KR: A Bargain Dividend Growth Stock Or Value Trap?
Brian Bollinger | Aug 23, 2016 09:43AM ET
Kroger (NYSE: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.
Business Overview
Kroger was founded in 1883 and is the second largest food retailer after Wal-Mart (NYSE:WMT) 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.
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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:
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.
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 (NASDAQ:AMZN)).
Source: Simply Safe Dividends
I view Kroger as arguably one of the best-managed grocers in the industry thanks to its scale, vertical integration, strong customer satisfaction ratings, focus on technology, long operating history, and somewhat differentiated in-store experience.
However, it’s hard for me to get fully comfortable with management’s long-term guidance calling for 8-11% annual earnings per share growth.
Kroger’s existing market positions are very strong, but profitably expanding into new areas is very difficult.
Without acquisitions, Kroger’s store count has essentially remained stagnant for more than a decade:
Source: Kroger Annual Reports, Simply Safe Dividends
This wasn’t always the case for Kroger. At the end of 1993, Kroger had 2,200 locations. It’s footprint expanded by more than 60% over the next decade to hit 3,600 locations in 2004.
Since then, organic store count has essentially treaded water near 3,600 locations. The increases seen in 2013 and 2015 were the result of two acquisitions.
In other words, future earnings growth will need to come from same-store sales growth (i.e. favorable food inflation and fuel margins), continued share repurchases, and the expansion of newly-acquired store concepts such as Mariano’s.
If I would ever consider investing in a retailer that operates in extremely competitive markets, I would prefer if the company had a differentiated enough concept to profitably continue growing its store count.
Tesco (LON:TSCO), a large grocery retailer based in Britain, highlighted just how difficult it can be to profitability expand operations.
The company attempted a multibillion-dollar expansion into the U.S. that resulted in a bankruptcy filing in 2013.
Even worse, Tesco began looking market share to competitors Aldi and Lidl in its home market, sparking a major pricing war.
Tesco ultimately slashed its dividend by 75% despite having increased its dividend for more than 25 consecutive years
While demand for grocery products is usually stable, pricing pressure can be extreme enough to crimp profitability.
Aldi and Lidl are both targeting major expansion plans in the U.S., and it remains to be seen how this could impact retailers such as Kroger, Wal-Mart, and Target.
Kroger’s key performance indicators all remain healthy for the time being, but it is worth monitoring how the company responds to an increasingly competitive retail environment and the secular changes that are impacting how consumers shop (e.g. e-commerce).
Dividend Analysis: Kroger
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Kroger’s Dividend Safety Score of 81 suggests that the company’s dividend is very safe. The company’s strong dividend safety is driven by its low payout ratio, non-discretionary products, consistent free cash flow generation, and commitment to its dividend.
Over the last four quarters, Kroger’s dividend payments have consumed just 20% of its earnings and 25% of its free cash flow, providing a healthy margin of safety and plenty of room for continued dividend growth.
As seen below, Kroger’s free cash flow payout ratio has been pretty consistent since its dividend was reinstated nearly 10 years ago, generally remaining near 25%.
Steady payout ratios can be a sign of a more predictable business and usually indicate that a company’s dividend growth (if any) has been fueled by underlying growth in earnings and free cash flow.
Source: Simply Safe Dividends
Another factor impacting dividend safety is how well a company performed during the last recession. Generally speaking, cyclical businesses carry greater dividend risk because their cash flow generation can suddenly change for the worse.
Not surprisingly, Kroger’s business holds up very well during periods of economic weakness. Consumers must continue to eat, and it’s more affordable to cook at home rather than dine out when budgets are thin.
We can see that Kroger’s sales grew each year during the last recession. The company’s stock was also flat in 2008, outperforming the S&P 500 by nearly 40%.
Source: Simply Safe Dividends
While grocery stores aren’t the most exciting business out there, Kroger’s scale and dominant market positions has helped it generate reliable free cash flow each year for more than a decade.
Without free cash flow, companies cannot sustainably pay dividends unless they issue debt or equity. Kroger’s dividend is nicely protected by the company’s consistent cash generation.
Source: Simply Safe Dividends
A company’s return on invested capital is one of the most important financial ratios for investing because it provides clues about a company’s moat and ability to quickly compound earnings.
Businesses that earn high and steady returns are deploying their assets effectively to create economic value. They often have a stronger ability to pay steady, growing dividends as well.
Opening and maintaining grocery stores is very capital intensive. Kroger estimates that it costs close to $20 million to open a single supermarket location.
Despite the high level of investment required, Kroger has managed to earn a double-digit return on invested capital most years – about in line with Wal-Mart’s and Target’s efficiency.
This is a respectable return and highlights Kroger’s strong market share, vertical integration (private label goods), and capital allocation skill (part of management’s compensation is tied to the company improving return on invested capital over time).
Source: Simply Safe Dividends
Despite their stability, recession-resistant products, and typical free cash flow generation, grocery stores can still be dangerous because their capital-intensive operations are financed with loads of debt.
Kroger has approximately $12.4 billion in total book debt compared to $1.3 billion in cash on hand.
The company maintains a BBB credit rating with S&P, which is only one notch above the lowest investment-grade credit rating possible.
While the probability is low, a price war coupled with low food inflation, shrinking fuel margins, and volatile consumer confidence could quickly erode Kroger’s sub-5% operating margin and cause moderate balance sheet trouble (depending on the timing).
Source: Simply Safe Dividends
As it stands today, Kroger’s dividend payment is extremely safe. While lower fuel margins and weak food inflation trends in 2016 are disappointing, the company continues generating excellent cash flow, maintains low payout ratios, and is still recording same-store sales growth.
Competitive intensity would really have to increase for Kroger to become stressed. After all, the company has thrived for more than 130 years and proven its ability to manage through many unfavorable environments.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Kroger’s Dividend Growth Score is 90, which indicates that the company’s dividend growth potential is very strong despite its reputation as a low-growth grocery chain.
Since reinstating its dividend in 2006, Kroger’s dividend has nearly tripled. Dividend investors have been rewarded with 15.2% annual dividend growth over the last five years, and Kroger boosted its payout by 14% in June 2016.
The company’s dividend has increased every year since 2006, making it a dividend achiever.
Source: Simply Safe Dividends
Looking ahead, Kroger’s dividend has the potential to continue growing at a double-digit clip.
Management expects the company’s earnings to grow near 10% over the long run, and Kroger’s low payout ratios provide additional growth flexibility.
Valuation
Kroger’s shares trade at a forward-looking P/E ratio of 14.7 and have a dividend yield of 1.5%, which is in line with their five-year average dividend yield.
Kroger believes it can grow diluted earnings per share by 8-11% per year over the long term.
If this assumption holds true, the stock appears to offer annual total return potential of 9.5% to 12.5% (1.5% dividend yield plus 8-11% annual earnings growth) and looks very reasonably priced.
Kroger has more than accomplished its goal over the last five years. The company recorded 18.8% annualized earnings growth and delivered a staggering 32.4% annual total shareholder return that nearly tripled the market’s 12.4% annual return.
However, I am less optimistic about Kroger’s earnings growth over the next 5-10 years.
New store expansion is very difficult in the grocery industry, and it’s no small feat to continue increasing same-store sales.
Kroger’s revenue almost doubled from 2004 through 2015 while its total locations increased by roughly 11%. I would be surprised if the company can replicate those results again for the next 10 years.
I view Kroger as more of a low- to mid-single digit earnings grower, which suggests the stock offers annual total return potential closer to 5-7%.
Conclusion
Kroger is arguably one of the highest quality and best-managed supermarkets in the world. The headwinds impacting the company (and its stock) appear to be transitory issues that shouldn’t impact Kroger’s long-term earnings power.
However, I just can’t get myself to invest in a grocery chain. While Kroger has rewarded shareholders with tremendous returns over the last decade, I worry that growth could be more challenging to come by over the next 10 years due to increased competition, stagnant new store growth, and evolving consumer shopping preferences.
I view Kroger as more of a mature, defensive cash cow, but its current dividend yield of 1.5% does not reflect that status (nor is it enough for retirement living).
For now, I prefer to keep my capital invested in other quality dividend stocks that have greater pricing power, healthier balance sheets, stronger moats, and numerous opportunities for long-term earnings growth.
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