Kroger Makes The Best Of Tough Environment

By Stephen D. Simpson, CFA | November 30, 2012 AAA

For those who think supermarket operators can't produce worthwhile capital gains, Kroger's (NYSE:KR) roughly 18% move up over the past three months is a good counter-argument. What's more, while food retailing continues to be a tough business, made even more difficult by price competition from entities like Walmart (NYSE:WMT) and dollar stores and economic pressures on shoppers, Kroger continues to execute at a high level. Although this stock still does not look all that cheap on a cash flow basis, investors should never be quick to abandon well-run companies.

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Solid Third Quarter Results Despite Tough Conditions
Nielsen data wouldn't have given investors much reason to expect a great quarter, as food volumes have been softening, but Kroger's results prove that divination can only take you just so far in the market.

Revenue for the third quarter rose almost 6%, with identical sales (ex-fuel) up 3.7%. With product cost inflation of about 1.4%, Kroger saw volume/traffic growth of almost 2% (1.8%), the best result in about two years.

Profits were mixed, but positive. Adjusted gross margin eased off about a quarter of a point, suggesting that Kroger probably had to give back a bit in pricing to keep traffic up. Tight expense control more than compensated, though, as adjusted operating income rose nearly 19% and operating margin rose about a quarter-point.

Is Business Bifurcating?
Kroger doesn't offer a tremendous amount of granularity on its revenue, but it sounds like its higher-end products are doing well. That would fit in with the relative strong comps seen at other food retailers that cater to better-off shoppers like Whole Foods (Nasdaq:WFM) and The Fresh Market (Nasdaq:TFM). On the other hand, more budget-bound shoppers are still seeing fairly tough times, and that seems to be limiting some of the volume expansion of Kroger's store brands.

Competition Is Looking to Step up the Game
At the end of the day, a key issue in food retailing is that Cheerios are Cheerios, and it doesn't really matter where you buy them. That's not to say that shoppers don't have preferences, but it does mean that price matters quite a lot and the narrow margins of the business do put some limitations on what companies can do in terms of promotion.

Walmart is definitely getting aggressive on the grocery side. In addition to rolling out neighborhood market concepts, the company is looking to spend billions in "price investments" over the next five years, with a particular focus on fresh fruits and vegetables. At the same time, Safeway (NYSE:SWY) is launching a new customer loyalty program that offers discounts based upon past purchases. And while all of this is going on, Target (NYSE:TGT) and a host of dollar stores are also looking to grab a bigger piece of the grocery trade for themselves.

It's a tough environment, but I wouldn't write off Kroger. The company has been very good at driving higher revenue per square foot over the past decade, and its loyalty program is arguably the best in the business. The company is also making investments in areas like private label manufacturing and building fuel stations at more locations - both of which give the company more levers to pull on pricing and consumer rewards/loyalty programs.

The Bottom Line
I suspect that the perception of Kroger as a less-risky enterprise may explain why the stock rarely looks cheap by free cash flow analysis - investors accept a much lower discount rate and/or they just don't consider all of the company's net debt in the valuation analysis. Running with that assumption and turning to EV/EBITDA analysis, Kroger stock is priced at a 25% premium to Safeway and Supervalu (NYSE:SVU) and a 32% discount to Walmart and Target. Those comparisons seem broadly fair to me, though I suppose less discount to Walmart or Target could be appropriate. All in all then, I continue to see Kroger as a very well-run company, but not a tremendously compelling stock.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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