For a while I’ve pretty much ignored an entire industry in the stock market. I’ve really had nothing to do with any grocery related company, except through ownership of Target Corporation (NYSE:TGT), and I didn’t buy Target because of their push into the grocery business. To be blunt, the grocery business is cutthroat, margins are terrible, and many companies just seemed to be on bad financial footing. I won’t say that I’ve changed my mind completely, but The Kroger Co. (NYSE:KR) is making me question my view.
Not just a supermarket
The thing that’s different about The Kroger Co. (NYSE:KR) is, the company isn’t just a supermarket chain. The company owns over 2,400 supermarket stores, along with 786 convenience stores, 328 fine jewelry stores, over 1,100 fuel centers, and 37 food processing plants. The company’s diversity helps insulate them from challenges that have beset lesser grocery store chains.
However, Kroger doesn’t just have to worry about regular supermarkets. The company faces competition from both Target and Wal-Mart Stores, Inc. (NYSE:WMT), as well as organic grocers like Whole Foods Market, Inc. (NASDAQ:WFM). With Target and Wal-Mart Stores, Inc. (NYSE:WMT) offering a much broader selection of products, and Whole Foods offering a broader selection of organic foods, Kroger is trying to strike a balance between the two.
The Kroger Co. (NYSE:KR) has been successfully competing, with sales up 3.7% in the current quarter, and EPS up 16%. These strong results were driven by a same-store sales increase of 3.5%. Kroger likes to point out that the company has, “37 consecutive quarters of positive same-store sales growth.”
I Wish That Was Enough
There are a few issues holding me back from buying the shares. First, the company’s gross margin puts the company at a disadvantage to their peers. In the current quarter, Kroger’s gross margin was 20.92%. By comparison, even Wal-Mart has a better gross margin at 26.56%. Target’s slightly better pricing power allowed a 27.70% gross margin, and Whole Foods margin stands at 34.96%.
This lower gross margin means The Kroger Co. (NYSE:KR) can’t afford to cut prices to compete with these companies. In addition, for customers that want an organic selection, there is no comparison between Kroger and Whole Foods. Customers who want to buy everything they need in one trip would be better off shopping at Target or Wal-Mart Stores, Inc. (NYSE:WMT).
A second issue at Kroger is something that would normally be a positive. The company has retired 8.41% of their diluted share count on a year-over-year basis. In the last year, Kroger’s adjusted free cash flow was over $1 billion, looking at just net income, plus depreciation, and then subtracting capital expenditures.
Using this adjusted free cash flow calculation; the company paid just 24.38% in dividends. This would argue that Kroger should have had plenty of money to retire shares. However, the company actually took on over $700 million in additional long-term debt to fund these repurchases. Longer-term, I would prefer the company not spend money it doesn’t have.
It’s highly unlikely that the company can continue to retire shares at this pace with debt financing. This means that investors expecting a 16% increase in EPS like in the current quarter could be disappointed in the future. The Kroger Co. (NYSE:KR)’s debt-to-equity ratio is 0.68, which is okay relative to Target at 0.89. However, on a relative basis, Wal-Mart Stores, Inc. (NYSE:WMT)’s debt-to-equity of 0.57 or the debt-free Whole Foods, are in a relatively better position.
Last but not least, Kroger’s accomplished much of their earnings increase through a substantial decline in SG&A expenses. While this is normally a good thing, I worry that the company’s SG&A percentage isn’t sustainable. In the last three months, Kroger’s SG&A expense as a percentage of sales was 15.27%. By comparison, Wal-Mart’s SG&A percentage was 18.18%, Target was at 19.19%, and Whole Foods was at 28.40%. It seems likely that Kroger’s SG&A percentage will revert to the norm, thus hurting the company’s earnings.
Here’s My Main Problem
The biggest thing standing in my way of investing in Kroger is there are better values elsewhere. Kroger’s yield of 1.83% is better than Whole Foods at 0.9%, but isn’t as high as either Target at 2.1% or Wal-Mart Stores, Inc. (NYSE:WMT) at 2.5%. Kroger’s estimated EPS growth of 8.2% also falls short of all of its peers. Whole Foods leads the way with analysts calling for 18.68% EPS growth. Target is expected to grow by 11.87%, and Wal-Mart should grow by 9.04%.
It’s true that Kroger’s forward P/E ratio is just 11.87. Compared to P/E ratios of 14 at Wal-Mart Stores, Inc. (NYSE:WMT), nearly 15 at Target, and 30 at Whole Foods, The Kroger Co. (NYSE:KR) looks cheap. However, Kroger’s lower yield and lower growth means the company’s shares should sell for a discount.
Of their peers, Target appears to be the best alternative value. The company has an expanded grocery selection in 75% of their stores. Target’s combination of yield and growth gives investors a total expected return of 13.97%, which is far better than Kroger at 10.03%. Target’s P/E ratio of 14.85 is only higher than Kroger by 25%, but the company’s total expected return is almost 40% higher.
I really want to like Kroger, but as long as the company runs up debt to repurchase shares, and Target offers a better value, it’s hard for me to find a reason to buy. Investors in Kroger should seriously consider trading up to hit the bullseye with their returns.
The article I Like The Company, But These 3 Numbers Worry Me originally appeared on Fool.com and is written by Chad Henage.
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