Shares of The Kroger Co. (NYSE:KR) have caught my eye early this morning, and it's something you don't see every day. What am I talking about? Well, shares are down today heavily, but may reverse as the news of earnings wasn't all bad. Recall that the stock was crushed into May where it traded as low as the $33 range. I picked up shares on the first big pullback in March at $36.75. You may also recall that last year I called this "a dream stock." Well, guess what? I maintain that this stock continues to be the best supermarket investment possible. It was a winner, plain and simple, but shares have been pulling back steadily this year, so recent buyers including myself are under water. The stock's troubles have continued, but if you can get shares under $30, that would be a major bargain. While the sell-off may seem painful, the reality is that Kroger's growth continues.
Its performance has been stellar, but it operates in a difficult sector. This stock is not one that is vastly overvalued on a P/E basis and priced nominally. It trades around 15 times earnings. Fundamentally, the company is sound as evidenced by the Q3 earnings, which had a few weak points that spooked investors. I will cover the company's key metric performance and describe why I continue to believe this is a fantastic, shareholder-friendly company.
I've said it before and will reiterate. This is a growth story. I say this because this company is still a rather regional name, and I don't have a Kroger here in New York, but there are dozens of other market choices. It is a tough business with thin margins and a ton of competition, but Kroger is doing it right. It is the strongest supermarket play out there. Although this is a somewhat large corporation, there is a lot of room for expansion. That is the kind of investment I look for.
So let's discuss its recent earnings. The third quarter was decent in many respects and follows a strong Q1 and decent Q2. While many other competitors continue to just limp along, Kroger once again delivered a solid quarter that saw a strong revenue beat, but a one penny miss on earnings.
The company saw revenues of $26.56 billion, which was up 5.9% year over year and beat the consensus by $310 million. I will add that these sales would have been much higher if it weren't for the weakness in fuel prices. If you back out fuel sales, revenues were up 7.1% year over year. While a top-line beat is strong, there was an earnings "miss", but that does not concern me at all. Net earnings came in at $0.41 per diluted share, which missed the consensus estimates by $0.01. What did surprise me is that the company's supermarket strength has been outstanding with strong same-store sales growth. This quarter, however, its same-store supermarket sales growth was 0.1% year over year (excluding fuel).
As I have said, many of the competitors in this sector tend to see slower growth of 1% year over year same-store sales, and while not as high as years past, this is the 52nd consecutive quarter of same-store sales growth. That said the decline in the rate of growth has me concerned. Gross margins were 22.2%, upticking 10 basis points from the sequential quarter. Comparable operating expenses were up. If we back out fuel, Roundy's and an $80 million contribution to the UFCW Consolidated Pension Plan, expenses were up 19 basis points as a percent of sales compared to the prior year. Chairman and CEO Rodney McMullen stated:
"I am proud of our associates for continuing to connect with our customers in a difficult operating environment. Deflation persisted as we expected during the quarter. We are firmly focused on our long-term strategy of improving our connection with customers and associates, and continue working on process changes to lower costs. We don't change our strategy based on quarterly swings in results. We remain committed to delivering on our long-term earnings per share growth rate guidance."
So what are the plans for growth? Well, the company's long-term financial strategy is to use its financial flexibility to drive growth while also returning capital to shareholders. As part of this plan, it will reduce its prior guidance for capital spending to increase financial flexibility. This has some investors a bit nervous, but the company wants to maintain its investment grade debt rating. This best allows the company to use its cash flow to take advantage of whatever opportunities may arise. This includes expansion to new markets, possible purchases of smaller entities, the repurchase of shares and dividend increases.
Speaking of the latter, the company is incredibly shareholder friendly. Kroger returned $1.8 billion to shareholders through share buybacks and dividends over the year. The company plans to continue to use its cash flow from operations to repurchase shares, pay dividends and increase investment. It repurchased $1.5 billion in shares and also paid $418 million in dividends. What is hurting the name today is that expectations for full-year net earnings in 2016 were reduced and are now expected to be $2.03 to $2.08, which is down from $2.10 to $2.20. Recall last quarter it was revised down from $2.19 to $2.28. So now we potentially will have no growth as this guidance compares with 2015's earnings of $2.06. Doesn't this mean the growth is over? Well, no, not exactly. You see Kroger is in the process of investing for its future, such as the $866 million merger with Roundy's, and the company will begin to see returns on this investment strongly in 2017 and beyond.
Note from the author: Christopher F. Davis has been a leading contributor with Seeking Alpha since early 2012. If you like his material and want to see more, scroll to the top of the article and hit "follow." He also writes a lot of "breaking" articles, which are time sensitive, actionable investing ideas. If you would like to be among the first to be updated, be sure to check the box for "Real-time alerts on this author" under "Follow."
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.