Risks Persist As Kroger Stock Continues To Rise

  • Kroger's own brand "Simple Truth" has been an enormous success since inception. This combined with customer analytics has resulted in enormous growth for the company in its health food divisions.
  • Kroger has more private label products than its competitors. This is keeping margins elevated.
  • Its gasoline stations are crucial as they drive traffic in-store. It still has scope here in this area as only 50% of its stores are selling gas.
  • Recessionary risks and online threats are the two biggest risks I see for Kroger going forward.

Kroger (NYSE:KR) has seen solid growth over the past few years and few watchers doubt that it can keep its momentum going as Kroger stock has currently rallied hard to $41+ per share levels. Excellent growth rates recently have ballooned its price to earnings ratio to just under 21, which is its highest ratio in a good few years. Price to sales (currently 0.4) and price to cash flow (currently 9.3) multiples are also well above their historic averages, meaning there is a good bit of future growth priced into this stock at this juncture. The difficulty for investors in this specific sector is that you have other retailers like Walmart (NYSE:WMT) with significantly lower valuations. Walmart has a current p/e ratio of just over 12 and a price to sales ratio of 0.4, which is the same as Kroger's, but below its historic average. Walmart expects to make just over $15 billion this year which will be a decrease of more than 7% compared to its last fiscal year. Kroger on the other hand expects to make $1.93 billion which will be a 12%+ increase in earnings on its last fiscal year. So should you go with the cheaper stock with less momentum or Kroger, which is expected to achieve identical store sales growth of around 5 to 6% going forward? Well since heavy investment in the near term is expected to delay Walmart's growth potential, I believe Kroger should be your choice for retail especially for a 2 to 4 year time frame.
KR stock chart

Kroger and Walmart PE ratio comparison chart by amigobulls.com

Kroger's overall business may not be Amazon proof but it is definitely operating in areas where it is not going to be hurt as much as its competitors. One such area is its natural food division which was one of the main reasons why the company enjoyed a 5.4% increase in the third quarter of this year. There are two elements of this division that I believe will improve growth rates even more going forward. The first is its own brand "Simple Truth" which offers different health food offerings compared to its competitors. This brand is growing at a phenomenal pace not just because of its offerings but also because of the shift to health and organic food. This trend is not going to slow down soon, as McDonalds (NYSE:MCD) found out, to its detriment over the past 3 years. The second is, advanced customer analytics the firm uses to "tie up" long term customers through the use to the retailer's loyalty card and personalized promotions. Analyzing consumer behavior and projecting demand levels is definitely putting Kroger above other retailers in this space at the moment. Investment into this area is key because there definitely is a shift underway in the US among consumers towards a more healthy lifestyle, and furthermore (besides the growth rates), Kroger makes more margin from this division, which means over time, company-wide gross margins should increase gradually.

Where Kroger is also winning against its competitors is its private label products which now make up 25% of the company's portfolio of products compared to the industry's average of 20. Furthermore, Kroger manufactures 40% of its private label products meaning margins from these items are again elevated due to the retailer being able to cut out the middle man in the supply chain process. Moreover Kroger sells gasoline at 1,360 gas stations, (just over 50% of its stores) which again keeps rivals such as Walmart and Costco (NASDAQ:COST) at bay, both of which deploy fuel as a loss leader in order to drive customers into their stores. Therefore as a result, many investors believe Kroger is shielded to a big extent against the threats of online and offline retailers. While this statement may be predominantly true, I still see risks ahead for the company.

Whereas it has been an advantage up to now that the retailer's health and organic section has not come up against tough online resistance, Kroger knows that it must grow its footprint substantially in the US to keep its growth rates going. There is plenty of room to grow, as currently the retailer only operates in 34 states. Last month, it acquired Milwaukee based supermarket chain Roundy's for $800 million. Before that, it was a $280 million acquisition for vitamin seller Vitacost. Therefore expect to see plenty of acquisitions going forward. Whole Foods Market (NASDAQ:WFM) would seem a prudent choice, and it is right in line with Kroger's vision) as the retailer looks for more real estate to expand its growing empire. However finding good stores to buy will undoubtedly bring integration risk which is why shareholders hope that Kroger will continue to expand with prudence and make sure that every acquisition adds value to the company.

Furthermore when you look at the company's performance in the great recession, its net income metric slumped sharply to $70 million in 2009 before rebounding to $1.1 billion the following year (see chart). The Fed is on the verge on raising rates in the US but we still don't know how the economy will react to money being more expensive. Moreover, the US on average has had a recession every 6 years. It is eight years now since the last one which means we are due one any year now. Why may Kroger be affected more than its bigger competitors in a recessionary environment? Well fundamentally I believe its comes down to scale and pricing power. Walmart for example does nearly 5 times the revenue Kroger does. Costco could also pare back food prices significantly due to its membership business model whereas traditional grocers need margin from their food sales to stay profitable. This would put Kroger at a cost disadvantage if things got tight.

KR net income chart

Kroger net income chart by amigobulls.com

To sum up, Kroger is a perfect example of a company that is riding the new trend in the US of the shift to healthier and organic food. This combined with its own expanding brands (which have higher profit margins) demonstrate to me that growth should continue in the near term. However with delivery times becoming shorter and shorter for fresh food combines with recessionary fears (which would adversely affect Kroger more than its competitors), risks still exist for Kroger. Personally I would be watching US retail sales numbers and economic activity. If the economy continues to strengthen keep your capital in Kroger. If not, I would be thinking of a company with a lower valuation in this sector like Walmart, as the risk to the downside would be less.

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