Kroger As A 'Low Bar' Investment

| About: Kroger Co. (KR)

Summary

Kroger has put out a rather lofty growth rate assumption for the long-term, which may be a bit ambitious.

However, this factor alone does not mean it will be a poor investment.

For a number of reasons Kroger is beginning to look like a “low bar” investment.

In a previous article I outlined why the expected growth rate for Cincinnati-based grocer Kroger (NYSE:KR) may be a bit too lofty. Management has a goal (which it recently reiterated) to grow diluted earnings-per-share by 8% to 11%, plus an increasing dividend, over the long-term.

Just to give you a point of reference, Kroger previously grew earnings by about 10.5% per year over the past decade. And today the company is much larger, with higher sales and more stores. Moreover, the profit margin has increased and the dividend payout ratio is now a bit higher as well. All things that can impede Kroger's growth rate anticipations.

Indeed, Kroger recently reported 2016 earnings that were basically flat year-over-year (as compared to an expectation of ~8.5% growth for 2016 when results were published for 2015). And guidance for 2017 is for 5% to 9% growth depending on if you're looking at accounting or adjusted numbers, but this also includes a 53rd week.

In short, Kroger could meet its ambitious growth goal, but personally I'd want to scale that mark back significantly to develop a baseline. The interesting thing is that now that the share price has decreased materially - shares are down ~27% since the end of 2015 - a reduced growth expectation does not simultaneously imply a poor investment to come. Let's work through an example to get a better feel for what I mean.

For 2016 Kroger earned nearly $2 billion in net profits. Instead of presuming that this will grow (a decade ago it sat at $1.1 billion) let's take a much more pessimistic view and suggest that this number will stagnant for the next five years.

Kroger is currently in the middle of paying a $0.12 quarterly dividend or $0.48 on an annual basis. As of the most recent report there were 929 million average common shares outstanding. So the current dividend requirement is about $450 million.

Over the past five years Kroger has spent roughly $1.1 billion per year on share repurchases, although this number goes down to around $800 million after you take out simultaneous issuance and stock based compensation. Combined - $800 million for share repurchases and $450 million for dividends - you still only have a firm paying out ~63% of its earnings power.

So there's quite a bit or room for either a more robust share repurchase program or else a dividend that easily outpaces earnings growth. In any event, let's see what the above assumptions imply.

If you keep the total earnings, dividends paid and share repurchases constant, Kroger's market value will also be constant assuming the same beginning and ending earnings multiple. However, shareholder results are going to be better as a result of the reduced share count.

After five years of stagnant company-wide results you may anticipate Kroger retiring perhaps 110 to 120 million shares. (As a point of reference ~180 million shares were retired in the last five years)

With this aspect alone, both earnings and dividends would be about 15% higher in the next five years. You might anticipate collecting $2.60 in dividends per share and a future price around $37 with a future earnings multiple of about 15. That would equate to a total value of just under $40 per share, or a total gain of roughly 5.7% per annum.

Personally I find that sort of thing to be impressive. It's not the best of returns, but it's important to remember that this is a lesser scenario as well. Instead of 8% to 11% growth as the company has told you to anticipate, here Kroger can deliver reasonable returns even with stagnant business results.

The reasoning is threefold: 1) a growing dividend that contributes some, 2) a share repurchase program that can add perhaps twice as much as the cash dividends and 3) a reasonable starting valuation. Combined these factors allow "poor" business results to turn into fine investment results.

And naturally the potential returns get better as your assumptions improve. For instance, if you suppose Kroger can grow company-wide earnings by 3% per year, and pay out 80% in dividends and share repurchases, suddenly you could be looking at 10% annual gains as a starting point.

To be sure there are challenges, especially in retail (although you can make a separate argument for grocers). However, Kroger also has a lower "investment bar" in a number of ways. The share price has come down materially, the valuation is on the lower end of the historical norm, the payout ratio is still quite low and the share repurchase program has proven to be very effective.

Even without growth Kroger could turn in reasonable results. And should a bit of growth formulate, suddenly the potential results could become that much better. Naturally an investment today doesn't have to work out, but there are a lot of "low bar" factors working in the company's favor.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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