Kroger (KR): A Bargain Dividend Growth Stock Or Value Trap?

Kroger (KR) is starting to get the attention of value and dividend growth investors alike after its year-to-date stock price decline of 22%.

Kroger’s stock now trades for less than 15x forward earnings guidance and offers double-digit annual total return potential if management’s growth guidance is to be trusted.

Even better, most of the factors weighing on Kroger’s business today have no impact on the company’s long-term earnings potential.

These are usually my favorite type of investment opportunities, but readers won’t be surprised to hear that I am very reluctant to invest in any retailer – especially debt-laden, growth-challenged grocers.

However, Kroger could be an exception. The company has delivered extremely reliable results for decades and rewarded shareholders with double-digit annualized dividend growth since 2006.

With recession-resistant products, time-tested operations, and a reasonable valuation, let’s take a closer look at Kroger to see if the stock is an attractive dividend growth investment.

The Kroger Co (KR)

Business Overview

Kroger was founded in 1883 and is the second largest food retailer after Wal-Mart with over $100 billion in annual sales.

The company operates over 2,700 supermarkets in 35 states, and about half of its locations also have fuel centers. Supermarkets generate 94% of the company’s sales.

The company’s stores operate under the brand names Kroger, Harris Teeter, Fred Meyer, Mariano’s, Pick ‘n Save, Metro Market, Pay Less, Smith’s, Owen’s, Baker’s, Fry’s, and others.

Roughly 26% of supermarket sales are generated by private label corporate brands, and approximately 40% of Kroger’s private label brand units are manufactured at the company’s 38 food production plants. This vertical integration benefits Kroger’s margins.

In addition to supermarkets, Kroger operates (by franchisees or through its subsidiaries) 784 convenience stores, 323 fine jewelry stores, and an online retailer. All of the company’s revenue is generated in the U.S.

Business Analysis

Grocery stores are cutthroat businesses. Consumers typically have a number of grocery chains to shop at in their local markets, and most are looking for the best quality produce available at the lowest prices.

Differentiation can be difficult, and Wal-Mart has wiped out many grocery chains based on price alone over the last few decades.

Despite Wal-Mart’s increased focus on grocery products over the last 30 years, Kroger has continued delivering superb results.

The company has gained more share of the massive food market for 11 straight years and holds the #1 or #2 market share position in 46 of the 51 major markets that it operates in.

As the largest player in most of its locations, Kroger’s scale helps it acquire products at lower costs and spread its fixed costs out more efficiently than smaller rivals.

However, Kroger knows that competing on price is ultimately a losing game. Instead, the company has instilled a culture focused on knowing the customer best to improve satisfaction and loyalty.

Kroger invests heavily in technology to understand what consumers are buying and capitalize on evolving shopping trends such as healthy eating and e-commerce.

In fact, Kroger’s customer analytics and insight business, which employs over 500 people, was named one of the Top 100 places to work by Computerworld magazine.

As a result of its customer-first strategy, convenient store locations (nearly all are within two miles of customers’ homes), broad selection of quality merchandise, and reasonable prices, Kroger scores near the top of pack for customer satisfaction, as measured by net promoter scores (see below).

Kroger’s net promoter score is nearly double Wal-Mart’s score:

The Kroger Co (KR)

Source: Satmetrix

Satisfied customers have helped Kroger report positive identical supermarket sales growth (excluding fuel) for a remarkable 50 consecutive quarters.

Some of the company’s important investments for the future include its efforts to capitalize on the online shopping trend. Kroger’s acquisition of Harris Teeter in 2014 provided it access to the company’s ExpressLane technology, which enabled online ordering and store pick-up.

The company then launched ClickList, its own online ordering service that is now available in 25 markets.

It’s far too early to judge which companies will have the most success in the online grocery business, but Kroger brings a track record of getting trends right – even if it’s not the first mover.

Back in the brick-and-mortar world, Kroger’s 2015 acquisition of Roundy’s also gives the company additional growth opportunities.

Roundy’s stores primarily operate in Chicago and Wisconsin, two new markets for Kroger, and have a number of opportunities for new store growth.

As long as Kroger continues to invest in its existing supermarket locations and stay on top of evolving customer shopping preferences, the company should remain relevant and protect its market share.

Key Risks

Kroger’s business results can be impacted by a number of transitory factors over the near term.

Poor weather, low food inflation, lackluster consumer confidence, and volatile fuel margins are just a few of the key uncontrollable factors that can hurt Kroger’s earnings any given quarter.

However, over the long run, none of these issues should impact Kroger’s earnings power and growth opportunities.

Most recently, Kroger has been hurt by low food inflation and shrinking fuel margins.

The chart below is a little hard to read but it shows the year-over-year change in food prices going back more than 50 years. The black line marks 0% on the chart.

Recent food inflation is at its lowest level since the Great Recession, and the chart shows that food inflation has rarely ever fallen below 0% for more than 50 years.

In other words, it’s hard for me to imagine food inflation trends getting much worse than they currently are.

It seems likely that inflation trends will reverse within the next year or so if history is any guide. Rising commodity prices will help same-store sales growth because they result in high grocery prices.

The Kroger Co (KR)

Source: Federal Reserve

Kroger is also being impacted by a drop in fuel margins. Over 1,300 of Kroger’s retail stores also have convenience stores, which sell gasoline and non-durable consumer goods such as packaged foods, beer, and tobacco.

Kroger’s fuel margin is the difference between retail gasoline prices and the amount it pays for wholesale gasoline supplies.

The retail price of gasoline is much less volatile than the wholesale prices Kroger pays, which causes fuel margins to move around.

Kroger’s fuel margins typically expand when gas prices fall and benefited greatly over the last 1-2 years, running nicely above their five-year average.

Of course, not all good things last forever. Management guided for fuel margins to be at or slightly below the five-year average in 2016.

Personally, I’m not overly concerned about either of these unfavorable macro trends. While they could impact the next couple of quarters, I buy a company with plans to hold it forever.

I am more worried about the competitive nature of the retail grocery industry.

Operating margins are razor thin (see below), pricing pressure is intense, few barriers to entry exist, capital intensity is high, debt burdens are large, and new competition emerges every day (including Amazon).

The Kroger Co (KR)

Source: Simply Safe Dividends

I view Kroger as arguably one of the best-managed grocers in

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