Kroger Co. (NYSE: KR) remains BUY. While Kroger benefited from high demand for groceries as COVID-19 spread, we think the company has excellent prospects after the crisis, helped by affordable private brands and world class customer analytics, as well as by online ordering and curbside pick-up at virtually all of its stores. We believe Kroger will be a survivor.
Kroger is gaining market share. It was gaining share before the crisis and said that it has gained share during the pandemic, with help from attractive prices. In the third quarter KR said that it gained market share in fresh food, fresh prepared foods, and with its private brands. It continues to use ‘big data’ to drive successful promotions and merchandising decisions. Kroger has its own ‘digital’ solution with annual sales that probably exceed $5 billion. The company offers the pick-up of digital orders from over 2,200 locations and delivery from almost 2,500 locations, covering 98% of households. The company’s vigilance in getting its stores up and running has helped it in the current crisis. Digital sales rose 92% in 1Q, 127% in 2Q and 108% in 3Q. We believe that customers like curbside pick-up because they can get their orders at their own convenience rather than having to wait for a delivery. We also believe that many shoppers will use the online services as the pandemic curve flattens, and perhaps permanently. This is supported by the company’s customer research.
The presence of Amazon in the brick-and-mortar grocery sector is certainly a concern, but we and others have long considered the impact of AMZN becoming more aggressive in the sector. An increasing risk is that Walmart and Target, which are here-and-now competitors in many markets, appear to be gaining traction and investing heavily in their online ordering, and delivery capabilities. To be sure, Kroger has not been standing still. It reached $1 billion in annual sales from its own Simple Truth natural and organic brand in just two years and the brand grew about 9% in FY20 to reach $2.5 billion of sales, which made it the biggest natural and organic brand by volume. The company’s private brands had FY20 sales of about $23 billion. The company’s own brands gained market share in 3Q. Simple Truth grew 20%. Kroger is also building a presence in the popular ‘plant-based’ meat category, which grew more than 30% in 1Q (we don’t have data for 2Q or 3Q). KR launched 50 new plant-based products in 3Q.
Kroger has a portfolio of successful private brands that is growing faster than national brands, as well as an industry-leading customer analytics business called 84.51 that deliverers more than $1 billion of digital coupons annually. (The name of the analytics business refers to the longitudinal position of its headquarters.)
Kroger recently broadened its view of its addressable market to ‘share of stomach.’ This means that KR will place increasing emphasis on its prepared food business, going after everyone who sells food, including restaurants. This doubles the company’s potential market to $1.5 trillion. KR plans to use its relationships with over 60 million households and its data-management expertise to gain share.
The company earned $0.80 on a GAAP basis, which excluded a $115 million gain on investment. Sales were strong. The company did a good job controlling costs, fuel profitability was better than expected and the alternative profit businesses, including advertising sales was strong.
One explanation is that investors are concerned that the benefit of COVID-related buying is fading. Identical sales growth slowed from 14.6% in 2Q to 10.9% in 3Q. These are still strong sales and we aren’t modeling future growth at these levels.
Management did provide full-year guidance. Management expects adjusted EPS to grow by about 50%-53% to $3.30-$3.35 per share, up from previous guidance of $3.20-$3.30 per share. The pre-release consensus was $3.30 and our pre-release estimate was $3.20. The guidance implies 4Q earnings of $0.64-$0.69 per share, compared with our pre-release estimate of $0.64 and the pre-release consensus of about $0.68. The implied-guidance may not have offered enough upside relative to consensus. The company expects identical sales to grow by about 14% for the year. The pre-release consensus was 12.5% for the year. It is likely that the company’s gas stations will be a constraint on earnings growth. They will be lapping very strong fuel margins, and gallons sold may be flat or down if customers continue to drive fewer miles.
We believe that Kroger is making the right decisions to generate long-term growth and market share. Customers give Kroger higher ratings for fresh goods than its big-box competitors. The company’s private brands are also gaining share. Simple Truth, natural and organic, comps were up about 15% in the third quarter.
Adjusted operating income was $871 million, up from $653 million a year earlier. Our estimate was $727 million. Gross margin decreased by 2 basis points, excluding fuel. The company continued to reduce prices and had a lower mix of prepared foods. KR benefited from more efficient sourcing and growth of alternative profit streams, including in-store advertising sales. Operating, general and administrative expense improved as a result of strong sales, partly offset by COVID-19 related spending.
Kroger’s net debt/EBITDA ratio decreased to 1.7-times from 2.5-times a year earlier. The company is below its target range of 2.3-2.5-times.
EARNINGS & GROWTH ANALYSIS
Our estimate of total sales is up slightly. We are also comfortable with the company taking the long view – investing in associates and e-commerce infrastructure to make sure that the business stays strong and relevant.
In 2017, the company unveiled a plan called Restock Kroger to better compete against various competitive options that bypass traditional grocery stores with online ordering and either delivery or drive-by pick-up. The company is also offering more prepared-food options to take business from fast-food and casual-dining restaurants. KR is making investments in technology, online selling capabilities, improving associate wages and continuing to reduce prices.
We expect sales to benefit from fuel sales, continued use of personal coupons, and improving digital capabilities. An improving offering of the company’s own brands should help the company to win value-conscious shoppers and slightly improve margins. KR is also aiming to differentiate itself with a wider offering of fresh foods – including prepared foods, improving in-store efficiencies, and building alternative profit streams. The company’s objective is to deliver a total shareholder return of 7%-11.5%, which includes 4.5%-9% EPS growth and a 2.5% dividend yield.
FINANCIAL STRENGTH & DIVIDEND
The grocery business is highly competitive and margins are notoriously low. One salvation is that the business is less cyclical than many segments of retail. In the current COVID-19 crisis, Kroger was one of the fortunate retailers whose stores remained open for business.
When things return to ‘normal,’ competition could be amplified as Wal-Mart continues its push to grow store traffic, Amazon attempts to justify its purchase of Whole Foods, a growing number of restaurants and retailers offer delivery services, and other grocers attempt to maintain their market share. On the positive side, demand for groceries tends to be quite stable, shoppers increasingly value fresh meat, fresh produce and meals to go, and rapid inventory turnover tends to enhance return on equity and cash flow generation. While Kroger doesn’t match Walmart on price it typically has fast checkout times and good produce and prepared foods.
The company has said that its priorities for allocating capital are: investing in the business, maintaining net debt at 2.3- to 2.5-times EBITDA, consistently increasing the dividend, and using any excess capital to repurchase shares.
In its April 1, 2020 business update, management said that it borrowed $1 billion under its revolving credit facility on March 18. This was to preserve financial flexibility and reduce dependence on the commercial paper market. Cash and temporary cash were $2.2 billion.
Kroger owns approximately 45% of its supermarkets including ground leases, where it owns the store but leases the land beneath the store. This isn’t as high as Walmart or Costco, but it still represents a significant asset for the company. The company believes that it saves about $1 per square foot when it owns rather than leases stores.
Short-term borrowing could be constrained if Kroger loses investment-grade status – something we don’t expect. This could reduce capital efficiency because the company would need to maintain higher cash balances.
At the end of 4Q19, debt of $15.2 billion was about 66% of capital. We estimate that the capitalized value of the company’s lease expense was $6 billion. This raised fixed obligations to about 73% of capital. At the beginning of FY20, Kroger and other retailers were required to include the value of leased assets and liabilities on their balance sheet rather than in a footnote in the annual report.
The company’s balance sheet also includes about $543 million of pension and post-retirement obligations that are not included in this calculation, up from $471 million a year earlier. The company’s pension situation is complex and not insignificant. We believe that Kroger has been transparent and proactive in addressing, managing, and improving the situation.
In addition, the company contributes to other so-called ‘Multi-employer’ plans where it does not have direct obligations. KR has said that its share of the underfunding – on an after-tax basis – is approximately $2.3 billion, or about $1.8 billion after tax. Kroger contributed approximately $290 million to multi-employer plans in FY17, $954 million in FY18, $358 million in FY19, and $461 million in FY20.
Goodwill of $3 billion, including Harris Teeter and Roundy’s, represents 6.3% of assets and 30% of equity. Write-downs could be a drag on reported earnings, though not necessarily cash flow.
The company-provided net-debt to EBITDA calculation was 2.5 at the end of 4Q20, down from 2.8-times a year earlier due to increased borrowings to fund the investment in Ocado, the planned merger with Home Chef, and pension funding. Following the Harris Teeter acquisition, which raised the debt metric, KR reduced the ratio to 2.0-2.2 a few quarters earlier than expected. The ratio was down to 1.81-times at the end of 1Q21 and 1.7-times at the end of 2Q, and 1.74-times at the end of 3Q, which is strong for a company with BBB credit ratings. The company recently raised the target range to 2.3-2.5. This isn’t really a material change. First the company has raised debt to fund pension obligations. There have always been obligations and this has been understood, but the difference is that the obligations are now funded, which brings them into traditional debt calculations.
In June 2014, the company announced that it completed its existing repurchase plan and initiated a new authorization for $500 million. Repurchases were $1.3 billion in FY15 and $703 million in FY16. During FY17, KR repurchased $1.8 billion of stock. In March of 2017, the company added an additional $500 million to the buyback. In FY18, the company repurchased $1.6 billion. In FY19, the company repurchased $2.3 billion of its stock, boosted by $1.2 billion in proceeds from the sale of the convenience store business. In 1Q20, the company repurchased $15 million.
At the end of 2Q, KR had $546 million remaining under its buyback authorization. At the November 5 investor meeting, Kroger replaced that authorization with a new $1 billion repurchase program. The company said on the 3Q call that having its leverage ratio in line with plan would allow it to repurchase shares in 4Q20. The company repurchased $400 million of its stock in 4Q. KR was obviously feeling better, repurchasing $211 million of shares in 2Q and authorizing a new $1 billion program on September 11, 2020, which replaced a small remaining balance on the old plan. KR repurchased $304 million of shares in 3Q and probably had about $700 million left on the repurchase plan. The company paid dividends of $0.39 per share in FY11. FY12 dividends were $0.43. FY13 dividends totaled $0.50. Kroger paid FY14 dividends of $0.615.
FINANCIAL STRENGTH & DIVIDEND
idend by 14% to $0.16. FY20 dividends were $0.60.
Kroger has held up very well in both the early stages of the coronavirus crisis and as the pandemic has evolved. Unlike many retailers, Kroger’s stores have remained open for business and have pharmacy departments. The company still faces COVID-related risks. Employees may not be willing or able to work enough hours, unions could demand more money, there may be disruptions at the plants that make the company’s private-label products, ordinances could make store cleaning procedures burdensome, the company may not be able to get adequate supplies of brand-name products, and government regulation could increase significantly. Sales may suffer after the virus subsides if consumers have stockpiles in their cabinets and freezers. The company might see restricted access to credit, and there could be disruptions to payment networks. While sales of food may be strong, sales of fuel have declined because people are driving less.
On January 1, 2014, President and COO Rodney McMullen succeeded Dave Dillon as CEO. The two executives worked together for 25 years. Mr. Dillon remained chairman through calendar 2014.
In December 2018, Kroger announced that Gary Millerchip would succeed Michael Schlotman as CFO. Mr. Schlotman retired from the company in December 2019. The transition started with Mr. Millerchip becoming CFO in April 2019.
The company’s fundamental operating philosophy is to maintain and increase market share. Management said that market share has grown for 14 consecutive years through FY19.
The biggest ongoing concern is that Amazon’s ambitions to grow market share and more specifically, its purchase of Whole Foods and WSJ-reported ambitions to open another chain of food stores, will raise competition in the grocery business. It will raise competition, but there are some things that are worth considering. The first is that there isn’t a lot of overlap between Kroger and Whole Foods stores. Kroger’s stores are more suburban and Kroger does not have stores in the Northeast. California and Chicago are the two markets where there is the most overlap.
Another issue is that there is probably a fairly small universe of customers who are truly up for grabs. Over the years, Kroger has done an excellent good job of offering fresh and organic products to satisfy its core customers and keep them from venturing to Whole Foods. As a reminder, Kroger’s fresh and organic sales were about the same as the entire Whole Foods chain at the time that Whole Foods was acquired. Another issue is that Kroger doesn’t really target the hard core Whole Foods customer and probably has little chance of winning her. We believe Kroger has an opportunity to offer more fresh and organic items to entice Whole Foods shoppers who still go to a regular supermarket to buy Coke, Pampers, Tide, Bounty, M&Ms and Kleenex. One possibility is that a new Amazon chain would sell more of these mainstream consumer products and potentially offer lower-priced merchandise than Whole Foods. A new chain could also target more markets than the high-income, high-education enclaves that Whole Foods typically targets. A further risk for Kroger and existing sellers is that Whole Foods will be willing to offer lower prices and accept lower grocery profitability than the stockholders of a pure grocery or discount store would demand.
Our biggest concern is that there could be intense, across-the-board competition between Amazon and Wal-Mart that would further reduce grocery prices. Wal-Mart is a much more relevant competitor to KR. Kroger operates in 49 major U.S. markets (9 or more stores). It has a number 1 or number 2 share in 42 of those markets and Wal-Mart is the major competitor in about 29 of the 49 markets based on the 2019 Kroger Fact Book. WMT is the number 2 competitor in 16 markets. In Wichita, and Little Rock, Wal-Mart Super Centers and Wal-Mart Neighborhood Market are the top two competitors. Whole Foods is not a top-two competitor in any of the major markets. It is the number two competitor in two secondary markets (3-8 stores), Boulder, where KR has 8 stores and Edwards, Colorado where KR has 4 stores. Target is not a top-two competitor in any market.
A significant competitive issue is that Amazon has raised the bar on expectations for shipping and delivering products, and this is forcing Kroger and others to invest more. Kroger remains a leader among traditional grocers, but Target and Walmart have improved significantly.
While selling food is a pretty stable business, inflation, deflation or a weak economy could all thwart management’s efforts in particular time periods.
We also believe that Walgreen and CVS represent a significant source of competition for KR’s pharmacy business, which is the fifth biggest in the U.S. (Please see our notes on WAG and CVS for a more comprehensive overview of some of the risks that could affect the drug store business.) One major risk is that various insurance plans which account for the vast majority of pharmacy sales are trying to reduce the prices they pay for drugs. Pharmacy is another huge business where Amazon appears to have aspirations.
We also believe that the company must be very skillful in executing its operating plan because margins are so thin. This means that management must be very careful in avoiding worker injuries and the related costs.
The company has a three-tiered distribution system. The first tier serves stores within a radius of about 200 miles and takes care of high-turnover perishable items. The second-tier DCs serve a slightly larger radius and focus on items like pharmaceuticals, dry groceries and other merchandise that has slightly slower turnover. The third-tier DCs ship seasonal and promotional items. The company owns the majority of the trucks and trailers it uses for deliveries.
Contracts are regularly up for renewal. Healthcare and pension costs are likely to be key issues for some time.
The company has some outstanding legal matters that are described in the annual report.
Kroger shares have returned 10% this year.
We believe Kroger is taking the right steps to defend and increase its market share. The company has a successful track record of using technology to stock its shelves with the right merchandise and offer the right promotions. While we think Kroger can compete effectively against Amazon, competition is likely to remain high as Walmart fights against Amazon and as Target and others invest more in their digital businesses. We think that WMT and TGT have improved significantly.
This is in line with the five-year average multiple of 16. Kroger is a leader in market share and innovation, with world-class data analytics, but that only matters if it translates into earnings and dividend growth. The shares are trading at less than 10-times our estimate for the current FY21 because EPS in the last three quarters has been boosted by COVID-related buying.
Based on the company’s recent resilience, we might be able to justify a lower cost of equity. The counterpoint is that the margin structure is very low and the company does have debt and pension obligations.
This excludes operating leases, which is consistent with how we have been valuing KR and the rest of our universe. Safeway, which had a buyout offer, had been trading at 17-times. Whole Foods was trading at almost 20-times after the merger announcement with Amazon. We believe that the current multiple for KR is at a low level because EBIT has been elevated over the last three quarters. At an enterprise value of 14-times our EBIT estimate for FY22, which is an unchanged multiple from our previous note, Kroger would be worth $44. We expect EBIT to rise over the next few years as the company benefits from ongoing investments and new profit streams. We are maintaining our 12-month target price at $40. There is upside to our estimate.
On December 7 at midday, BUY-rated KR traded at $30.98, up $0.40.