Kroger (KR) released its 2013Q3 earnings report before the opening bell yesterday morning and held its 2013Q3 earnings conference call a few hours later. The stock traded down to as low as $39.56 (-4.8%) on heavy volume (3x average) before closing at $40.06 (-3.5%). In this article, I'll touch on the earnings, the conference call, details about the company and the reasons I believe the dip in Kroger shares is great for investors.
Kroger is the seventh largest grocery retailer in the world and, along with Wal-Mart (WMT) and Costco (COST), one of only three U.S. companies in the top ten. Extending well beyond its retail grocer core business, Kroger operates under nearly two dozen banners including: Kroger Real Estate, The Little Clinic, I-Wireless, Kroger Convenience Stores, Littman Jewelers, Fred Meyer Jewelers, Kroger Manufacturing, Kroger Pharmacies and the recently-acquired Harris Teeter Supermarkets. About half of the Kroger's supermarkets also include gas stations and the company also recently expanded its successful foray into electric car charging stations. For more information about The Kroger Company, see the corporate website.
(click to enlarge)Source: Kroger 2012 Fact Book
Kroger reported third-quarter EPS of $0.53, which is in-line with analysts' consensus expectations. There are two important things to note about the EPS performance:  while it is indeed in-line with analysts' expectations, the expectations were raised from $0.51 in just the last few months, and  the EPS grew 15% from the prior-year period EPS of $0.46, which is particularly impressive for a grocery retailer.
Kroger reported third-quarter revenue of $22.5 billion, slightly missing analysts' consensus expectations of $22.7 billion. There are numerous important things to note about the third-quarter revenue performance:  although revenue slightly missed what I believe were unreasonable expectations, revenue actually grew 3.2% from the prior-year period  revenue also grew for the last two quarters in a row, by 4% in the second quarter and by 3% in the first quarter, so perhaps perpetual fast growth is indeed unreasonable  revenue growth excluding fuel was 4.7%, well above the 4.2% industry average, despite the fact that the retail price per gallon of fuel was down 8% for the quarter  same-store revenue grew 3.5%, representing 40 consecutive quarters of same-store growth. As Chairman and CEO David Dillon explained during the conference call:
"I am most proud … of another distinctive achievement, team Kroger's 40th consecutive quarter of positive identical sales. It is not simply the scorecard that makes this meaningful, although 10 full years without skipping a beat is extraordinary. What makes 40 consecutive quarters of positive identical sales so remarkable is the underlying importance of the metric. For retailers, identical sales are the strongest indication of whether or not we are connecting with our customers over time."
Upside Potential, Downside Risk And Time Horizon
For my valuation calculations, the table below provides the current-year EPS estimate of $2.80, which is the mean of 19 estimates. The next-five year EPS growth rate of 9% is based on the company's evergreen 8% to 11% projection that it consistently meets or exceeds. With a conservative 12% discount rate and 4% terminal growth rate, my calculations return a fair value of $44.69, which is the basis of my 9-12 month $45 price target (~17% above my ~$38-39 recommended buy range). I see 17% as a worthwhile return, especially from a low-risk safety stock with a ~1.6% dividend yield. While my current $45 price target is slightly below my previous 12-month target of $46, I fully expect to raise it back above $46 within the first six months of my shortened 9-12 month time frame. There are numerous reasons for that and why my $45 final price target is slightly higher than the $44.69 calculated fair value. For example, Kroger's final guidance for fiscal 2012 EPS was $2.44 to $2.46. The company gave that guidance during its 2012Q3 earnings report -- the quarter before the end of the fiscal year, just like now. Fiscal 2012 EPS ended up being $2.77.
Another reason my final target price is $45 is that KR trades at only a 13.8x P/E ratio and 13.3x forward P/E ratio, while comparable competitor Safeway (SWY) trades at the much higher multiples of a 21.9x P/E ratio and 19.8x forward P/E ratio. Granted, SWY trades at higher multiples because it isn't as far along in realizing its growth expectations as KR, but that does not justify such extreme valuation discrepancies. In fact, KR is not only a much stronger business, but KR is clearly the "best of breed" among grocery retailers. Even so, I'm not suggesting that KR should trade at unreasonable 20x multiples. If KR traded at just a 16x P/E, the share price would be $44.80. Just as additional reference points, Harris Teeter (HTSI) had a P/E of ~20x before it was acquired by Kroger, while as younger businesses, Whole Foods (WFM) and Fresh Market (TFM) regularly have P/E ratios in the ~30x to ~40x range.
(click to enlarge)Source: MarketWatch
I don't consider there to be much downside risk at all with KR, especially after the post-earnings selloff. Rather than offer a price that would only apply for short time, I hope it will be more helpful to say that I consider the downside risk to be ~5-7% below the 50-day exponential moving average at any given time. Clicking the "Source" link beneath the Yahoo chart below will always lead to the updated version of that chart. The brown line and the "EMA" number represent the 50-day moving average.
Why The Opportunity Exists In Kroger Shares
I believe the dip from the earnings report presents a great opportunity to open a new position or add to an existing position since the dip is only a result of various forms of unrealistic expectations. Most of the unrealistic expectations are from momentum chasers who either refuse to accept that trees grow toward the sun, not to the sun, or who heard about the Harris Teeter deal and didn't bother following up on the details.
On my first point, the following comments from Kroger's Chief Financial Officer Michael Schlotman during yesterday's conference call are very important to understanding why there was so much panic over nothing:
"We do realize such a wide range of potential EPS results this late in the year can be somewhat confusing. It could also raise questions about where our trends are going into next year. We remain very confident in our ability to deliver 2014 results in line with our 8% to 11% earnings per share growth targets. This is why Dave discussed 2014 expectations. Normally we would not talk about this until our year end release in March, but felt it was important to be clear about the underlying confidence we have in our team and the future."
On my second point, below is a quote from the Harris teeter acquisition announcement press release:
"Including the effect of allocating some free cash flow to debt reduction, Kroger expects net accretion to earnings per diluted share in the range of $0.06 - $0.09 in the first full year after the merger, excluding transition and transaction expenses. Kroger expects to maintain its current 8-11% long-term net earnings per share growth rate off of this higher earnings base. Kroger expects to achieve annual cost savings of approximately $40 to $50 million over the next three to four years. Much of the savings is expected to come from the benefits of Kroger's scale. Kroger has a strong history of achieving synergy goals. Being patient in achieving those goals reduces the risk of the transaction and sets the stage for sustainable growth."
Clearly, many people only saw the numbers and skipped right over the critical parts like "in the first full year after the merger," "over the next three to four years" and "being patient in achieving those goals reduces the risk of the transaction and sets the stage for sustainable growth."
The reality is that there was not anything at all negative in the earnings report or conference call. In fact, as discussed in the "Earnings Review" section above, the numbers were actually great. Even so, the incredible performance from Kroger over the last eighteen months led to unrealistic expectations that the stock would continue gaining at the same breakneck speed into perpetuity. In other words, there were very many short-term momentum chasers in the stock, even though that's not usually a concern with "boring" safety stocks like a grocery retailer since chasers usually stick with "sexy" flavor of the month stocks. Well, many who didn't belong in the stock in the first place are now selling like crazy. That's actually great for investors who know what we own and why we own it since it can be very unhealthy to own stocks that have too many holders with zero conviction and who will dump a stock for any reason, or no reason at all.
(click to enlarge)Source: Yahoo Finance
What Might Drive Realization Of The Opportunity
I believe Kroger will maintain the strong growth it has shown due to a combination of  revenue, earnings and cost savings from the Harris Teeter acquisition starting to hit the top and bottom lines in the coming year  strong organic growth from customer loyalty trends, expansion initiatives and new customers from continued industry consolidation  consistent shareholder-friendly practices that continually attract investors to replace fleeing momentum chasers.
The press release that announced the Harris Teeter acquisition clearly stated the expectation that the "transaction is accretive to Kroger earnings in year one". It does not say "month one" or "quarter one," for that matter. In fact, the deal is not even expected to close until sometime during the current quarter so, technically, the clock hasn't even started.
As an aside in case anyone is inclined to read too much into rumors, I think the lawsuits mentioned in this article are frivolous. There are always lawsuits after acquisition announcements and they're always filed by the same law firms that convince acquiree shareholders who don't know any better that the acquirer didn't pay a high enough premium. That is occasionally a valid claim, but in this case as in most cases, dollar signs in the eyes apparently blind to the fact that the only reason HTSI ever traded beyond its $35-40 range was speculation of a buyout since HTSI had been struggling due to lack of resources to fend off competition. In other words, the rest of the premium was already baked into HTSI shares over the six months of speculation preceding the official acquisition announcement. Therefore, HTSI shareholders are indeed getting all that is due at ~$50, especially considering the $100 million in debt Kroger assumed with the acquisition.
When I first started buying KR at ~$22 a few years ago, many people said I was crazy because they thought Whole Foods was going to "eat Kroger's lunch." Well, Kroger still has its lunch and I still have my sanity, arguably. A part of my thesis is the idea that few things in life are truly the either/or zero-sum choices that many people want to oversimplify everything into. In other words, I don't see the fact that others are doing well as an indicator that KR will be driven into bankruptcy, as many people actually argued a few years ago. In fact, my thesis was and remains precisely the opposite.
Specifically, the fact that traditional grocers are under attack from every direction actually benefits Kroger as the strongest player. Health foods stores like Whole Foods have taken some high-end shoppers and discount stores like Dollar General (DG) are selling basic grocery items, attracting some low-end shoppers. Meanwhile, multi-retailers like Wal-Mart are now grocers too, delivering decisive blows to the industry mid-section. Despite the outcome many expected, the net result has been that weak traditional grocers stumble and fall, the industry consolidates and Kroger scoops up even more customers from the fallen. Importantly, Kroger also retains its customers incredibly well as the customer loyalty metrics discussed on the conference calls show. That is how it has played out for years now and the evidence suggests that will continue. Kroger has been increasing market share organically, as well as accelerating the process via acquisitions like the Harris Teeter deal announced in July. Another example is the recent announcement that Kroger is investing $150 million in Texas to build five new stores and expand three existing stores. Since I particularly like investing in job creators, it's an added bonus that this growth initiative will create more than 1,700 jobs that offer "competitive pay, health care plans, retirement options, product discounts and other incentives." In fact, Kroger has added a total of 33,000 jobs over the last five years.
Kroger recently announced a succession plan and pending retirement of CEO David Dillon who is widely considered one of the best CEOs in retail, if not in all of business. Even though Mr. Dillon is one of many reasons I invested in Kroger in the first place, his retirement isn't concerning since I'm confident that he built a strong bench, so to speak. In fact, Kroger has a long history of strong leadership so there's no reason that will change. Yesterday's call was Mr. Dillon's last as CEO since the next call will be led by the new CEO, Rodney McMullen. Mr. Dillon closed with a comment that I think speaks volumes since he could have simply not said it:
"I hope you will continue to invest in Kroger in the years to come. I know I will. I could not be more confident in Kroger's future, knowing that our entire leadership team and Rodney McMullen will guide Kroger to even higher levels of performance."
I don't blame Mr. Dillon since Kroger is also a very shareholder-friendly company, having returned more than $8.3 billion to shareholders through dividends and share repurchases since reinstating dividends in 2006. In fact, Kroger has raised its dividend at double-digit compounded growth rates for the last seven consecutive years, including throughout the Great Recession. During the most recent dividend increase announcement in September, the company stated that it "continues to expect an increasing dividend over time." While Kroger has said that it may slow the pace of buybacks to focus on debt reduction, the company has already reduced its float by over 108 million shares in the five years from 2008 to 2012. In the third quarter alone, the company repurchased 3.6 million shares and, in the last four quarters, Kroger has returned over $752 million to shareholders via buybacks and dividends.
Having funded the entire $2.5 billion Harris Teeter acquisition with debt and having assumed $100 million of the company's debt, Kroger currently carries fairly high debt. However, a number of factors make the debt load not particularly concerning. As reported via yesterday's earnings release, Kroger's current net debt is $8.2 billion, which is actually a $525 million decrease from a year ago and prior to the HTSI acquisition. On a rolling four quarter 52-week basis, Kroger's net total debt to adjusted EBITDA ratio is 1.86 compared to 2.08 during the same period last year. Kroger has a long history of financing debt at attractive rates and successfully servicing debt. In April 2012, the company refinanced $850 million in debt via $500 million of 10-year bonds and $350 million of 30-year bonds. In July 2012, that debt refinancing was increased to a total of $1 billion on high demand. It is also worth noting that Kroger competitors such as Safeway and Supervalu (SVU) also carry comparably high levels of debt, which means the debt doesn't weaken Kroger's competitive position.
The FCC is seeking a ~$4.4 million fine that Kroger may be liable for, but I don't consider it a significant concern for several reasons. First, the final decision has not yet been made so it's still possible that the issue may go away or that the amount may be reduced. At risk of sounding crass, even if Kroger is liable, the amount is little more than a drop in a bucket for a ~$21 billion company. The main reason this doesn't affect my opinions is because I'm an investor, so relatively minor one-time events don't affect the time periods that interest me. In fact, if I weren't so obsessive about research, we probably would've never even heard about the issue since the news services don't seem to consider it newsworthy (it has only been reported in a local newspaper in Ohio where Kroger is based). The bottom line is that it doesn't affect my price target for Kroger since one of the reasons I use conservative valuations is to leave a bit of wiggle room for the unforeseeable events like this that can come up with any company.
The federal assistance program that many know as "food stamps" is now called the Supplemental Nutrition Assistance Program [SNAP]. A recent reduction in SNAP benefits is likely to impact the entire retail industry since food purchases take priority over other items like clothing. However, some families that are already struggling may not have funds that can be diverted from other needs to buy food, so the cut in SNAP benefits could still affect the grocery industry. The reduction in SNAP benefits took effect very recently so the potential impact on the grocery industry is unknown. With that said, I don't believe this issue will weaken Kroger's competitive position or financial performance. My opinion is that there are two likely ways the issue could play out. First, any impact may distribute evenly throughout the grocery industry, rather than affecting any one player and disturbing the balance. Perhaps that may further weaken retailers that are already struggling and accelerate industry consolidation, freeing up more market share for Kroger. Second, there could be disproportionate impact on discount retailers, which may cause new entrants to grocery item sales to retreat from business lines seen as more difficult than anticipated.
Thanks for reading. I researched and wrote this article 12/4-12/6.
Additional disclosure: I am long KR and may buy additional shares at any time.