Kroger's Growth Strategy Makes Shares A Buy

Aug.19.14 | About: Kroger Co. (KR)

Summary

Kroger shares have more than doubled in the past two years on strong operating results.

Debt is slowly becoming a problem, but isn't prohibitive yet.

The company's growth-by-acquisition strategy is working, and organic growth at existing stores should power shares higher over time.

Shareholders in Kroger (NYSE:KR) have had an interesting year indeed. The company runs an enormous grocery chain that carries the parent company's name, but it has also gone to work integrating Harris Teeter, and has recently announced the acquisition of Vitacost.com (NASDAQ:VITC). Either one of these acquisitions is a burden to integrate into the company, but KR execs have shown a propensity to do this sort of thing. Shares have, apart from a multi-month dip around the start of the year, been on a very steady uptrend for the past two years or so, peaking where they trade now at around $50. After the run, is there still value in Kroger or has the story run its course?

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To find out, I'll use a DCF-type model you can read more about here. The model uses inputs such as earnings estimates, which I've sourced from Yahoo, dividends, which I've set at 6% growth annually, and a discount rate, which I've set at the 10-Year Treasury rate plus a risk premium of 6.5%, reflecting the stability and predictability of KR's business.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior-year earnings per share

$2.85

$3.28

$3.63

$4.00

$4.41

$4.87

x(1+Forecasted earnings growth)

15.10%

10.70%

10.24%

10.24%

10.24%

10.24%

=Forecasted earnings per share

$3.28

$3.63

$4.00

$4.41

$4.87

$5.36

Equity Book Value Forecasts

Equity book value at beginning of year

$9.79

$12.41

$15.34

$18.60

$22.23

$26.26

Earnings per share

$3.28

$3.63

$4.00

$4.41

$4.87

$5.36

-Dividends per share

$0.66

$0.70

$0.74

$0.79

$0.83

$0.88

=Equity book value at EOY

$9.79

$12.41

$15.34

$18.60

$22.23

$26.26

$30.74

Abnormal earnings

Equity book value at begin of year

$9.79

$12.41

$15.34

$18.60

$22.23

$26.26

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

$0.88

$1.12

$1.38

$1.67

$2.00

$2.36

Forecasted EPS

$3.28

$3.63

$4.00

$4.41

$4.87

$5.36

-Normal earnings

$0.88

$1.12

$1.38

$1.67

$2.00

$2.36

=Abnormal earnings

$2.40

$2.51

$2.62

$2.74

$2.86

$3.00

Valuation

Future abnormal earnings

$2.40

$2.51

$2.62

$2.74

$2.86

$3.00

x discount factor(0.09)

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc. to present

$2.20

$2.12

$2.02

$1.94

$1.86

$1.79

Abnormal earnings in year +6

$3.00

Assumed long-term growth rate

3.00%

Value of terminal year

$49.99

Estimated share price

Sum of discounted AE over horizon

$10.14

+PV of terminal year AE

$29.81

=PV of all AE

$39.95

+Current equity book value

$9.79

=Estimated current share price

$49.74

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As you can see, the model produces a fair value of about $50, or within pennies of where the stock is trading today. That would imply that shares are fairly valued right now with little or no upside, right?

Not exactly. The model produces a fair value for shares as of right now. In other words, the model is calculating the present value of the company's future earnings stream, adjusted for dividends. This is different from a price target, which is forward-looking and projects a price into the future. The model is saying KR is neither overpriced nor underpriced right now.

So what do we do then? The good news is that KR shares are somewhat unusual in today's market in that they aren't overvalued. Many stocks today have become quite extended from the multi-year bull run, and although KR shares have certainly participated in this run, the business has kept pace as well. Let's evaluate KR's business in order to determine if the stock is worth a look.

Kroger has done a decent job of growing revenue in the past, but it will get a big boost from Harris Teeter, the proposed Vitacost acquisition, and the potential for it to bid for Market Basket, a large regional chain from the Northeast. Kroger has gone out of its way in recent years to address revenue growth, and I applaud management's strategy thus far. The Harris Teeter acquisition was brilliant, and I like the idea of trying to diversify towards e-commerce with the Vitacost acquisition. If we see Kroger add Market Basket to the mix, it will be yet another source of revenue growth going forward. In short, I think management has the right strategy to grow revenues, and I also think, more importantly, they are pursuing that strategy sensibly. All too often, managements of leaders like Kroger buy imprudently and cost shareholders money, but I don't see that here.

One area I'd like to see Kroger slow down is in taking on debt. The chain always operates with some debt, which I don't have a problem with if it is cheap and utilized to grow the business, but after the Harris Teeter acquisition, Kroger is carrying 6 to 7 times annual earnings in debt on its balance sheet. That is high, and while not unsustainable, with Kroger seemingly constantly making acquisitions, I fear the total will only grow. The company is on track to pay about $600 million in interest expense this year, and for a company that made $1.5 billion last year, that is a lot of money. I'm not concerned with KR's liquidity or servicing the debt, but what I don't want to see happen is for the company to take on so much debt that servicing the debt eats away a large portion of earnings. It will be something to keep an eye on.

Analysts have been keen on Kroger shares for a while now, including this recent upgrade from a BAML analyst citing organic food expansion and the company's Fuel Rewards program as growth drivers. Other analysts have chimed in as well over the past few months, and we've also seen earnings estimates gradually climb for next year in the same time frame. In other words, the analyst community loves KR, and I tend to agree, given its push to grow not only Kroger stores' sales but also to strategically acquire sources of additional revenue growth. The combination could result in potentially double-digit earnings growth for the foreseeable future.

Overall, Kroger seems like a buy here. Yes, shares are fairly valued, but I also think there is upside to earnings estimates given Kroger's push to grow sales at its own stores and the additions it is making to the company. Management has proven itself quite competent, and I think we'll see KR materially higher in the next few years. If we get a pullback, take the opportunity to add KR to your portfolio, because as the company integrates its acquisitions fully, I think shares will be much higher over time.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.