- KR has rallied hard in recent weeks.
- But the company is already showing signs it will struggle to replicate 2020 results.
- The stock is fully valued and Kroger is a pass.
It must be said that grocery stores were one of the biggest beneficiaries of the pandemic that shut down much of the world last year. Having been allowed to remain operational due to their essential status, and seeing inflated demand due to the fact that other channels for food – restaurants, entertainment venues, etc. – were suddenly shut, grocery stores were in the right place at the right time.
But with the world’s economies slowly reopening, including things like restaurants, grocery stores, in my view, will be headed back to their former levels of revenue over time. In other words, increased demand from COVID-19 almost certainly won’t prove sticky because the demand that moved from the other channels to grocery stores should come back as vaccines are deployed, and COVID-19 becomes a memory.
One company I think is pricing in a rosy future that may not exist is old-school grocery chain Kroger (NYSE:KR).
Shares are very close to their recent highs (excluding the massive spike in early January) after a swift rebound rally in the past couple of weeks. With shares at $38, I see Kroger as fully valued at best, and a bit expensive at worst.
The chart looks bullish and I won’t deny that, but with the PPO having crested +2 again, which is about the same level the prior stalled, it appears the stock needs a breather. The short-term darker line has also crossed below the longer-term red line, indicating waning short-term momentum. The PPO, in other words, is telling me the stock is overbought.
But apart from a short-term headwind from a sharp rally needing to be digested, I think Kroger is overvalued based upon its ability to generate revenue and profit growth in the years to come, particularly in light of what will almost certainly be lower demand following the normalization of conditions.
An uninspiring history of growth, and not much better today
Kroger has been around since 1883, and while that kind of longevity is to be respected, I’m not sure its business has changed that much since 1883. It’s a consumer staple that isn’t necessarily better than any of the other countless purveyors of foodstuffs.
In recent years, Kroger has finally gotten into a pickup service, which in my experience, takes longer than actually going into the store and shopping myself. But outside of that, there isn’t exactly a lot in the way of growth or innovation.
Source: Seeking Alpha
That’s shown here with revenue that is essentially flat each year with the exception of the infrequent M&A Kroger does. That changed last year with pandemic-fueled demand, and Kroger saw ~$10 billion of incremental revenue, its first year of meaningful revenue growth since 2018. But like I said in the open, this demand has very little chance of remaining sticky once the economy is back open. Consumers were forced into grocery stores at higher rates during the pandemic because takeaway became much more difficult to get, and dine-in was eliminated entirely for some time. With those restrictions lifting, the overall need of grocery stores will decline, and since I don’t see Kroger having any competitive advantage in a highly commoditized field, it stands to reason at least some of that demand will disappear.
Indeed, Kroger produced an otherworldly comparable sales number last year for this reason, and is slated to see a mid-single digit decline this year.
There is undoubtedly still some residual pandemic demand floating around for grocery stores, but moving into 2022 and beyond, it certainly appears at this point we’ll be back to some form of normal. That means we’re back to slightly above flat comparable sales in all likelihood in Kroger’s case, which needs to be reflected in its estimates.
In addition, the pandemic hasn’t even appreciably helped Kroger with its margins, which I’ve shown below using gross margins and SG&A costs.
Gross margins ticked higher with the pandemic as comparable sales increased, but so did SG&A costs. In a cruel twist of fate, it therefore stands to reason that not only will Kroger lose some of its comparable revenue, but given that higher revenue was very clearly responsible for better gross margins last year, at least some of that should go as well. Remember that pandemic demand allowed grocery stores to stop discounting as they normally do last year; that tailwind should abate as well.
Summed in a single metric, we can see margins have already begun to decline, with trailing-twelve months operating margins depicted below.
The slope of the line looks very steep, but these numbers are very small, and look at just one quarter’s worth of more normalized conditions; operating margins are coming down in a hurry and I expect to continue to see this until we get back to 2% to 2.2%. In short, while many businesses are seeing sticky demand from the pandemic, Kroger is not one of them, and should not be priced as such.
Reasonable valuation, but nowhere near a buy
Kroger isn’t quite as expensive today as it has been, but it isn’t far off. We’re at 13.4 times earnings today, with a massive decline in EPS guided for in fiscal 2022.
Source: Seeking Alpha
Subsequently, we should see Kroger back to its old ways of mid-single-digit EPS growth, as is customary for it. In other words, we should see a valuation that reflects pre-pandemic Kroger, because that’s what Kroger will be post-pandemic.
Finally, let’s take a look at the company’s valuation history to give us a better idea of where Kroger may trade.
In the past three years, the stock has averaged a forward multiple of 12.4, with the high at 15.2 and the low at 9.4. Late last year, Kroger was at ~11X forward earnings, which was a decent valuation for buyers. The recent rally has rather ruined that, however, and at its current price of 13.4X forward earnings, it’s at least fairly valued, but I’m leaning towards it being slightly expensive. Just before the pandemic, Kroger sported a multiple of ~12X forward earnings off of its nadir that was set in the summer of 2019. That seems reasonable to me for a business with very little in the way of growth prospects, and also-ran dividend yield, and no competitive advantages.
Given all of this, while I’m not saying Kroger is going to plummet to the earth, I think your money is better served elsewhere. The value proposition for shareholders today is difficult to understand with macro headwinds in 2021 and beyond with pandemic normalization, restaurants and entertainment venues opening back up, etc. Outside of pandemic demand, Kroger doesn’t have much to offer, so I simply don’t understand wanting to own it today.
This article was written by
I've been covering financial markets for ten years, using a combination of technical and fundamental analysis to identify potential winners (and losers) early, particularly when it comes to growth stocks.
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