A Beaten-Down Dividend Growth Name: Deep Value In Kroger

Summary

• Shares of Kroger have been beaten down by nearly one-third in the last year and a half, with a major leg down following the most recent earnings.
• The fundamental picture suggests there are strengths and weaknesses in key indicators, and while this justifies some selling, we believe it is overdone.
• We see deep value at $20 even utilizing the conservative end of 2018 guidance.
• Keep in mind this is a dividend growth name.
• The company is innovating by pushing for digital improvements, testing concept restaurants and utilizing smart pricing.

Kroger (NYSE:KR) has been a battleground stock for over a year. With the most recent action in the name, we alerted members of BAD BEAT Investing to this stock last week but we feel it is prudent to share this with the broader Seeking Alpha community. It is our thesis that despite flat earnings, sentiment has driven this name into value territory. The company remains highly profitable, and is in our opinion a valuable long-term investment for dividend income, as well as market value capital gain.

Recent price action

We believe that the stock has seen an incredible fall and could be under pressure in the coming months, allowing the savvy investor to pick his/her spots to enter the name:

Source: Yahoo finance

We are of the opinion that Kroger shares are in value territory and are a bargain the closer they get to $20. At $20 a share, or below, shares offer deep value in our opinion. So what is going on here with this action?

Latest earnings resulted in another leg down

The most recent earnings were painful, but Kroger’s strategic developments and large market presence will give them an edge in the grocery industry for years to come. While there are 'scary' and 'new' headwinds in the form of strong industry competitors, we think these fears are overblown. Despite the convenience of online shopping, most groceries are still purchased in person. That said, Kroger has also successfully managed to compete in this regard as well. We see them as undervalued based on even modest quantitative forecasts, as well as new strategic initiatives.

When we think about the most recent few quarters, the key takeaways to be aware of are that sales are growing, margins have been slightly pressured, and earnings are about flat. While guidance is shaky, the stock is no longer above $30; so even with a slightly changing story, shares have more than priced in the fundamental changes. And for the most part, the fundamentals remain attractive, especially at current share prices. Let us discuss.

Sales commentary

Total sales increased 12.4% to $31.0 billion in the fourth quarter compared to $27.6 billion for the same period last year. Total sales, excluding fuel and the 53^rd week, increased 2.7% in the fourth quarter over the same period last year.

Source: SEC filings

This is an impressive trend in our opinion. You would not think that a stock that has declined by 1/3 in value in 18 months would be seeing such sales increases. We also note that the trajectory remains positive for the year.

For the year, total sales increased 6.4% to $122.7 billion in 2017 compared to $115.3 billion in 2016. Excluding fuel, the 53^rd week and the Modern Health merger, total sales increased 2.2% in 2017 compared to 2016. Where the Street may have some concerns are in the slowly contracting margins.

Margins

Margins have felt a bit of a pinch over the last year or so as the company has had to be more promotional and price-competitive to keep its customers loyal and coming back. We believe that despite the pressure from this promotional environment, margins have held up well.

Source: SEC filings

Gross margin was 21.9% of sales for the fourth quarter. Excluding fuel, the 53^rd week and the LIFO credit and charge, gross margin decreased 31 basis points from the same period last year. Gross margin was 22.0% of sales in 2017. Excluding fuel, the 53^rd week, the Modern Health merger, and the LIFO charge and credit, gross margin decreased 19 basis points compared to 2016.

So, while we are seeing decreases no matter how we slice it, and this is concerning, the magnitude of the declines is less than we would have expected when looking at these declines in the context of plummeting share prices, coupled with the fact that we all know the company is super-promotional right now. Still, these declines in margins have weighed on earnings.

Earnings

While the company has bought back shares, earnings are failing to grow organically thanks to the margin pressure. Net earnings in Q4 totaled $854 million, or $0.96 per diluted share. Of course, to ensure comparability we have to consider adjustments; adjusted net earnings for the fourth quarter totaled $562 million, or $0.63 per diluted share:

Source: SEC filings

We were pleased with this return to growth. Net earnings in the same period last year were $506 million, or $0.53 per diluted share. This trend is once again favorable and is surprising given the massive leg down in shares. That said, we should be mindful that earnings for the year were about flat, and this was driven by a lot of weakness early in 2017. While this certainly justifies a flat stock, or even some selling pressure, we think the magnitude of the selling is overdone, even with this annual trend:

Source: SEC filings

On a GAAP basis, net earnings for 2017 totaled $1.9 billion, or $2.09 per diluted share. Adjusted net earnings totaled $1.9 billion, or $2.04 per diluted share and this was below the net earnings in 2016 of $2.0 billion, or $2.05 per diluted share. Of course, if we were excluding the 2016 restructuring of certain multi-employer pension obligations, adjusted net earnings in 2016 were $2.0 billion, or $2.12 per diluted share. So there is a decline here, but is the Street overreacting here?

Balance sheet considerations

Before turning to the outlook and expectations, let us first check in on the balance sheet to make sure that our prior statement regarding the high improbability of a near-term bankruptcy holds water. To address this, we turn to the balance sheet highlights.

We know from the most recent earnings release that Kroger continues to enjoy an investment grade debt rating. While debt has increased, this is frankly because the company continues to invest in itself, whilst building value through share repurchases. Over the last year, Kroger has also used significant cash to fund its pension liabilities. These are not going away anytime soon. In 2017, Kroger used $1.2 billion pre-tax for company-sponsored pension plans and $467 million pre-tax to satisfy withdrawal obligations to the Central States Pension Fund. So that is eating some big cash. Kroger also repurchased over 61 million common shares for $1.6 billion in cash, while paying $444 million in dividends. Finally, Kroger has invested $3.0 billion in capital to build its future and revamp stores. This has taken a toll when we look at earnings relative to debt.

Kroger's net total debt to adjusted EBITDA ratio increased to 2.65 on a 52-week basis. This is slightly ahead of its adjusted net debt to EBITDA ratio target range of 2.30 to 2.50. This expansion really stems from the company's decision to continue to fund its pension obligations.

So, aside from generating strong cash flow to fund the dividend and other expenditures, we learned in the earnings release that the company is also planning to use the proceeds of the sale of its convenience stores to reduce debt and further repurchase shares. The sale of these convenience stores should close in the present quarter, and will generate $2.15 billion in proceeds.

At the end of the day, the company still has $339 million in cash on the books. While that is not that impressive relative to $15 billion in long-term debt, we know that operating cash flow is far more than sufficient to fund its debt obligations. Obviously, we would prefer to see the company pay this debt down and bring its debt ratios lower; however, we are not greatly concerned here, so long as operating cash flows remain strong. Kroger generally has operating income of $3 billion annually and it would take just over 4 years to pay back this debt if all of the cash flow went to these purposes. That said, while paying down principal is a goal for Kroger, it has a very manageable interest expense obligation of about $500 million a year. While the debt is high, it is manageable. Let us turn to the expectations going forward about the company's performance.

Outlook

A key focus for us at Quad 7 Capital moving forward will be on same-store sales. We know that Kroger is targeting identical supermarket sales growth, excluding fuel, to range from 1.5% to 2.0% in 2018. This is positive. Comparable same-store sales had been trending lower, but we think that this is a rather optimistic outlook considering the competitive climate in the grocery space.

So, why did shares get slammed? Well, the earnings guidance suggests earnings could be flat again this year, if not down slightly. This warrants a cautious sentiment, but at the risk of sounding like a broken record, we believe the selling pressure is overdone and driving shares into value territory. The company expects net earnings to range from $1.95 to $2.15 per diluted share for 2018.

The company expects capital investments, excluding mergers, acquisitions, and purchases of leased facilities, to be approximately $3.0 billion in 2018. What is most notable about this guidance is that Kroger expects its 2018 tax rate to be approximately 22%, but earnings projections were in range that disappointed the Street.

Still, we think it is prudent to recognize that as shares approach the $20 level, we have to keep in mind a massive new buyback program, boosting shareholder value.

Stock price downside at $20 is limited and that is deep value territory

Although we think you should be a buyer as the stock approaches $20 for deep value, we want to point out that major declines are unlikely in the future. Recall that Kroger lost 28% of its value overnight in June of 2017 as a result of the Amazon (AMZN) acquisition of Whole Foods. We believe that this massive gap down in Kroger stock was irrational. It was a huge opportunity for BAD BEAT Investing, as we bought shares as the dust settled and saw gains of 30% in just a few months, even if we were early on the trade.

As it stands now, we see value, not just a trade. Even with competition, we just do not see any company that could impact Kroger the way Amazon did in June of 2017 any time soon. Not Aldi, not Whole Foods or Amazon, etc. This is not to say another drop in market price could not occur, especially if Kroger happened to report poor quarterly or year-end results, or issues weak guidance. But we do not think the magnitude of the 2017 declines in Kroger will be seen again, at least not in a single session or two. The only exception would be if Kroger were to somehow file bankruptcy, which is exorbitantly improbable. As such we believe any big decline in Kroger’s price would be short-lived and a result of mispriced bets. Use it to your advantage.

If we get to $20, there are a few valuation metrics we want to point out. At the lower end of the company's own guidance, say it brings in $2.00 per share, the company will be trading at just 10 times forward earnings. That is dirt cheap. From a price-to-sales perspective, the market cap at $20 per share would be around $19 billion, and we are looking at about $125 billion in sales, which gives us a rough price-to-sales ratio of 0.15. That is attractive. When we factor this with a company that is consistently raising its dividend, and currently yielding 2.13%, and would yield 2.5% at $20, we are intrigued.

Source: SEC filings

As you can see, this is without a doubt a dividend growth name. What about the future?

What we like for the future with Kroger

We believe that Kroger is attempting to rebrand itself. What do we mean? Well, in an effort to change the grocery shopping trip from a boring errand, into an experience, it has made a number of changes. There are several new initiatives underway such as mass grocery delivery, concept restaurants and more that we believe will have minimal impacts on overall revenues on their own but will serve to bring traffic into the stores and increase the likelihood of additional purchases, which will drive same-store sales higher in our estimation.

One such initiative is the in-store concept restaurant Kitchen 1883. Make no mistake, moving into another highly competitive, tight margin business is a risk, and the sole location has only been open a short time.

The new restaurant is a full-service restaurant, unlike some of the other stop-and-go, takeout, counter style offerings seen in other grocery markets across the country. The idea is not to make a lot of money from the restaurant. Sure, it wants to be profitable, but the goal is to help bring foot traffic into the store and to change the experience by offering this dining setting. If it works, then expect more of these restaurants.

Source: Kitchen 1883 home page

And it may be working as we learned Kroger just announced that it plans to open its second Kitchen 1883 restaurant later this year with an opening in the greater Cincinnati area.

The company says the Kitchen 1883 restaurant brand features a made-from-scratch menu inspired by American and international flavors, hand-crafted cocktails and a community-centered atmosphere.

Kitchen 1883 is just one way Kroger is redefining the customer experience through innovative concepts, as we outlined in Restock Kroger"

This was said by a key executive in the news release.

We think Kroger is reshaping the shopping experience like this. Some may say it is a waste of space, or could lead to reduced sales from shoppers that are no longer hungry. Others say liquored up shoppers may spend more. The results remain to be seen, but we applaud the innovation. Finally, we want to comment on digital sales, which are part of the "Restock Kroger" plan.

Digital sales

It may seem silly to think of grocery stores and digital sales in the same sentence, but that is the world we live in now. Digital revenues are another area where the company needs to focus going forward, especially as it seeks to compete with Amazon.

In 2017, digital revenue was up 91%, driven by Kroger's ClickList offering. However, the real impact from Amazon's competition stems from the ability to shop from home. Kroger must continue to grow revenue from this source by investing in user-friendly, seamless shopping experiences from home.

Thus far, a near doubling of revenue is a good start from this digital approach. The company has expanded its delivery coverage area, which helps, but Walmart (WMT) is right on its heels making huge forays into the space. While Kroger must continue to ensure it has a piece of this market, we still think the best approach is improving the in-store experience, and that is where the "Restock Kroger" plan comes in even further.

Aside from the in-store restaurant, and digital sales, this plan is the comprehensive strategic plan for the rest of the decade to make targeted investments to redefine the customer experience. Below is a snippet from a recent investor presentation, where we see digital as a strong component of investment in the next few years, in conjunction with smart pricing:

Source: Investor Presentation

If successful, we expect growth of shareholder value and growth of same-store sales. Kroger will now invest over $3 billion into this strategic plan this decade, up from $1.7 billion, while reducing its spending on building new stores. Let us be clear. We love this approach, as Kroger is correcting what it sees as needing improvement, before investing in continued expansion.

Take home

The bottom line here is that shares in Kroger have been crushed. If you believe the company will continue to slowly erode into oblivion at the hands of Amazon, Walmart and the multiple other lower-tier competitors, then this is not the stock for you. However, if you are looking for value in a dividend growth name that is actively working to turn the ship around while growing sales and adapting with the times, Kroger has got to be on your list at $20.

Quad 7 Capital has been a leading contributor with Seeking Alpha since early 2012. If you like the material and want to see more, scroll to the top of the article and hit "Follow." Quad 7 Capital 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 "email alerts" under "Follow."

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in KR over 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.