Summary
This post is to provide my thoughts on Kroger's (NYSE:KR) business and stock. I am bullish on KR as the business has seen very strong, solid trends in the recent quarter, with positive momentum heading into 1Q24. With the refocus on expanding the number of stores, KR should be able to easily grow in line with the US GDP growth rate.
Business
KR is the largest supermarket operator in the US, operating mainly under the “Kroger” brand. The business has a revenue size of more than $150 billion as of FY23 (fiscal year ends in end-January) and has exhibited GDP-like growth over the past two decades on average. In terms of profitability, KR has demonstrated a strong track record of maintaining margins within a tight range, where gross margin bounced around low 20%, EBIT between 2 and 3%, and net income in the low-single-digit range. KR showed strength in its recent performance, which has me turning bullish on the stock. In 4Q23, total sales grew 6.4% to $37.1 billion, driven by an increase in total and loyal customer households along with strong growth in digital. Gross margin also increased 20 basis points y/y to 22.7%, mainly driven by private label, sourcing benefits, and lower supply chain costs. Better cost management also led to an EBIT margin coming in at 3.6%, better than what consensus expected (3.2%). In terms of competition, KR competes against Grocery Outlet Holdings (GO), Sprouts Farmers (SFM), Natural Grocers (NGVC), Albertsons Cos (ACI), and big players like Walmart (WMT) and Costco (COST), who are more indexed towards general retail than supermarkets.
Investment thesis
I expect KR to see positive FY24 performance, as 4Q23 saw solid sales trends with improving volumes and a positive inflection in traffic. While 4Q23 identical sales [ID] sales ex fuel were down 0.8%, core underlying sales actually saw growth of 0.1%, and importantly, KR saw improving trends throughout the quarter after fully cycling the change with Express Scripts and better volumes. Which means KR exited January with positive growth (>0.1%), setting up a good base for 1Q25 performance. Additionally, traffic turned positive in 4Q23, suggesting that management promotion strategies were effective in growing loyal customer households and increasing trip frequency among those customers. KR should be able to retain a large portion of this traffic as it continues to: (1) expand its product assortment (which is helping KR win share in product); (2) invest in its digital capabilities, which saw digitally engaged households increase by 18%. One thing to note here is that omnichannel customers typically spend 3–4 times more than in-store shoppers, which is a positive for both growth and gross margin expansion.
Customers value the ability to shop on their own terms with zero compromises, and we are increasing the number of omnichannel households in our ecosystem. Customers who shop both in-store and online spend 3x to 4x more compared to in-store only shoppers. 4Q23 earnings results call
Additionally, the shift in resource allocation from building out eComm capabilities (i.e., large CFCs) to building out more stores in the coming years is going to provide further support for growth. This impact could be clearly seen in KR ID sales ex-fuel (I used a 3-year stack to compare because of COVID impacting recent y/y performance), which has slowed to mid-single-digits vs. the historical ~10% rate. I believe the shift in capital allocation came at the right time, as the economy should start to gradually recover from here, which I expect to be fully normalized by FY26 (i.e., inflation goes back to 2%, rates do not stay at 5+%, etc.). In a normalized environment, it is vital for KR to have enough brick-and-mortar stores to capture new customers and improve its market share position. While these two are not like-for-like competitors, it gives a good sense of how much whitespace is available for KR to open stores. WMT currently has more than 4500 stores in the US, while KR only has ~2.7k stores (under different brands) in the US. I would think that consumers that need general retail products are going to need groceries as well. As such, based on this simple comparison, KR still has a long runway ahead in terms of store penetration. While some might argue that KR is giving up on its digital growth opportunities, digital sales are still less than 10% of total grocery sales, so I think the focus should still be on physical stores to drive growth.
On top of positive sale growth outlook, I also have a positive view on KR’s ability to expand gross margin as it starts to reap the benefits of its private label, digital capabilities, and loyalty program investments over the past few years. We have seen how this impacted margins in 4Q23, where gross margin expanded much more than expected due to these reasons. In particular, KR’s loyalty program should reduce future gross margin volatility as it need not rely on promotions as much as it did in the past to retain traffic. On the digital front, it is another driver to gross margin expansion. According to management, over the next three to five years, it will supposedly ramp up, with in-store digital probably matching in quality to in-store shopping and CFCs potentially surpassing stores in the long run.
Valuation
My target price for KR based on my model is $67, implying a 19% share price upside and, if including capital returns, a total return of 26%. My model assumptions are that KR will see growth recover back to GDP-like levels, exiting FY26 with 3% top-line growth. In terms of margin expectations, although I expect KR to see gross margin expansion, KR will likely need to invest in operating expenses to support the loyalty program, back-end IT costs, and private label R&D costs. Also, based on historical performance, KR FY23 net margin is at its highest level over the past 20 years, forcing me to take a conservative view on how much it can continue to expand given that one of KR's strategies is to invest in low-priced products for consumers.
In terms of capital returns, KR has been returning capital to shareholders via share buyback and dividends historically. Over the past 5 years, KR has bought back shares at an average annual pace of 1.5%, and with my expectation of an improved sales outlook and a positive earnings margin, KR should have no issues continuing this trend of buying back shares. Regarding dividends, KR has paid dividends for the past 15 years, and I don’t see a major reason for it to stop doing so. Using the street’s DPS expectation, investors should get ~4.3% yield over the next 2 years.
As growth improves and KR shows that margin can sustain at the current high levels, I expect KR to see its valuation run up a little more to its historical level of 13.2x forward PE (from the current 12.7x forward PE).
Risk
KR is heavily exposed to the US economy. In my model, I believe KR can see growth return to US GDP growth levels by FY26; however, this may not turn out to be the case if inflation remains sticky for longer than expected, pushing out the Fed's decision to lower rates. This would reduce consumer willingness to spend, and even if they do need to spend on necessity items, they are most likely to cut down on quantity and/or trade down to cheaper items.
Conclusion
In conclusion, my rating for KR is a buy due to its refocus on physical store expansion and solid recent performance. Strong same-store sales trends and a shift towards brick-and-mortar investment position KR to capitalize on future economic recovery. While digital remains a focus, the near-term growth potential lies in capturing market share through additional stores. This, combined with potential gross margin expansion and continued capital returns, got me bullish on KR shares. The key risk is a prolonged economic slowdown.
Jay Capital
I take a fundamentals-based approach to value investing.I disagree with the common misconception held by many investors that low multiple stocks must be cheap. I look for companies that offer the best long-term durability at the most affordable prices. Consequently, I have a propensity to be drawn to companies with steady long-term growth, no cyclicality, and a robust balance sheet.Nevertheless, investing in successful company is risky because one may end up paying too much (this is where valuation matters). I firmly believe this, yet there are situations where the development runway is so vast that price matters much less in the immediate future.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.
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