Market Dominance Positions Kroger to Compete

The grocer also benefits from strong data analytics amassed over a number of decades, enabling it to tailor its merchandising mix and promotions to more effectively align with customer preferences. We believe the combination of its cost edge and intangible assets positions Kroger well to compete with other mass merchants as well as alternative outlets, including e-commerce and hard discounters such as Aldi and Lidl.

In terms of its physical store footprint, the company expands units methodically; organic gross square footage has ticked up around 1% a year, but after closing underperforming stores, total square footage nets sub-1% growth. We believe the company will grow organically on a similar trajectory by filling in existing markets (we estimate 13% more units over the long run) and occasionally acquiring competitors to enter new markets. Kroger acquired Roundy’s in 2015 for $800 million and Harris Teeter in 2013 for $2.5 billion, both of which were prudent uses of shareholder capital, in our view.

Kroger’s customer-first mantra focuses on extracting costs to afford the ability to reduce prices, evident by declining gross margins. We don’t think the company will shift its strategy, but we expect it will also work to improve its e-commerce/digital experience. Kroger has approximately 640 click-and-collect (order online and pickup) stores with plans to double the number of locations. Further, we think testing meal kits in select markets and home delivery could win over consumers who favor the convenience of online shopping. In combination, we think these efforts should enable Kroger to benefit from the attractive growth of online grocery--at an industry level, we estimate a 20%-plus compound growth rate for grocery e-commerce from 2017 to 2021--and withstand competitive headwinds.

Cost Advantage Drives a Narrow Moat We see Kroger as having a narrow economic moat driven by a cost advantage and intangible assets, which should result in returns on invested capital of nearly 9.5% on average over the next five years, above our 7% cost of capital estimate. The company's cost advantage is driven by its ability to turn items 14 times, exceeding the 10 times average for our retail defensive coverage list and 12 times average for traditional grocers Albertsons, Safeway, and Supervalu. This enables higher volume to leverage its fixed store costs, thus reinforcing its ability to provide customers lower prices. We believe this advantage is evident in Kroger's sales per square foot, which are around $650, among the highest across our retail defensive space; only Costco COST is higher at $1,100. Additionally, when attempting to garner a cost advantage in the grocery space, regional market share becomes a more important metric than national size, in our view, particularly given that consumers make decisions in terms of where to shop based on location. Such regional market share dominance is important for three reasons: Kroger can leverage fixed costs and scale distribution centers on a local level, fend off competition by making it costly and risky for others to enter after Kroger amasses sufficient share in a region, and leverage marketing capabilities and other overhead spending. Kroger has captured the number-one share in 46 of its 51 major markets (nine stores or more) and the number-one or -two share in 52 of 69 minor markets (three to eight stores), indicating to us that on a regional basis, Kroger stands to benefit from a cost advantage.

We also view its private-label mix, which is vertically integrated in its supply chain, as a cost advantage over other retailers. With its penetration of private brands at 26% of sales versus the industry at 18%, we think Kroger is able to not only provide its customers with differentiated, lower-priced fare but also bolsters its own margin profile, as private-label fare boasts margins that are 1,000 basis points over those of branded products. We view this outsize exposure to private label as affording the company a leg up in the intensely competitive landscape, particularly as Aldi and Lidl (where private label accounts for around 75% of merchandise) expand in the U.S. Further, because Kroger manufactures 40% of its private brands--in contrast with its peers, which mostly outsource to a third party--we believe it has a higher level of quality control.

We think Kroger benefits from intangible assets derived from its brand recognition as the number-one traditional grocery player by revenue in the U.S. and its all-encompassing merchandise offerings, fuel proposition, and data analytics. Kroger has used these assets to continually deepen penetration of existing households, with increasing spending per customer; as a result, it has posted positive same-store sales virtually every quarter over the previous 13 years, a feat others in the highly competitive retail defensive space are unable to boast. Our belief is that a store’s overall value proposition is more important than convenience alone; we estimate the average U.S. household shops at a supermarket or supercenter approximately 3.8 miles from home even though the nearest store averages 2.1 miles from home.

Kroger’s value proposition is bolstered by its partnership (and the acquisition of certain assets from which it claims an exclusive benefit) with DunnhumbyUSA, now called 84.51 Degrees, which leverages decades of customer analytics to understand consumer behaviors, needs, and patterns. By doing so, Kroger can better personalize offerings and yield higher returns on its promotional dollars toward its most loyal customers. This has also enabled Kroger to win new households and garner higher spending per household, according to the company, working to expand its market share dominance. Its value proposition is deepened by fuel offerings at approximately 50% of stores, which increases the appeal of shopping at a Kroger outlet and better insulates it from e-commerce threats. Customers spending at a Kroger-owned banner earn discounts on fuel, and the combination mutually reinforces the company’s value proposition.

Even as we see Kroger benefiting from a narrow moat with above-average sales per square foot and inventory turns, we are held back from bestowing a wide moat rating because of the competitive nature of the grocery space, a challenge that we view as unlikely to dissipate over the near to medium term. While we think the combination of a solid brand intangible asset and cost edge should enable Kroger to defend against pending threats, these competitive headwinds (which include the likes of Wal-Mart WMT, Costco, Amazon AMZN, and the emergence of hard discounters such as Aldi and Lidl) temper our confidence that Kroger will be able to generate excess returns on invested capital for the next 20 years.

Competition Could Constrain Profitability Competitive pressures are intensifying in the grocery space. We see competition on a few fronts: traditional mass merchants (including Wal-Mart, Target TGT, and now Amazon/Whole Foods WFM) lowering prices to prompt traffic; dollar stores expanding their fresh/frozen food offerings as well as units, with long-term goals of doubling their footprint; and hard discounters Aldi and Lidl expanding in the U.S. It's hard to pinpoint the single catalyst for such competition, but as these players work to drive traffic in their outlets, profitability may be constrained further--a notable challenge for an industry where margins are already quite thin. As evidence of these competitive headwinds, Kroger's gross margins have contracted every year since 2005 (after adjusting for the acquisition of the higher-margin Harris Teeter business), and we forecast profit degradation is likely to persist.

Despite the potential to prompt traffic to its stores, the company’s fuel stations subject Kroger to volatility in fuel costs. Additionally, with its private-label penetration at roughly 26%, input cost volatility could challenge profitability in any given period if Kroger cannot raise prices to offset inflationary headwinds without hurting traffic. Our valuation assumes that U.S. corporate tax reform reduces Kroger’s effective tax rate by about 700 basis points in fiscal 2018, but the ultimate policy changes could affect our valuation if they are different than our estimates.

We think Kroger’s financial health is solid and don’t foresee any issues arising with its liquidity. The company returns a plethora of cash to shareholders after it invests in the business. We believe Kroger’s top priority for its excess cash is to continue paying its dividend, but we expect the company will also opt to repurchase shares from time to time. With its current payout ratio of around 20%, we see room to increase the dividend 10% a year on average and repurchase around 2% of shares annually. We think the company could continue to make acquisitions to enter new markets, but the timing and magnitude are difficult to model. As such, we have not included any potential tie-ups in our outlook. However, given the prudence Kroger has exhibited in its past pursuits, we don’t think any deals would unduly weigh on the company’s financial position.

Stewardship Is Exemplary Management has consistently driven positive comparable same-store sales, gained market share, and created value for shareholders. W. Rodney McMullen took over as CEO in January 2014 and was elected as chairman in January 2015. With 37 years at Kroger, his tenure and experience bode strongly for the company and its shareholders, in our view. However, we would prefer if the chairman and CEO roles were held by different individuals to increase independence. The board consists of 12 members, 11 of which are independent.

Return on capital has consistently exceed our 7% cost of capital estimate in an otherwise difficult industry, which shows wise capital allocation. The company allocates capital to the business first (capital expenditures) and pays shareholders second, which we believe is a prudent strategy. Management has repurchased $11.8 billion in stock at an average cost of $12.51 since 2000, has paid an annual dividend since 2006 (22% payout ratio, which we expect to continue increasing), and has made strategic acquisitions, most recently Roundy’s for $800 million including debt. Kroger’s compensation structure generally aligns management’s interests with those of shareholders, in our view. Management’s compensation is roughly 90% at risk, in line with peers, and tied to performance-based metrics like associate engagement, operating costs, and ROIC, which strikes us as fair.