Is The Crash In Kroger Stock An Opportunity?
Summary
- KR stock took a beating after the company delivered a bad profit guide.
- Most of the tax reform windfall is going back into the business to stave off competition.
- KR stock is now very cheap.
- We see 15% upside over the next 12 months.
Average fourth quarter numbers and an ugly fiscal 2018 earnings guide have sent Kroger (NYSE:KR) stock reeling to levels not seen since Amazon (AMZN) first acquired Whole Foods. Although we do not think Kroger stock will be a big winner in the long term as competitive headwinds will persist into the foreseeable future, we do think that this sell-off has plunged the stock into undervalued territory. We are optimistic that shares can head higher from here, and realistically see 15% upside over the next 12 months.
Despite the stock price reaction, the quarter wasn't all bad, and current trends still support the thesis that Kroger will be around for the next 10-plus years as the biggest grocer in the United States.
Comparable sales growth accelerated to 1.5%, from 1.1% last quarter. On a two year stack basis, comparable sales growth is also positive (up 0.8%), so concerns about Whole Foods, Walmart (WMT), Target (TGT), and others eating Kroger's market share seem to be slightly overdone. Indeed, Kroger actually gained market share in the quarter, according to management.
Meanwhile, digital sales are soaring (up 90%) as the company is starting to flesh out its omni-channel presence. The company's ClickList program has rolled out to 1,000 locations, and Kroger is successfully building out a grocery store chain with comprehensive buy-online, pick-up-in-store capability. In addition to an enhanced customer experience, Kroger is also successfully building out its organic and private-label brands. Sales of organic foods are soaring, while private label brands recorded record unit share in 2017.
This is all very critical to the Kroger growth story. Robust digital sales growth coupled with enhanced omni-channel capability means that Kroger is successfully adapting its business to be more convenient for digital-oriented consumers, and more competitive to Amazon-enhanced Whole Foods locations. Organic food growth means Kroger is adapting to customer needs. Private label brand growth means Kroger is successfully building customer loyalty and adding to its competitive moat. These are all material positives for the long-term growth narrative, and signs that point to the fact that Kroger will still be America's largest grocer over the next 10-plus years.
Consequently, it looks like positive comparable sales growth is here to stay into the foreseeable future. But margins are a major concern going forward. Despite the major tax reform windfall, earnings next year are expected to be basically flat year-over-year even though comparable sales growth is expected to be positive. That is no good, and management is blaming the profit short-fall on the fact that the company is investing a bunch of its tax savings back into the business.
That has both positive and negative implications. The negative implication is that Kroger has to invest in its business in order to remain relevant in the highly competitive grocery market, meaning margins will be on watch into the foreseeable future. The positive implication is that these big investments are short-term in nature, and should largely phase out over the next several years after the company has fully built out its omni-channel capabilities, invested in its own brands, and reduced prices to competitive levels.
Thanks to these big investments, Kroger expects to generate $400 million in incremental operating margin from 2018 to 2020. Operating profits were just over $2 billion last year, so that is a substantial 20% boost. In the long-term, then, Kroger is looking at low single digit comparable sales growth on top of some healthy margin drivers, which should kick in after this year and fully materialize over the next several years. That combination should lead to somewhere around 5-10% earnings growth per year after this year.
Historically speaking, this stock has found a bottom when the forward PEG ratio (forward earnings multiple divided by long term earnings growth estimates) is 1.6. A 1.6 PEG on 7.5% earnings growth prospects leads to a fair forward earnings multiple of 12. Thus, we think that at the conclusion of this fiscal year, KR stock should trade at 12x forward earnings.
Fundamental Chart data by YCharts
KR data by YCharts
EPS estimates for next fiscal year currently hover around $2.28, but we think those will come down to around $2.20 considering the weak fiscal 2018 earnings guide. A 12x multiple on $2.20 fiscal 2019 earnings estimates implies a year-end price target of just over $26.
KR EPS Estimates for Next Fiscal Year data by YCharts
All in all, we think Kroger as a company is doing just fine growing sales amid a competitive backdrop and adapting its business to changing consumer needs and habits. But the growth potential for Kroger earnings is limited, given competitive pressures put a lid on how high margins and comparable sales growth can go. As such, we don't realistically see Kroger stock heading back to $30 and up anytime soon.
But we do see this stock rebounding from these depressed levels. We don't think it will be a quick and powerful rebound, but if the company can show margin stabilization and positive comps throughout 2018, then competition fears will once again fade into the background and KR stock will grind higher. We realistically see ~15% upside over the next 12 months.
This article was written by
Analyst’s Disclosure: I am/we are long KR, AMZN, TGT. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (22)
KR will be a ok but I would wait on buying more of it.
There the best in the worse profit business.
======================...Per the conference call, the midpoint of FY2019 guidance was $2.05 (1.95-2.15). Where did you get $2.28? If you mean analyst estimates, I would stick with management guidance personally.
