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.
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.
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.
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 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.
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.
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.
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.
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.
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.
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.