Description

Kroger is the largest conventional grocer in the U.S., and was last written up as a long on VIC in 2017. Kroger is generally viewed as the ‘best-in-class’ conventional grocer, with high private label penetration, benefits from scale, and an industry-leading technology platform that they are just now beginning to monetize. What is less often discussed is that Kroger is one of the largest retailers of gasoline in the country, and this has been an extremely lucrative business for the company over the past few years, with all-time high gas margins in excess of peers allowing them to paper over declines in the core grocery business. You won’t hear much about this from Kroger management, who prefer to speak relatively when discussing fuel and focus solely on year-over-year top-line impact, but entirely avoid discussing the business’ substantial profit contribution on an absolute basis.

While the Covid impact is undoubtedly beneficial for sales in the near term (EBITDA and FCF impact TBD, but likely far less meaningful), looking out beyond 2020 Kroger is likely to face difficult comparisons as not only the core grocery business reverts back to normal, but a reversion in the gas business may put Kroger in jeopardy of missing continually increasing earnings expectations. A normalization in fuel margins could lead to a $500-600m impact on EBIT (vs. T12M EBIT of $3bn) and a $0.50-0.60 hit to EPS (T12M EPS of $2.19) causing Kroger to materially miss current consensus expectations for ongoing earnings growth.

Overview:

The core of Kroger’s business is conventional grocery, a difficult industry that has been under substantial pressure from a number of competitive threats including hard discounters (Aldi & Lidl), discounters & warehouse clubs (Wal-Mart, Costco), premium / fresh / organic (Whole Foods / Sprouts), and pretty much everyone who doesn’t have the same antiquated heavily unionized and fixed cost structure that the conventional grocers do.

Despite being viewed as the best-in-class conventional operator, Kroger still has struggled to generate growth, with EBIT declining at a 2% clip over the past 5 years, EPS growing by 4% (only thanks to a ~20% decline in the share count).

The upside case for Kroger is that this phenomenon of low single digit growth, and low to mid-single digit EPS growth accelerates due to scaling of Kroger’s “Alternative Profit Steams”, and a new story is that covid will boost sales in the near-term while structurally shifting a portion of “Food away from home” spending to “food at home”, and as the largest conventional grocer, Kroger stands to benefit. However, the near-term covid impact is likely to be immaterial from a cash perspective, and any long-term benefits to grocery from covid are unproven and likely to be competed away. Lastly and most importantly, if Kroger’s supernormal profits in fuel normalize, they will fall materially short of estimates over the next few years.

Kroger’s Fuel Margins:

As of February 1st, Kroger operated 2,757 grocery stores, of which 1,567 (57%) have gas stations. While not often discussed, Kroger is actually one of the largest retailers of gasoline in the country, selling $14bn of fuel // 5.4bn gallons of gasoline in 2019. The most important metric in the gas business is gross profit, measured in pennies per gallon.  While the company has done a commendable job steering focus away from fuel, the fuel business has become an increasingly important profit center for Kroger.

The gas business is very commoditized, and margins generally fluctuate based on movements in oil prices. Sharp declines in oil prices lead to expansions in fuel margins until retail gasoline pricing catches up with oil pricing. Over the long term, Kroger’s fuel margin has averaged $0.14/gallon, and in 2019 reached $0.30/gallon, with margins peaking at $0.35/gallon in 2q19. $0.15/gallon in incremental profit on 5-6bn gallons of gas is $750-900m of incremental EBIT, which is quite material on a business doing ~$3bn in overall EBIT.

Admittedly looking at a long-term average for fuel margins is no longer representative of normalized margins for the industry. The industry has consolidated substantially over the past decade, and gas station operations have shifted into the hands of those with more of a profit motive, rather than simply a distribution vehicle for refineries. Couche-Tard (ATD/B CN), the largest independent retailer of gas in the U.S. has acquired a number of brands, and overall the consolidation as well as structurally higher operating costs have pushed normalized gas margins up to $0.20/gallon, a number that numerous other industry participants, including Couche Tard & Speedway (owned by MPC) confirm to be normalized.

In the past three years, Kroger’s gas margins have not only increased in excess of history & normalized levels, but have increased well in excess of peers to $0.30/gallon, while the next highest-earning player is Couche Tard at $0.24/gallon (who admitted they were likely unable to sustain those levels).

The impact of any normalization in fuel margins is material. Kroger sells 5-6bn gallons of gas per year, and the rough rule of thumb is that each penny of fuel margin equates to $0.05/share in annualized EPS, vs. T12M (pre-covid) EPS of $2.19/share (1 penny fuel margin = 2-3% impact on EPS). If Kroger’s fuel margins were to revert to normalized levels of $0.20/gallon, that would equate to a $500-600m impact on EBIT (vs. T12M EBIT of $3bn), and a $0.49-0.59 hit to EPS. 

Core Grocery Business:

As pointed out earlier, Kroger’s EBIT has actually declined over the past five years despite a substantial increase in Fuel Gross Profit. With very high flow-through from pricing / gross margin changes, this benefit from fuel should be flowing through to the bottom line. In fact, over the past 5 years, Kroger’s consolidated EBIT has declined by $350m, while Fuel Gross Profit has increased by $481m, implying an $831m spread, which can largely be attributed to declines in the core grocery business.

Kroger last disclosed fuel’s EBIT contribution in 2013, and unsurprisingly scrapped that disclosure as it allows analysts to better understand the trends of the core grocery business. If you assume similar levels of allocated fuel G&A per gallon or fuel station, you can back into the mix of Kroger’s earnings that are attributable to fuel and the core grocery business, as well as the incremental changes in both. There is a bit more noise in looking on an EPS basis due to changes in share count, tax rates, adjustments, etc, but it is instructive nonetheless. Since 2015, Fuel has increased from about $0.29 in EPS to $0.96, while core grocery has declined 31% from $1.77/share to $1.23.

Without fuel covering up declines in the core grocery business, Kroger’s earnings would have been down substantially over the past five years, and the company would likely be trading at a different valuation than 15x EPS. It is worth noting the decline in core grocery may even be more severe than presented, as Kroger has only just begun to disclose the incremental (not absolute) EBIT from their alternative profit streams, and any historical contributions from the alt profit business are unknown.

Core Grocery Secular Challenges:

While Kroger might be the best-in-class conventional grocer operator, they are still a conventional grocer, which makes them a structurally disadvantaged operator in an extremely difficult industry. In short, Kroger has competitors on all sides, with stiff competition from both low and high end players who all have much more flexible cost structures. 

On the low end, major competitors include Walmart (who has had well documented success in grocery), as well as lesser known players like the hard discounters Aldi & Lidl. Lidl is much smaller with only 101 stores on the East Coast, while Aldi has 1,900 and is looking to grow to 2,500 by 2022. Both operate under a no-frills ‘hard discounter’ model, with >90% private label penetration, extremely limited labor & overhead, allowing for prices 30% below other discount options like WMT for a standard grocery basket. The below shows a local price comparison (pre-covid) between Aldi, Walmart, Stop & Shop, Amazon Prime (Whole Foods), and Peapod (online version of S&S). There were no comparable Krogers in the area, but this demonstrates Aldi’s pricing nonetheless.

On the high end KR faces encroaching competition from chains like Whole Foods & Sprouts, who provide fresh/organic focused offerings. Perishables generally carry some of the best margins within the store, so any competition here can be impactful. The biggest difference between Kroger and all of these competitors is the workforce. Kroger is burdened by their legacy unionized workforce, which considerably increases their cost structure vs. peers, and limits their flexibility.

Covid Impact

Kroger has been viewed as a beneficiary from covid in two ways. The more immediate and obvious is the sales lift they have experienced due to stock-ups, lockdowns, and closures of restaurants. The more long-term, uncertain, and harder to quantify benefit would be if there is a structural shift from eating at restaurants to at home. Given that impact is far more uncertain, it’s worth focusing instead on why the near-term sales lift is unlikely to be a game-changer. 

The only hard data Kroger has provided thus far has been that comps were +30% in March, which is well in excess of any comp performance in history. April and May likely remain elevated as well, though there have been some data points indicating that the level of demand is tapering off somewhat. Ahold Delhaize, one of the largest grocers on the East Coast (owns Food Lion / Stop & Shop / Giant / etc), said in early May that April comps moderated from the +30%+ they experienced in March, and they expected continued normalization.

Even under a great scenario where Kroger comps up 30% for an entire quarter at 27.5% incremental margins (equal to merchandise margins, so assuming $0 of incremental cost), that would only equate to $1.2bn of incremental cash, or 3% of the enterprise value & 5% of the market cap. A more realistic scenario is the 30% comp is not sustained for an entire quarter, and incremental margins come in well below merchandise margins given all of the costs around covid (hiring private security for stores, implementation of sneeze guards, constant sanitizing, extra hourly labor, labor bonuses, freight inefficiencies, etc). In a case where KR comps +20% for 12 weeks at 15% incremental margins, they would generate $450m of cash, or 1% of the enterprise value and 2% of the market cap.

In other words, the windfall is hardly a game changer. 

The second impact which is harder to quantify is the impact on fuel margins from all the volatility in the energy markets in March & April. The oil price war combined with an unprecedented decline in gasoline demand likely caused retail fuel margins to explode to $1.00-$1.50/gallon. However, fuel volumes were likely down substantially (COST volumes seem to maybe be down 15-30% in Apr/May, MUSA down ~30% in Mar/Apr, cited industry volumes down ~50%) offsetting some of this. Given the fall-off in demand, it has also maybe taken gas retailers longer than expected to work through higher-cost inventory. Either way, it’s likely gross profit dollars will be up in the gas business by up to $750m ($1/gal in GP with ~30% hit to volumes), leading to a $590m after-tax cash benefit (2% of MC / 1% of EV).

Valuation:

At $32.50, KR is trading at 15x T12M earnings, and 13x 2021 Consensus earnings of $2.50/share. Normalizing that number for a $0.20/gallon fuel margins, KR is currently trading at 16.5x normalized EPS.  If Kroger traded for 11x earnings, reflecting the ongoing challenges and issues in their core grocery business, the company would be worth $21.50/share, or 34% downside from current prices.  Alternatively, if Kroger manages to expand gas margins sustainably even further to $0.35/gallon, and there is no further decline in the core grocery business, and the company trades for 15x EPS, there would only be ~26% upside from current prices.  We think the former scenario is much more likely. 

For a company that focuses heavily on EPS and meeting their ~25 analyst estimates, it is worth noting that based on current consensus estimates, there is really no room at all for fuel margins to normalize even slightly if Kroger wants to meet expectations.

Kroger also may be aware of this difficulty, and notably did not provide hard long-term guidance at their most recent investor day. Historically KR provided long-term EBIT and/or EPS guidance, though struggled to meet it in recent years even with a strong tailwind from fuel. Instead, Kroger has moved to a long-term TSR target, perhaps indicating they don’t feel they can meet a set long-term EBIT or EPS target. Also notable, in page 36 of their proxy, KR shifted their long-term compensation to include TSR  in addition to growth in EBIT/cumulative FCF, though weightings of these compensation drivers are not yet disclosed.

Risks:

Alt Profit:

A common reason people own Kroger is their “Alt Profit” revenue stream, which is comprised of a number of components, including Kroger Personal Finance (the largest piece), Kroger Media / Data / marketing / etc, and more. These revenue streams may help Kroger mitigate some of the decline grocery business, but are unlikely to be sizeable enough to offset a full normalization of fuel (>$550m of EBIT). Should Kroger elect to provide better disclosure on the absolute size of these Revenue / EBIT streams, you may be able to better judge the impact they will have. But in the meantime, a successful year for them was $100m of incremental EBIT (off of an unknown base) and it will take much more to offset both declines in core grocery and in fuel profitability.

Online Grocery:

Kroger’s scale does allow them to be on the leading edge of online grocery / delivery, and covid may cause some permanent shift in that model.  Like alt profit, it’s a bit too early to know how successful or meaningful this could be in offsetting declines to the core business.  KR’s investment & partnership with Ocado is still largely unproven, and Ocado’s centralized distribution model may or may not be suited for the less-dense U.S. considering Ocado’s origins in the UK.  

Catalyst

Difficult grocery comparisons post-2020 as core grocery business reverts back to normal

Normalization in fuel margins could lead to a $500-600m impact on EBIT (vs. T12M EBIT of $3bn) and a $0.50-0.60 hit to EPS (T12M EPS of $2.19), causing Kroger to materially miss consensus expectations for ongoing earnings growth