Tuesday, March 12, 2013

Kroger Sets The Standards in the Grocery Sector

The markets have been in bullish mode recently and seem determined to price in a glass half full scenario in response to most companies' results, a fact that I felt was particularly pertinent when looking at Kroger’s (NYSE: KR) results. There was nothing wrong with them, but then again I’m not sure what has changed that the company is evaluated 20% more than it was a month or so ago. In summary, the company is extremely well run, and its management has reacted very well to a difficult environment in the last few years. However, it remains a play on general macro conditions.

Kroger’s Good Christmas

I last discussed the company in an article written before Christmas and speculated that it was headed for a decent quarter. In a triumph of randomness over experience my prediction turned out to be correct. Kroger’s numbers were pretty good, and I think many of the positives will roll over to 2013. Inflation is moderating, and the economy is gradually improving with employment gains now coming through in line with a normal type of economic recovery.

Against this positive view comes pressure from the potential for disappointments in consumer spending coming from ongoing political uncertainty, tax changes and volatility in gas prices. Indeed, Kroger mentioned variability in sales patterns on a week by week basis, a sure sign that consumers remain stretched. The mass market retail sector remains categorized by volumes (or tonnage) being driven by promotions and discounts.

In the end its identical sales ex fuel came in with a 3% gain. This is okay but it is at the low end of the 3-3.5% guidance that I discussed in the article before Christmas. This is superficially disappointing, but investors need to understand it in the context of a mix of tonnage and pricing issues. Inflation moderated as the year went on, and this encouraged greater tonnage and some alleviation of gross margin pressure in Q4.

Furthermore, the dramatic increase in generic drug releases this year comes coupled with the Walgreen / Express Scripts debacle. Kroger expressed its confidence in keeping Walgreen customers, but it certainly wouldn’t be alone in this. From Wal-Mart (NYSE: WMT) to CVS, it seems that everyone is confident in retaining these customers. From a Walgreen investor's perspective I wouldn’t worry too much because the stock remains good value. Moreover, with Kroger the generics releases are arguably more important. Generics tend to be lower priced but generate higher margins for the retailer.

Kroger’s Good Year

Furthermore, Kroger’s performance last year is a story of inflation moderating as the year went on, leading to increased tonnage as a consequence. Kroger’s management described itself as being surprised by how quickly tonnage came back, but I think this is a lesson that the retail market has learned this year. The consumer has become incredibly sensitive to pricing. We can see aspects of this in the reaction to Kroger rolling out corporate brands (the Simple Truth range among them). Consumers want trading down options, and Kroger has the footfall in order to be able to offer them.

Initiatives like expanding corporate brands have helped Kroger compete better in the value segment while its initiative on healthy artificial ingredient free foods is a timely measure to capture much of the market that Whole Foods Market (NASDAQ: WFM) plays in. It’s easy to get worried about competition in this space, but I think the overall pie is getting bigger here, and there is room for all these players to grow. Indeed, as Whole Foods expands it will create a greater awareness of healthy eating and should allow Kroger to expand sales of its own product range to consumers. In other words it is not a zero sum game.

On the other hand, Kroger is competing with Wal-Mart, Safeway and other grocers for market share. The Neilsen data quota in the conference call was pretty balanced with Kroger increasing market share in 9 of the 17 categories where it competes with Wal-Mart. The impression I got was that tonnage and price competitiveness increased as the year went on thanks to an abating of inflationary measures and internal execution.

Where Next for Kroger?

Analyst estimates are for double digit EPS growth for the next couple of years, and internal guidance is for 2.5-3.5% identical sales growth excluding fuel. With a forward PE ratio of around 10, this doesn’t look like a demanding evaluation. On the other hand Kroger’s earnings are largely a function of macroeconomic considerations, and my gut feel is that this stock will move around with sentiment over the economy. In a sense this is a positive because in terms of company execution there aren't many managements that are doing a better job right now than Kroger's.