Description

Kroger is an attractive core position for any stock portfolio given low P/E multiple, dependable and sticky earnings, and cash flow.

Today’s stock price, $48:
- 10.5x 2023 P/E
- $35B market cap
- My conservative DCF suggests 33% upside to $64

I use 9% cost of equity, which is conservative vs. Damodaran's estimation of 7.85% cost of equity in grocery retailing. I also fade ROE from last-year's 33% to 27%. If you think Kroger’s earnings are stable at all, Kroger is a buy. If you think Kroger will continue to grow earnings as they have for 20 years, Kroger is a home run.

Why is Kroger so cheap and what is the market missing?
- A VIC short pitch on Kroger from 2020 said Kroger is a “structurally disadvantaged operator”. This prejudice against conventional grocery originates from some high profile crappy conventional grocers (A&P, Safeway, Supervalu, Roundy’s, Fairway). In fact these companies were just doing it wrong, and Kroger's track record of strong sales and earnings growth has proven that conventional grocery can thrive (as have several private players like HEB, Wegmans, Market Basket, and others). Habitual customers can become a moat for food retailers, permitting high throughput and low prices even at an acceptible operating margin 
- The market doubts that the announced merger with Albertsons will achieve regulatory approval, driving away shareholders who would buy Kroger for M&A benefits. Kroger has halted habitual share repurchases to amass dry powder for the M&A, driving away shareholders who would buy Kroger for cash return. 

For me, either 2024 catalyst is great, likely driving rerating in the stock:
- If the Albertsons merger goes through, analysts will recognize powerful shareholder benefits and earnings accretion immediately and through 2028
- If the merger is blocked, Kroger will repurchase billions in stock to readjust leverage to desired corporate targets (repurchases should be $9B, 26% of the float, perhaps executed over 12 - 24 months)

These catalysts highlight the extremely significant capital allocation actions likely to mark 2024 for Kroger. CEO Rodney McMullen owns 6.4M shares of Kroger, worth ~$300M, aligning McMullen with shareholders.

In the rest of this document, I discuss:
- How other grocers gave the industry a bad rap in the 2010s
- Kroger survived and thrived through relentless focus on the value proposition for customers
- Today Kroger’s competitive position is strong, allowing it to earn sustainably high return on equity
- Kroger’s earnings are stable and growing
- Share repurchases should be a positive catalyst if the merger doesn’t go through; merger with Albertsons would be incredibly positive

Conventional grocery got a bad rap:

From 1990 to 2010, new food retailing formats emerged, spread, and pressured conventional grocery stores. These formats included big box retailers (Walmart, Costco, etc), specialty grocers (Whole Foods, Trader Joes, Sprouts, etc), and small box discount stores (Aldi, Dollar General). While these challengers are diverse, they have several characteristics in common:
- They tend to operate without unions
- They often have 80% lower SKU counts vs. traditional grocers, leading to an advantage in inventory management and supplier bargaining; their customers are trained to expect few options and be happy about it (e.g. Costco and Trader Joes)
- They focus relentlessly on customer experience and value (low prices, good experience)

Some analysts believed that these new formats would ultimately destroy conventional grocers, and in fact many grocers folded or struggled. A&P, once the largest grocery chain in the United States, was forced into bankruptcy in 2010. Over the following decade, many conventional grocers faced financial stress, bankruptcy, or restructuring. In 2013 and 2014, after years of deteriorating financials, Safeway was broken up, with some stores closed and others sold to private equity and grocery peers. Supervalu, Southeastern Grocers, Roundy’s, Fairway Market, and others all went through similar processes during this time.

Kroger meanwhile, has thrived, with sales growing at a 5% CAGR over the past 20 years, enough to hold and sustain market share and grow EPS at a 9% CAGR (plus dividends).

Kroger survived and thrived through relentless focus on the value proposition for customers:

The secret to Kroger’s success was an early identification of the new threats and relentless sharpening of the value proposition for customers, including capital investments in stores, good merchandising, investment in proprietary brands, and lowering prices.

These investments were initially costly for shareholders. For example, EPS barely grew from 2002 - 2010, increasing at a 1.7% CAGR, which was entirely driven by share repurchases (share count declined at 2.7% CAGR). Over this period, gross margin fell from 27.0% to 22.3% due to investments in better customer value, driving operating margin from 5.0% to 2.7%. Net income declined over these eight years.

Despite declining margins and profits, Kroger’s investments were making the chain more competitive with customers, causing identical store sales growth to exceed inflation by 1.2% CAGR from 2002 to 2022:

1.2% real growth in identical stores is significant over two decades, and proves that the problem with conventional grocery (A&P, Supervalu, Safeway, Roundy’s, and others) wasn’t unions or an outdated format, but rather complacency within the industry beset with new competitors. Some customers still prefer to shop in a conventional store, with its wide variety and convenience compared to bigger boxes.

A&P, Safeway, and Supervalu had lower identical store sales for at least five years prior to their serious financial difficulties. When a grocer becomes “offsides” in its value proposition (including high prices and/or lousy store experience), sales don’t collapse all at once. Grocery preferences are habitual and sticky. Rather, some few customers leave this year, some next year, and some the year after that. If a grocer avoids addressing the problem (usually due to complacency and protecting profit), the slow bleed will eventually destroy the company.

Alternatively, if a grocer makes costly investments to improve the shopping experience and/or prices, the impact on sales will take years to fully materialize. Kroger’s investments in 2002 - 2010, paid off for years later.

Today Kroger’s competitive position is strong, allowing it to earn sustainably high return on equity:

Kroger is the second largest player in US groceries and the largest conventional grocer, with 7.3% US food market share (comparing to 17.1% for Walmart, 5.7% for Costco, and 4.5% for Albertson’s. Kroger’s impending merger with Albertsons would further solidify its position (more on the merger later).

Source: https://www.foodnavigator-usa.com/Article/2022/10/14/kroger-to-acquire-albertsons-for-24.6bn-solidifying-its-position-as-2-grocery-retailer-with-11.8-market-share

While national market share is important in grocery for negotiating with suppliers, local market share is even more important for economies of scale in distribution, store infrastructure, and labor cost. Kroger decided in the early 2000s to become #1 in every one of its local markets, relentlessly investing in lower prices and better shopping experience in order to increase sales in its stores. Due to the high identical-store sales discussed in the prior section, Kroger’s sales-per-square foot are now 27% higher vs. 20 years ago (on a real, inflation-adjusted basis):

Sales per square foot is incredibly important in grocery because it permits leverage on SG&A and physical assets, allowing a grocer to sustain lower prices yet with acceptbible operating margins. High sales per square foot is a network effect advantage: the customer base allows for high throughput, low gross margins, and better value for the customer. This better value for the customer helps grow the customer base (slowly over time). The habitually-trained customers, therefore, are the moat. Another grocer with lower customer counts cannot replicate Kroger's value proposition, as they would do so with low throughput and significant operating losses for years before attracting enough customers. This is different from discretionary retailing, where customers browse but don't necessarily habitually buy. At a grocer, the customer has mostly decided their ticket before walking into the store (they have a shopping list).

I mentioned earlier that Kroger’s gross margin declined from 2002 to 2010. From 2010, gross margins continued to decline very slightly until 2022 by 0.2%. Operating margins, on the other hand, have slightly increased from 2.7% to 2.8%. Higher sales per square foot permitted leverage on SG&A. The grocer enjoyed a virtuous cycle combining lower prices, lower gross margins, slow share growth, higher leverage on store costs and infrastructure, stable operating margins, and slowly increasing returns on equity, which increased from the low 20s in 2002 - 2010 to the low 30s in 2020 - 2022:

So even as Kroger lowered prices (and therefore gross margins) over the 20 years, slow and steady share gains have driven higher ROEs. These returns are remarkably consistent, reflecting both the consistency of grocery retailing and Kroger’s competitive strength.

Today, Kroger’s sales-per-square foot are substantially higher than other grocers with publicly available information:

Note: I’ve chosen these comps because of data availability; Supervalu and Safeway were the largest peers and underwent restructuring ten years ago. Albertsons is now made up largely of the best banners previously owned by Safeway and Supervalu (the worst banners/stores were closed). There are other strong chains, but they are mostly private and non-overlapping with Kroger (HEB in Texas, Publix in the Southeast, Market Basket in the Northeast, etc.).

Costco has ~2x the sales per square foot of Kroger, and that’s reflective of a different format, as well as an even stronger competitive position for Costco. Costco trades at 40x P/E (TTM), and I believe it has one of the best moats in the world. But there will always be customers who prefer a conventional format, and Kroger (along with other best-in-class regionals like HEB, Wegmans, Market Basket, etc) are in a strong position for that customer.

Over twenty years, Kroger improved the customer experience including through store investments and lower prices, allowing higher sales per store, lower prices, better leverage on store costs, and a competitive moat.

Kroger’s earnings are stable and growing:

Due to the moat Kroger has developed, I am confident in management’s long-term guidance of 8 - 11% TSR driven by 6% - 9% EPS growth and ~2% dividend yield. Kroger has achieved the high end of this goal over the past twenty years, growing adjusted EPS by 8.9% CAGR (despite barely growing EPS at all from 2002 to 2010). This growth has been with incredible stability:

Notes:

 - 8.9% CAGR in adjusted EPS for 2002 - 2022

 - Doesn’t include benefit of ~2% dividend for shareholders

 - Very few down years, and adj. EPS was only once down more than 11% in a single year

 - Growth in earnings is primarily driven by sales growth, in addition to ~3.8% average annual reduction in shares through repurchases

A 2020 VIC short-pitch on Kroger noted that EPS only grew by 4% from 2014 - 2019. However this period was anomalous. Kroger goes through earnings cycles, usually related to competitive banner rollouts, where EPS can grow slower or faster than usual. The 20-year trend shows strong and consistent earnings growth driven by moderate sales growth and share buybacks, consistent with Kroger’s moat in a sticky consumer staples industry.

We could see some slow-down in earnings growth in the next few years following the EBIT-margin expansion since 2020 (food at home has gained and retained share since the pandemic). Consequently, I model a slight reduction in ROE from 33% in 2022 to 27% in coming years. However, EPS should show significant growth even in this scenario, largely due to capital allocation as discussed in the next section.   

Share repurchases should be a positive catalyst if the merger doesn’t go through, and a merger with Albertsons would be even better:

2024 should mark significant capital allocation events for Kroger, and I expect the company to maximize shareholder value given CEO McMullen’s ~$300M of personally-owned stock.

Kroger and Albertsons announced the intention to merge in October 2022, with Albertsons stock and operations being absorbed into Kroger by early 2024. The merger has faced some pushback from unions and Democratic lawmakers, and today the outcome is uncertain. Albertsons stock today trades for $22 per share, significantly below the merger price $34 per share, indicating market skepticism about the deal.

If the merger fails, Kroger shareholders will win from resulting share repurchases, which could total $9.0B, or 26% of the float. Kroger has significantly slowed its share repurchases over the past four years, declining steadily from $2.0B in 2018 to less than $1.0B in 2022 and zero in Q1 2023, even as earnings doubled and leverage was cut in half (to make borrowing capacity to payout Albertsons shareholders). If the merger doesn’t close, Kroger would have to spend ~$9.0B to catch up to the midpoint of corporate net-debt to adjusted EBITDA targets (2.3x - 2.5x vs. 1.3x today; leverage was at 2.8x in 2018). At current prices, $9.0B in buybacks this is an eye-popping 26% of the current market cap.

Kroger may not spend all of this $9.0B on share repurchases in the first year, but I expect it to be a source of significant earnings growth (and buy-pressure on the stock) for several years. Kroger’s history with share repurchases and CEO McMullen’s incentives give me confidence that Kroger will use this tool if superior M&A tools fail.

On the other hand, the merger scenario would be even better for shareholders. The merger is incredibly sensible given:
- Kroger management has extensive acquisition experience over the past ten years
- Albertsons business model is incredibly similar to Kroger’s, reducing integration risks
- Merger synergies in the following categories should be straightforward to execute: 1) supplier sourcing / cost of goods sold; 2) own brands cross merchandising; 3) management and other SG&A costs; 4) closure of overlapping / underperforming stores 5) sharing of e-commerce and other corporate platforms / systems
- CEO McMullen owns ~$300M of Kroger stock, aligning him with shareholders during this crucial moment of transformation

Assuming the merger closes, Kroger will pay $34.10 per share for Albertsons, or a total enterprise value of $24.6B. Kroger will pay for the Albertson’s deal primarily through new issuance of debt. Kroger has been reducing leverage in anticipation of the merger:

With current 10-year treasuries at 3.7% and Kroger’s long-standing BBB credit rating, I expect that Kroger could raise 10-year paper at 4.5% - 5.5%, with the high end considering that Kroger will slightly exceed corporate leverage targets. Albertson’s earnings power for equity holders is a bit of a moving target: 2022 GAAP pre-tax net income is $1.9B, while adjusted pre-tax net income is $2.5B. Some add-backs seem sensible for a company in transition (merger advisory fees and others).

Allowing for a range of earnings and interest cost scenarios, the merger will be accretive to Kroger EPS from day one:

*Table includes 21% tax rate

Additionally, Kroger has guided to $1.0B in annual cost synergies, achieved ~4 years from the merger’s close, an additional $1.09 in after-tax EPS accretion. The combined entities have ~$200B in cash cost from which to find the $1.0B in synergies. I expect Kroger to exceed the $1.0B in synergies, but reinvest some of the proceeds to further lower prices. I further expect additional synergies to materialize beyond the first $1.0B recognized in the first 4 years

If the merger closes and is successful, the upside in the stock will become glaringly obvious, driving the current ~10x P/E multiple to ~7x once factoring the accretion from Albertsons earnings and benefit of synergies to be recognized over the first four years.

Conclusion:

Kroger is a strong company with steady earnings and responsible management. Its stock is undervalued, and 2024 should highlight the valuation disconnect with either a share repurchase scenario or a highly accretive Albertsons merger.

Catalyst

In 2024, the Albertsons merger will be approved or rejected, in either case catalyzing EPS-enhancing capital allocation:

• The Albertsons merger would be accretive due to synergies and from buying Albertsons earnings at 10% earnings yield and funding it with 5% debt
• In a buyback scenario, Kroger will have $9.0B to deploy just to get back to the midpoint of corporate leverage targets (25% of the float)