Kroger: How The COVID-19 Crisis Could Provide Long-Term Tailwinds

Summary

• Despite impressive first-quarter results, the stock barely budged.
• Kroger’s e commerce sales nearly doubled.
• Changes in consumer behavior spurred by the COVID-19 crisis could result in long-term growth.

An investor in Kroger (NYSE:KR) cannot be pleased with the results over the last five years. The stock tallied a 12% loss during that time period versus a 47% gain in the S&P. On the other hand, a ten-year timetable has KR stock up nearly 217% versus a 186% gain for the S&P.

So, is a potential investor more likely to own the Kroger of the last 5 years or the company that beat the market? The answer may lie in last quarters’ earnings and recent initiatives launched by Kroger.

Last week, Kroger reported double-digit increases in revenues and sales. Looking at the resulting price action, you would think the company experienced a revenue miss.

Investors know grocers operate in a competitive, low-margin business. With Amazon (AMZN), Walmart (WMT) and Target (TGT) as rivals, it’s easy to believe Kroger is unlikely to experience outsized future returns.

I see Kroger as a dynamic company. I believe the pandemic will provide long-term tailwinds, and I contend the company’s initiatives are bearing fruit.

Recent Developments

Even considering the COVID-19-induced surge in sales, Kroger’s Q1 results were impressive. EPS increased YoY to $1.52 from $0.95, same-store sales (excluding fuel) grew by 19%, and digital sales climbed by 92%.

Kroger also increased gross margins by 2.1% YoY and reported a growth of adjusted operating profit from $957 million to $1.45 billion.

Compare the results tallied by Walmart and Costco (COST). The former company reported a 10% increase in comps and a 74% surge in ecommerce sales. Costco’s comparable sales grew by 9.2% in the US, while online sales were up by roughly 108% (note, the companies’ reporting dates differ).

The Digital Business And Online Orders

According to research provided by Invesp, digital grocery sales should double from 2018 to 2023, to $60 billion.

Future Market Insights projects a 23% CAGR for global online grocery sales through 2030.

Prior to the pandemic, Kroger increased ecommerce sales at a double-digit pace. The company’s “Restock Kroger” initiative resulted in $1 billion in cost savings in 2018 and 2019.

Unfortunately, ecommerce grocery sales present difficulties for grocers. Case in point:

Skipcart is an on-demand, same-day delivery service. In February, the firm informed Walmart it would end grocery delivery services for customers at 126 stores in 32 states.

Skipcart joins Uber, Lyft, and Deliv on the growing list of last-mile delivery companies calling it quits with Walmart.

The grocery model does not work. It doesn't work today, and it's not going to work six months from now. We're all losing money.

- Skipcart's CEO, Ben Jones

According to a study by Capgemini Research Institute, the average increased cost for an online grocery order is $10.10; however, the average sum recovered is only $8.08.

The same study determined the average net profit margin would drop from 3.48% to 2.58% due to delivery costs.

However, research by Incisiv determined grocers offering online delivery for 12 months or more recorded an average 15.8% increase in revenues. Furthermore, 82% of retailers reported no cannibalization of in-store sales related to online delivery. But profits per order fell for 60% of those surveyed.

But there could be a silver lining for the businesses that can excel in this endeavor. Capgemini research reported 20% of shoppers will switch retailers if online shopping is not offered, and 74% of those surveyed said when satisfied with their online shopping experience, they are likely to increase spending by up to 12%.

Here is where I believe Kroger has the winning formula, and I think the developments related to the COVID-19 crisis will serve the company well.

Where Kroger Will Lead The Pack

Source: OneSpace

Management stated digital sales remained elevated in the second quarter, increasing by a triple-digit rate in the first three weeks.

We’ve also seen a lot of customers new to Kroger come and use our delivery and pickup business and we’re seeing nice repeat purchases from those customers.

- Rodney McMullen, CEO, Kroger

Kroger currently boasts of over 2,000 pickup locations and 2,400 delivery locations that reach 97% its customers.

As a customer of Kroger, I noted an uptick in ecommerce sales well before the pandemic developed. I saw a marked increase in employees fulfilling orders, and I recognized the parking area devoted to online pickup was always near capacity.

The company recently expanded a pilot program with Walgreens (WBA) which provides a Kroger Pickup Service at participating Walgreens stores. This partnership solves many of the problems associated with delivery of groceries. Perishable items are appropriately stored within the WBA store until the customer arrives. Many of the costs and other problems with delivering to a client's doorstep are removed from the equation.

Considering Walgreens has stores within 5 minutes of 75% of the US population (and think of the number of those that drive past Walgreens en route from their workplace), I believe Kroger solved the delivery problem in a way that rivals will have difficulty duplicating. I will be surprised if the two companies do not expand this initiative nationwide.

I’ve outlined the negatives associated with online shopping; however, there is data that indicates grocers can ultimately profit from the movement to ecommerce sales. The graphic below provides some data to back my claim.

(Source: OneSpace)

The COVID-19 crisis may accelerate the process whereby online grocery sales morph from an overall drag on profits to a net positive. At least that may be true for the 40% of grocers with positive revenues from ecommerce sales.

... when a customer first switches to online, it typically takes three or four years before that customers’ profitability is the same as when they shop in the store. But what we find is we get a significantly higher share of that customer’s total household spend.

- Rodney McMullen, CEO, Kroger

A Second Positive Trend Related To COVID-19

The closing of restaurants increased grocery sales. It also introduced much of the US to a forgotten art: home-cooked meals.

A study by AMC Global indicates Americans' eating habits may be altered by the pandemic. The research determined 32% of those surveyed intend to consume more home-made meals after the virus subsides. Until a vaccine is developed, 14% of consumers are reluctant to eat in a restaurant.

The same research indicates 40% of the public intends to increase its savings rate post pandemic. Data from other sources indicates eating out is 5 times more costly than home-cooked meals. I contend that a nation in recession will discover home-cooked meals are a means of saving money.

Debt, Dividend And Valuation

Kroger's debt is rated in the mid-to-high BBBs with stable outlooks. The company’s net total debt-to-adjusted EBITDA is 1.81, down from 2.54 a year ago. This is below management’s target range of 2.3-2.5.

Prospective investors should be aware that Kroger’s pension plans were underfunded by approximately $2.3 billion as of the end of 2019. While the sum owed is manageable (the pension plans are over 80% funded), the situation should be monitored by those holding the stock.

Approximately 45% of Kroger’s supermarkets are owned by the company. This includes ground leases where the store is owned by the company, and the land beneath the store is leased.

Kroger’s yield currently hovers around 2%. The payout ratio is roughly 23%, and the 5-year dividend growth rate is a hair above 12%.

As I type these words, Kroger trades for $32.82 per share. The average 12-month price target of 23 analysts is $33.67. The average target of the 6 analysts that rated the stock over the last month is $35.00.

My Perspective

My intention is to focus on how the pandemic may affect an investment in Kroger. For additional insights into the company, you can read an article I penned: "Kroger: A New Initiative That Could Be A Game Changer."

I perceive Kroger as an outstanding investment for the risk-averse, dividend growth investor. I do not claim the trends I outlined will result in massive growth for the company. Rather, I contend the surge in e commerce and the changes in consumer behavior, specifically an increase in homemade meals, will drive incremental growth.

We had as many new customers come to us in a couple of weeks as what we did all of last year and we continue to have a lot of new customers.

- Rodney McMullen, CEO, Kroger

I also believe that some of the new customers brought in by the pandemic will become habitual Kroger shoppers.

There are those that will disagree, but I view Walmart as the only competitor with the scale needed to serve as a true rival of Kroger. The cost benefits derived from increased scale will serve to differentiate the winners from the losers in the grocery wars.

Unlike Walmart, Kroger can expand by acquiring existing competitors and blending their businesses into the Kroger model. Furthermore, Kroger currently operates in only 35 states, leaving room for robust growth of the business.

Although the stock is off of the March lows, it still trades more than 10% below its 52-week high. Management forecast second-quarter EPS growth at a mid-to-high single digit rate.

Consequently, I rate Kroger as a Buy.

When the nature of the pandemic-inspired market selloff became apparent to me, I sold my shares in Kroger to raise funds for opportunistic investments. I am motivated to make a long-term investment in the stock; however, I have concerns regarding current market valuations.

Rather than buying shares outright, I sold puts that expire in the middle of next month. That contract provides me with a potential entry point roughly 10% below current levels and gives me contract income equal to about 3% of my potential investment.

One Last Word

I hope to continue providing articles to SA readers. If you found this article of value, I would greatly appreciate your following me (above near the title) and/or pressing "Like this article" just below. This will aid me greatly in continuing to write for SA. Best of luck in your investing endeavors.

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.

I have no formal training in investing. All articles are my personal perspective on a given prospective investment and should not be considered as investment advice. Due diligence should be exercised, and readers should engage in additional research and analysis before making their own investment decisions. All relevant risks are not covered in this article. Readers should consider their own unique investment profile and contemplate seeking advice from an investment professional before making an investment decision.