The Kroger Co. Stock: More A Hold Or Add Than Initial Buy (NYSE: KR)

On Friday, February 11, 2022, The Kroger Co. (NYSE:KR), a consumer staple in our family portfolio, outperformed a sinking S&P 500 index by 434 basis points or 4.34 percentage points.

KR was initially added to the portfolio right before the Coronavirus pandemic in February of 2020 as a core defensive holding and has thus far delivered a dividend-adjusted return of over 60% while outperforming the market benchmark by around 30 basis points during the same holding period.

Now, two years later, I was compelled to again put the stock through my market-beating research checklist of value proposition, shareholder yields, returns on management, valuation multiples, and downside risk.

In this updated report, I share how KR has transitioned from a pre-pandemic buy to a current hold or low-cost basis position add.

Unless noted, all data presented is sourced from Seeking Alpha and YCharts as of the market close on February 11, 2022; and intended for illustration only.

A complimentary Glossary of Investing Terms is provided in a linked Google Sheet for article brevity and quick reference. The glossary is exclusive to Seeking Alpha readers. It is recommended to open the sheet in a separate window or tab. For convenience, a link back to SA is provided.

Kroger Originated The Supermarket Model

KR is a dividend-paying mid-cap stock in the consumer staples sector’s food and staples retailing industry.

The Kroger Co. operates as a retailer in the United States. The company operates combination food and drug stores, multi-department stores, marketplace stores, and price impact warehouses. Its combination food and drug stores offer natural food and organic sections, pharmacies, general merchandise, pet centers, fresh seafood, and organic produce; and multi-department stores provide apparel, home fashion and furnishings, outdoor living, electronics, automotive products, and toys. The company’s marketplace stores offer full-service grocery, pharmacy, health and beauty care departments, and perishable goods, as well as general merchandise, including apparel, home goods, and toys; and price impact warehouse stores provide grocery, and health and beauty care items, as well as meat, dairy, baked goods, and fresh produce items. It also manufactures and processes food products for sale in its supermarkets; and sells fuel through 1,596 fuel centers. As of January 30, 2021, the company operated 2,742 retail food stores under various banner names in 35 states and the District of Columbia as well as an online retail store. The Kroger Co. was founded in 1883 and is based in Cincinnati, Ohio.

(Source: Seeking Alpha)

Ultimately, investing in individual common stocks should aim to beat the benchmark index over time. For example, the chart below demonstrates how KR has outperformed its broader sector, represented by the Consumer Staples Select Sector SPDR Fund ETF (NYSE:XLP) and the overall market per the SPDR S&P 500 ETF Trust (NYSE:SPY) during the last ten years.

My value proposition elevator pitch for KR: Originator of the supermarket model leveraged its experience and scale to outperform direct competitors, the non-cyclical consumer sector, and the broader stock market.

Free Cash Flow Yields Over Twice The 10-Year

As part of my due diligence, I average the total shareholder yields on earnings, free cash flow, and dividends to measure how the stock compares to the prevailing yield on the 10-Year Treasury benchmark note.

Earnings Yield

I target an earnings yield greater than 6 percent or the equivalent of a P/E multiple below 17 times.

With trailing one-year earnings per share of $1.33, the earnings yield for KR was 2.88%.

Free Cash Flow Yield

I target a free cash flow yield or FCFY of 7 percent and higher or the equivalent of fewer than 15 times the inverted price-to-free cash flow multiple.

Based on $3.82 free cash flow per share, the FCFY for KR was 8.25%.

Dividend Yield

Although not a dividend investor by definition, I prefer dividend-paying stocks for compensation in the short term while waiting for capital gains to compound over time.

The trailing yield for KR was 1.69%, supported by a payout ratio of 21.79%, suggesting a safe if not modest dividend.

Average of Yields vs. the 10 Year Treasury

Next, I take the average of the three shareholder yields to measure how the stock compares to the prevailing yield on the 10 Year Treasury benchmark note. The average shareholder yield for KR was 4.27% vs. 1.92% for the 10-Year.

Arguably, equities are deemed riskier than US bonds. However, equities that reward shareholders at more than twice the government benchmark yield favors owning the stock instead of the bond.

Remember that earnings and free cash flow yields are inverses of valuation multiples, and the earnings yield suggests KR as overvalued, while the FCFY implies an undervalued stock price. I’ll further explore valuation later in this report.

My weighted shareholder yields rating for KR: Bullish.

Topline Growth Upends Low-Profit Margin

Now, let’s explore the fundamentals of The Kroger Co., uncovering the performance strength of its corporate and operating management.

Revenue Growth

I am biased toward established growth instead of executive promises and sell-side analyst projections when analyzing a business.

Kroger had a three-year CAGR revenue growth of 7.19%, in line with the consumer staples sector’s 8.98% median growth.

Net Profit Margin

I screen for profitable companies to avoid unnecessary speculation, as witnessed in the money-losing disruptive growth stocks of late.

Kroger had a trailing three-year steady pre-tax net profit margin of 0.75%, underperforming the 2.21% margin of its food retailing peers and the 5.22% median net margin level for the sector.

Return on Equity

Return on equity or ROE reveals how much profit a company generates from shareholder investment in the stock. I target an ROE of 15 percent or higher to discover shareholder-friendly management.

Kroger had an underperforming trailing three-year return on equity of 10.62% against 26.24% for the retail food industry and a 12.16% median ROE for the sector.

Return on Invested Capital

Return on invested capital or ROIC measures how well a company uses its working capital to generate returns.

I target an ROIC above 12 percent, and Kroger had a 4.56% three-year trailing return. The performance indicates that senior executives are less efficient capital allocators. However, returns market-wide appeared challenged during the pandemic.

The ROIC needs to exceed the weighted average cost of capital or WACC by a comfortable margin giving credence to management’s ability to outperform its capital costs. For example, Kroger had a trailing weighted average cost of capital of 2.93% (Source: GuruFocus).

The thin spread between ROIC and WACC, combined with the positive topline growth, low-margin profitability, and modest equity returns, indicates an average management performance in Cincinnati.

My weighted returns on management rating for KR: Neutral.

Inflation Affecting Food And Stock Prices

As highlighted in my latest book, Build Wealth With Common Stocks: Market-Beating Strategies for the Individual Investor, I rely on four valuation multiples to estimate the intrinsic value of a targeted quality enterprise’s stock price.

The book is a case study on our concentrated family portfolio of predominantly dividend-paying common stocks that have collectively outperformed the broader market since 2009 based on an equal-weighted average total return of each position vs. the S&P 500 during the same holding periods. Access to The Model Portfolio is, at present, complimentary. Visit my Seeking Alpha Author Profile for the link.

Please note that I do not attempt to predict specific future share prices or percentage targets as I view such practices as arbitrary, if unreliable.

Price to Sales

The price-to-sales ratio or P/S measures the stock price relative to revenues.

I target fewer than 2.0 times, and KR had a price-to-sales ratio of 0.26. By comparison, the trailing P/S was 0.31 for the food retailing industry, 1.45 for the consumer staples sector, and 3.02 times sales for the S&P 500. Thus, market sentiment suggests that KR is fairly valued relative to its topline.

Price to Earnings

Although often a hit or miss multiple, I target price-to-trailing earnings or P/E of fewer than 17 times or below the target stock’s industry averages.

KR had a price-to-earnings multiple of 34.78, compared with the industry trailing P/E of 28.25 and sector median P/E of 22.00, indicating that investor sentiment fairly values the stock price relative to its earnings. Further, KR, its industry, and sector are each fairly valued to the S&P 500’s recent overall P/E of 25.36 (Source of S&P 500 P/E: Barron’s)

Price to Cash Flow

I target single-digit price-to-operating cash flow multiples for the best value.

KR had a price to cash flow of 6.15, compared to the sector median of 14.35, indicating the market undervalues the stock price relative to Kroger’s current cash flows.

Enterprise Value to Operating Earnings

Enterprise value to operating earnings or EV/EBIT measures whether a stock is overbought, a bearish or neutral signal, or oversold, a bullish or neutral signal, by the market.

I target an EV/EBIT of fewer than 15 times, and KR was trading at 23.74, compared to a sector median of 17.64 times, signaling that the stock was overbought or undersold by the market.

Margin of Safety

Investing in the stock market is not rocket science. On the contrary, I have discovered that uncovering the common shares of quality companies temporarily trading at reasonable prices is basic science.

I am biased toward outstanding companies whose share prices are temporarily experiencing out-of-favor market sentiment as suggested by lower ratios of price-to-sales, price-to-earnings, price-to-operating cash flow, and enterprise value to operating earnings. Thus, I weigh the above key indicators to determine the overall market valuation of the targeted company.

The weighting of my four preferred valuation multiples suggests that the market has placed a premium on KR’s price as of this writing. Therefore, based on the fundamentals and valuation metrics uncovered in this article, risks and catalysts notwithstanding, I would call KR a fair value-priced, undersold stock of a competitive operator in the food retailing industry.

My weighted valuation rating for KR: Neutral.

A Low Volatility Defensive Stock

When assessing the downside risks of a company and its common shares, I focus on five metrics that, in my experience as an individual investor and market observer, often predict the potential risk/reward of the investment.

I assign a downside risk-weighted rating of above average, average, below average, or low, biased toward below average and low risk profiles.

Alpha-rich investors target companies with clear competitive advantages from their products or services. An investor or analyst can streamline the value proposition of an enterprise with a moat assignment of wide, narrow, or none.

For example, Morningstar assigns Kroger a narrow moat rating.

We assign Kroger a narrow moat rating based on its intangible assets and a cost advantage. The U.S. grocery industry is highly competitive, with an already-intense rivalry among traditional grocery stores, mass merchandisers, and club stores inflamed by Amazon’s 2017 acquisition of Whole Foods and broader push into the sector. Considering the price competition that permeates the industry, we believe there is an increasing premium on the cost leverage that scale affords, including in the emerging digital grocery realm. While this places most conventional grocers at a disadvantage, we contend that Kroger’s scale, vast library of customer transaction data (amassed over decades), private-label strength (accounting for over $25 billion in fiscal 2020 revenue, which we estimate was roughly 30% of unit sales), and advantaged locations set it apart from its rivals.

–Zain Akbari, CFA, Equity Analyst, April 6, 2021

Long Term Debt Coverage

A favorite of the legendary value investor Benjamin Graham, long-term debt coverage demonstrates balance sheet liquidity or a company’s capacity to pay down debt in a crisis. Generally, one-and-a-half times current assets to long-term debt is ideal.

As reported on its November 2021 financial statements, Kroger’s long-term debt coverage was 1.18, or just enough liquidity necessary to cover its longer-term leveraging needs. Moreover, in a further test of the company’s paydown capacity, its long-term debt to equity was 133.13%, below my 200% threshold. In other words, investors should become concerned only when a company’s debt is more than twice its equity–not an issue for the balance sheet at Kroger.

Short Term Debt Coverage

Current liabilities coverage or current ratio measures the short-term liquidity of the balance sheet.

I target higher than 1.00, and Kroger’s short-term debt coverage was 0.80, providing 80% of the liquid assets necessary to pay down its current liabilities such as accounts payable, short-term borrowings, and income taxes.

Keep in mind that current ratios below 1.00 are typical for consumer non-cyclicals such as KR.

Stock Price Volatility

As a long-term investor, I use a five-year beta trend line and screen for stocks with betas lower than 1.25 or no more than 125% volatility to the market.

KR’s 60-month trailing beta was 0.46, reflecting a defensive-oriented stock that offers far less price volatility than the S&P 500 on the whole.

Short Interest

The short interest percentage of the KR float was 4.52%, under my 10% threshold. Although bears view KR as a core non-cyclical holding in institutional and retail portfolios, there is the ongoing concern of fierce competition in the supermarket space that drives low prices and thus low margins.

Nonetheless, Kroger is a fundamentally adequate company and, as a consumer staple, enjoys a lower risk profile.

My weighted downside risk rating for KR: Below Average.

A Low-Cost Basis Add At Best

Catalysts that could accelerate or contradict my overall neutral investment thesis on The Kroger Co. and its stock include, but are not limited to:

• Longer than the anticipated period of food price inflation or supply chain disruptions, plus its publicized labor issues put further pressure on its lower-than-industry average net margins.
• The growth-oriented bull market makes an unexpected return, relegating defensive value stocks back to forgotten equities.
• Kroger maintains its rapid growth in digital sales, accelerated by its strategic transition to autonomous deliveries.
• The company continues successfully leveraging its vast customer data and private label strength.

Kroger has delivered as expected after adding its value-priced shares to our family portfolio two years ago as a defensive holding to an overheated market.

Then, the pandemic had a counter effect on the supermarket chain, driving a much-needed and rapidly growing delivery model while challenging operations with food price inflation, supply chain disruptions, and labor challenges.

Cash flow margins and multiples suggest an underbought stock, while earnings and enterprise value scream overbought. When factoring in fundamentals and risks, my updated report on the originator of the supermarket model concludes the stock as a current hold more so than an initial buy.

Nevertheless, with an adjusted cost basis of under $30 or >60% of the February 11, 2022 closing price, I am also open to adding to our existing KR position to leverage its defensive posture.