Kroger Will Reward Patient Investors

| About: Kroger Co. (KR)

Summary

Kroger’s comps are increasing at a decreasing rate.

Kroger’s focus on private label offerings makes it truly unique.

Kroger generates significant value for its shareholders which is why it could reward investors in the long-run.

By S. Hasan Abid

Kroger (NYSE:KR), the biggest player in the grocery store space, is developing a habit of beating analysts' earnings estimates and posting positive comp sales growth quarter after quarter. In Q1 2016, despite facing deflation headwinds, Kroger's same-store supermarket sales grew by a reasonably impressive 2.4%. Mr. Market, however, wasn't impressed.

Too often I've seen companies becoming a victim of their own success. Once you start posting comps close to 5%, you raise expectations and then delivering anything below say 3%, has a depressing effect on the stock price. This is exactly why Kroger's stock is languishing slightly below $35, exactly where it was way back in January 2015.

Recall, in Q1 2015 and Q1 2014, Kroger's comps sales growth clocked in at 5.7% and 4.6% respectively. When viewed against these numbers, 2.4% looks small. Does that necessarily mean Kroger's growth is slowing down? Technically, no company can keep growing forever and Kroger's growth is bound to slow down at some point. But as it stands, Kroger has ample room to keep expanding and investors shouldn't be excessively worried about Kroger's comps growth. Fundamentally, Kroger's business remains strong.

The U.S. food retail market, notorious for razor thin margins, is fiercely competitive. Maintaining price competitiveness is crucial and it isn't easy for individual grocers to stand out. With the arrival of ruthless discounters like Aldi to the big stage, many conventional grocers such as Winn-Dixie are finding it hard to stay relevant. Kroger, though, is coping well and stands out in conventional grocery retailing for a number of reasons. In particular, Kroger's focus on private label offerings makes it truly unique, giving it an edge over smaller players that might be dominant in specific regions and allowing it to consistently take market share away from the retail giant Wal-Mart (NYSE:WMT).

The chart below shows how the revenue contribution of Kroger's corporate brands has increased in the last 9 quarters. Two years ago, corporate brands represented 24.5% and 26.2% of Kroger's sales dollars and unit volume respectively. These figures have now increased to 27.9% and 29.9% respectively. While in percentage terms this may not seem like much, when you have quarterly sales amounting to $25-30 billion, a ~3% increase translates into something like $750 million. Thus, increasing penetration of private label offerings has a meaningful impact on Kroger's top-line. And obviously, as private label products carry higher margins than regular products, this helps Kroger's operating margin.

Click to enlarge

(Source: Kroger's Transcripts)

Considering the jaw-dropping expansion of Kroger's Simple Truth organic line, these results aren't surprising. In merely 2 years, Simple Truth has become a $1 billion brand and it is no coincidence that in the same period Whole Foods' (NASDAQ:WFM) comps have turned red. Going forward I see Simple Truth reaching new heights as Kroger launches this brand's offerings in laundry, household and health and beauty care.

Coming back to the point about the strength of Kroger's business, I believe Kroger is a terrific investment right now because of its capacity to generate value for its shareholders. Value created by a company can be precisely calculated by finding out the difference between the company's Return On Invested Capital ("ROIC") and Weighted Aggregate Cost of Capital ("WACC"). If a company doesn't generate value for its shareholders, then investors are better off placing their money elsewhere.

So let's first calculate Kroger's WACC. Please note:

Market premium, which is the difference between expected return of the market and the risk-free rate of return, has been set equal to 5.5-6.5%. The risk free rate has been set equal to the 10-Year Treasury Constant Maturity Rate. Kroger's 5-year average tax rate has been used. I have used unlevered beta of firms in the grocery stores industry to calculate levered beta of Kroger.

Complete calculations can be seen here.

Inputs Summary

Low

High

Levered Beta

1.52

1.80

Market Risk Premium

5.5%

6.5%

Risk-free Rate

1.7%

1.7%

Cost of Long-term Debt

4.0%

5.0%

Tax Rate

33.0%

33.0%

Debt % of Capital

20.0%

30.0%

Implied WACC Range*

8.6%

11.1%

Selected WACC

10.0%

Calculations

Cost of Equity

Low

High

Re-levered Beta

1.52

1.80

(NYSE:X) Market Risk Premium

5.5%

6.5%

Adjusted Market Risk Premium

8.3%

11.7%

(+) Risk-free Rate

1.7%

1.7%

(+) Additional Risk Adjustments

0.0%

1.0%

Cost of Equity

10.0%

14.4%

Cost of Debt

Cost of Long-term Debt

4.0%

5.0%

Tax Rate

33.0%

33.0%

After-tax Cost of Debt

2.7%

3.4%

Debt % of Capital

20.0%

30.0%

Equity % of Capital

80.0%

70.0%

WACC Range

8.6%

11.1%

Chosen WACC Estimate

10.0%

Click to enlarge

Currently, Kroger's ROIC is~13%, ever so slightly higher than the company's three-year average ROIC. 13%, as you can see, is higher than even my high WACC estimate. Hence bearing in mind the difference between Kroger's ROIC and WACC, it is fair to say that the company generates $2-4.5 for every $100 invested capital. For a grocer this is pretty good. The good news is that companies whose historical ROIC exceeds estimated WACC are expected to continue returning value to shareholders.

Conclusion

The past year and a half has been more or less the 'dead period' for Kroger's stock. But that shouldn't be a cause of concern for investors who take a long-term view to investing and understand the following words, spoken by the wise Benjamin Graham: "In the short run, the market is a voting machine but in the long run, it is a weighing machine". Those unhappy with Kroger's stock performance should take a closer look at the history of Microsoft's (NASDAQ:MSFT) stock. Remember how in 2011-12 MSFT was stuck around the $25 mark. Back then, a lot of people must have sold MSFT imprudently, missing out on great returns which were inevitable due to the company's solid financial performance. The upshot is Kroger's stock, so to speak, could do a MSFT. Sporting a modest forward multiple of 15.5, I strongly believe Kroger is undervalued and could prove to be an excellent long-term investment.

Disclosure: I am/we are long KR.

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.