Nobody seems to have much love for supermarkets these days. With the assumption being that superstores like Walmart (NYSE:WMT) and Target (NYSE:TGT), as well as more specialized stores like Aldi, will pressure the mass-market end while players like Whole Foods (Nasdaq:WFM) and The Fresh Market (Nasdaq:TFM) take the high end, mainline supermarkets like Kroger (NYSE:KR) have largely been left behind by the market. Although this company is an exceptionally well-run player in its industry, management needs to figure out how to generate more cash from its assets for the stock to be more attractive.
Fiscal Second Quarter Solid, but not Spectacular
By reasonable standards, I would say that Kroger had a solid quarterly result.
Revenue rose almost 4%, with comps up 3.6% on a 1.4% improvement in volume. Although gross margin did decline about a third of a point from last year, it was steady on a quarter-on-quarter basis. Elsewhere, the company posted better than a 12% growth in GAAP operating income, with operating margin improving a bit from last year, but worsening from the fiscal first quarter.
SEE: Understanding The Income Statement
Can Proprietary Production Assets Offset Deflation?
One of the worries that analysts seem to have about this sector concerns the impact of food deflation and a higher component of generic drugs in pharmacy sales. At this point, deflation may be an overstated threat - companies like Kellogg (NYSE:K) may have backed off a bit on price increases lately, but I think there's a reasonable chance that next year will see another round of cost-driven price increases from packaged food and protein companies.
Either way, though, I wonder if Kroger has an edge. More than one-quarter of Kroger's sales are private label, and they manufacture 40% of their own private label products. While that does not eliminate the threat of price competition from the likes of Walmart or Safeway (NYSE:SWY), I would argue that it could soften the blow.
So too with the company's loyalty program and gasoline operations. Kroger's strong loyalty program has been at least a positive contributor to the company's strong record of per-square foot revenue growth, while offering a gasoline-based rewards card helps shrink some of the competitive gap with warehouse clubs like Costco (Nasdaq:COST) and Walmart's Sam's Club.
Can Kroger Operate More Efficiently?
Where Kroger isn't necessarily so impressive is in its cash flow and returns on capital. Relative to companies like Walmart and Whole Foods, Kroger is a notable laggard across both metrics, and this holds back the valuation on the shares.
Disposing of non-core businesses could be one option; I'm not sure that Kroger really benefits from running over 300 jewelry stores. I'm not sure the same is true for the private label operations - although I think the company could get a good price for it, they may lose more than they win over the long term.
Improving store profitability ought to be a priority as well. Though Kroger has demonstrated strong sales growth over the years and has a No.1 or No.2 position in almost all of its major markets, the company has long been a laggard when it comes to profitability. Perhaps there's more to be gained from the supply chain, but it's a significant dead weight on the valuation.
The Bottom Line
Speaking of valuation, I have a difficult time assuming that Kroger can lift its free cash flow margin beyond the 1.5% area, and even that level may be too ambitious. That's significant, as although the company's P/E and EV/EBITDA ratios look low, a long-term discounted cash flow model doesn't suggest much incremental value in the shares, particularly when factoring in the debt.
SEE: 5 Must-Have Metrics For Value Investors
Even the assumption of over a 7% growth in annual free cash flow over the next decade (ahead of the company's trailing growth rates) suggests fair value only in the low $20s, making this perhaps a decent enough idea for conservative long-term investors, but no real bargain.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
Stock AnalysisWal-Mart is the largest company in the world, with a sterling track-record of profits and dividends. So why has its stock fallen sharply in 2015?
Stock AnalysisA summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
Options & FuturesInvesting during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
MarketsLearn how this simple calculation can help you determine a stock's earnings potential.
Investing BasicsHeld onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
InvestingThe Black Friday creep may have hit a wall as some stores are shutting their doors on Thanksgiving and even Black Friday to give employees the day off.
InvestingWe look at the meaning of two terms that often get confused, duration and maturity, to set the record straight.
EconomicsWill remaining calm and staying long present significant risks to your investment health?
Stock AnalysisIs DKS a bargain here?
Investing NewsA third of Americans use an AT&T mobile phone. How did it evolve from a state-sponsored monopoly, though antitrust and a technological revolution?
When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>
Nonprofit organizations continuously face debate over how much money they bring in that is kept in reserve. These financial ... Read Full Answer >>
A company's working capital turnover ratio can be negative when a company's current liabilities exceed its current assets. ... Read Full Answer >>
Working capital is a commonly used metric, not only for a company’s liquidity but also for its operational efficiency and ... Read Full Answer >>
The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>