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Kroger (NYSE:KR) is set to release its first quarter earnings this Thursday before market open. The consensus estimates are: earnings of 54 cents on revenues of $24 billion. This would equate to an 18% drop to the bottom line despite a 5% gain in sales vs. fiscal 2009 first quarter results of 66 cents, and $22.8 billion.

However, KR should beat this forecast by delivering earnings of .57 on sales of $24.05 billion based on the company’s history of routinely exceeding expectations. The conundrum being, how will they tweak their guidance? Because an earnings beat with a lowering of guidance is a recipe for shareholder indigestion. For what it is worth, S&P Equity just upgraded their opinion from a hold to a buy , and the firm’s $26 price target, translates into a juicy 30% premium.

Why it will beat forecasts: Unlike its competitors in the traditional supermarket space (such as SVU and SWY who have had a string of losses in identical same store sales) KR is seeing improvement is this area, as it wrapped up its fourth quarter with a 1.2% increase. It is apparent that it is stepping up to the plate to challenge WMT head on with pricing reductions, and although a sacrifice to margins has occurred (KR’s GPM dropped 214 basis points to 22.48%) this plan is starting to pay dividends, as both basket size and customer counts have increased. Once deflationary pressures abate, more of these incremental sales should be captured on the bottom line, especially with costs being trimmed (its Operating, General and Administrative costs fell 73 basis points to 16.98%).

The Stock is cheap, but is it a bargain? I think so, because at a forward multiple of only 11 times estimates, and near a four year low, the stock represents compelling value. The company seems to concur on the value of its shares, as it is “putting its money where its mouth is”, by acquiring 4.2 million shares in open market share purchases. With only $337 million remaining on its stock buyback plan, it is inevitable it will be increased another $1 billion. Its 2% cash dividend is just the cherry on top.

Shorts covering and option activity: Short interest has plummeted 28% from 15.31 million to 11 million shares. It is apparent that many shorts do not want the risk exposure going into an earnings event, as the probability of an earnings beat is more likely than not. Besides, options expiration occurs in five days, adding the prospect of heightened volatility to the equation. For instance, the June 20 calls carry a higher premium, and traded ten times the contracts as their corresponding put options, so the option players seem to be leaning towards the bullish camp on this one.

Bottom line: the shares are oversold, they have simply dropped too much in too short of a time frame. KR management is proficient at playing the “under promise”, and “over deliver” game, so a probable upside earnings surprise should buffer the share price 10% higher before profit taking emerges.

Disclosure: Long swy, svu and kr

Source: Kroger's Cheap, But Is It a Bargain?