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Is Kroger a Value Play or a Falling Knife?

Kroger (NYSE: KR), the largest supermarket chain in America, was once considered a promising growth stock. Between 2006 and 2016, its annual sales surged 74% from $66.1 billion to $115.3 billion, and its EPS rose 33%, buoyed by the stability of its core business and acquisitions of smaller chains.

Kroger's stock surged more than 300% during that decade, compared to the S&P 500's 55% gain. But over the past three years, it has lost about a third of its value as it faced tougher competition from Costco (NASDAQ: COST), superstores like Walmart (NYSE: WMT) and Target (NYSE: TGT), and Amazon (NASDAQ: AMZN) -- which acquired competitor Whole Foods in 2017.

That three-year sell-off reduced Kroger's forward P/E to less than 10, and it still pays a decent forward yield of 2.4%. Do those numbers indicate that Kroger is a value play for patient investors, or is it a falling knife that could still wound the bulls?

A grocery cart in a supermarket aisle.
A grocery cart in a supermarket aisle.

Image source: Getty Images.

Understanding Kroger's predicament

Kroger's identical-store sales, excluding fuel sales, held steady over the past year, indicating that it wasn't losing too many shoppers to its rivals.

Metric

Q1 2018

Q2 2018

Q3 2018

Q4 2018

Q1 2019

Identical-store sales*

1.9%

1.6%

1.6%

1.8%

1.5%

Source: Kroger quarterly reports. *Excluding fuel.

Kroger's forecast for 2% to 2.25% adjusted identical sales growth for the full year was also encouraging. However, Kroger's gross margin is contracting due to the lower margins and softer performance of its pharmacy segment.

Kroger's gross margin of 22.2% in the first quarter initially looks like a 40-basis-point improvement from a year earlier. But on a FIFO (first-in, first-out) basis, which excludes fuel sales, its gross margin fell 40 basis points.

Kroger's operating margin also slid from 2.7% to 2.4% as it pumped more cash into its "Restock Kroger" turnaround plan. That three-year initiative, which started in late 2017, aims to optimize prices and product selections with analytics, expand its portfolio with private-label and acquired brands, and launch new e-commerce services and delivery options.

A young man checks his smartphone as he shops for groceries.
A young man checks his smartphone as he shops for groceries.

Image source: Getty Images.

Widening its digital moat

These efforts are paying off. Kroger's digital sales rose from nothing in 2014 to an annual run rate of $5 billion in 2018. That accounted for just 4% of Kroger's top line, but its digital sales are still soaring, with 42% growth in the first quarter. Kroger believes that it can eventually hit $9 billion in annual digital sales.

Kroger also noted that its digital services now cover 93% of its customers. That reach was boosted by the launch of its pickup service ClickList, its direct-to-consumer shipping platform Ship, partnerships with couriers like Instacart, and a big investment in British online grocer Ocado.

These moves all widen its moat against Amazon, Walmart, and Target -- which are all ramping up their grocery pickup and delivery efforts in a digital arms race. Between January and December 2018, the number of "click-and-collect" locations at select retailers across America surged from 2,451 to 5,800, according to CommonSense Robotics -- with Amazon, Walmart, and Kroger leading the charge.

Earnings growth looks stable

Kroger's margins will remain throttled by its Restock initiatives, but it expects its steady sales growth and consistent buybacks to boost its adjusted EPS 2% to 6% for the full year. It has also hiked its dividend for 10 straight years.

Kroger's growth is stable, and like Walmart, it can counter Amazon by turning its network of 2,761 stores into hubs for digital pickups and deliveries. But Kroger can't afford to grow complacent, since Amazon is still aggressively cutting prices at Whole Foods (especially for Prime subscribers), and Walmart and Target are launching even more aggressive digital initiatives.

The bottom line

I think Kroger's low valuation, decent dividend, and sound turnaround plans make it an attractive investment at these levels. It probably won't rebound until its margins stabilize, but I think its downside is fairly limited.

More From The Motley Fool

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends Costco Wholesale. The Motley Fool has a disclosure policy.

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