Description

Summary: Although the recent AMZN / WFM seems to be a material negative for KR, it seems that some market observers have overreacted to the news.   Kroger is still a scale leader (both nationally and in its local market) with notable competitive advantages, and it remains well-positioned to compete (and evolve as consumer preferences change) in the slow-growing U.S. grocery market.

Details:

If we put the elephant in the room -- the question of ecommerce aside for a moment (addressed below), there is no question that Kroger has a market leading position (with modest competitive advantages) in a stable, slowly growing market: consumer spending on food.

Competitive advantages

• Largest traditional grocer (cost advantage and operating leverage compared to smaller competitors)

• Critical mass in KR's key markets (#1 in 90% of their major markets, top-2 in 75% of their minor markets)

• This enables cost-efficient local marketing and favorable unit economics for distribution

• Best-in-class vertical integration

• Private label products are >25% of sales vs. high teens for the industry

• Higher private label products provide more consumer value and are also higher-margin for KR

• KR manufacturers much of its own private label (40%), providing better quality control over core fresh food and staples

• Customer-first philosophy and recent price "investments" should yield future dividends

• The "house rake" (in casino parlance) hasn't been too aggressive; KR has wisely been a low-price leader (in grocery, short-term gains from pricing increases are followed by expensive cuts to attempt to win back consumers)

• Strong brands (both store banners and private label)

• Better operating economics than peers (Albertson's, Safeway, and SuperValu)

• Inventory turns of 15% higher than competitors (14 vs. 12 for )

• Highest sales/square foot among grocery chains ($650)

• KR is piloting best-in-class analytics (among traditional grocery) and new technology

• Dunnhumby partnership has enabled gains in consumer wallet-share via personalized promotions and targeted marketing

• Harris Teeter's click & collect is robust and profitable, having been developed over 15+ years

• KR is piloting ClickList for online ordering at a minority of Kroger stores (order online, pickup at store)

• Solid management team

• Chairman & CEO McMullen gets credit for operational improvements and disciplined M&A since becoming CEO in 2014

• McMullen also owns >$50MM of stock (he has skin in the game)

• History of disciplined, value-creating M&A

• Harris Teeter ($2.5B in 2013) and Roundy's ($780M in 2015) were both strategically sensible and financially prudent purchases of upscale groceries in underpenetrated KR markets

https://www.wsj.com/articles/kroger-to-buy-roundys-for-178-million-1447250113

https://www.wsj.com/articles/SB10001424127887323368704578595310330531012

• Notable room for geographic expansion (Northeast, Florida) remains

Risks

• KR has executed well over the past few years; unclear if "low hanging fruit" for operational improvement remains

• Grocery space is inherently competitive - including other traditional supermarkets, superstores (WMT, COST) and discounters (Aldi), plus emerging e-commerce competition

• Mitigant: Superstore concepts are not new, and KR is price competitive with many superstores, including WMT.  Discounters generally provide inferior-quality product at very low pricing.

E-commerce

On to the “elephant in the room”: the e-commerce threat and the recent Amazon / Whole Foods Merger.  Entire books can (and will be) written about this topic, but here are a few brief thoughts on Amazon’s move and the implications for Kroger.

• The news on June 16 that Amazon would be buying Whole Foods understandably spooked investors in traditional supermarkets.  Amazon's track record to-date suggests that we shouldn't bet against the e-commerce giant, but it's also important to assess AMZN's likely motivations and behavior.  It's unlikely that Amazon is planning to re-invent Whole Foods; it's more likely that Amazon plans to leverage Whole Foods' sourcing and distribution to provide its home delivery AmazonFresh service with efficient scale.  Most obviously, Whole Foods should strengthen Amazon's product offerings and unit economics for home delivery, which may quicken the pace of grocery e-commerce growth.

• However, e-commerce is still a small minority of grocery spend -- and in some ways Amazon's move underscores the difficulties that they have had with AmazonFresh.  AmazonFresh, after 10 years of operation, is offered in 12 metro cities and has estimated sales <$2B, placing it well even middling grocery chains.  Even if e-commerce grocery growth accelerates, it is not clear that a large portion of the U.S. population will opt to receive their groceries this way, or that the structural costs of bagging and delivering food items (sometimes perishable, chilled, and delicate) can make home delivery price competitive with store pickups.  Unlike some retail items -- that have seen massive disruption by Amazon -- grocery items are lower-margin and more difficult to deliver.  Additionally, some industry observers seem to be overstating the pace of change.  I have personally tried AmazonFresh and found the quality to be middling and the price to be high.  For now, consumers continue to have a number of other reasons to visit Kroger stores: fuel, prepared food, fresh coffee, consumer-selected produce, fresh-baked goods, and convenient "just in time" pickup.  

• In short--Kroger's dominant local share on a market-by-market still should provide superior unit economics to Amazon, and if online ordering does become widespread, the frequent consumer purchases, high degree of price awareness, and existing customer base and brand should give Kroger a fighting chance at creating their own ordering portal.  (While consumers may not price-shop many retail items that can readily be ordered from Amazon, there may be greater consumer awareness prices for food, a primary household expenditure.)  Thus, it's not clear that (#1) online ordering will become a dominant consumer choice for grocery purchases, and (#2) that if it does, Amazon will have structurally cheaper unit economics than a national leader like Kroger.  

Summary

• In Kroger, we have a well-run market leader with structural advantages.  Kroger's results reflect these advantages: an ROIC well above its cost of capital (in the low teens, 11-12), annual market share gains for the past dozen years, and positive same store sales over almost every quarter during this period.  http://ir.kroger.com/Cache/1500100492.PDF?O=PDF&T=&Y=&D=&FID=1500100492&iid=4004136

• Despite a weak quarter, the long-term prospects for the business remain solid.  Yes, e-commerce poses risks, but Kroger's scale and strong local market positions should provide it opportunities to efficiently provide products if consumer purchasing habits change.  For now, the market reaction seems excessive.  Applying a 15x multiple to 2018E analyst estimates of $2.00 in normalized EPS suggests a fair value of $30 -- a 34% premium to today's closing price.  

Catalyst

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