitly reminded us that it rarely misses its EPS guidance; it has many levers to pull to stay within each year’s guidance range.”

I honestly can’t believe Kroger would let JP Morgan go public with that note (as written). Personally, there are few things that would make me less interested in owning a stock than a management team that is so blasé about earnings management - though I appreciate their frankness because it saves me the difficult work of spotting their financial shenanigans on my own).

I don’t own Kroger shares, and have no intention of initiating a position at this time.

Disclosure: None.

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.

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