Scale Helps Kroger Fight Competition

Of the traditional grocers, we believe Kroger KR is uniquely positioned to defend its returns against a competitive onslaught that should intensify as Amazon AMZN, hard discounters, and mass merchandisers price aggressively to boost volume. Though industry factors are diminishing its competitive standing, we think Kroger still benefits from enduring intangible assets and cost advantages.

Grocers use price as a primary lever to drive traffic, which we believe necessitates efficiency and cost leverage (spurred by high traffic) to deliver returns. We expect this environment to endure as the industry changes, with an omnichannel experience likely to prevail as customers use a combination of deliver-to-home, click-and-collect, and in-store shopping, particularly since most American consumers drive past grocers on their commutes and home delivery can be inconvenient for buyers with uncertain schedules. In physical retail, we anticipate that shoppers will use a variety of sellers to meet their needs based on convenience, price, and breadth of assortment, demanding high value as well as a compelling store environment.

We believe Kroger should be able to capitalize on the changing landscape. We maintain that Kroger's local market scale allows it to derive cost leverage that fuels competitive pricing as well as the investments needed to build on its already-considerable presence in each of the emerging channels. In our view, its progress should be accelerated by partnerships (with Ocado, Walgreens, Microsoft, and others) that we do not believe are available to smaller rivals, which cannot deliver the same value to counterparts.

Kroger's data-related efforts should play a large role in its embrace of the new grocery landscape, fueling promotional efforts and customer engagement while informing assortment and providing saleable insights that can create alternative revenue streams. We expect data to play a key role in retailers' efforts to drive traffic, efficiency, and conversion and anticipate that Kroger's long, intimate relationship with its numerous customers (96% of sales are tied to a loyalty card) has created a monetizable asset that few rivals can match.

Scale Brings Cost Advantage We assign Kroger a narrow economic moat rating based on its intangible assets and a cost advantage. We assume that its returns on invested capital exceed our estimate of its weighted average cost of capital by roughly 160 basis points over the next decade, at 8%.

The U.S. grocery industry is highly competitive, with an already-intense rivalry among traditional grocery stores, mass merchandisers, and club stores inflamed by Amazon's acquisition of Whole Foods and broader push into the sector. Considering the price competition in the industry, we believe there is an increasing premium on the cost leverage that scale affords, including in the emerging digital grocery realm. While this places most conventional grocers at a disadvantage, we contend that Kroger's scale, vast library of customer transaction data (amassed over decades), private-label strength (accounting for over $20 billion in revenue, or roughly 30% of unit sales), and advantaged locations set it apart from its rivals.

As the largest pure grocer in the United States (trailing only Walmart WMT in overall grocery sales and at approximately double the revenue of number-two Albertsons), Kroger is uniquely positioned to capitalize on its size with vendors while also leveraging costs. The scale advantages emerge at a local and national level.

Locally, Kroger held the number-one or -two share in 46 of the 52 major markets it operated in as of the end of fiscal 2017. We believe this scale is vital, as it allows a grocer to leverage distribution and advertising costs in a way that smaller competitors cannot. Kroger can use its transaction volume in a local area to keep trucks full and distribution centers operating at nearly full capacity. Subscale participants, including online sellers, are forced to incur similar costs, particularly since many products are perishable, without the turnover needed to maximize operating profits. Kroger turned inventory at 14 times in fiscal 2018, well ahead of Albertsons' roughly 10 times, which we believe is an indication of the economic benefits of scale even between the top two market participants. Furthermore, Kroger's leading local market position allows it to derive a better return on local advertising expenditures, with traditional media costs in the market spread over a larger sales base (generating an average of around $165 in sales for every advertising dollar it spent over the last three years, versus less than $130 for Albertsons).

Nationally, we believe the company's scale allows it to capitalize on the digitization of grocery. We believe an omnichannel approach is most likely to prevail in the sector, with customers using a combination of delivery to home, click-and-collect, and in-store sales. However, we believe the click-and-collect approach will be especially prevalent in the U.S., as it is often more convenient for a customer who is already driving to or from work or other engagements to stop at a nearby grocer than schedule around the arrival of a delivery of (often perishable) items. This should reward companies that can combine local market scale with cost leverage over national omnichannel investments (such as digital ordering platforms, distribution network optimization, and the development of intimate relationships with vendors to ensure products are packaged in a way that is conducive to a variety of fulfillment options and presented in such a way that they carry appeal in person and in a picture online), as well as labor-saving initiatives, including automation and mobile-based checkout. Kroger's scope should allow it to manage the transition of trade spending; for example, the company is already offering boosted search placements to food manufacturers, allowing them to pay to have their products listed at the top of search results in a high-impression, high-conversion venue.

Kroger's top line is roughly double that of Albertsons, and we believe that has led its adjusted EBITDA margins to exceed its smaller rival's by about 30 basis points over the past three years, on average. We suspect the profitability differential is more pronounced against smaller rivals; the U.S. grocery industry is highly fragmented, with the top four grocers only holding about 40% market share and Kroger's management indicating that around 45% of the market is held by sellers without discernable economies of scale. We believe unscaled retailers will serve as share donors as digital and deep discount rivals grow. We think Kroger's ability to leverage distribution costs, investments in omnichannel offerings, and supply chain capabilities should allow it to continue to outperform its pure-play rivals. We also think Kroger's in-house production of many of its private-label offerings bolsters its cost standing in addition to improving the quality of its assortment, with smaller rivals unable to justify the investment needed to follow the same path.

Kroger's scale fuels valuable intangible assets that we believe will be difficult for rivals to replicate. The company has met the challenge of digital grocery with partnerships with a variety of companies, tie-ups that we believe are enabled by Kroger's significant size, established market position, and grocery industry leadership as it is uniquely positioned to deliver meaningful value to its counterparts. Kroger is testing a roughly 2,300-item own-branded product lineup at certain Walgreens locations, including its recently acquired Home Chef meal kits; working with Instacart on home delivery as a bridge to further developing its own capabilities; and using autonomous vehicle startup Nuro to send grocery orders to customers using a test fleet of driverless cars in Scottsdale, Arizona, and Houston. Additionally, the company announced a partnership with Microsoft in early 2019 that will see the two giants develop digital-rich stores and an as-a-service software suite that will be marketed to other retailers. We think these initiatives will ease Kroger's ongoing evolution, combining the company's formidable scale with emerging approaches in a way that few rivals can match.

Perhaps most intriguing, Kroger established an exclusive relationship with European online grocery leader Ocado in 2018, taking a mid-single-digit percentage stake in the company. According to its filings, Kroger's investment in Ocado had a market value of $620 million as of the end of fiscal 2018. We believe the deal should significantly accelerate Kroger's development of its deliver-to-home and click-and-collect offerings, with Ocado's flexible, low-cost warehouse-based model extending Kroger's reach beyond its existing markets in a cost-efficient, tested manner. Ocado's highly automated warehouse approach should allow Kroger to compete effectively with Amazon, creating the flexibility to serve orders from dedicated centers that would not incur the same order picking costs that constrain profitability when fulfilling from a traditional store. Furthermore, the deal's exclusivity takes Ocado off the table as a potential partner for smaller retailers looking to quickly expand their delivery presence, while also foreclosing future direct competition with the digital seller.

On the private-label front, we believe Kroger's strong suite of offerings is additive to the company's intangible assets, bolstering its brand in consumers' eyes. Unlike rivals, Kroger manufactures around 43% of its own-brand grocery offerings, allowing it to elevate quality while containing production costs. Its efforts have allowed Kroger to position its labels (particularly Simple Truth and Private Selection, which cater to customers seeking clean-label and premium options) as a branded-equivalent alternative, often with flavors and characteristics that are not available elsewhere. Kroger's labels are the largest brands sold at its stores, accounting for roughly 30% of unit sales excluding fuel and pharmacy (ahead of a U.S. penetration rate of around 15%-20%). We believe the quality and value of Kroger's own labels spur customer affinity for the stores while differentiating the assortment from rivals, bolstering the company's standing with shoppers (and traffic) even as the company sells meaningfully more lucrative products. The company's move to introduce an assortment of own-brand products at Walgreens should extend the value of the brands further. We also have a favorable view of the company's efforts to capitalize on its $2 billion Simple Truth brand's strength and foreign label in China, where it is introducing a select lineup of products on Alibaba's Tmall site.

Kroger's grocery stores are often paired with fuel stations and a pharmacy, both of which we believe add recurring customer traffic and further embed the company's stores into shoppers' daily routines. Over 80% of Kroger's locations boast pharmacies and roughly half have fuel centers, initiatives that are difficult for rivals to implement from scratch.

Collection of Customer Data Is Best in Industry We believe Kroger's vast trove of customer data is a powerful intangible asset that should unlock opportunities for targeted advertising and promotions, in-store advertising, assortment optimization, and analytics sales to vendors. Around 96% of its transactions are tied to a loyalty card, leaving Kroger with 60 million households' worth of behavioral information and data that extends back years. We believe the robustness of this data set is the richest in the industry, giving Kroger lifecycle insight into shoppers' buying behaviors.

Kroger monetizes this information in a number of ways, with plans to significantly expand its use of data analytics and sell related insights underway (spearheaded by its in-house analytics company, 84.51). The company is able to use purchase history to target promotions and discounts, boosting customer engagement and traffic while increasing the return on its marketing investments and refining its local market assortment. The rewards program offers Kroger ways to encourage traffic through fuel and recurring pharmacy sales by offering points and discounts based on purchases made.

We believe that Kroger can use its low-margin grocery business to fuel high-margin data, media, and personal finance (including credit card) revenue, somewhat analogous to wide-moat Costco's COST use of nearly break-even merchandise sales to drive the membership fees that constitute the majority of its operating income.

While several non-U.S. grocers that we cover carry no-moat ratings, we believe Kroger’s capabilities and the nature of the U.S. market have allowed the company to maintain a competitive edge. The U.S. grocery sector is fragmented, leading us to believe that subscale retailers--which have neither the cost leverage nor the ability to invest in the omnichannel experience and private label to the same extent as Kroger--are the likely market share donors for new and growing entrants (Amazon and the hard discounters). Combined with its data insights into the key U.S. market and the likelihood that click-and-collect and in-store shopping will remain relevant in the country (considering the prevalence of driving commutes), we contend that Kroger’s unique combination of a strong store network, procurement leverage, and the resources needed to keep pace with changing industry demands will keep the company better positioned than most of the pure grocers we cover. We believe these factors contribute to an efficiency that underlies Kroger's $667 in fiscal 2018 sales per square foot, which easily outperformed Albertsons' roughly $530 and is ahead of all but Costco in our defensive retail coverage.

Competitive and Quickly Changing Landscape a Risk A fast-changing grocery environment amid intense competition from physical and digital sellers in a sector with limited switching costs constitutes the primary threat to our outlook.

Amazon's acquisition of Whole Foods in 2017 significantly altered the competitive landscape for grocers, dramatically reducing the time they have to develop capabilities required to ensure continued performance in an omnichannel world. While we believe Kroger has done well to embrace the industry's future, consumer buying habits are unsettled as food purchases are increasingly nationalized, upending the traditional distance- and routine-based relationship between customers and grocers. The dynamic could work to Kroger’s benefit or detriment; if execution is strong, it could benefit from smaller grocers' struggle to keep pace, but if its ability to retain customers falters, the chain could find itself with too many stores and persistently diminishing economics. We believe price competition in grocery will continue for the foreseeable future, necessitating scale-based economies and efficient execution; while we anticipate Kroger will meet the challenge, the stakes are high.

Kroger's growing efforts to monetize its consumer data introduces risk as it grows in segments (such as media, market analysis for clients such as consumer packaged goods companies, and personal finance) outside its core competency. Furthermore, while Kroger plans to sell data based on aggregated insights and not customer contact information or purchasing history, a breach could rapidly impair the value of its transaction information. With switching costs low, the importance of trust is high, so data breaches, which could also compromise customer payment information, or food-safety missteps in its private-label portfolio could have a meaningful impact on performance.

Kroger is in sound financial health, and we believe it should be able to finance the $9 billion of capital investments from fiscal 2018 to 2020 that it plans for its Restock Kroger optimization initiative with internally generated funds. As the company shifts focus to its omnichannel capabilities from store growth, we anticipate that needs will fall over the long term.

Kroger has a history of returning capital to shareholders via dividends and share repurchases; we expect that to continue. By the end of our explicit forecast, we assume Kroger returns just over 10% of free cash flow to investors via dividends and share repurchases. Kroger is also likely to pursue further partnerships or acquisitions to bolster its omnichannel efforts and meet changes in the grocery landscape; however, we do not incorporate such transactions because of their uncertain timing and nature. We think management’s stewardship of shareholder capital is exemplary.