Kroger And Walmart: A Look Away From Amazon
Summary
- U.S. grocery e-commerce is the fastest-growing product category online.
- Most investors focus (rightfully) on Amazon, yet Kroger and Walmart are also leaders in the grocery space, both offline and online.
- You will see why Kroger holds a more attractive spot than Walmart on our investing roadmap.
- In uncertain times like these, a simple roadmap helps us generate higher returns at lower risks with fewer but well-understood holdings like Kroger.
- Looking for a helping hand in the market? Members of Envision Early Retirement get exclusive ideas and guidance to navigate any climate. Learn More »
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The investment thesis
E-commerce is the future, and most of the spotlight in this future is focused on Amazon, for good reasons. However, going forward, grocery e-commerce is the fastest sub-category. And eMarketer estimated that the grocery e-commerce sales will grow at an annual rate of around 23%. Buy online, and pick up in-store ("BOPUS") is one of the key drivers of this growth. This leads to the main characters of today's discussion: Kroger (NYSE:KR) and Walmart (NYSE:WMT).
You will see that "traditional" retailers like KR and WMT actually have an inherent advantage here. Their brick-and-mortar stores (once perceived as a drag) now become a key strategic piece in the BOPUS revolution. As seen, Amazon still takes the first spot. But WMT and KR have secured their 2nd and 3rd spots. And furthermore, KR's YoY growth rate is a spectacular 66%.
Source:eMarketer.com
Under this background, the main thesis of this article is twofold:
- Under the current conditions, both KR and WMT provide far superior returns for long-term investors than the overall market. The key argument is built on the following chart. This chart is also the roadmap that we use in our marketplace service to pick our tactical holdings. You will see from the following chart, KR is projected to provide about 10% annual return ("ROI") in the long term and WMT about 7.5%, while the overall market is only about 6%. The fundamental reason is both KR and WMT enjoy consistent ROCE (return on capital employed) and are well-poised for future growth opportunities like those mentioned above.
- Then we will detail the reasons why we only own KR. As you will see, the primary reasons include KR's more attractive valuation, its faster expansion of its e-commerce reach, and its better scale and depth in the grocery space. KR, not WMT, is actually the nation's largest grocery store operator by sales.
Source: author
How did we build our roadmap?
The key in building this road is to think like a business owner, not a stock trader. As detailed in our earlier article:
The long-term ROI for a business owner is simply determined by two things: A) the price paid to buy the business and B) the quality of the business. More specifically, part A is determined by the owner's earning yield ("OEY") when we purchased the business. And that is why PE is the first dimension in our roadmap. Part B is determined by the quality of the business and that is why ROCE, the most important metric for profitability, is the second dimension in our roadmap.
Now, the long-term growth rate is governed by ROCE and the Reinvestment Rate. These are the two most important growth engines, and they mutually enhance each other. High ROCE means every $1 reinvested can lead to a higher growth rate, which leads to more future profits and more flexible capital allocation to fuel further growth, and so on. So to summarize:
Longer-Term ROI = valuation + quality = OEY + Growth Rate = OEY + ROCE*Reinvestment Rate
The remainder of this article will show how the above roadmap applies to KR and WMT.
How did our roadmap perform?
Before going into further details, you must be wondering if it really works. Currently, our stock portfolio holdings are shown in the next chart. Using the date I first published it on 5/31/2021 as the inception date, its performance relative to the S&P 500 (represented by SPY) is shown below. SPY has lost an average of 3% since then and our stock holdings have gained an average of 11.8%. As a result, at the current levels, our stock holdings are leading the SPY by about 15%. A few other notes:
- What is shown here is a short timeframe compared to our horizon and there is no need to read too much into the specific numbers. It can all change within a few days of random market fluctuations. We have been applying this method consistently since 2012 (we started developing it around 2007 and it took us a few years to mature it). This approach has helped us become retirement-ready after about 15 years of work. Our own journey has shown that sticking to FEWER but well-understood holdings not only generated higher returns but also LOWER risks despite the fact that we consistently applied leverage.
- AAPL has been a legacy holding and its returns are not included in these charts (otherwise, it will completely dominate the picture). These returns did not include dividends, so the actual returns from our holdings are slightly better than reported here because they have a higher average dividend yield than SPY.
- And cells highlighted in blue put these holdings on the roadmap. As you can see, they all tend to be stocks with a good combination of quality and valuation than the overall market - and that is how we achieve a superior return in a consistent and relaxed way with only a handful of holdings.
Source: author. Source: author.
KR and WMT: consistent and healthy profitability
We start with their profitability. As you can see from the following chart, their profitability is quite similar in many metrics. Admittedly, quantifying profitability is difficult (if possible at all) because so many multiple metrics can be used and these metrics also evolve over time. For example, WMT currently enjoys a higher gross margin and operation margin, but KR makes it up with higher asset turnover rates and ROE. In the end, it always involves a degree of subjective judgment.
Source: Seeking Alpha
As aforementioned, the most important profitability metric in my opinion is ROCE because it measures the return of capital ACTUALLY employed in a business. Details of KR and WMT's ROCE analyses have been provided in my early articles already and here we will just directly quote the result as shown below.
You can see that both have been maintaining a remarkably consistent and healthy level of ROCE, on average about 22.9% in recent years for WMT and about 19.3% for KR. And these calculations considered the following items capital employed A) Working capital, including payables, receivables, and inventory, B) Gross Property, Plant, and Equipment, and C) Research and development expenses are also capitalized. To put things under perspective, the average ROCE for the overall economy is about 19% (approximated by its ROE).
Looking forward, both companies enjoy a balanced mix of existing segments and future growth opportunities. The existing segments provide both the customer reach and strong cash support so they are well-positioned to pursue new growth opportunities, as detailed immediately below.
Source: author and Seeking Alpha.
KR and WMT: growth potential and capital allocation
In its most recent earnings release (Mar 3, 2022), KR reported a strong fourth quarter and 2021 full performance. The business is also well-positioned for long-term sustainable growth. Highlights included a 4.0% increase in identical store sales (excluding fuel), 14.6% comps versus the previous year, and consistent gross margin despite price increases and increased supply-chain costs, and 105 percent growth in 2-year stack digital sales.
Looking ahead, the company expects to increase identical sales excluding fuel by 2.0% to 3.0% in 2022, with adjusted EPS ranging from $3.75 to $3.85. With healthy profits to back it up, the company intends to spend between $3.8 billion and $4.0 billion on CAPEX investments to fuel future growth. As commented by CEO Rodney McMullen (highlights added by me):
Our strategy of leading with fresh and accelerating with digital propelled Kroger to record performance in 2021, on top of record results in 2020. As we look to 2022, we expect the momentum in our business to continue and have confidence in our ability to navigate a rapidly changing operating environment. We are leveraging technology, innovation, and our competitive moats to build lasting competitive advantages. Kroger continues to generate strong free cash flow and remains committed to investing in the business to drive long-term sustainable net earnings growth, maintaining its current investment grade debt rating, and returning excess free cash flow to shareholders via share repurchases and a growing dividend over time.
Source: KR earnings report
WMT too reported a strong performance for its Q4 and full-year 2021. On a two-year stack, its comp sales in the United States climbed by 6.4 percent and 15.0 percent, respectively. Also, over a two-year period, its e-commerce sales increased by 11.0% and 90%, respectively. It also reported that it increased market share in the food category and saw particularly high demand in the consumables and apparel categories around the world. In 2023, it anticipates consolidated revenues to rise by approximately 3% in constant currency. Consolidated operating income is expected to rise by about 3% in constant currency. And finally, EPS is expected to grow by about 5% to 6% after its divestitures are factored out.
Many of its strategic initiatives are promising. The membership offering, Walmart+, increased capacity by nearly 20% in 2021. In terms of CAPEX, it plans to spend the upper end of 2.5 to 3.0% of net sales as capital expenditures with a focus on supply chain and automation.
Source: WMT earnings report
KR and WMT: Back to the roadmap
Now, with their growth potential and CAPEX assessed, we can go back to the roadmap to project future growth and returns. At its current price levels, the OEY (owners earning yield) is ~6.9% for KR and about 4.4% for WMT. Note that here I used the EPS as an approximation for the owners' earnings.
The growth rate is projected to be about 4.4% for KR and about 4.8% for WMT by assuming a 10% reinvestment rate for both following the assessment of the projected CAPEX expenditures. As a result, the total return is projected to be about 11.3% for KR and about 9.1% for WMT. Note that I have added a 2.5% escalation factor to adjust for inflation. I think this is well justified given that both have demonstrated the long-term pricing power to at least keep pace with inflation. As a result, the nominal organic growth rate for KR would be 1.93% of the real growth rate (ROCE * reinvestment rate = 19.3% * 10% = 1.93%) plus 2.5% of the inflation escalator factor, leading to a total of 4.4%. The organic growth rate for WMT is obtained with the same approach, and it is slightly higher at about 4.8% due to its slightly better ROCE.
This also brings us to one of the reasons that we like KR better. It provides a higher return potential with its higher OEY.
Source: author
Final thoughts and risks
When we invest like a business owner, not a stock trader, our long-term ROI is simply the sum of two things: A) the price paid to buy the business and B) the quality of the business. As such, both KR and WMT feature quite attractive return potentials for long-term investors.
Furthermore, both WMT and KR have secured a critical scale in the e-commerce movements. Their brick-and-mortar stores are a strategic asset rather than a liability perceived by the market. Both companies also enjoy a balanced mix of existing segments that provide strong cash support for them to pursue new growth opportunities. This is another key advantage compared to Amazon, which is facing a deteriorating free cash flow problem as analyzed in my earlier article.
Although we only hold KR for the following considerations tailored to our own investment style and risk profile. We like a concentrated portfolio and therefore typically limit our exposure to one stock per sector. There is nothing wrong to own both if you like a more diluted portfolio with more stocks.
Finally, both KR and WMT also face some risks.
- Both face some macroeconomic risks. The pace and degree of the post-COVID economic recovery are uncertain and can impact both. The current Russian/Ukraine geopolitical issues pose another risk, especially for WMT's extensive international operation.
- Also, both face tough comparisons ahead (especially for WMT). Last year's COVID-19-related stimulus measures provided a major boost to sales that likely won't repeat.
- KR keeps aggressively rolling out its customer fulfillment centers. These highly automated facilities are major CAPEX investments. And Kroger is also using them to break into new markets (such as Cleveland, Ohio, and Austin, Texas where it doesn't currently operate stores). The ultimate success of these new initiatives is uncertain and won't be known till a few years later.
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This article was written by
** Disclosure: I am associated with Sensor Unlimited.
** Master of Science, 2004, Stanford University, Stanford, CA
Department of Management Science and Engineering, with concentration in quantitative investment
** PhD, 2006, Stanford University, Stanford, CA
Department of Mechanical Engineering, with concentration in advanced and renewable energy solutions
** 15 years of investment management experiences
Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.
** Diverse background and holistic approach
Combined with Sensor Unlimited, we provide more than 3 decades of hands-on experience in high-tech R&D and consulting, housing market, credit market, and actual portfolio management. We monitor several asset classes for tactical opportunities. Examples include less-covered stocks ideas (such as our past holdings like CRUS and FL), the credit and REIT market, short-term and long-term bond trade opportunities, and gold-silver trade opportunities.
I also take a holistic view and watch out on aspects (both dangers and opportunities) often neglected – such as tax considerations (always a large chunk of return), fitness with the rest of holdings (no holding is good or bad until it is examined under the context of what we already hold), and allocation across asset classes.
Above all, like many SA readers and writers, I am a curious investor – I look forward to constantly learn, re-learn, and de-learn with this wonderful community.
Disclosure: I/we have a beneficial long position in the shares of ALL STOCKES IN THE TACTICAL HOLDINGS LIST either through stock ownership, options, or other derivatives. 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.