Kroger Has The Quality, But Value Is Less Certain

By Stephen D. Simpson, CFA | September 09, 2012 AAA

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.

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