There Is More Than One Reason To Like Kroger

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About: Kroger Co. (KR), Includes: AMZN, OCDDY
by: WideAlpha
Summary

As the leading American grocer, Kroger has an attractive franchise that generates substantial operating cash flows used to fund the dividend, share repurchases, and growth initiatives.

In the last couple of years competition has increased, putting pressure on margins and re-rating Kroger's valuation lower.

Kroger is responding with what we believe is a smart strategy to defend its current profitability, and to improve its competitive position in the future.

We believe the market is not placing much value on Kroger's long-term initiatives, which have considerable potential and we consider as free optionality.

Kroger (KR) has managed to successfully compete in the grocery sector which is arguably one of the most competitive. The company has also managed to earn the respect and appreciation of many of its customers, and has been named America's most beloved grocery store several times.

While Kroger has a pretty decent and very well-run business, what we found most attractive is where we think the company is going. It is in the process of creating a lot of optionality by making several smart strategic moves.

The last couple of years have been a particularly tough time to be in the grocery business. Amazon (NASDAQ:AMZN) purchased Whole Foods Market in mid-2017, and this put a lot of pressure on Kroger's margins and share price. Kroger responded with a plan which it calls "Restock Kroger," which has helped maintain the competitiveness of the business and defend margins. The company reduced the pace of new store openings to instead invest in technology and improvements in existing stores. We believe this strategy enabled it to defend profitability better than other competitors. In fact, even Amazon's Whole Foods Market seems to be somewhat capitulating, given reports that it is starting to raise the prices of many items.

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With competitors scaling their price wars, and the implementation of the "Restock Kroger" plan, we believe margins can stabilise and maybe even increase a little. The plan also emphasizes improving the customer experience, places significant importance on forming partnerships to create value and developing internal talent, and includes measures to reduce food waste by improving operations and donating food before it goes bad.

Source: Kroger investor presentation

Another move Kroger is making that we like is investing in its own brands, helping its customers save money and differentiating itself from other retailers. Its own brands are now so successful that they would be ranked in the Fortune 500 list if they were a separate company.

Source: Kroger investor presentation

In fact, the company's own brands generate the most revenue in its stores, which shows how much consumers appreciate them. This increases differentiation from competitors, and loyalty for Kroger.

Source: Kroger investor presentation

Given the success the company is having on this front, it plans to continue to invest and aggressively grow its three biggest brands.

Source: Kroger investor presentation

Valuation

Kroger is currently trading at a forward P/E of ~12, which we think is reasonable and maybe a little bit cheap.

Chart Data by YCharts

On a trailing-twelve-months EV/EBITDA, shares are near the bottom of the range at a roughly 5.5 multiple.

Chart Data by YCharts

One thing to keep an eye on though is net long-term debt. The need for significant capital expenditures has increased the total amount of debt considerably, although it still has a healthy interest coverage ratio.

Chart Data by YCharts

The company has been rewarding shareholders with a quickly increasing dividend that currently yields almost 2%.

Chart Data by YCharts

In addition to the dividend, shareholders have benefited from significant share repurchases that have considerably reduced diluted shares outstanding.

Chart Data by YCharts

Earnings per share have been growing at ~10% per year, but analysts have reduced their expectations for long-term earnings per share growth to ~5%. We think many of the initiatives and investments Kroger is making should allow it to maintain earnings growth close to what it has averaged in the past. Combining earnings growth with the dividend, our return expectations for the next few years are in the 7-12% range.

Chart Data by YCharts

Partnerships & technology

What excites us the most about Kroger is the optionality it has created, and how it is working to transform itself from a traditional grocer into a growth company.

Probably the best example is the agreement it reached with Ocado (OTC:OCDDY), which has developed impressive technology to automate warehouses. The agreement gives Kroger long-term exclusivity rights to Ocado's technology in the US market as long as it complies with certain conditions, and as part of the agreement Kroger also increased its stake in Ocado from 1% to 5% of the company's shares.

Kroger will identify at least 20 sites to build automated warehouses in the near term, and longer term it expects to build a multiple of that. Below we link to an impressive video of Ocado's technology at work. Thanks to its impressive technology and the partnership with Kroger, Ocado was one of the best-performing companies in the stock market in Europe last year.

The next part of the puzzle comes from Kroger's partnership with Nuro for self-driving car grocery delivery. A pilot has been launched in Scottsdale, Arizona where customers can get their groceries delivered for $5.95. To begin with, the self-driving cars will have a safety driver, but eventually the robot car will be making the delivery by itself.

Below we link to a video showing the very first customers receiving their Nuro deliveries.

As we were writing this article news came out that SoftBank (OTCPK:SFTBY) is investing $940 million in Nuro, further validating the strength of its technology and the potential of scaling at a fast pace. We like SoftBank too, and wrote in a previous article about the start-up portfolio it is building with the Vision Fund.

Finally, Kroger is entering the meal kit delivery business with the purchase of Home Chef, a meal kit and food delivery company. We are not as excited about this development as the previous two mentioned, but we like the way the acquisition was structured. Most of the purchase price is contingent on Home Chef achieving certain milestones.

The initial transaction price is $200 million and future earnout payments of up to $500 million over five years are contingent on achieving certain milestones, including significant growth of in-store and online meal kit sales. The merger comes on the heels of Home Chef's 150% growth in 2017, $250M in revenue, and two profitable quarters.

Sustainability & corporate responsibility

With a significant percentage of food produced in the US going to waste, we are happy Kroger is focused on reducing waste and is committed to donating meals to people in need as part of its zero hunger - zero waste vision.

Source: Kroger investor presentation

We also appreciate that the company is committed to reducing its impact on the environment, taking care of its employees, and helping the communities in which it operates. This has earned the company inclusion in sustainability indices.

Takeaway

We think Kroger is currently trading at a fair valuation that we believe could translate to returns in the high single-digit to low double-digits.

Longer term we see a significant upside optionality from the partnerships Kroger has established, and its transformation into a company that makes more use of the data it gathers, and leverages technology to better serve its customers and gain a competitive advantage versus its competitors. This vision was described by Chairman and CEO Rodney McMullen in its recent earnings release.

Kroger is transforming our business model. We're moving from a traditional grocer to a growth company with both a strong customer ecosystem that offers anything, anytime, anywhere, and asset-light, high-margin alternative partnerships and services. Restock Kroger is the blueprint for this transformation.

"We are strengthening the Kroger ecosystem by reducing costs and investing the savings in our associates, technology, and price to grow units, traffic and share. Leveraging our store, logistics and data assets in turn creates incremental new profit streams, which then further redefines the customer experience. In this way, our new growth model will be a virtuous cycle.

With Amazon's Whole Foods Market reversing some price reductions, and the "Kroger Restock" plan starting to deliver results, we think margins have a good chance of improving as competitive pressure recedes. The partnerships it has forged provide added optionality that could give returns a nice boost.

Disclosure: I am/we are long KR, SFTBY. 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.