Kroger: Looking Attractive At 52-Week Lows - The Kroger Co. (NYSE:KR)

I’m always intrigued when a well-known dividend growth company hits a 52-week low. I’m especially intrigued when these lows come roughly a week after a 14.3% dividend increase. One would believe that such a strong double digit increase would signal confidence in operational strength from management, right? Well, that’s the hope, anyway. This is exactly the situation that we’re seeing play out right now with Kroger (KR), the second largest food retailer in the U.S. The grocery space has been unloved by the market for some time now, but when I look at KR’s valuation, its dividend yield, its recent dividend increase, and the apparent moat that KR’s large scale creates relative to much of its competition, I can’t help but think that this name is being irrationally discounted, making it one of the few attractive opportunities that I see in an otherwise expensive market.

Kroger is a name that I’ve owned before. I originally bought shares of this major retailer in February of 2014 during a pullback for a split-adjusted share price of $17.79. I timed the bottom fairly well then and it wasn’t long before I was sitting on massive gains. In July of 2015, I sold half of that original position, locking in gains of 112%. Then, in March of 2017, I added to Kroger, buying shares for $29.50 because I believed they had gotten irrationally cheap again. However, this was during the retail wreck a few years ago when the eCommerce boogie man was really starting to rear its ugly head, so a few months later, in July of 2017, I sold those shares, alongside my CVS Healthcare (CVS) and Walgreens Boots Alliance (WBA). I only locked in 4% gains during that sale, but at the time, I was just happy to take a profit and reduce my exposure to what appeared to be an oncoming bear market in the space. And then, in April of 2018, I totally closed out my KR position at $24.45, locking in 37.5% gains on my remaining shares as I further reduced my exposure to physical retail.

So, while KR has been a bit of a dog in recent years, I’ve actually been able to make a lot of money off of these shares because of my focus on valuation. Over the last year or so, I’ve come to believe that the retail apocalypse that so many were calling for is probably not going to play out that way. I think there will be further disruption in the physical retail space, but the big brick and mortar stores have proven that they can compete, which is why I began to consider buying shares of KR once again during this recent bout of weakness.

Kroger is a relatively boring name, yet it’s a massive company. Honestly, I think the size and scale of KR is under-appreciated by investors. This name has generated over $121b in revenues during the trailing twelve months. Kroger operates nearly 3000 stores across the United States. More than two dozen brands have been consolidated under the Kroger Company’s wide umbrella. And, not only does KR sell groceries, but the company also has large gas operations with pumps outside of nearly 1500 of its store locations. It also operates roughly 2300 pharmacies and nearly 300 jewelry stores. In short, I think KR is a company that is more than meets the eye at first glance and these broad and diverse operations deserve a second look from value based, income oriented investors.

To me, the biggest potential issues with Kroger are competition and the company’s relatively low margins. KR’s net and operating margins come in at 2.5% and 2.2%, respectively. Generally, I avoid companies with such low margins because it means that their margins of safety in terms of generating profits are relatively low. However, the low margin story isn’t isolated to Kroger. Frankly, it’s an industry issue. Overall there’s a lot of competition in this space from low priced retailers which has led some to fear deflation in the food space. Yet, much of this competition is fragmented and while KR’s margins are noticeably low, they’re still higher than those generated by many of its smaller competitors.

To me, it’s not the smaller competitors that KR really needs to worry about, but instead the major retail behemoths who’ve been encroaching upon the food space in recent years. Walmart (WMT) is the nation’s largest food retailer and many believe that WMT simply uses its grocery operations as a loss leader to gain foot traffic in its retail stores (so that customers will buy other merchandise which much higher margin associated with it). This is a luxury that Kroger simply doesn’t have.

However, in terms of the pure-play groceries, KR is by far the largest, roughly doubling Albertson’s sales, which is the second largest pure play. This size and scale allows KR to beat the competition at a local level with more advertising and better distribution that helps to maximize capacity and therefore, profits. On a national level, KR’s size allows it to better benefit from investments made into its digital offerings and private label brands that continue to gain market penetration which results in higher profits for the franchise.

In recent years, we’ve seen foreign chains, such as the German names, Aldi and Lidl, and big tech companies such as Amazon (AMZN) make headway in the U.S. grocery space, adding further pressure to KR’s market position. This race to the bottom in terms of food pricing makes it difficult to invest in this space. The fast changing environment regarding digital sales and services also means that KR’s longstanding business model is ripe for disruption and while it’s clear that KR is doing its best to compete for these digital customers, eCommerce in the grocery space adds yet another question mark to the KR equation.

But, the situation for KR certainly isn’t all bad. Sure, the current valuation appears to point towards a dire operational existence, but when I read over recent annual reports and the company’s recent shareholder meeting transcript, I get a sense that this management team remains confident in its ability to compete and the company’s long-term viability. Management continues to highlight the “Restock Kroger” initiative that it launched in 2017 that revolves around meeting customer needs with “anything, anytime, anywhere.”

With regard to the changing grocery environment and KR’s attempts to evolve with it via this Restock Kroger program, in the recent shareholder meeting CEO Rodney McMullen noted that in 2014 this company had $0.00 in annual digital sales and in 2018, the company produced ~$5b in online sales. Management expects its future run-rate to be in the ~$9b area, meaning that this is an incredibly fast growing segment of the overall Kroger operations.

Regarding this growth, here’s what McMullen had to say:

Kroger is focused on the omnichannel system, allowing customers to pick and choose how they use the Kroger services. This appears to be the popular choice amongst many retailers (inside and out of the grocery space). Even Amazon is adopting a similar system with its Whole Foods grocery platform. Amazon has experimented with Amazon Fresh and other initiatives that were more focused on strictly digital offerings, yet with things like fresh food it appears to be proving difficult to meet consumer demands with the current infrastructure available in terms of last mile shipping. KR is working to try and solve some of these issues on its own. It is building out fulfillment centers across the regions where it does business and the company is even spending R&D funds on autonomous technology with delivery in mind.

In the age of technology it's important to note that KR has a massive data trove due to the fact that the vast majority of its transactions are completed with a loyalty card. This data is a strong intangible asset that the company can use to be more efficient in its operations and capitalize on consumer trends derived from the information that it has on shoppers making up some 60m U.S. households that goes back years and years. Kroger’s ability to track consumer buying habits at scale and use this information to better service its customers, keep shelves stocks with relevant products, and predict demand trends its yet another advantage that its scale gives it over its smaller rivals.

McMullen also mentioned how his company is adapting from a product point of view. With the health foods craze happening across America, it was of the upmost importance that KR carve out market share in the organic space. To help achieve this, KR created the Simple Truth brand. This in-house natural and organic brand did not exist 6 years ago and now it’s the largest natural and organics brand in the country with more than $2.3b in annual sales. McMullen mentioned that KR introduced over 1000 new products in 2018 and another 200 new offerings in the first quarter of 2019. KR is stepping into the meal kit category as well with recent acquisitions which should help to build out its store brand offerings in this growing space.

And lastly, KR is also taking steps to improve its standing with consumers and employees alike via social measures such as higher average and minimum wages across the franchise (right now, KR’s average hourly rate is above $20 and the company continues to offer benefits that many of its competitors don’t match). Management has recently highlighted higher employee retention rates due to these measures which help to lower cost and improve productivity over the long-term. And, with the social conscious consumer in mind, KR is also taking steps to increase its efficient, reduce its waste, and phase out things like single use plastics and plastic bags that contribute to pollution across the planet.

In short, this company isn’t content to sit back and let the competition surpass it in this new digital age. The Restock Kroger plan is always paying off, with over $1b in savings in 2018 alone. Management noted that the positive momentum that these efficiencies create has already carried over into the first quarter of 2019 and it expects this momentum to continue long-term. But, I have to admit that while all this talk about innovation, sustainability, natural and organic foods, digital offerings & automation, and improved social measures is nice to hear, at the end of the day a stock is judged primarily upon its operational results, so let’s get into the fundamentals.

Although KR has struggled with top-line growth during the trailing twelve months (KR’s revenues are down 1.2% during this period of time), taking a bit of a step back, we see that KR has offered fairly reliable growth over the last 5 to 10 years. KR has posted positive revenue growth in 4 out of the last 5 years, including a 10.3% growth year in FY2015 and 6.4% growth in FY2018. The company’s bottom-line results have been even more impressive, with positive results in 8 out of the last 10 years. KR has more than doubled its EPS during the last 5 years alone when looking at GAAP figures. The adjusted earnings picture isn’t quite as rosy, though it still shows reliable, low to mid-single digit growth and analyst expectations of similar trends holding true moving forward.

KR’s operational cash flows have remained steady in the $4b range throughout the last 5 years. I’d obviously like to see growth here, but at the end of the day, I’m not going to complain about operational cash flows that cover capital expenditures and allow the company to sustainable return cash to shareholders. KR has established itself as a formidable dividend grower with a 14-year annual dividend increase streak and a double digit dividend growth CAGR since the initiation of its current dividend policy. Kroger’s 5 and 10-year dividend growth rates come in at 11.5% and 11.9%, respectively. This double digit growth, combined with the 3% yield that the company offers after recent share price weakness makes for a very attractive income oriented opportunity.

I believe that KR’s 3% dividend yield is safe. KR’s recent dividend increase, from $0.14/share to $0.16/share means that the company’s forward annual dividend is now $0.64/share. Right now, analyst estimates for KR’s 2019 EPS is $2.17. This means that we’re talking about a 29% payout ratio. This low ratio signals to me that KR can not only maintain its dividend should it hit a rough patch in terms of bottom-line growth, but potentially increase it as well. This is the type of comforting margin of safety I’m looking for when doing due diligence on dividend growth names.

And as successful has KR has been in terms of its dividend growth, its buyback program and the massive share count reduction that it has produced in recent years may be even more impressive. During the last 5 years alone, KR management has used its buyback program to reduce the outstanding share count by 17.9%. This has helped to contribute to the company’s bottom-line success and it makes double digit dividend increases more sustainable over the long-term due by significantly lowering the burden that the dividend has on the company’s balance sheet.

KR is down nearly 33% from recent highs made in August of 2018. After its sell-off, KR shares are trading for just 10x ttm earnings. This ~10x level is essentially where the stock found support during its massive 2017 sell-off. These 10x levels are actually lower than the 11-12x support levels that KR bounced off of during the Great Recession. I find it odd that the market is willing to place a larger discount on KR than it was during a period of time when some believed that the economic system as we know it was going to crash.

Over the last 20 years, KR’s average P/E ratio is ~14x. Over the last 10 years, KR’s average P/E ratios is 13.8x. And, over the last 5 years, KR’s average P/E ratio is 15.8x. So, as you can see, today’s multiple is well below the company’s historical averages using a variety of time horizons as guides.

It is worth noting that KR’s future EPS growth rates are expected to be lower than its historical norms during 2020 and 2021; however, we’re not talking about negative EPS growth, but instead 8% growth expectations in 2020 followed by 4% EPS growth expectations in 2021. I could understand the precipitous sell-off and the steeply discounted premium if the market was falling for negative EPS growth moving forward, but since this isn’t the case, I think KR is being valuated irrationally. Using forward EPS estimates, we see that KR shares are trading for 9.1x 2020 estimates and 8.75x 2021 estimates. Those are incredibly cheap multiples, which is why it intrigued me to add shares to my portfolio.

I think this image sourced from Simply Safe Dividends sums up the undervalued nature of Kroger in a nutshell.

So, while KR isn’t an exciting company, it is a blue chip name trading at a steep discount to the broader markets. The company appears to have a strong focus on its customers and shareholders, as proven by its restructuring actions and the fact that upper level management pay is largely tied to performance. It’s easier for me to buy beaten down names when I know that shareholders are being prioritized. Does this company face risks? Sure it does. Anytime you’re up against the likes of Walmart and Amazon in a fight, there’s cause for concern. However, recent years have shown that these big retail/tech giants cannot simply swoop into the grocery space and disrupt it as easily as the market previously believed. Certain products on the grocery shelves are easy to buy online and ship, yet much of KR’s offerings have proven to be rather un-Amazonable. While I think the battle for market share in the grocery space is far from over, I believe the risks are worth the potential rewards when I look at KR’s dividend metrics combined with its low valuation. There aren’t many physical retail names that I like long term, but Kroger is one of them.

This article was previously published for members of The Dividend Growth Club.

Disclosure: I am/we are long AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Nicholas Ward is not long KR, but may initiate a long position over the next 72 hours.

Source: Seekingalpha.com

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