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Kroger Just Gave Its Shareholders a $1.2 Billion Surprise

Jamal Carnette, CFA, The Motley Fool

Earlier this year, shares of Kroger (NYSE: KR) irrationally sold off after it released its fourth-quarter earnings report. After the company met or beat quarterly expectations, shares dropped 12% due to investor aversion to Kroger's plans to distribute the benefits of the recently enacted corporate tax cut between employees, capital investments, and shareholders to create what it refers to as a "more-sustainable business model." Later the company announced an aggressive hiring spree of up to 11,000 new employees to improve the consumer experience and roll out online ordering.

Although shareholders weren't initially enthused with Kroger's plans, it appears the store has not forgotten about them, and a recent announcement shows the company is putting its money where its mouth is with a new share buyback authorization -- $1.2 billion of its money, to be exact. Instead of the money coming from operations, however, it will come from an asset sale.

Shopping cart in a store aisle.

Image Source: Getty Images

Kroger's getting less convenient to become more focused

As announced in the fourth-quarter call, Kroger decided to exit the convenience store business by selling it to the England-based EG Group for $2.15 billion, closing the deal this month. Per Kroger, the company will receive $1.7 billion after taxes, paving the way for the $1.2 billion authorization. Note that this is in addition to the $1 billion in share buybacks the board authorized just last month. A $2.2 billion buyback is significant at almost exactly 10% of the grocery chain's current market capitalization.

The remainder of the after-tax funds, $500 million, will be used to lower its total debt, which will put the company on a stronger financial footing -- which is important in an industry known for its cutthroat margins. Bond ratings agency Moody's referred to the sale and plans as "credit positive." In addition to the cash infusion, it also affords Kroger the focus to fully commit to its grocery business. This smaller convenience store business always seemed out of place with its plans going forward, and took focus off the core business.

Kroger's valuation is becoming more compelling

Considering Kroger's recently announced buybacks, it's clear the company is relatively undervalued. As of this writing, shares currently trade hands at less than 12 times forward earnings, while the greater S&P 500 trades at 17 times forward earnings. Note this is before Kroger's stock buybacks, which, using back-of-the-envelope math, would lower its forward PE to 10.6 times if the full repurchase were conducted at today's prices. 

Admittedly, some of Kroger's valuation is reflective of the industry in which it operates; as previously stated, the grocery industry is notoriously low-margin, with the expectation that better operators can turn a profit on efficiency and volume. As such, pure-play grocers tend to have lower valuation multiples than companies in other industries. Even accounting for industry characteristics, however, Kroger appears irrationally valued. More recently, Kroger has sold off on fears that Amazon's recent purchase of Whole Foods would disrupt the entire industry.

To date, however, the Amazon/Whole Foods combination has been less disruptive to the overall industry and more disruptive to Whole Foods' operations, with both customers and suppliers raising concerns about the brand post-acquisition. While Amazon/Whole Foods will most likely succeed, the grocery market is big enough for strong, experienced-focused operators. Kroger has shown an ability to grow in a tough industry, reporting 12% growth last quarter, and shouldn't be priced for Armageddon.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Jamal Carnette, CFA owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon and Moody's. The Motley Fool has a disclosure policy.