For the first time in a long time, shares of America’s largest grocery chain, Kroger (NYSE:KR), are showing signs of meaningful strength. Specifically, Kroger stock is up nearly 20% over the past two months, marking the equity’s best two-month stretch in over a year.
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Is this rally the real deal, and the beginning of a secular rebound in Kroger stock? Or is it just a head-fake that will ultimately end in KR stock resuming its long-term downtrend?
I think the former for two big reasons.
First, the fundamentals underlying KR stock are very healthy and are only getting better. Additionally, the markets are undervaluing shares. Second, improving optics surrounding KR stock support continued robust demand for shares for the foreseeable future.
As such, I’m embracing this rally in Kroger stock. I don’t think it’s over. On the contrary, I think it’s still in the first few innings.
Changing Grocery Landscape
Before we get into the bull case for Kroger stock, we must acknowledge the challenging environment for grocers.
There are big concerns out there that grocery stores are going the way of movie rental stores as Amazon (NASDAQ:AMZN), Walmart (NYSE:WMT), and Target (NYSE:TGT) make big pushes into the space. The concerns are legitimate.
For several years, Amazon, Walmart, and Target have been aggressively pushing into the grocery market. The traditional grocery space has declined substantially in market share in the past few decades. Additionally, traditional grocery supermarkets have dropped 2.5% in market share last year.
The Fundamental Case for Kroger Stock
However, KR stock may be a distinct case. Over the past three years, Kroger has only reported one negative comparable sales growth quarter.
In other words, as Kroger’s competition has beefed up over the past few years, Kroger has also responded aggressively. The company has continued to fire off positive growth quarters. Sure, margins are taking hit because the company is having to lower prices to compete with Walmart’s and Target’s reduced prices. However, Kroger still maintains a viable ace up its sleeve.
Why? Because grocery shopping is something consumers like to do in-person at a place they trust. This is, after all, not something you are putting on your body like a shirt. It’s stuff you are putting in your body.
Therefore, consumers want to buy that stuff where they can see and touch the products prior to purchase. That’s a big advantage to the online sales channels developed by Amazon, Walmart and Target.
As such, in the big picture, Kroger will continue to grow alongside the stable growth U.S. grocery industry. That implies healthy low single digit revenue growth for the foreseeable future. Margins are starting to stabilize and should fully stabilize over the next few quarters. Buybacks will remain in play. Net-net, Kroger projects as a mid-single digit profit grower in the long run.
That puts earnings per share squarely around $3 by 2025. Based on a market average 16-times forward earnings multiple and a 10% discount rate, that equates to a 2019 price target for KR stock of about $30.
The Optics Are Also Improving
Second, the optics surrounding Kroger stock are similarly improving, and provide support for further upside over the next few months.
Long story short, we are seeing a massive shift in equity markets from momentum stocks to value stocks. As recession fears increased throughout the summer of 2019, investors piled into momentum stocks that don’t require a good economy to go higher (since they have secular tailwinds), and ditched value stocks that do require a good economy to go higher.
But over the past month or so, those recession fears have backed off. As they have, investors have booked profits on their momentum stock winners, and bought the dip in economically sensitive value stocks like KR.
Going forward, the economic outlook should continue to improve, as U.S.-China trade tensions ease and central banks globally inject sizable stimulus into the economy. As the economic outlook does improve, investors will continue to buy into economically sensitive value stocks, especially since these stocks aren’t pressured by the long end of the yield curve moving higher.
Consequently, over the next few months, investors will continue to be attracted to Kroger stock because it’s cheap in an environment where cheap should work with the economy in rebound mode.
Bottom Line on KR Stock
Kroger stock is solid value stock that’s breaking out from multi-year lows. It looks like this rebound bid has legs, meaning investors would be wise to embrace — not run away from — the recent strength in this beaten up grocery stock.
As of this writing, Luke Lango was long KR.
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