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Kroger: A Tough Climb Ahead

- By The Science of Hitting

Kroger (KR) reported lackluster results on Thursday. For the fourth quarter, identical supermarket (ID) sales, excluding fuel, declined by 0.7%. This is the first time Kroger has reported negative quarterly comp store sales in more than 13 years.

For fiscal 2016, comps increased 1% - a meaningful decline from the ~5% increase Kroger reported in 2014 and 2015 (and below management's expectations of 2.5% - 3.5% growth).


Some of the headwinds they're facing, particularly food cost deflation, are a sign of current industry conditions. It's a temporary matter that doesn't reflect on Kroger's competitive position.

But there are other company-specific issues as well, which we can see by looking at Kroger's results relative to its largest competitor in groceries: Walmart (WMT). In the most recent quarter, Walmart's comparable store sales in the U.S. increased 1.8% - a full 250 basis points higher than Kroger's. That doesn't sound like much until you remember that Walmart's annual U.S. grocery sales are roughly $170 billion (nearly half a billion dollars every day). In 2016, Walmart's U.S. comparable store sales increased by 1.4%, outpacing Kroger's 1.0% increase (excluding fuel). After years of trailing by a few hundred basis points (the gap was nearly 400 basis points in 2015), Walmart's comp store sales came out ahead of Kroger's in calendar 2016.

Kroger isn't the only one feeling the heat. After reporting disappointing fourth-quarter results earlier this week, Target (TGT) essentially announced a reset to near-term financial expectations. They will invest in lower prices in categories that drive store traffic to boost sales. Those categories - primarily consumer packaged goods (CPG) and food and beverage - are right in Kroger's sweet spot. We've seen a similar reaction to difficulties from Whole Foods (WFM) and others. Across grocery, there's intense pressure to keep customers coming into the store.

And this is all before considering the role that Amazon (AMZN) hopes to play in this space five, 10 and 20 years down the road. Up to this point, e-commerce has done little to impact how the average consumer shops for groceries in the U.S. After a few decades and billions of dollars in invested capital, online grocery still accounts for a low single-digit share of the market. While I continue to believe grocers like Kroger are much better positioned to deal with this shift than Whole Foods, it would be foolish to assume the status quo will hold in perpetuity. If price, selection and convenience continue to improve, it's safe to assume that online grocery will take meaningful market share (time will tell whether brick-and-mortar grocers will fare better than their peers in other categories have as retail sales moved online).

This brings us to Kroger's long-term EPS growth target of 8% to 11% per year. On the fourth-quarter conference call, management reaffirmed its belief that this is a sustainable target, even though it fell well short in 2016 (EPS increased ~3%) and projects another shortfall in 2017 (EPS increase of ~5% at the midpoint, inclusive of the benefit from the 53rd week). Personally, based on the experience of Kroger's peers in recent years, there's reason to be skeptical.

Let's start with Walmart, which shocked the financial community in October 2015 when it reset financial targets. Despite solid underlying business results in the past few quarters (at least by my analysis), management projects earnings in fiscal 2018 will be $4.20 to $4.40 per share. For context, even the high end of the range is less than Walmart's reported earnings in fiscal 2012. Note that sales have increased ~10% (cumulatively) and the number of outstanding shares has fallen ~10% (cumulatively); the offsetting variable in this equation has been lower margins.

Now let's return to Target, which I briefly discussed a moment ago: guidance for 2017 calls for EPS of roughly $4.00 per share, a decline of 20% from 2016. Based on the sales guidance given (comps down low single digits), we can see that management is expecting a significant reduction in margins in 2017 (I'd argue we're also likely to see flat to lower margins in fiscal 2018). By my math, the contract in net margins will be somewhere around 60 basis points. At the midpoint of 2017 guidance, Target's earnings will be lower than they were in 2012 as well.

That brings us back to Kroger. In 2016, Kroger reported adjusted earnings of $2.12 per share. Back in 2011, Kroger reported EPS of $1.00 per share - good for a five-year CAGR of 16%.

But what's most interesting to me is how it got there. Sales over the period went from $90.4 billion to $115.3 billion - a compounded growth rate of 5% (largely driven by comps). The share count went from 1.179 billion shares to 942 million shares - an annual reduction of more than 4%. The remainder of the benefit is attributable to margin expansion. Over the past five years, Kroger's net margins have increased by one-third, from ~1.3% to ~1.8% (its margins are much lower than peers' due to a meaningful amount of fuel sales).

As we think about the years ahead, there are challenges in each of the three buckets. On sales, I've discussed the competitive issues the company is currently facing. Investors hoping for a return to midsingle-digit comp store sales growth are too optimistic.

On the second bucket, Kroger's low dividend payout ratio (roughly 20%) enables sizable share repurchases and/or M&A spend. At the same time, the leverage ratio (net debt to EBITDA) has climbed from 2.0x to 2.3x over the past five years, ahead of management's targeted range. While the math suggests it can still retire 3% to 4% of shares out each year, I wouldn't expect more.

That brings us to margins. It's difficult to look at Kroger and other retailers/grocers on an apples-to-apples basis due to a different business mix, most notably due to fuel sales at Kroger. Looking at Kroger in isolation, fuel has fallen from ~20% of sales in 2011 to a low mid-teens percentage in 2016; because fuel sales have very low margins, this mix shift has benefited reported margins (the impact is difficult to quantify due to the lack of disclosures in the 10-K). Considering where we're starting from, I wouldn't expect a similar benefit going forward.

I don't have a great way to quantify the other component either: heightened competition. The impact from competitive actions (and responses) can flow through the P&L as lower sales or lower margins (or both). As I noted earlier, we're already starting to see some of the former. Personally, I wouldn't be surprised if we see pressure on the latter measure as well.

Conclusion

Kroger has put together solid results for the past 10-plus years. With that said, 2017 will mark the second year in a row that earnings growth will be well below long-term expectations. As industry peers like Walmart and Target aggressively invest in their business - lowering prices and strengthening offerings like pure play e-commerce and grocery pickup - I don't think Kroger will be able to continue growing earnings anywhere near the mid-teens pace of the past five years. While I think it could hit the low end of long-term guidance (helped by a low payout ratio), I'm skeptical double-digit EPS growth is attainable for Kroger over the next few years.

Disclosure: Long Walmart.

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