Kroger Set To Continue Growth Trend In 2015

| About: Kroger Co. (KR)

Summary

Growth will continue because of improved economic conditions and attractive promotions.

KR working to improve margins through private labels and cost-cutting initiatives.

KR also offers an attractive sustainable yield.

Kroger Inc. (NYSE:KR) is one of the largest food retailers in the U.S. with 3,700 stores across the country. The company also manufactures and processes some of the food items sold in its stores. I am bullish on the company, because of its strong same stores sales [SSS] and recent acquisitions. KR recently acquired Harris Teeter, YOUtech and VitaCost, which will help it increase its coverage and online presence. The company has managed to deliver strong sales growth, which I believe will continue in the future due to its cost cutting initiatives, private labels and strong organic line. KR also offers an attractive sustainable yield.

Continued Growth in 2015
The acquisition of Harris Teeter, with its 212 stores and great human resources, has contributed to the company's sales growth in the third quarter. This acquisition has helped the company grow into new markets, which includes urban centers like Charlotte and Washington D.C. The click and collects system will allow KR to build its online presence for the convenience of its online customer. KR could also integrate its pharmacy and food processing products through these stores. Harris Teeter is expected to contribute $0.06-$0.09 per share to the current EPS.

The other important acquisition is of YOUtech, which is one of the leading IT service providers. KR is expecting to improve its services by tracking customers, which will help the company develop a better customer retention strategy by predicting their buying behavior etc. KR also acquired VitaCost, which will help strengthen its online business, as VitaCost is an e-commerce company that sells more than 4,500 items online. It also operates in those areas where the company did not previously have a presence.

The acquisitions of Harris Teeter and YOUtech were financed through debt, which created a strain on the company's financial leverage. But KR's management is committed to keeping leverage (net debt to adjusted EBITDA ratio) in a range of 2.00x-2.20x by mid-to-late 2015.

The U.S. GDP has expanded by almost 5% in the third quarter of the current year. Similarly, the labor market has improved, as the unemployment rate has fallen to 5.8% in the third quarter. The downturn in fuel prices will also positively impact the company. All of the above mentioned factors will enhance the buying power of customers, so they will be more willing to spend more on shopping in stores. Furthermore, the reduction in oil prices will result in lower transportation costs, which has the largest proportion in the company's operating costs.

The company has the ability to pass the modest rise in inflation to its customers. The differentiation model (i.e. holding wide range of products from discounted products to premium brands) helps the company create loyal brand customers, which in turn increases the traffic at its stores. These differentiated stores allow easy access to target customers due to their dispersed locations. Moreover, customers have a choice to buy at the right price as per their purchase power. The locations of the KR stores are very suitable and they cater to a populace within a two-and-a-half mile radius. It also provides speedy service, as average customers wait around 30 seconds before their first item is scanned.

I believe the current macroeconomic environment suits the company, as inflation has been in a range of 1.4%-1.6% in the past, which has enabled it to pass inflation to customers without increasing its expenses. The Fed is expecting inflation to be in a range of 1%-1.6% for next year, which means inflation will not be a concern for the company.

Discounts are the primary attraction for customers. The company has smartly planned and executed its promotions by a simple change in its discount offering days from weekends to mid-week i.e. Tuesday and Wednesday. By doing so, it has attracted customers throughout the week rather than just on weekends. Through its successful promotional strategies and expanded dispersion of locations, the company has attained customer loyalty and has experienced growth of 5.6% in the third quarter of 2014; expected growth stands at 9.10% for the first quarter of 2015.

Margin Expansion Opportunities

The company is keen to expand the share of its private labels, especially in the non food area. Private labels cater to customers with low income levels, as they are cost efficient in comparison to other corporate brands. KR established the 'simple truth brand' in 2013, which is the private label for its organic products. The management expects that its simple truth brand will become a $1 billion brand by the end of next year. Both these initiatives will help increase margins due to its cost efficiency and its large customer base. The management is taking several initiatives to reduce its operating cost as well. It has entered into deals with suppliers, resulting in a decrease of 21 basis points in general and operating costs as a percentage of sales. KR is also working to get more discounts via bulk purchasing, and is looking to bring down costs such as energy by being more efficient.

Dividends

The company offers a yield of 1.20%, which is lower than the average of its peers, but the company has the lowest payout ratio of 20% among its peer companies. It shows that the company's current dividends are safe, and it even has the potential to increase its dividends in the future. The company also runs an aggressive share buyback program and has repurchased 600,000 shares worth $29 million. The company still has the authorization to buyback $500 million worth of shares, which is expected to be exercised this year.

Dividend Yield

Payout Ratio

KR

1.20%

20%

Target Corp (NYSE:TGT)

2.80%

76%

Costco (NASDAQ:COST)

1.00%

29%

Wal-Mart (NYSE:WMT)

2.20%

39%

Average of Peers

2.0%

48%

Source: Yahoo Finance

Risks
The company is facing intense competition due to the saturation of the retail sector. There are certain markets in North America that have the potential to generate sufficient revenues, but they are not currently catered to by the company, which resulted in the loss of "first mover advantage". Furthermore, most of the staff at KR is unionized, which puts pressure on the company regarding wage rates and other issues. Strikes could impact operations and hurt revenues. A large percentage of staff is on short term contracts, which raises the risk of unavailability of labor. Lastly, the company needs to increase its online presence to better compete in the industry.

Conclusion
The company reported sales growth of 5.6% in the third quarter. I expect the company to continue this growth in the future because of improved economic conditions and attractive promotions. KR is also working to improve its margins through its private labels and cost-cutting initiatives. Lastly, the company has made some strategic acquisitions, which will increase its future growth prospects.

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.

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