Warren Buffett’s Berkshire Hathaway (BRK.B) (BRK.A) purchased a large stake in Kroger (NYSE:KR) during the final months of 2019 for two primary reasons. First, the company was (and remains) dirt cheap vs. its trading history. Second, it has become a leader in ecommerce, with customers ordering groceries online, followed by curbside or in-store pickup. Then, the coronavirus pandemic showed up and business for the nation’s biggest grocery chain has boomed. (The company maintains a #1 or #2 food retailing position in about 90% of its markets.)
With the November announcements of successful vaccine therapies coming to rescue the day, the first thought is Kroger’s fortunes will soon flatten or even sour. Investors seem willing to quickly sell shares, as the world hopefully gets back to normal sometime next year. Guess what? Kroger will still be feeding America in 2021, and the stock hasn’t risen much relative to Wall Street’s historic snapback to all-time highs overall.
Image Source: Supermarket News Website
In the end, I can argue Kroger remains a terrific buy, with an improving balance sheet and a leading, necessary retail position in much of the U.S. If you believe people will continue eating next year, like I do, perhaps you should review the cheap investment proposition the stock offers. Measured against the most overvalued Wall Street situation in history, per the market’s record pricing to trailing sales and GDP output, Kroger may be a worthwhile bargain to hold. Steady sales trends, regular profit margins, a strong balance sheet, and a nice dividend yield story have convinced me to own the name.
Image Source: Multpl Website
Image Source: Long Term Trends Website
Old-timers like myself would prefer a company have sound value when purchasing a buy-and-hold equity position. For decades, the train of thought on how to evaluate the cheap vs. expensive argument for each stock quote was to review a 10-year, cycle-adjusted trading picture. What am I getting for my investment dollars, in terms of underlying operating fundamentals? I will now draw a number of ratios to compare and contrast the current Kroger price setup on business results, using a rolling 10-year median average.
We’ll start with the most bullish relative numbers I can find. Earnings, cash flow and free cash flow have made significant strides during the COVID-19, stay-at-home environment. Operating gains have been quite robust, even stronger than the small 2020 stock price advance would suggest. Below are decade-long charts of trailing 12-month results for each data point, with 10-year median calculations to evaluate stock worth. While the average U.S. equity from the S&P 500 is trading in the “top” quartile (25%) of long-term comparisons for high price to earnings, cash flow and free cash flow, Kroger is valued on the low end of the spectrum, usually in the “bottom” quartile (25%) against its past history.
Specifically, Kroger’s basic price to earnings valuation is in the bottom 10% of its 10-year average setup for new investment capital. In other words, it has traded above today’s P/E ratio 90% of the time since 2010.
Price to cash flow and free cash flow valuations are at 10-year record lows right now. So logically, enormous potential upside exists if cash generation does not fall from here.
Cash flow as a percentage of sales, and as a function of capital expenditures has dramatically improved with the pandemic to record levels vs. the last decade. If high margins and returns are the goal for your investment dollars, Kroger’s underlying business trend has reached a historically positive point.
Likewise, price to net tangible asset worth is in a bottom 10% zone vs. past valuation readings, pictured below. 90% of the time, investors have been willing to pay a greater premium vs. hard asset, accounting book values.
Contrary to the market's highest ever reading, Kroger’s price to sales valuation is still in a normal range today. The price to sales valuation of 0.20 is half the early 2016 high of 0.39.
Profit margin is now an above-average 2% against a long-term normal reading of 1.5%. The income return on total assets employed is almost exactly normal at 5.7%. Basically, the 2020 pandemic gain in results has been a function of higher sales, with only minor margin improvement.
The last data point I wish to highlight is the company has done a masterful job of using its cash generation windfall from the pandemic to pay down debt. Management understands the stay-at-home phenomenon will not last forever. Kroger is intelligently keeping debt to assets at the lowest reading of the past decade to prop up operating results after 2021. Between February and August, Kroger reduced net debt by $3 billion (total debt minus cash). Conversely, the majority of companies in America have issued mountains of debt to raise cash, with the goal of surviving coronavirus business disruptions.
Kroger has systematically repurchased common shares at a rate of 1-2% annually for years, an effort to return capital back to owners and leverage future per share results. Perhaps the most exciting part of the Kroger investment proposition is its conservative and rising dividend yield, with the potential for rapid payout raises. While a 2.1% annualized, trailing cash distribution may not sound as good as the cash payouts offered by other income stocks, the odds Kroger will give you the same amount or more each year are exceptionally slanted in your favor.
The dividend cover from earnings of 5x is far above the typical S&P 500 company ratio in the 2-3x range. What this means is Kroger has plenty of room for dividend payout growth. If management wanted, the dividend payout could comfortably DOUBLE to $1.28 a share annually. [And, that may be Buffett’s plan over time.]
Not only is the dividend cover top-notch, but the actual rate is well above its usual setting vs. other equities or risk-free Treasury bond alternatives. Below I have drawn 1-year and 10-year charts contrasting yields to the SPDR S&P 500 ETF (SPY), the iShares Russell 2000 (IWM) small caps, the Invesco Nasdaq 100 (QQQ) big techs, and the iShares 20+ Year Treasury ETF (TLT). Essentially, today’s Kroger yield is the highest it has been the last decade, relative to this group of investment choices. If the beginning rate is better than peers, and the growth rate will likely be far stronger, what’s not to like about the Kroger income story?
My computer momentum sorts continue to place Kroger in the accumulation column. Despite only marginal price gains, the 2020 technical health gauges are the most bullish in many years. And, the momentum trend has remained positive during the September-November price decline.
On the 1-year and 5-year charts below, you can review the nicely rising Accumulation/Distribution Line [ADL], Negative Volume Index [NVI] and On Balance Volume [OBV] situation this year. Ascending trendlines are consistent with strong buying during the trading day, buy-skewed volume on slower news days, and more net dollars entering the stock on up days vs. leaving it on down days.
All told, the climbing NVI and OBV creations the last several months are telegraphing significant “buying on weakness” volume is taking place. The last time both indicators were rising in the face of a sizable price decline happened during the autumn of 2017, circled in green, just before a large 50% uptick in price over four months.
Wall Street analyst earnings estimates are projecting a slight decline in earnings during 2021-22. As sales moderate after an expected end to the pandemic, income and cash flow will surely come down. However, we have already seen increases in future EPS estimates of 15-20% above the level forecasted just before COVID-19 issues appeared in February. Management will keep the extra cash and inventive ways of doing business to better the corporation’s fortunes permanently.
All evidence considered, the 15% rise in the stock quote during calendar 2020, and flat quote vs. five years ago are telling me investors are not exactly bullish on the Kroger grocery business. What other industry-leading names can be purchased at 10x this year’s income stream and 12x expected 2021-22 operating results? Not many.
After you factor in the limited use of financial leverage in your search, Kroger morphs into an interesting bargain at $32 a share. At current elevated cash flow rates, Kroger could theoretically pay off all net debt, IOUs and liabilities in four short years (subtracting current assets from total liabilities, then dividing by operating cash flow). This ratio compares favorably to the typical S&P 500, net business liability to annualized cash flow ratio around 6x.
From a momentum investment perspective, reviewing a 10-year valuation study, and contemplating the super-positive dividend setup, Kroger shares appear to be a solid selection for both value and income-focused portfolios. Outside of a stock market crash, the biggest risk to your capital may be people quit eating or decide to boycott their local grocery store. Even a pandemic and scary recession drop in consumer spending did not hurt the business model’s profitability one bit. If you are searching for a truly recession-proof equity to buy, Kroger should be near the top of your research list.
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Disclosure: I am/we are long KR. 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.
Additional disclosure: I am short SPY and QQQ.
This writing is for informational purposes only. All opinions expressed herein are not investment recommendations, and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity and is not a registered investment advisor. The author recommends investors consult a qualified investment advisor before making any trade. This article is not an investment research report, but an opinion written at a point in time. The author's opinions expressed herein address only a small cross-section of data related to an investment in securities mentioned. Any analysis presented is based on incomplete information, and is limited in scope and accuracy. The information and data in this article are obtained from sources believed to be reliable, but their accuracy and completeness are not guaranteed. Any and all opinions, estimates, and conclusions are based on the author's best judgment at the time of publication, and are subject to change without notice. Past performance is no guarantee of future returns.