The Kroger Co. (NYSE:KR) is one of the best consumer staples stocks available on the market thanks to its numerous competitive advantages, recession-resistant business model and cheap valuation. In addition, Kroger has invested heavily in growth and is successfully competing against e-commerce giants such as Amazon (NASDAQ:AMZN).
Kroger recently gave its investors a double-digit dividend increase. With a 3% dividend yield, low valuation and potential for future growth, Kroger is one of the best consumer staples stocks today.
Founded in 1883, Kroger has grown into the largest pure supermarket chain in the U.S., with a presence in 35 states that consists of over 2,700 stores, 1,500 fuel centers, 2,200 pharmacies and 250 fine jewelry stores. This massive footprint enables it to turn a massive volume of inventory each year in the process of serving over 60 million households. This large scale of inventory turnover gives Kroger economies of scale through its supply chain as well as significant pricing power with suppliers.
These cost advantages are essential given how competitive the grocery industry is getting in the U.S. as retail juggernauts such as Amazon, Walmart (NYSE:WMT) and Target (NYSE:TGT) are making heavy investments into the space. We believe that, despite these emerging challenges, Kroger's massive scale, decades of customer data, private label product portfolio and well-located real estate position it to sustain its position as a leading national grocer.
Given that over the past three years its adjusted Ebitda margins have beaten smaller rivals' by an average of approximately 30 basis points, Kroger's economies of scale give it the competitive edge it needs to weather any further pricing pressure from competitors. With 45% of the U.S. grocery industry market share held by businesses without significant scale, there remains tremendous opportunity for Kroger to continue to grow by stealing business from competitors.
Embracing an omni-channel approach
The company's national scale also sets it up to thrive in the ongoing transition toward an omni-channel approach to grocery sales. Kroger will be able to use its conveniently located stores in combination with its digital initiatives to capture market share in the rapidly growing curbside pickup ("click-and-collect") and home delivery portions of the grocery industry.
Finally, its extensive portfolio of private label products, complimentary convenience businesses (fuel stations and pharmacies) and vast quantities of consumer data give it a strong defensive position against competition that might try to target its existing customers. Its private label products account for nearly a third of its revenue, making a sizable portion of its inventory turnover unique to Kroger which serves to strengthen customer loyalty.
Thus far, Kroger's private brands have provided a strong boost to results, with sales in the category up 3.3% year-over-year in the most recent quarter, well above the 1.5% overall identical sales growth. In particular, Kroger's uncommon move to offer premium-quality private label offerings (as opposed to just economy-level product offerings) has been paying off, with double-digit growth in its Simple Truth brand. Further, its private label products actually bring in several hundred basis points higher profit margin than other products, making them a strong driver of profitability.
Recession-resistant business model
A second reason to like Kroger right now is due to its defensive business model late in the current record-long economic expansion. The company primarily sells food, beverage and pharmaceutical products along with gasoline at its fuel stations. All of these items are necessities for daily life and spending on them does not vary significantly, regardless of the state of the economy.
In fact, a recession might actually boost demand for grocery products as people will be more inclined to cut back on eating out at restaurants in order to save money. This was evident during the last recession when, while most companies were facing collapsing earnings, Kroger generated relatively stable earnings per share of 95 cents in 2008, 87 cents in 2009, 87 cents in 2010 and $1.00 in 2011.
Given the ongoing trade war, numerous signs of a global slowdown and the record length of the current expansion - which appears to be requiring additional monetary easing to continue - allocating capital into the grocery business appears attractive.
Attractive valuation and dividend
The third reason to like Kroger right now is its attractive valuation. Over the past decade, Kroger's average price-earnings ratio was 13.4. However, we believe that shares should trade at a lower multiple today given that growth has stalled in recent years after averaging 8.3% annual growth in earnings per share.
This slowdown has been primarily driven by the increasing competition and pricing pressure in the grocery business and should continue for the foreseeable future. But we still believe that the current multiple represents a compelling discount to our fair-value estimate since the company's business model does possess numerous competitive advantages, is recession resistant and still has some growth levers available.
Over the next five years, we expect earnings per share to grow at a mid-single-digit level thanks to efforts to drive new efficiencies, grow its higher margin private label brands and use retained free cash flow to repurchase shares. Over the past decade, Kroger has aggressively reduced its float at an average rate of 5% per year. With the valuation multiple suppressed even further, repurchases should have even more mileage in reducing the shares outstanding.
A third component of returns is Kroger's dividend. At just 20% of earnings, the dividend is safe and has room to continue growing with earnings without consuming too many resources away from important investments in sustaining competitive advantages and repurchasing shares at opportunistic prices.
Overall, we see Kroger offering double-digit total return potential when combining its dividend, earnings-per-share growth and slight multiple expansion over the next five years. When combined with its recession-resistant business model at a time when it is more likely than not that the economy is headed for a slowdown, Kroger appears set to outperform the broader market moving forward.
With its large economies of scale, large and fairly loyal costumer base, and attractive growth engine in its private label brands, the business should have sustainable power as a wealth compounder and dividend grower for many more years to come. Increased competition and disruption in the grocery industry will continue to meaningfully impact profit margins and earnings growth, but the stock has plenty of margin of safety to still generate attractive returns from here. We view the stock as a buy as a nice defensive addition to value, retiree and dividend growth portfolios.
Disclosure: No positions in any stock mentioned.
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This article first appeared on GuruFocus.
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