Image Shown: Kroger Company – IR Presentation
By Callum Turcan
On September 12, food retailer Kroger Company (KR) reported second-quarter earnings for its fiscal 2019 that ended August 17. The company posted 2.2% year-over-year same-store sales growth, when excluding fuel sales (due to the volatile nature of petroleum product prices), and that was assisted by 31% year-over-year digital sales growth. Its FIFO gross margin contracted by almost 30 basis points according to management due to pressures at its pharmacy and specialty pharmacy business. However, corporate initiative Restock Kroger allowed for the retailer’s GAAP operating margin to climb marginally year-over-year as operating expenses were kept relatively contained. Shares of KR, after a volatile trading session, ended flat September 12.
Restock Kroger focuses on using ”administrative efficiencies, store productivity and sourcing cost reductions” to reduce ongoing operating costs while seeking to enhance revenue generation. Expanding the number of Kroger’s stores currently offering delivery and pick-up services is also key as that strengthens the retailer’s digital sales growth trajectory (digital sales can’t materialize in regions where Kroger is unable to meet local demand) and ultimately same-store sales. GAAP revenue was up just half a percentage point year-over-year while Kroger’s GAAP operating profit rose by almost 2%.
Kroger generated $3.3 billion in net operating cash flow during the first half of its FY2019 while spending $1.6 billion on capital expenditures, allowing for $1.7 billion in free cash flows to easily cover $0.2 billion in dividend payments. Over the past 13 consecutive years Kroger has pushed through annual per share dividend increases, including a 14% payout boost earlier this year back in June. The retailer is targeting $3.0-$3.2 billion in GAAP capital expenditures in FY2019, and just over half of that has already been spent.
Shares of KR come under pressure due to the weak guidance management issued, with an eye on the incremental operating-income initiatives were supposed to add to Kroger’s bottom line over time. Management no longer forecasts that Kroger will add an incremental $0.4 billion to its operating profit over the next three years. While the retailer continues to think its initiatives will add $0.1 billion in incremental operating profit this fiscal year versus FY2018 levels, investors care more about Kroger’s medium-term trajectory than its short-term outlook. Here’s a key quote from management during the retailer’s second quarter FY2019 conference call (emphasis added):
“…we reconfirmed our 2019 guidance for identical sales, excluding fuel, adjusted EPS and adjusted FIFO operating profit, as well as reconfirmed that we are on track to deliver $100 million in incremental operating profit through alternative profit stream growth. We want to be clear on today’s call that we are not reconfirming the three-year $400 million in incremental operating profit expectation. In November, we will give detailed 2020 annual guidance.
I do want to highlight that we do expect to deliver FIFO operating profit growth in 2020 over 2019 confirmed guidance. We’ve outlined a handful of key goals for our Investor Day and would like to use this opportunity to provide you with a preview. At Investor Day, we plan to reinforce our commitment to the overall framework of our Restock Kroger transformation plan, sharing what has worked well and what has not worked well, thus far. We intend to do a deep dive into our supermarket business, which underpins the redefining grocery customer experience pillar of Restock Kroger.”
Over the long term, Kroger sought to augment its growth trajectory by launching Simple Truth: Plant-Based on September 5. This product line up will include meatless burger patties, grinds, sausages, and more along with plant-based cookie dough, dips, and other offerings. This private-label strategy seeks to both protect Kroger’s gross margins while also gaining exposure to potential revenue upside as alternative meat-like products grow in popularity. While once considered a niche, maybe even a niche of niche, plant-based meat-like products are quickly becoming mainstream.
Additionally, the types of consumers (generally speaking) who would seek out these types of products tend to be located in major coastal metropolises and higher paid (given that these meatless protein alternatives are relatively more expensive than their meaty competition), making it easier for a company like Kroger to command higher margins. Over time, the customer base of these products is likely to grow in both latitude and longitude as has been the case in the recent past (especially if economies of scale drive average prices per pound down). It will be interesting to see what kind of market share meatless meat-like products end up taking in a decade’s time. We will be providing plenty of updates on this space going forward, and member’s interesting in reading more about this trend should check out this article here.
Our fair value estimate for Kroger stands at $28 per share, a bit above where shares of Korger are trading at as of this writing, but we caution its large net debt burden is worrisome. At the end of its second quarter FY2019, Kroger was sitting on $0.7 billion in cash and cash equivalents combined versus $1.4 billion in short-term debt and a whopping $12.1 billion in long-term debt. A lot of Kroger’s free cash flows go towards share buybacks. If the US economy should slow down considerably or dip into a recession, lower consumer spending levels could put Kroger in a bind given its high fixed costs. We would prefer Kroger pursue serious debt reduction efforts, which the company has recently to some degree (emphasis added):
“Kroger’s financial strategy is to use its free cash flow to drive growth while also maintaining its current investment grade debt rating and returning capital to shareholders. The company actively balances the use of its cash flow to achieve these goals. Consistent with its financial strategy, Kroger reduced net total debt by $1.3 billion over the last four quarters. Kroger’s net total debt to adjusted EBITDA ratio is 2.46, compared to 2.59 a year ago. The company’s net total debt to adjusted EBITDA ratio target range is 2.30 to 2.50.”
That being said, management is targeting an aggressive capital structure in an industry that desperately needs flexibility. We see Kroger’s dividend coverage as very poor and overly reliant on access to capital markets. Kroger’s Dividend Cushion ratio stands at -1.4x (negative 1.4). Below is a concise summary of our thoughts on the food retailing space:
“Firms in the mature food retailers industry generally have slim profit margins and face significant competition from brick-and-mortar locations (discount, department, drug, dollar, warehouse clubs and supermarkets) as well as Internet-based retailers (including Amazon Inc (AMZN)). Though the industry is not terribly cyclical, economic conditions, disposable income, credit availability, fuel prices, and unemployment levels drive ticket size and traffic trends. Offering consumers a compelling value proposition is a must, even as higher-priced organic food offerings proliferate. We’re generally neutral on the group.”
Concluding Thoughts
Kroger’s same-store sales growth was a welcome sight as it relates to the current strength of the US consumer, but we are staying away from the retailer for a reason. Its large net debt load puts the company’s payout at risk during adverse economic conditions, and we think management should be battering down the hatches considering how late we are in the business cycle. Management ending Kroger’s incremental operating profit forecast is a troubling sign.
Food Retailing Industry – CASY COST CVS KR SYY TGT WBA WMT
Dollar Store and Department Store Industries – KSS M JWN BIG DG DLTR FRED PSMT
Retail – Apparel (Teen-30yrs, Off-Price, Outdoor) – AEO ANF BKE COLM GES GPS ROST TJX URBN
Retail – Apparel (Women’s, Men’s, Children’s) – CHS CRI GIL HBI LB PLCE
Related – BYND AMZN
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Callum Turcan does not own shares in any of the securities mentioned above. Dollar General Corporation (DG) is included in Valuentum’s simulated Best Ideas Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.