Kroger Stock Heading To Where It Belongs: The Low $20s
Summary
- Following a decent quarter and reasonable outlook, I believe Kroger's stock was ripe for a valuation pullback.
- I continue to be cautious about Kroger's near-term performance, given the earnings sensitivity to even minor margin pressure.
- While the grocery store chain is likely to do fine in the long run, I believe KR belongs in the low $20s range for now.
The results of Kroger's (NYSE:KR) 4Q17 were not too bad, and the outlook for 2018 was certainly not disastrous. Ordinarily, I would argue that a solid print should not have driven the bearish -10% stock price reaction in the early hours of Thursday's trading session. But following a six-month rush of 14% ahead of the broad market's (SPY) 11% returns, as of the end of last week, I believed KR was ripe for a valuation pullback.
Credit: Supermarket News
On the numbers
I argued earlier this week that, given strong peer performance across the food retail sector in the last quarter of 2017, Kroger was likely to deliver at least the 1.1% in identical sales set by the management team as the low end of its expectations. Excluding fuel, comps came in a bit better at 1.5%, helping to send total revenues $200 million above consensus.
See improved quarterly comps trend below.
Source: DM Martins Research, using data from company reports
Below the revenue line, however, GAAP gross margins (which include a LIFO credit of $54 million) dipped about 30 bps YOY to 21.9% after having improved 17 bps in 3Q17. Although not much more was shared in the press release regarding the deterioration, keeping profitability at healthy levels is crucial for Kroger to maintain its earnings power, given the company's razor-thin margins. Pricing pressure is an area of particular interest to me since any headwinds here would flow straight down to the bottom line.
Opex of $5.32 billion, adjusted for pension- and impairment-related charges, increased a somewhat concerning 18.6% YOY to account for 17.1% of total revenues vs. last year's 16.2%. It looks like the spike would have been less pronounced once fuel is excluded from the comparison. However, I estimate that non-GAAP EPS of $0.63 failed to beat consensus estimates despite strong revenues, in part, as a result of some loss of operating leverage.
Looking ahead and parting thoughts
Despite a current-year EPS guidance of $2.05 at the mid-point of the range that landed ahead of consensus $2.04, I continue to be cautious about Kroger's near-term financial performance. The company is still in the early stages of its "Restock Kroger" transformation plan that, while a necessity for the long-term success of the company, could very well add pressure to margins and cash flow in the short-to-mid term. With adjusted op margins hovering around a very low 2%, these headwinds can exert meaningful pressure on net earnings.
Source: Yahoo Finance
As the graph above suggests, KR (the purple line) has certainly corrected sharply from late January levels, particularly in the last day and a half of trading. But while more optimistic investors may see the pullback as a buying opportunity, I perceive it to be a needed trimming in valuation that should be more reflective of the company's fundamentals and earnings potential.
While I believe the grocery store chain will do fine in the long term, I also think that its shares belong in the low $20s range for now - which is exactly where KR seems to be heading toward at this moment.
Note from the author: I do not own KR in my portfolio because I believe I can generate long-term growth with limited downside risk in a much more efficient way. This is why I built my Storm-Resistant Growth Portfolio. To learn more about it, click here and take advantage of the 14-day free trial.
This article was written by
Daniel Martins is a Napa, California-based analyst and founder of independent research firm DM Martins Research. The firm's work is centered around building more efficient, easily replicable portfolios that are properly risk-balanced for growth with less downside risk.
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Daniel is the founder and portfolio manager at DM Martins Capital Management LLC. He is a former equity research professional at FBR Capital Markets and Telsey Advisory in New York City and finance analyst at macro hedge fund Bridgewater Associates, where he developed most of his investment management skills earlier in his career. Daniel is also an equity research instructor for Wall Street Prep.
He holds an MBA in Financial Instruments and Markets from New York University's Stern School of Business.
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On Seeking Alpha, DM Martins Research partners with EPB Macro Research, and has collaborated with Risk Research, Inc.
DM Martins Research also manages a small team of writers and editors who publish content on several TheStreet.com channels, including Apple Maven (thestreet.com/apple) and Wall Street Memes (thestreet.com/memestocks).
Analyst’s 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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Comments (72)
I don't mind taking the premium alone or owning the stock, collecting the mediocre dividend and selling calls.
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