Kroger Is Still A BUY If You Look For Long-Term Stability (NYSE:KR)

Introduction

As an investor who invests mainly in dividend growth stocks, I always seek new opportunities to invest in income-producing assets, primarily equities. I often add to my existing positions when I find them attractive. I also use market volatility to my advantage by starting new positions to diversify my holdings and increase my dividend income for less capital.

The consumer staples sector nowadays seems slightly overvalued as a sector, as investors flock to safer investments. These companies usually sell everyday products that are less affected by recessions. Therefore, many companies are overvalued as investors prefer these havens. Finding a decent consumer staples company that is attractively valued may be attractive. Kroger (NYSE:KR) may be one of them, and I will analyze it in this article.

I will analyze Kroger using my methodology for analyzing dividend growth stocks. I am using the same method to make it easier to compare researched companies. I will examine the company’s fundamentals, valuation, growth opportunities, and risks. I will then try to determine if it’s a good investment.

Seeking Alpha’s company overview shows that:

Kroger operates as a food and drug retailer in the United States. The company operates combination food and drug stores, multi-department stores, marketplace stores, and price-impact warehouses. Its combination food and drug stores offer natural food and organic sections, pharmacies, general merchandise, pet centers, fresh seafood, and organic produce, and multi-department stores provide apparel, home fashion and furnishings, outdoor living, electronics, automotive products, and toys.

Fundamentals

Revenues of Kroger have increased by 50% over the last decade. The graph below shows the steady sales growth even during the pandemic. The company grows sales by opening new stores, increasing prices, and selling more products in each store. The company will also grow significantly if and when it completes the $25B acquisition of Albertsons (ACI). In the future, as seen on Seeking Alpha, the analyst consensus expects Kroger to keep growing sales at an annual rate of ~1% in the medium term.

The EPS (earnings per share) has been growing much faster. The EPS more than doubled in the last decade, which is when we use GAAP numbers. Using non-GAAP figures, the EPS has almost tripled in one decade. EPS growth is linked to sales growth and also enjoys aggressive buybacks and cost-cutting that improve profitability. In the future, as seen on Seeking Alpha, the analyst consensus expects Kroger to keep growing EPS at an annual rate of ~4.5% in the medium term.

The dividend is one of the main reasons behind investing in Kroger, as the company offers a reliable and growing dividend. The dividend seems safe as the payout ratio is 30% using GAAP EPS and 23% using non-GAAP EPS. The negative side is that the current yield may not look attractive enough for investors at 2.2%. However, the company offers a record of sixteen years with dividend increases. Therefore, investors get a dividend growing faster than inflation (14% annual growth in the last decade).

In addition to dividends, companies, and Kroger, among them, return capital to shareholders via buybacks. Buybacks support EPS growth as they lower the number of shares outstanding. Over the last decade, the number of shares has decreased by 30% as Kroger initiated an aggressive share repurchase plan to take advantage of its valuation – the more attractive the valuation, the more influential the buybacks as each dollar buys more shares.

Valuation

The P/E (price to earnings) ratio of Kroger stands at 10.5 when using the forecasted EPS for the current year. Paying ten times earnings for a growing company and rewarding its investors with dividends seems fair. Moreover, the graph below shows that the current valuation has been attractive in the past twelve months. Therefore, it looks like this is a decent entry point for investors.

The graph below from Fast Graphs emphasizes that the current valuation of Kroger is attractive. Over the last two decades, the shares of Kroger traded for an average P/E ratio of 13.3. The current P/E ratio is significantly lower. During these decades, the EPS growth was faster, yet I believe this is insufficient to justify the valuation gap. This will be a great entry point if Kroger has decent growth opportunities.

Opportunities

Kroger is operating in a market where it is tough to shine. Therefore, it tries to differentiate itself by offering fresh products at a higher quality and using a shorter value chain. While most packaged foods are generic, and it’s hard to compete for anything but their price, fresh goods are more unique. There are different qualities and different levels of freshness. Higher quality and fresh products will allow Kroger to charge a premium.

Another growth opportunity is the seamless digital ecosystem that Kroger is building. Kroger allows customers to buy groceries online and deliver them in five different methods with different pricing. The company offers membership plans which provide personalized coupons and fuel discounts. The higher tier membership, which costs $99 a year, offers quick delivery with no additional charge. The combination of seamless digital experience and memberships makes Kroger more sticky.

The proposed merger with Albertsons is another growth opportunity for the company. It will create a nationwide player with a significant presence in most states. The map below shows the compatibility of the merger, as there will be very little cannibalism. Kroger expects the transaction to be accretive to earnings in the first year following close and double-digit accretive to earnings by year four, excluding one-time costs.

Risks

The competition is the first risk for Kroger. The company operates in a realm where it is hard to stand out, and the margins are slim. The company offers a 3% operating margin in a competitive environment, and therefore every hiccup in its performance may have a harsh impact on its growth plan. The company competes with giants such as Walmart (WMT) and Target (TGT).

The company is also dealing with the risk of inflation. As an operator of thousands of stores, labor cost is a significant expense, and it also has to deal with higher prices of its products. Therefore, the company has to raise prices or suffer from lower margins. Higher prices may turn into a lower market share, while lower margins when they are low, to begin with, may hurt the net income significantly.

Another risk is the risk of failure for the acquisition of Albertsons. The company relies heavily on this merger for growth. Without it, analysts expect mid to low single digits annual growth. This is a risk as many oppose the merger between the two companies. The company should work on an alternative plan if the merger is blocked to avoid muted growth in the short term.

Conclusions

To conclude, Kroger has excellent fundamentals. It shows steady top and bottom line growth over the past two decades. The company returns a significant portion of its earnings to its shareholders and still grows the business. With limited risks and a decent valuation, the company seems attractive for long-term dividend growth investors.

The acquisition of Albertsons is the primary short-term upside, as I believe there is a margin of safety in case the deal falls. Therefore, I think shares of Kroger are a BUY as the company transforms itself to offer a better digital experience and fresher high-quality products. Investors shouldn’t expect outsized returns but should expect high stability and high-single digits total returns in line with the company’s aim.