Kroger Stock: A Good Investment (NYSE:KR)

Scott Olson

About ten months ago – in September 2021 – I published my last article about Kroger (NYSE: KR). And while the underlying business has improved over that time, the stock is trading for about the same price as before then. I’ve already raved about Kroger in my last article, and I’m raved about Kroger once again.

Quarterly results

Kroger reported impressive growth rates in the first quarter of 2022. Sales rose from $41,298 million in the same quarter last year to $44,600 million this quarter – resulting in 8.0% year-over-year growth. Like-for-like sales without fuel rose 4.1%. Operating profit also increased from $805 million in 1Q/21 to $1,505 million in 1Q/22 – resulting in 87.0% year-over-year growth. Diluted earnings per share grew another 400% from $0.18 in the same quarter last year to $0.90 this quarter. And adjusted earnings per share rose from $1.19 in the same quarter last year to $1.45 this quarter — resulting in 21.8% year-over-year growth.

Kroger Stock: Strong First Quarter Results for Fiscal 2022

Kroger Q1/22 Presentation

And while digitally engaged households grew by more than half a million, digital sales fell 6.3% during the first quarter of 2022. But management seems confident that digital sales will accelerate through the year. During the earnings call, CFO Gary Millerchip made the following comment:

Digital sales fell 6% in the first quarter, broadly in line with our expectations. We continue to add digital growth initiatives common to our Investor Day, including enhanced personalization capabilities, Boost membership, customer fulfillment centers and Kroger Delivery Now. As a result of these initiatives, we grew digitally engaged households during the quarter, and we expect digital sales to accelerate as the year progresses.

Kroger also raised guidance for fiscal 2022. Earnings per share (adjusted numbers) are now expected to be in the range of $3.85 to $3.95 while free cash flow is expected to be between $2.0 billion and $2.2 billion dollars. And like-for-like sales are now expected to grow between 2.5% and 3.5% in fiscal 2022.

Kroger: Raises fiscal 2022 guidance

Kroger Q1/22 Presentation

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Kroger is also projecting capital expenditures to be around $4 billion, and we can look at how that amount is spent to get a sense of how management is trying to grow the business. Most of the capital expenditure will be used for sales growth initiatives. These include optimizing stores and opening new stores (during the last business update in March 2022, the company announced 22 new stores) as well as focusing on offering fresh and always available products (the complete, fresh, Kroger friendly). However, the bulk of capital expenditure will be spent on digital acceleration. A third aspect Kroger is focusing on is margin expansion, which will be achieved by investing in supply chains and focusing on waste reduction. And only a small part is spent on maintaining the business.

Kroger's CapEx Plan

Introducing Kroger’s 2022 Business Update

A large part of Kroger’s strategy has focused on its own brands, which generate about $28 billion in sales already and are making Kroger the ninth-largest CPG in the United States with four $1 billion brands. These brands include over 10,000 items that can only be found in Kroger’s own stores.

Kroger's net earnings growth

Introducing Kroger’s 2022 Business Update

When combining the various growth initiatives, Kroger expects net earnings to grow between 3% and 5% in the coming years — driven by sales growth of 2% to 4% and margin expansion should contribute about 1% to to 2% at the end. line. When we look at analyst estimates for the next ten years, we get similar growth rates as Kroger’s management expects in the years ahead. Between 2022 and 2032, analysts expect a CAGR for earnings per share of 5.15%.

KR Stock: EPS Consensus Estimates

Looking for Alpha

Overall, net earnings growth rates of 5% seem realistic, but analysts seem to be underestimating (or forgetting) the important role that share buybacks have played in the past and will likely continue to play. Over the past few decades, Kroger has consistently reduced the number of shares outstanding.

KR Stock: Diluted Average Shares Outstanding
Data from YCharts

Since 2002, the number of shares outstanding has declined at a CAGR of 3.83% and in the last twelve months Kroger has again decreased the number of shares outstanding by 3.6%. For years to come, we can assume stock returns will add at least 2% to 3% to bottom line growth.

The recession

As with almost every other article published in recent months, we also need to look at Kroger’s performance during past recessions and try to answer the question of whether the stock is a good investment ahead of a potential recession. And when we look at Kroger over the past few decades, we can see that revenue has hardly ever fallen during a recession—which is a good sign. Earnings per share on the other hand were volatile and fell steeply on several different occasions. Kroger seems to lack stability and consistency in terms of earnings per share, and while earnings per share clearly fell during recessions, EPS also fell in other years.

KR Stock TTM earnings and diluted EPS
Data from YCharts

And although earnings per share lack stability, Kroger should still be described as a recession-proof business. The company operates approximately 2,750 grocery stores, and these stores primarily sell everyday essential items that must be purchased during any economic condition – during a recession as well as during economic boom periods.

Dividend

Kroger doesn’t have an extremely high dividend yield (2.25% right now), but management recently increased the dividend by 24%. The quarterly dividend increased from $0.21 last year to $0.26 now. And when we look at the last five years, the dividend grew at a CAGR of 11.84% and Kroger also increased the dividend every year since 2007 when the company started paying a dividend again.

And despite the dividend increase, the annual dividend of $1.04 is more than covered by earnings. When we compare the current dividend to trailing twelve-month earnings per share ($2.89), we get a payout ratio of 36%, and when we use the midpoint of fiscal 2022 guidance ($3.90), we get a payout ratio of of only 27%.

Calculation of intrinsic value

When looking at simple valuation metrics, Kroger appears to be trading more or less in line with past numbers. Notably, the price-to-earnings ratio of 16 is close to the 10-year average of 15.48 and would indicate that Kroger is fairly valued right now. I usually focus more on the free cash flow ratio since it’s the best metric, and right now, Kroger is trading for just 13.82 times free cash flow. This is not only a very low P/FCF ratio, but also below the average of 21.16 over the past ten years. We can certainly argue that Kroger is fairly overrated or even underrated at this point.

KR PE Ratio, Price to FCF
Data from YCharts

To support this claim, we can also use a discounted cash flow calculation to determine an intrinsic value for the stock. As a basis for our calculation, we can use the midpoint of the company’s own guidance for fiscal 2022 (which is $2.1 billion in FCF). For the years ahead, let’s be realistic (and maybe a little cautious) and assume 5% growth between now and eternity. Calculating with 733 million shares outstanding and a 10% discount rate, we get an intrinsic value of $57.30 for Kroger making the stock already undervalued.

Kroger's total shareholder return

Introducing Kroger’s 2022 Business Update

But when we look at Kroger’s own growth assumptions for the years ahead, we can be a little more optimistic. When we assume 3-5% growth in net earnings and about 3% growth in stock returns, we can also assume 6% growth between now and perpetuity. All other assumptions being identical, we get an intrinsic value of $71.62 for Kroger, and the stock can be called a bargain at this point.

Cheaper than its peers

And in recent months, Kroger has clearly outperformed Target Corporation (TGT) – when looking at the stock price), but has lagged behind other companies like Walmart (WMT) or Costco (COST). Right now, Costco is trading about 25% below its all-time high.

KR, WMT, TGT, COST price chart
Data from YCharts

But among these four retailers, Kroger seems to be rated the most attractive (perhaps it’s a head-to-head race with Target). When looking at the price-to-earnings ratio, Target is trading for a lower P/E ratio (Target is trading for 13 times earnings compared to 16 times earnings for Kroger) but Kroger looks cheap compared to Costco Wholesale Corporation as well as Walmart.

KR, WMT, TGT, Cost Price for FCF
Data from YCharts

And especially when looking at the price-to-free cash flow ratio, Kroger is the cheapest of the four companies. And of course, a comparison between Kroger and Costco for example is a little late since Costco will probably be able to grow at a higher rate. However, Kroger seems to be a bargain.

Conclusion

Although Kroger saw its earnings per share decline during past recessions, we should still view the company as recession-proof (and earnings most likely won’t fall during the next recession). And while Kroger is trading for a reasonable valuation multiple and below its intrinsic value, it looks like a good pick right now.

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