Kroger – Not Just Your Ordinary Grocery Store

The Kroger Co. reports quarterly earnings on Thursday, Dec. 5, 2013. (AP Photo/Michael Conroy, File)

Kroger (NYSE:KR) operates retail food and drug stores, multi-department stores, jewelry stores, and convenience stores throughout the United States. It is one of the largest retailers in the U.S. The company also manufactures and processes some of the food for sale in its supermarkets. The company operates, either directly or through its subsidiaries, approximately 2,625 supermarkets and multi-department stores, approximately 1,330 of which have fuel centers. About half the the stores are operated in company-owned facilities. The company operates its 2,640 supermarket and multi-department stores under banners, including Kroger, City Market, Dillons, Food 4 Less, Fred Meyer, Fry’s, Harris Teeter, Jay C, King Soopers, QFC, Ralphs and Smith’s.

Competitive Landscape


Kroger operates in quite a few different spaces. They currently have four different store formats. The combination store format is by far the largest accounting for 86% of their store base. These stores include a complete supermarket, pharmacy, general merchandise department, natural and organic department, and some have fuel centers.

Markets

Kroger does not have a lot of stores across the country but they do compete in many markets.Below is a screenshot of their 20 largest markets.

Kroger Markets

It is clear by looking at their major competitors that Walmart (NYSE:WMT) is a major competitor in almost every market. This wasn’t a huge surprise considering half of Walmart’s sales come from grocery. However, these two stores are fundamentally different. I was surprised that ALDI wasn’t listed as a competitor in any market.

ALDI

ALDI is known as a no frills, discount retailer, which generally offers one of every item rather than a selection of the same item to choose from. By doing business this way the company can purchase these items in massive quantities at a discount, passing on the savings to the consumer. The other advantage of not having a wide range to choose from is that its stores can be small. Typically, an ALDI store will be 16,400 square feet in size, compared to the 100,000-130,000 Kroger store. For this reason the company is able to operate with an average employees per store number of 20-24, allowing the company to run very efficiently.

ALDI has been entering new markets over the last ten years. Most recently, they moved into the U.K and have expanded quickly. ALDI has done very well and stolen market share away from Tesco (LSE:TSCO.L), U.K’s largest supermarket. After ALDI entered the market, Tesco was forced to lower prices to keep customers which has deeply cut into their margins. By 2018, it is expected that ALDI will have 2,000 stores in the U.S.

Bull Case


KR has had positive identical sales (ID sales) for forty nine straight quarters. The business is consistent and the stores are filled with repeat customers. Management is continually looking for ways to boost customer experience. Additionally, they are always looking for ways to run more efficiently.

Corporate Brands

Kroger has done incredibly well creating corporate brands that customers love. In the last few years, private label brands have been growing much faster than name brands. Most likely because they are cheaper. Kroger’s private brands account for about 25% of all sales (excluding pharmacy and fuel). Kroger manufactures about 40% of their corporate brands which boosts margins.

In 2013, Kroger launched the Simple Truth and Simple Truth Organic brands. Less than two years later, this brand became a billion dollar brand. Together, they are now the largest natural food brand in the U.S. This brand goes along with the other 14 private label brands that continue to boost growth.

The strength of these corporate brands gives Kroger a competitive advantage because they are exclusively at KR. Additionally, this part of the business will not be affected by a competitor like ALDI. However, suppliers of Kroger could be affected. If ALDI begins to steal market share, KR will reduce prices and squeeze suppliers. Because of the strength of the corporate brands, Kroger will have plenty of leverage with suppliers. If they refuse to take a cut, Kroger could drop them and advertise the Kroger corporate brand substitute. The margins are better anyway.

Cost of Dining Out

The Department of Labor released its monthly consumer price data last week. The pricing data revealed that it has never been more expensive to eat out than right now. Since Sept 2015, the price of food at home has decreased 1% and food away from home has increased 1.5%. This trend is not going to slow down with the minimum wage hikes across the country. Dining out is going to get much more expensive. I believe people are going to transition to spending more money on groceries which we be a nice tailwind for Kroger. At some point, people will realize they can have better quality meals at home and will not dine out as frequently. Today, the average American spends more eating out than they do on groceries. Historically, this has never been the case until July of last year. I believe in the next few years, we will see consumers revert back to spending money on groceries. Eating out will simply be too expensive.

Bear Case


The grocery business is extremely competitive. Here in the U.S, the market is very fragmented. We have seen KR execute many acquisitions the last few years to try to increase their competitive advantage.

Competition

There are two competitors KR has not mentioned that worry me. The first is ALDI. As mentioned, this company is incredibly efficient. They use a Costco type approach on a much smaller scale and it has worked well. ALDI moved into the U.K and really disrupted the market. I don’t believe that will happen in the U.S because our grocery market is much more fragmented. I don’t think that ALDI will have much of an impact on Kroger because they won’t have much of a price advantage. Almost 30% of KR’s sales in Q4 were corporate brands. In addition, if ALDI picks up market share, I think it will be from the more inefficient parts of the market like Whole Foods (NASDAQ:WFM) or small market grocers.

The other competitor is Amazon (NASDAQ:AMZN). They are just getting into the grocery space but they seem to disrupt every market they enter. Kroger is already trying to fight back with the acquisition of Vitacost.com. This is an online retail company that ships natural and organic products straight to customers. However, I don’t believe that anyone has the ability to compete with Amazon. Any company that attempts to will end up losing money because they will be fighting for a zero margin business. Kroger’s time might be better spent by instilling their value proposition in customers.

Minimum Wage Increase

The trend of minimum wage increases will force Kroger to raise prices to keep current margins. However, I think Kroger might be a company that benefits from the rising minimum wage. Due to the volume of products sold, they will not have to raise prices much to keep their margins. They will also benefit from people buying more groceries and eating out less. Restaurants and small businesses will be hurt much more than a business like Kroger who’s employees are represented by unions. KR employees probably had favorable wages before the increases.

Valuation and Debt

The stock trades just below 18x earnings. This is in line with its three year average. However, the stock yields only 1.15%. The stock is cheaper than the S&P 500 but 18x is still rich. KR is also quite leveraged having a debt/equity ratio of 1.8. It is very surprising that they have this much debt. The balance sheet could be in a much better position.

Valuation


 

KR Valuation

The stock has more than tripled its value in the last four years. The valuation today is quite expensive. Based on the valuation I performed, I think the stock is grossly overvalued. The levered balance sheet is also unsettling. Looking at the balance sheet, I think they are finished with the acquisitions. At the end of 2015, they acquired Roundy’s for $800 million financed by debt. This added to the sloppy balance sheet. Hopefully, they can improve it over the next few years.

Bottom Line


Kroger is a very unique business. I really love the growth and success of their corporate brands. I think this will be a key competitive advantage for them going forward. Today 25% of sales are made up of corporate brands. I wouldn’t be surprised if it is closer to 40% in a few years. This would help insulate them from ALDI and Amazon.

The cost of dining out will continue to increase over the coming years. This should give the grocery business a nice tailwind. Kroger is a great business that I would like to own, just not at this valuation. The management team faces some difficult decisions going forward. Personally, I would like them to continue to be Kroger. They should focus on running more efficiently to lower prices while keeping current margins. I think it would be a mistake to try to compete with Amazon. This will be an interesting company to watch in the next few years. I would be very interested in owning it at a reasonable valuation.

Disclosure


No Position

 

 

Chipotle – Nearly Impossible To Value

chipotle

On January 8th, I posted an article about Chipotle (NYSE:CMG). Since then, the stock is up 8.1%. The S&P 500 is up 6.5% over the same period. In this post I outlined the struggles of the company and why it could be an opportunity for investors. I explained why I think the business is terrific and discussed the valuation of the stock. If you would like to read the post, you can find it here.

Since this post, a large amount of additional information has become available:

  • On February 1st the CDC closed their investigation of the multistate E. Coli outbreak. However, they were not able to identify the cause of the outbreak.
  • On February 2nd, Chipotle released their Q4 and full 2015 year results. Additionally, they disclosed that the company was served with a subpoena broadening the scope of the previously-announced criminal investigation by the U.S. Attorney’s office for the Central District of California. This will be a company wide investigation on food safety matters dating back to January 1, 2013.
  • On March 15th, Chipotle announced February sales comps of (26.1%). This was an improvement from (36.4%) in January.

In addition to these pieces of information there have been some large trends that have emerged. Some of these trends have already impacted the company, but all of them will have an impact going forward.

Macro Trends


Minimum Wage Increases

In the last two weeks we have seen both New York and California change their minimum wage legislation to $15 per hour. Chipotle has 338 locations in California and 122 in New York. Together these account for 24% of existing stores. Current minimum wages in these states are $10 in CA and $9 in NY. In addition to these two states, we have seen numerous localities around the country raise their minimum wage to $15. It is worth noting that Chipotle usually pays their employees above minimum wage but this will now change and potentially affect the their talent pool. Chipotle will pay the same wages as fast food and many other types of businesses. To offset these cost increases, they will have to raise menu prices. In 2015, Chipotle increased prices by 10% in San Francisco after the minimum wage was hiked 14%. They will need to continue to raise prices gradually as the minimum wage rises over the coming years. It is unclear how much pricing power Chipotle has. At some point customers will not allow the company to push the minimum wage hikes on them. Customers might also not have much tolerance for pricing increases after the foodborne illness outbreaks.

In 2015, labor costs were 23% of total restaurant sales. If labor costs rise by 30% over the next five years, Chipotle will need to raise menu prices by 7% just to keep their margins constant. A 7% increase doesn’t sound like much but this will be on top of any food inflation or other costs. It is difficult to forecast how this trend will affect CMG’s margins over the next five years.

Social Media

In my post on January 8th, I mentioned I thought comp sales would be bad through Q1. However, the comps have been worse than I had anticipated. I have been amazed by how many people became aware of the outbreak. It is my belief that social media put a magnifying glass on the company during the outbreaks. This increased the population that became aware of the incidents. Chipotle’s foodborne illness issues are the first to happen since social media became widely used. I haven’t been able to find any research discussing the increased reach of bad news from social media. The good news is, even though more people were made aware of this outbreak, Chipotle could still use the increased reach of social media to help them come back. We will see if this materializes.

Millennials Eating Healthy

Healthy diets for Millennials are considered very normal today. I would attribute a lot of this to technology that has allowed for better education. For instance, it was once believed that three meals a day was optimum. But now some health experts say six meals is better. The Millennial generation grew up during the fast food era, even celebrating birthdays with Ronald McDonald. Today, Millennials understand fast food and that is why we choose the healthier alternative like Chipotle. This is not a fad, it is a massive trend that will continue with Generation Z. I eat Chipotle probably three times a week and have for several years now. Chipotle uses 68 quality ingredients across the entire menu compared to typical fast food where a single item have can as many as 100 ingredients, many of which are chemicals. Chipotle is an easy choice for Millennials and Generation Z because it is fast, healthy, consistent, and affordable.

Foodborne Illness Outbreak


E.Coli

In late October an E.Coli outbreak at Chipotle restaurants in the northwestern United States resulted in a shutdown of 43 restaurants. Then in late November, another E.Coli incident occurred. On December 18th it was confirmed that between the two incidents 53 people fell sick in the nine state outbreak.

Norovirus

The week of August 18th, 204 people were infected with norovirus at a southern california Chipotle. Then the week of December 7th, 141 boston college students fell sick with norovirus. Between these two separate outbreaks 345 people became ill.

On February 1st, the Centers for Disease Control and Prevention (CDC) closed their investigation of the multistate E.Coli outbreak. However, they were not able to identify the source of the outbreak. Privately, Chipotle blamed an Australian beef supplier for the multistate E.Coli outbreak but this was never confirmed. If this is what the company believed to be the cause, then why did they implement additional procedures for boiling onions and thoroughly washing vegetables? My guess is the company still has no idea how the outbreaks happen. In my view, the outbreak remains unresolved and it could happen again.

The media coverage around the incidents would make you think this was a large outbreak. But in reality, neither the E.Coli or norovirus were anything different than other outbreaks going on at the same time. Chipotle’s were probably smaller than some happening at the same time. According to the CDC, there are more than 250,000 cases of E.Coli annually. Additionally, there are 19 to 21 million cases of norovirus annually. The average person will have norovirus five different times throughout their life. This means that on average each day, there are 685 people that become sick with E.Coli and over 54,000 with norovirus. Between the two E.Coli outbreaks, 53 people became sick. Between the two norovirus incidents, 345 people became sick. Why didn’t the media talk about the other 3,000,000+ people that fell sick with norovirus from other places during that same timeframe? Probably because headlines like “E.Coli Outbreak at Chipotle” get good ratings. Even though I believe people have completely overreacted, if CMG has another incident, the stock will probably get crushed again. People don’t take the time to understand the big picture. They just eat somewhere else. If Chipotle were able to identify the cause of the outbreak as a certain supplier and cut ties with them, I would have a different opinion. But at this point, the outbreak is unresolved and another could happen because we really don’t know if the cause has been remediated.

Operating Margins


Chipotle has quite a bit of operating leverage which is currently working against them. When same store sales are growing, you have fixed costs spread out over more meals. Currently, same store sales are down sharply so the opposite is happening. Chipotle has increased operating margins over the last ten years from 7.53% in 2006 to 16.96% in 2015. The company has recently announced they would be implementing a new food safety program that will shave 200 basis points off of operating margins. In addition, they have the headwinds from the rising minimum wages working against them. In my valuation, I forecast a long term operating margin at 11%. This is still a phenomenal margin for a fast casual restaurant but I think the days of 16% margins have come and gone.

Valuation


CMG’s stock is incredibly difficult to value. I attempted to value the stock in my last post using a relative valuation. That is now worthless due to the amount of change in analyst estimates in the last three months. On January 8th, analysts expected Chipotle to earn about $15.50 in 2017. Today they only expect $13.44. This makes the stock quite a bit more expensive today than it was on January 8th even though it has only moved 8%. Due to the fluctuation of analyst estimates, I have decided to perform an intrinsic valuation. Please refer to the chart below.

CMG Valuation

The stock is currently trading at 39x forward earnings which is in line with the historical average. However, I think the pressure on operating margins will slow the growth rate down from what we have seen the last few years. I have factored in the pressure on operating margins in my normal valuation where I calculated a share value of about $400. This assumes an average annual growth rate of 17% over the five years. If Chipotle bounces back and grows closer to 21% a year, investors buying the stock today around $440 most likely have limited upside.

Conclusion


I continue to believe that Chipotle is a great business and want to own it. However, with the current information available, the stock is too expensive to buy right here. The company will report Q1 earnings on April 26th and they are expected to be horrible. After these earnings, we will have more information about how fast customers are returning to the stores. The stock currently has a lot of tail risk between the open criminal investigation and risk of another foodborne illness incident. If the company were to have another incident in the next year, no matter how small, the stock would get crushed. I plan on staying patient and hoping the valuation will become more reasonable over the next few months.

Disclosure


No Position 

 

 

 

 

Richie Bros. Auctioneers – Trying To Bulldoze The Competition

A line-up of crawler tractors on the Ritchie Bros. auction ramp at the world's largest heavy equipment auction of 2014 in Orlando, FL - February 17 - 22, 2014 (CNW Group/Ritchie Bros. Auctioneers)

Richie Bros. Auctioneers (NYSE:RBA) is an auctioneer of industrial equipment. The company is engaged in providing unreserved auction services to equipment buyers and sellers. Ritchie Bros. focuses on the sale of heavy machinery. The company operates through four segments: Core Auction segment, EquipmentOne segment, Mascus segment., and the Private Treaty segment. The Core Auction segment offers a network of auction locations that conduct live, unreserved auctions with both on-site and online bidding.  The EquipmentOne segment is a secure online marketplace that facilitates private equipment transactions. The Mascus segment was just acquired in Q1 2016 and is a leading used equipment listing service. Private Treaty was launched in 2015 and is a brokerage channel for highly specialized assets. Richie Bros. sells equipment through unreserved auctions at around 44 auction sites around the world. Through the Company’s unreserved auctions and online marketplaces, it sells a range of used and unused industrial assets, including equipment, trucks and other assets used in the construction, transportation, agricultural, material handling, mining, forestry, energy and marine industries.

Revenues


Richie Bros. has four primary unreserved auction revenue channels. Please refer to exhibit below:

RBA Revenue

Straight commission transactions make up most of the revenue. However, underwritten transactions are a hot topic for the company due to the adjustments in how they approach these transactions. Underwritten transactions accounted for 29% of Gross Auction Proceeds (GAP) in 2015, compared to 31% in 2014, and 28% in 2013. On the surface it is difficult to notice anything different. However, CEO Ravichandra Saligram has emphasized the company’s new controls over underwritten transactions. They will not simply use these transactions to “buy GAP”. Over the last year, RBA has taken a more calculated approach to these transactions and it is paying off. The company is getting away from doing “dumb deals.” It is leveraging its knowledge and experience to ensure underwritten transactions are beneficial to the company. Investors are seeing this methodology flow through to the financial statements with strong revenue growth and higher revenue rates. Revenue rates are calculated by dividing revenue by GAP for the period. This ratio indicates how much of GAP the company is able to convert into revenue. Historically RBA has averaged between 11%-12% but they produced above 12% three out of the four quarters in 2015. I think investors may see the company average 13%-14% in a few years.

Growth and Productivity


During 2015, the company emphasized increased productivity. In Q1 2015, they expanded their training strategy and introduced new leadership training programs for the sales management team. This contributed to an increase in sales force productivity to $12.1 million per revenue producer for 2015, compared to $11.6 million in 2014 and $11.7 million in 2013. Investors hope that they can continue the momentum into 2016. Part of this training included the roll out of the new process for evaluating underwritten transactions which has been effective in reducing losses. The company continues to focus on productivity of existing operations by cutting capex and shifting capital to incentive compensation. They want to reward revenue producers for increasing productivity.

Used Equipment Market

Richie Bros. competes for a $360 billion global equipment market. The market is highly fragmented with many small companies that compete in the online auction market. RBA has shown tremendous monthly active user (MAU) growth on its two established platforms. In 2015, the Core Auction website demonstrated 14% growth on top of a 31% comp last year. EquipmentOne came in with 11% MAU growth on top of a massive 100% comp last year. The macro influences that drive transactions include total U.S. construction spend, U.S housing starts, construction and agricultural machinery manufacturing, and transportation equipment new orders.

According to the Construction Machinery Manufacturing industry outlook report from IBIS World, industry revenue is forecast to rise at an annualized rate of 2.8% in the next five years including a 3.6% rise in 2016. Domestically, the value of residential construction is expected to grow an annualized 5.3% over the next five years. This will facilitate greater demand for construction as new construction takes place.

Growth Strategies

Richie Bros. has several growth strategies it is focused on in 2016. They plan to grow geographies by depth vs. breath. Essentially, they want to dig further into existing markets vs. enter new markets. There is tremendous growth opportunities in Alberta and in Texas going forward. Both of these markets happen to be in the oil patch but they remain incredibly strong. Texas achieved a whopping 30% increase in gross auction proceeds (GAP) in 2015. Additionally, they will focus on growing the transportation and agriculture sectors. Sector diversity will aide the company in being more consistent. Today, 85% of GAP consists of heavy machinery. Due to the lack of diversification, Richie has had ebbs and flows in its business. In 2010 there was a large reduction in new heavy machinery production which weighed on the company in the last couple years. Now that this lack of production has worked its way out of the market, RBA is seeing significant improvement in the age of equipment it sells. Refer to exhibit below:

RBA Age

RBA’s sweet spot in the age of equipment it sells is the 3-5 year range. You can see that dip in 2010 new equipment production showed up in 2013 and 2014. As RBA continues to diversify into different sectors, they will not be exposed to these ebbs and flows. Additionally, Richie is adding additional platforms that cater to different customer needs which will also reduce cyclicality.

New Platforms

The EquipmentOne platform addresses the needs of a customer that wants more control over the sales price, time, and purchaser. This segment showed strong growth with website traffic up 11% in 2015. Going forward, I would expect the EquipmentOne marketplace to be selling equipment from sectors that are experiencing soft pricing at that point in time. This platform will allow sellers to have more control over pricing. Previously, if cosignors wanted to sell equipment, they did not have this option. Their only options were to enter an unreserved auction and hope that pricing firmed up or to not sell the equipment. The Mascus and Private Treaty segments will allow sellers to have even more control over these factors. The collection of Richie Bros. platforms now allows nearly any seller to have an option in selling their equipment. These additional sellers will give GAP a nice tailwind going forward.

Financials


Richie

Recent Financial Results

Richie Bros. had a terrific 2015 despite a bland Q4. The company faced substantial foreign currency headwinds throughout the year. However, on a constant currency basis they did very well. Refer to exhibit below:

RBA 2015

The organic growth shown in the right column indicates the strong growth the company experienced in 2015. The solid growth in revenue can be attributed to the increase in the revenue rate to 12.14% in 2015 compared to 11.42% in 2014. The revenue rate in Q4 was the lowest of the 2015 at 11.93%. However, that was a seventy seven basis point improvement over Q4 2014. It is clear the company’s productivity initiatives are showing up in the financial results. Investors have to be excited about the improvement in the business operations.

Valuation


RBA Valuation

The stock is currently trading at an expensive 21x trailing earnings of $1.27. Additionally, the company generates a fair amount of free cash flow but the stock still trades at over 15x the enterprise value. In the above calculation, I obtained growth rates from RBA’s evergreen financial model. This model indicates annual growth targets for a variety of performance metrics. The evergreen model expects RBA to have EPS growth in the high single digit to low double digits. The above calculation assumes a normal growth rate of 9%. I believe this estimate is attainable for the company going forward especially considering the improvement in the revenue rate over the last year.

The calculation above suggests the stock is maybe on the expensive side. Even if the company delivers 13% earnings growth which would be on the high side of their model, I think there would be limited upside if investors buy the stock around $27 today.

Bottom Line


Richie Bros. is a terrific business. I am looking for opportunities to buy great companies at reasonable prices. However, I am not sure that RBA meets this description today. Investors have a lot of things to be excited about but I personally do not want to pay for excessive valuations. I plan on staying patient and hopefully the valuation will become more reasonable in the months to come.

Disclosure


No Position