Despite some bumps along the way from concerns over the delta variant to COVID, 2021 is set to be a rewarding year for investors. As a provider of an essential service, supermarkets have been able to manage the crisis relatively well. Within this environment, Kroger (NYSE:KR)--which is surprisingly the largest supermarket in the U.S. and second only to Walmart (WMT) in general retail--outperformed the broader market with a ~30% return YTD vs. ~18% for the S&P 500. During this same time period, Dollar Tree (DLTR) contracted ~9% while Walmart was roughly flat.
A big reason for the outperformance is the company's strong execution. In the most recent quarter, the company beat expectations by 20% on EPS of $1.19. Key highlights included productivity enhancements on track to deliver annual cost savings of $1 billion for the fourth consecutive year; 15% acceleration in pickup capacity to accelerate digital sales; and improvement in stock fill rate. This followed the previous three quarters, where Kroger posted a beat of 19%, 8%, and 35%. So, clearly the company is firing on all cylinders.
According to Seeking Alpha data, however, the Street is highly pessimistic on the stock. Only ~23% of the 27 analysts are "bullish". ~19% even are "bearish". The negative sentiment has grown over time, with nearly ~50% of the Street being bullish on the stock back in May 2020. The Street is largely concerned about fierce competition from Amazon (AMZN) and other discount retailers. With grocery undergoing rapid upheaval to an omnichannel model that includes more deliveries, it's unclear how Kroger may fare, with margins possibly needing to get compressed as a result of the competition.
DCF Analysis Indicates Discount to Intrinsic Value
To get a sense of the company's intrinsic value, I ran a DCF analysis. No DCF analysis can provide a perfect picture of future returns for shareholders; however, they can provide an illustrative "story" of the likelihood of different scenarios. In my DCF analysis, I assumed 4% revenue growth. I also assumed EBIT margins expanding 40 bps to 2.5%. I flat-lined depreciation, changes in net working capital, and capex assumptions, which have been relatively consistent across the years.
Source: Created by author using data from Yahoo! Finance
Assuming an EBITDA multiple of 7x and a 7% discount rate, the stock has ~10% upside. The stock has generally trading along the 6-9x range over the last two decades, so, if anything this estimate may be somewhat on the conservative side.
Source: Created by author using data from Yahoo! Finance
As my sensitivity tables above illustrate, even if the multiple contracts to below the historical range to 5x, the stock would only have 20% downside-this is not all that significant given how overvalued the general market is right now. Indeed, the implicit returns baked into the 7% discount rate would offset the valuation correction. On the flip side, if the multiple were to expand to the high-end at 9x, the stock would have nearly ~50% upside. Despite the bearish sentiment on the Street and the recent outperformance, the stock continues to have significantly more reasonable pathways to upside than downside.
Upside Catalysts
While it's hard to take a contrarian position on a company like Kroger that is not bound to excite the market any time soon (let's face it, it's a fairly boring stock and brand), there are several underappreciated catalysts the grocer has to prove the bears wrong. Firstly, the "grocery economy" is moving towards more of an omnichannel market, where consumers are looking to order more online or have orders ready for pickup. When the pandemic hit, I personally moved to Instacart and came to appreciate the ease, safety, and predictability of having groceries delivered. I and many others are unlikely to go fully back to just simple in-person shopping. Within this new "grocery economy", I believe Kroger is actually positioned to do quite well, particularly with the well-timed Ocado investment. For one, Kroger provides discounted rates, which help to offset the premiums thrown on top of delivery services. Secondly, its leading scale in the sector makes it a heavyweight against the competition. Kroger has unmatched data on 60 million households with a #1 or #2 market share position in the majority of markets. Most importantly, the company is delivering the performance to suggest continued success. The company delivered 2x e-commerce sales growth y-o-y in 2020, which was 5x the growth rate of 2019, to $10 billion in digital. The company is also expanding both its store buildout and food options with digital specifically in mind. The latter includes meal-ready options.
Another major catalyst for the company is demonstration in margin expansion. The company is changing up its product mix to include more private selection, with Simple Truth and Big Pack growth outpacing total company 2-year stack. The company is on track to deliver 1-2% margin expansion, net of investment, while maintaining disciplined capital investments. Over the last ten years, the company's gross margins have trended upwards, though it has contracted of late, so investors are keyed into seeing sustainability here.
Risks
As bullish as I am on Kroger, there are a few reasons to be hesitant on the stock. Firstly, a fifth of the company's business is in gasoline retail. Given that that is a commodity business, investors may not be aware of how much they are betting on something beyond Kroger's immediate control. In addition, the company faces a high degree of execution risk in shifting towards a new delivery business model-as successful as the company has been to date, there are a lot of variables that are hard to predict at the current moment. Competition from the heavy discount supermarket giants will also continue unabated. On the other hand, Kroger's strong existing exposure to private label enables it to better navigate any coming price wars. Kroger currently manufactures two-fifths of its product mix, so its existing base of customers have already recognized the quality and price value of private label.
I am also concerned about Kroger's exposure to alternative profit streams, like Personal Finance, Media, and Marketing data. Collectively, these alternative streams are expected to deliver an additional $100 to $150 million in operating profit this year. While that's not enough to turn the needle if they prove successful, it is enough, in the event of a miss, to give the Street a reason to justify the bearish sentiment.
Conclusion
As mentioned earlier, it's hard to be contrarian on such a boring stock with historically mid-single digit growth. However, at the current price, with the current growth opportunities and demonstrated execution, Kroger has earned its spot on my list of bullish contrarian picks. For those worried about the downside, consider that Kroger also provides a generous capital allocation policy, with 5-6% cash payout through dividends & buybacks. In the most recent quarter, the company even authorized a new $1 billion share buyback program. With a beta of 0.4 and a 2.0% dividend yield, the stock offers a stronger degree of downside protection than most (at least on a technical basis). And at just 13.9x forward earnings, the stock is at an undue discount to Walmart (23.0x), Dollar Tree (14.7x), and Target (21.5x). As the company continues to demonstrate momentum in digital and the utility of its network for an economy where shoppers are delivering more groceries, I believe the multiple is highly likely to expand from here. Accordingly, I strongly recommend investing in the stock at today's valuation.
