Kroger Bulls, Mind The Competition

|
About: Kroger Co. (KR)
by: Siddharth
Summary

Would it be wise to buy the dip on Kroger?

Stable top line, volatile bottom line.

Capex cut was to be expected.

Kroger’s (KR) second-quarter earnings report on Friday suggested that a discounting threat is now advancing in the grocery retail industry. Apart from a 7.5% dip in its own stock, the news led to a negative price action in several other grocery businesses as well. I saw a lot of people writing (here in the comments section) they had bought into the dip. In line with my pre-earnings piece, I argue why this may not be wise.

Q2 Review and Commentary

Net sales increased 3.9% to $27.6 billion. For a firm of Kroger’s size and scale, this is quite an impressive growth figure. But it was achieved at the expense of a 30 basis point decline in gross margins, highlighting the tough competitive landscape in the industry. Gross margins (21.7%) stated above is excluding fuel, ModernHEALTH and LIFO charges. In the earnings call, the company stated that it won’t lose against Aldi and Lidl on pricing. I inferred from this statement that they were going to follow the same strategy they used against Wal-Mart (NYSE:WMT) in the early 2000s. The company matched Wal-Mart’s prices but used a broader product offering and enhanced customer service to get customers on its team. This doesn’t take away the fact that Kroger will have to reduce prices to compete effectively in stores near Aldi and Lidl. In a Deutsche Bank study in June, prices in Lidl were found to be 15% lower than the ones in Kroger.

A lot of the Kroger bulls are dismissive about the looming competitive threat from Aldi and Lidl. Loyalty to a single store though is waning, especially among millennials. In the ongoing power shift from producers to consumers, stores that are easily reachable, with shopping experiences that offer both value and convenience are likely to grow faster than the overall industry. The biggest advantage that Kroger has is that it is convenient due to its vast network of stores spread across the country. The problem is Aldi and Lidl are going to be easily reachable and therefore more convenient in the coming years as well. With the lure of proximity and value coming together, I don’t see why consumers would mind switching retailers. The appeal of the German duo is likely to transcend beyond penny-pinchers and pricing challenge highlighted in Kroger’s earnings report was just another wakeup call. And they have set lofty precedents in other markets, with traditional grocers in the UK market naming Aldi and Lidl as “the worst disruptors in the retail industry.” I therefore think it would be wise to conservatively discount this threat in the valuation of Kroger.

Then there is a chorus of people arguing that the e-commerce threat in groceries is overblown. As we have seen in apparel retail as well, change happens slowly, at the beginning, and suddenly, after. I don’t think Kroger itself is taking this threat for granted. The company’s digital sales increased 126% this quarter and it continues to expand its offerings in this channel. I therefore see threats on this side of the channel as less of a problem compared to Aldi and Lidl.

As the company’s net income margins are barely above 1%, even a 30-basis point move in gross margins leads to volatile swings in net income. Net income, therefore, fell 9.2% to $353 million in the quarter. The sensitivity of Kroger’s bottom line adds a key dimension of risk that makes a bull case on the ticker problematic. The company’s suspension of providing a long-term earnings guidance was probably the biggest affirmation of this assertion.

In my pre-earnings piece, I had highlighted how the company’s free cash flows could drop below $200 million as capex as a percent of sales had increased over the years. Kroger has announced that it will be trimming planned capex by $600 million in 2017 and 2018. This isn’t really surprising as free cash flows falling below $200 million could have triggered a downgrade from rating agencies. Given the company’s debt load, wafer thin margins, and a tough competitive landscape, Kroger simply cannot afford a downgrade at this stage.

Conclusion

Kroger currently trades at a forward P/E multiple of 10.5x (Source: Morningstar). Relative to other players in the industry, it does seem like the company is trading at a discount. And this holds true even when we adjust the company’s forward multiple for growth.

Stock Forward P/E PEG Ratio
Kroger 10.5 2.3
United Foods 13.6 2.7
Wal-Mart 18.1 3.2
Target 13.1 8.8
Sprouts 19.1 1.4

However, markets price an asset in a manner that reflects their expectations about its future. In Kroger’s case, the market seem to have priced the stock for volatile swings in its net income which in turn drives its free cash flows. The company’s multiple will expand only if a new information meaningfully turns these expectations. Think about it in this manner. In June, the company downgraded its EPS guidance and the competitive landscape in the industry became a lot tougher. This was a downside shock that eroded its market cap. For Kroger’s multiple to expand, the company needs a similar upside shock to current investor expectations. It is hard to imagine a scenario that could be labelled as an upside shock at this stage. We now know that Whole Foods has been gaining traction after ceding its control to Amazon (NASDAQ:AMZN). I can’t think of a cogent argument as to why Aldi and Lidl will fail in their expansion. Therefore, despite the substantial drop in its stock price, I don’t think Kroger is a steal at these multiples. I would therefore exercise caution on adding this grocer to my portfolio.

Note: Unless otherwise stated, figures have been sourced from company filings.

If you find the article interesting, kindly follow me to be updated about my latest insights.

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.