Valuentum Exclusive Analysis for the Discerning Investor

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Image Source: The Kroger Company – Fiscal 2019 Annual Report

By Callum Turcan

On June 18, The Kroger Company (KR) released its first quarter fiscal 2020 earnings (period ended May 23, 2020) that beat both top- and bottom-line estimates. Comparable store sales (excluding fuel) grew by 19% year-over-year as consumers flocked to its various grocery stores and supermarkets (under brands such as Fred Meyer, Fry’s Marketplace, Pick ‘n Save, and others) to stock up on consumer staples products as the coronavirus (‘COVID-19’) spread across North America. Kroger’s digital sales surged 92% year-over-year last fiscal quarter as curbside and home delivery options have become increasingly popular during the pandemic. Shares of KR yield ~2.0% and are trading in the upper bound of our fair value estimate range as of this writing.

Macro Update

Here’s what Kroger’s CFO, Gary Millerchip, had to say during the food retailer’s latest quarterly conference call (emphasis added):

“Leading into the pandemic, our sales [were] strong. Building on momentum from the second half of 2019, February identical supermarket sales without fuel were ahead of our internal expectations. During the last few days of February, we started to see a shift in customer behavior as shoppers started stockpiling and that trend accelerated into March with identical sales of approximately 30%. Sales remained elevated in April and May, both up approximately 20%, as customers continue to eat more at home.

In the first few weeks of the [fiscal] second quarter, we are starting to see some changes in demand with sales growth becoming more balanced across the store, as state restrictions have started to ease. Customers remain focused on health and safety and are still stocking up, but to a lesser degree than during the shutdowns. We are also starting to see a return to some splurge an impulse buying. Customers are still cooking more at home even with the eating restrictions and identical sales so far in the second quarter are trending in the mid-teens. We do expect sales to continue to taper as the quarter progresses.”

It appears the initial boost in consumer spending at supermarkets and grocery stores is starting to fade according to Kroger’s management team, keeping in mind the recent increase in US unemployment rates (the official rate was 13.3% in May 2020) and the negative impact that will have on consumer purchasing power. The downturn in economic activity seen late in the first quarter and during the first half of the second quarter of calendar year 2020 was partially offset by a boost in US unemployment benefits and a one-time cash payment in households (under certain income levels) due to the Coronavirus Aid, Relief, and Economic Security Act (‘CARES Act’) getting signed into law.

President Trump recently mentioned that he would support another round of direct cash payments to US households during an interview with E.W. Scripps Company (SSP) according to a transcript provided by Forbes. Details on the potential program will be announced in the coming weeks.

During Walmart’s latest quarterly conference call, the company’s CFO Brett Biggs noted that the fading impact of fiscal stimulus efforts (particularly programs targeted directly towards US households) will likely materialize soon (emphasis added):

“Store sales slowed during the first half of April due to soft Easter seasonal sale and additional social distancing measures. In mid-April, sales reaccelerated across the business as government stimulus money reached consumers with general merchandise sales particularly strong… We've had a solid start to May in the U.S., but we believe stimulus spending has been a big driver, which we don't anticipate staying at these levels throughout the quarter.”

Another round of direct cash payments to many/all US households would support consumer purchasing power in the near-term as the economy slowly begins to recover. Please note that the risk of a second wave of COVID-19 infections represents a threat to US economy activity. Beyond direct cash payments, there is a small but growing chance that a bipartisan infrastructure bill could materialize. Reportedly, the White House is contemplating a ~$1.0 trillion infrastructure bill according to Bloomberg. House Democrats have put forth a ~$1.5 trillion infrastructure bill, so there is room for a deal here though both sides of the isle in Congress remain far apart on several key issues.

Digital Strategy Update

Kroger’s GAAP revenues grew by ~12% year-over-year in the first quarter of fiscal 2020. Economies of scale played a leading role in enabling Kroger to grow its GAAP operating margin by almost 80 basis points year-over-year last fiscal quarter as its GAAP operating income rose by 47% year-over-year. During Kroger’s last quarterly conference call management noted that the firm’s “FIFO [first in first out] gross margin rate, excluding fuel, increased 44 basis points due to sales leverage related to shrink, transportation, warehousing and advertising costs” and additionally that “rent and depreciation, excluding fuel, decreased 37 basis points due to sales leverage” which offset the impact of sharply higher ‘operating, general and administrative’ expenses. Kroger recently hired an additional ~100,000 employees to meet surging demand for consumer staples products.

Going forward, Kroger expects its response to the pandemic will result in elevated operating expenses in part to meet rising demand for consumer staples products and in part to adjust to the “new normal” which includes greater sanitation efforts. Kroger is also making meaningful investments in its digital operations to better keep up pace with its many competitors including Amazon (AMZN), Walmart (WMT), and Target (TGT).

Specifically as it relates to Walmart and Target, both supermarket operators have made great strides and hefty investments in their digital operations over the past several years. In Walmart’s first quarter of fiscal 2021 (period ended April 30, 2020), its Walmart US division’s e-commerce sales were up 74% year-over-year. Pivoting to Target, the company’s digital comparable sales were up 282% in the month of April 2020 on a year-over-year basis, after being up 33% in February 2020. Rising demand for curbside and home delivery options were cited as key factors in driving up e-commerce sales from retailers across the board.

Amazon acquired Whole Foods back in 2017 to better position itself for the rise of online grocery shopping and home delivery. The online grocery business is significantly different than delivering “hard goods” (toys, furniture, kitchenware, etc.). For instance, cold-storage warehouses are needed when storing fresh and frozen foods (meats, fruits, vegetables, ice cream, yogurt, prepackages and prepared foods, etc.) and some beverages (especially milk) to prevent those products from spoiling. Furthermore, as grocery products have a short expiration date in many instances (especially for fresh foods), the company’s supply chain and distribution system need to be well run to allow for proper inventory management. Buying an existing operation helped speed that process along for Amazon, while Kroger is leaning on its existing physical presence (that it is actively expanding) to support its online grocery sales growth strategy. 

Kroger’s management had this to say regarding the retailer’s digital operations during the firm’s latest quarterly conference call (emphasis added):

“Digital sales grew 92% and contributed slightly over 3% to identical sales without fuel. New customer engagement with our pickup and delivery services spiked significantly during the quarter and we have been encouraged by early customer repeat usage. Digital sales in the second quarter remain elevated, up triple-digits in the first three weeks. We continue to invest in digital and offered a free pickup promotion to provide more value for our customers in ways that are most relevant at this time. We were also excited to announce several new enhancements to our digital customer experience, including the launch of our check-in on arrival option for pickup customers and the launch of contactless doorstep delivery.” --- CFO of Kroger

To keep the momentum going, Kroger is building additional distribution centers including a new 200,000 square foot facility in the Pacific Northwest and a new 150,000 square foot facility in the Great Lakes region. On the other side of things, Kroger launched its first pickup only store in Cincinnati, Ohio, earlier this calendar year. We appreciate the investments Kroger is making to support its e-commerce operations, and so far, the company is seeing real progress on this front.

Financial Overview

Kroger had $2.7 billion in cash-like holdings on the books as of May 23 (represented by ‘cash’ and ‘temporary cash investments’) versus $1.1 billion in short-term debt (‘current portion of long-term debt including obligations under finance leases’) and $12.4 billion in long-term debt (‘long-term debt including obligations under finance leases’). The company’s large net debt position hinders Kroger’s financial flexibility immensely.

In the fiscal first quarter, Kroger’s net operating cash flows surged while its capital expenditures dropped year-over-year which allowed for over $3.5 billion in free cash flow. That fully covered $0.1 billion in dividend payments and $0.4 billion in share repurchases. Here’s some additional commentary from management during Kroger’s latest quarterly conference call:

“We are being disciplined in how we deploy capital and all aspects of our capital plan are being evaluated to make sure that our investments position Kroger for long-term success post COVID-19. We still expect total capital expenditure of between $3.2 billion and $3.4 billion in [fiscal] 2020. Kroger’s net total debt to adjusted EBITDA ratio is 1.81, compared to 2.54 a year ago. This is below our target range of 2.3 to 2.5.” --- CFO of Kroger

We give Kroger a “VERY POOR” Dividend Safety rating and a Dividend Cushion ratio of -1.3 (negative 1.3) due to its large net debt load. Kroger did not provide an outlook for fiscal 2020 due to the uncertainties created by the ongoing pandemic. Should Kroger continue to experience elevated sales going forward, potentially due to US households spending more on consumer staples products than compared to pre-pandemic levels, that could help improve its dividend coverage strength moderately (though the company would be better served paring down its total debt load, in our view). As an aside, the company contributed an additional $0.2 billion towards “multi-employer pension plans to help stabilize future associate benefits” last fiscal quarter.

Concluding Thoughts

Kroger is benefiting from changing US household spending habits, where consumers are spending more on consumer staples products relatively speaking. However, pressures facing consumer discretionary product sales (which often carry higher margins) and the US economy as a whole need to be kept in mind going forward. Another big fiscal stimulus package getting signed into law in the US would support Kroger’s near-term outlook, though what matters most is its long-term outlook. How effective Kroger is at winning e-commerce grocery market share in the US will be key in determining the trajectory of its future free cash flows.

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Dollar Store and Department Store Industries – KSS M JWN BIG DG DLTR PSMT

Food Products (Small/Mid-Cap): CALM FLO FDP HAIN HRL JJSF LANC MKC SJM THS TSN

Food Products (Large/Mid-Cap): ADM BG CPB CAG GIS HSY K KHC MDLZ NSRGY UL UN

Food Retailing Industry – CASY COST CVS KR SYY TGT WBA WMT

Household Products Industry – CHD CLX CL ENR HELE JNJ KMB PG

Specialty Retailers Industry – AAN BBBY BBY GME HD LOW LL ODP SHW TSCO WSM

Related: AMZN, SPY, SSP, VDC, SFM

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Callum Turcan does not own shares in any of the securities mentioned above. Dollar General Corporation (DG) and Johnson & Johnson (JNJ) are both included in Valuentum’s simulated Best Ideas Newsletter portfolio. Johnson & Johnson is also included in Valuentum’s simulated Dividend Growth Newsletter portfolio. The Vanguard Consumer Staples ETF (VDC) is included in Valuentum’s simulated High Yield Dividend Newsletter portfolio. Both the simulated Best Ideas Newsletter and Dividend Growth Newsletter portfolios include a SPDR S&P 500 ETF Trust (SPY) put option holding with a $295 per share strike price that expire on August 21, 2020. Some of the other companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.