Kroger Is Positioned for Long-Term Success, but Now May Not Be the Time to Buy
We believe current trading prices offer little opportunity among the pure-play grocers we cover.
A relentlessly competitive grocery environment in the United States does not mean that long-term investors should ignore the sector. Kroger KR enjoys the safety of an economic moat, and Sprouts' SFM budding turnaround efforts are improving its standing.
While the pandemic has lifted all boats in the sector, sales have started to normalize, and we expect long-term trends to re-emerge, including intense price competition, increasing reliance on digital sales (which can be more expensive to fulfill), and growing disruption from Amazon AMZN and hard discounters.
As focus shifts to grocery's long-term prospects, we believe current trading prices offer little opportunity among the pure-play grocers we cover: Kroger, Albertsons ACI, and Sprouts. Still, we see meaningful differences among the companies. For investors looking to make a more immediate purchase in the consumer sector, we suggest wide-moat Kellogg K, which is trading at a 25% discount to our valuation with a nearly 4% dividend yield.
Kroger Is Uniquely Positioned to Protect Returns Despite Competitive Onslaught
Although we think the long-term landscape will be tremendously challenging for traditional grocers, we believe Kroger, through a combination of scale and prudent investment, has developed a meaningful bulwark. We project Kroger will outearn its cost of capital over the next decade, and our confidence extends to our downside scenario.
For that reason, Kroger is the only pure-play American grocer we cover that has an economic moat, based on its private-label, omnichannel, and transaction data and analytics capabilities.
- Private label. We believe Kroger's private-label assortment, which has long been an area of attention for the grocer, helps draw customers while boosting margins. Rather than merely create cheaper, unbranded copies of easy-to-differentiate items, Kroger has focused on elevating its premium store brands. As a result, Kroger's private-label penetration handily outpaces the national average.
- Omnichannel. Like other grocers, Kroger's omnichannel effort grew markedly during the pandemic, with e-commerce rising from a low- to mid-single-digit share of overall sales to nearly 10%. However, we believe Kroger, unlike most other grocers, could enjoy meaningful margin upside from its digital efforts in the years to come. Its numerous partnerships should ease its omnichannel transition, and as the largest pure-play grocer, it should continue to be a partner of choice for other advantaged firms looking for a stake in the future of the industry.
- Data and analytics. Kroger has long featured the leading domestic grocery loyalty program, with over 95% of transactions tied to a membership card. While this has provided benefits for quite some time, we believe the company is still in the earlier days of monetizing its data set in ways that few retailers will be able to match. From a demand standpoint, Kroger has moved aggressively toward more targeted advertising, increasingly substituting tailored promotions meant to bring an individual customer back to its stores regularly for the broadly oriented discounts that still characterize much of the grocery sector. On the supply side, Kroger's insight into local market demand allows it to optimize store assortments, increasing in-stock levels while reducing shrinkage.
Albertsons Has Made Progress in Loyalty and Omnichannel but Remains More Vulnerable
Despite its status as the second-largest pure-play grocer in the United States (albeit with only about half the sales of leader Kroger), Albertsons has had a difficult path to its present state. The product of numerous acquisitions and divestitures, Albertsons has been slow to embrace many of the factors that have allowed Kroger to build a sustainable competitive edge.
While it continues to make progress, we do not believe Albertsons is as well protected from the industry’s relentlessly challenging competitive dynamics. As a result, while we award Kroger a narrow economic moat rating, we consider Albertsons a no-moat company.
This discrepancy between the companies manifests itself in a few ways:
- While Albertsons has made progress in bolstering its private-label assortment, we believe it continues to trail Kroger's capabilities. Albertsons has indeed boosted penetration recently, with private-label goods' share of overall sales rising into the mid-20s from the low 20s a few years ago. We are encouraged that the firm has not shied away from tackling complex items that require more flavor and format development work than commodities; however, the assortment lags the level of differentiation that Kroger's lineup commands.
- Though Albertsons has made progress with loyalty programs, we believe it still lags Kroger's efforts considerably. While we believe that newer moves to include experiences as possible uses of grocery reward points should be marginally helpful, there is little that Albertsons can do to quickly close the data depth gap between it and Kroger. We see little near- to medium-term opportunity for Albertsons to match Kroger's efforts to sell data insights to third parties and gain an edge in price competition.
- Albertsons similarly has focused on improving its omnichannel capabilities, efforts that accelerated considerably during the pandemic. However, its efforts trail those of Walmart and Kroger, which both had done considerably more work before the crisis to develop pickup and delivery capabilities. We believe the difference shows in Albertsons' omnichannel penetration, which stands at around half of Kroger's roughly 10% mark as a percentage of sales.
Despite Lacking a Long-Term Edge, Sprouts' Turnaround Is Worth Monitoring for Opportunities
In contrast with competitively advantaged Kroger and Albertsons' building capabilities, we believe Sprouts is particularly exposed to the upheaval in the grocery industry, contributing to its no-moat rating. Although the firm's optimization work should improve results, we do not see the emergence of an economic moat as likely.
We harbor no illusions about the challenges that smaller grocers face over the long term. Our no-moat rating for Sprouts reflects the lack of switching costs in grocery, rampant competition, and a store assortment that features products that are generally available elsewhere. Sprouts' own-brand penetration pales in comparison with that of its larger peers. Despite the fact that the chain's assortment skews away from larger national consumer packaged goods brands, we believe the lack of exclusivity exposes the company to competition, especially considering that the brands it stocks can tap into e-commerce via Amazon and other marketplace and fulfillment partners.
Furthermore, Sprouts depends on third parties for its e-commerce capabilities (especially Instacart) and does not have a loyalty program of any kind. We believe this considerably limits its ability to collect and analyze customer transaction data in the service of optimizing its assortment, personalizing its advertising, and tailoring its store assortments.
We do still believe that Sprouts is on the right track toward long-term improvement, although the transformation remains a work in progress. Sprouts is no exception to the thin operating margins seen in the grocery sector, averaging a roughly 4% mark in the three years before the pandemic. With fixed-cost leverage a significant key to profits, revenue generation remains critical.
With Grocer Shares Rich, Look to Kellogg for Well-Priced Wide-Moat Consumer Exposure
While waiting for a buying opportunity in U.S. grocery stocks, investors should consider Kellogg, whose efforts to target snacking and emerging markets are underappreciated by the market.
Kellogg’s shares are trading at about a 25% discount to our valuation, which we believe stems from outdated views of the company and its portfolio. From our perspective, its snacking lineup gives Kellogg exposure to a much more on-trend category than its legacy cereal portfolio, with advantaged brands that intersect with consumer interest in convenient, health-oriented fare.
While cereal surged in 2020 amid the pandemic, growth had been hard to come by in the years before the crisis. We do not expect this dynamic to change materially after the pandemic.
That said, we believe Kellogg has taken prudent steps to set up its snack portfolio for success. Its revamped, lower-cost distribution architecture has freed resources for enhancing its analytical capabilities and brand-building through research, development, and marketing.
Kellogg has built a strong presence in emerging markets that should provide ample growth opportunities, countering more tepid expansion prospects in developed areas. The snack portfolio has proved essential in achieving geographic diversification; although cereal demand is inconsistent globally, Kellogg's snacking acquisitions (particularly Pringles) have led it to derive nearly one fourth of its mix from developing regions, well above the sub-10% mark General Mills GIS boasts and the inconsequential presence that rivals Campbell Soup CPB, Hostess TWNK, and Post POST feature.
With Kellogg trading at an attractive multiple relative to several other leading U.S. packaged food operators, we contend that the current share price poses a compelling opportunity for investors seeking consumer sector exposure in a high-quality, wide-moat company.