Kroger: Food for Thought

Kroger (NYSE:KR) July 6, 2009 - $21.40

52-week range: $19.39 (Mar. 9, 2009) - $30.99 (Aug. 15, 2008)
Dividend = $0.09 quarterly = 1.68% current yield

Kroger is America’s largest grocery store operator with almost 2500 stores in the Midwest, South and West. They also own and operate about 675 convenience stores and 375 jewelry retail locations. FY 2008 saw all-time high sales of $76 billion and record earnings of $1.90/share.

Despite the poor economy Zacks is now looking for FY 2009 and 2010 earnings of $2.04 and $2.24 respectively (FY’s end January 31st of the following year).

Here are Kroger’s per share numbers from continuing operations as reported by Value Line:

At yesterday afternoon's quote of $21.40 Kroger shares now trade at just 10.5x this year’s and < 9.6x next year’s estimates. Those are the lowest multiples for KR shares in almost 20 years.

Dividends were initiated in 2006 and have been increased steadily to the current rate of $0.36/year. The 1.68% current yield is better than most money market accounts are now paying.

Value Line sees Kroger as having above average safety and notes its ‘stock price stability’ and ‘earnings predictability’ percentiles as 95th and 75th (with 100th being best). Kroger’s Beta is a very low 0.65 – people gotta eat!

Morningstar is also a Kroger fan right now. They assign KR their highest, five-star rating and see ‘fair value’ as $33/share.

With today’s quote below the calendar year lows of 2007 and 2008, I don’t see a lot of downside here. A rebound to even 12 times this year’s estimate of $2.04 would bring KR shares back to $24.48 by early 2010.

Here’s a very conservative, less than seven-month play, that makes sense to me:

If Kroger shares rise by at least 5.2% (to > $22.50) by Jan. 15, 2010:

• The $22.50 calls will be exercised.
• You will sell your shares for $22,500.
• The $22.50 puts will expire worthless.
• You will have collected $180 in dividends.
• You will have no further options obligations.
• You will hold no shares and $22,680 of cash.

That’s a best-case scenario net profit of $5,180 / $17,500 = 29.6% achieved in less than seven months on shares that only needed to go up by 5.2% or more.

What’s the risk?

If Kroger shares finish below $22.50 on Jan. 15, 2010:

• The $22.50 calls will expire worthless.
• The $22.50 puts will be exercised.
• You will be forced to buy another 1000 KR shares.
• You will need to lay out an additional $22,500 cash.
• You will have collected $180 in dividends.
• You will have no further option obligations.
• You will own 2000 Kroger shares and hold $180 cash.

What’s the break-even point on the whole trade?

On the first 1000 shares it’s their $21.40 purchase price less the $1.40 /share call premium = $20.00 /share.

On the ‘put’ shares it’s the $22.50 strike price less the $2.50 /share put premium = $20.00 /share.

Your break-even is $20 /share (excluding dividends) or $19.82 /share including dividends.

Kroger shares could drop by as much as 7.3% without causing a loss on this trade.

Summary:

Low-volatility, high-quality Kroger shares appear cheap by historical standards. A rebound of 5.2% or better over the next six and a half months would produce a total return of almost 30% to investors buying and writing as indicated here.

In a worst-case scenario you’d end up owning a double sized position at a net average cost of $19.82 /share. That net price would be below the lows of 2007-2008 and within 2.3% of the panic low set on March 9, 2009 when the whole market hit its final nadir.

Kroger shares actually traded at peak prices of $24.50, $31.90, $31.00 and $26.90 in 2006, 2007, 2008 and 2009 (YTD) respectively. Unless you see hidden danger lurking, this appears to be a trade with excellent risk/reward characteristics.

Disclosure: Author is long KR shares and short KR options.

Comments

[mdpath:]

What about their pension liabilities?

Jul 07 09:35 AM

[U Dontknow ...:]

Kroger has about $850MM in underfunded pensions.

With about 650 million shares outstanding that equals about $1.31 per share pretax. That's not a crippling amount and, hopefully, it will decrease quite dramatically over time as the markets gradually recover.

Jul 07 11:00 AM