Kroger: On The Sidelines Despite The 5% Yield (NYSE:KR)

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Kroger (KR) shares have done well year-to-date, but I would be hesitant about buying into the medium- to longer-term story. Competition has been intense in the space, with the company losing share to Walmart (WMT) in recent years, and I think the dynamic will continue to limit upside to identical store sales and margins over the coming years. While KR has been one of the few retailers that have benefited through the COVID-19 pandemic and offers a c. 5% total yield (dividend and buybacks) at current valuations, I view the long-term upside as limited.

Encouraging Headline Q2 Numbers

For the latest quarter, KR reported upside where it mattered, as total company sales ex-fuel grew 13.9%. Identical store sales growth (ex-fuel) also rose at a +14.6% pace, which notably beat consensus expectations of +11%. What made the number even more impressive was that it largely sustained the +19% growth in Q1, a 16-week period that saw heavier stock-up activity from consumers.

Source: Kroger Press Release (Q2 ’20)

The quarter also saw the announcement of a potential $1 billion buyback, alongside a generally optimistic fiscal 2020 outlook based on sustained food-at-home trends. The reinstated fiscal 2020 guidance calls for over 13% identical sales growth and EPS of $3.20-$3.30, which likely implies continued comparable sales growth in the high-single-digit % and moderate (ex-fuel) EBIT margin expansion in the second half. Assuming some continuation of the strong first-half trends, these targets seem achievable and signal an orderly deceleration as conditions normalize in the coming quarters.

Source: Kroger Press Release (Q2 ’20)

Underlying Concerns Remain Amid Gross Margin Slowdown

Despite strong results and guidance, the one knock on KR’s Q2 results was the lack of gross margin expansion in the core business despite the favorable tailwinds. On a FIFO, ex-fuel basis, KR’s core GM expanded by c. 5 bps for the quarter, which pales in comparison to the broader Food at Home CPI, which has averaged c. 5% over the prior twelve months.

Source: Consumer Price Index Data (August 2020)

The modest gross margin expansion amid a favorable backdrop is a key concern coming out of Q2. While wider price gaps could help preserve share as the environment normalizes, continued price investments point toward intense competition in the grocery space. The fact that pickup fees remain suspended (fees were initially suspended at the onset of COVID-19) also highlights the underlying margin pressure, which could become more apparent as the COVID-19 impact fades.

Fuel Could Prove to be a Near-Term Headwind

Despite declining Y/Y, fuel sales were notably better than the company had initially expected. Nonetheless, the average retail price of fuel at $2.14 remains well below the $2.71 level in the prior year. Gross margin per gallon has moved to $0.37, as a result, implying a c. 17% margin in Q2. This is still above the $0.35 in the prior year (c. 13% margin), but well off Q1 levels at $0.48 (c. 23% margin).

Q2 ’19

Q3 ’19

Q4 ’19

Q1 ’20

Q2 ’20

Gross Profit per Gallon

$0.350

$0.300

$0.330

$0.480

$0.370

Gross Margin

12.9%

11.5%

12.8%

22.5%

17.3%

Source: Company Data

The company still expects margins to continue deteriorating in the upcoming quarters, as demand continues to be impacted by limited consumer mobility. The impact of any normalization in fuel margins is material – fuel contributed c. 8% of sales in Q2 ’20 and c. 12% in fiscal 2019. Assuming fuel gross margins contract at a similar pace to Q2, for instance, this would equate to a c. $40-50 million operating profit headwind.

Digital Sales Trending Positively

Online sales were a bright spot, growing 127% Y/Y and contributing c. 4% of the 14.6% comparable sales growth for Q2, with the vast majority being pickup (rather than door-to-door delivery). Encouragingly, the company has also made progress in reducing its in-store costs to handle pickup orders, helping to boost online profitability.

The fact that management continues to waive the pickup fees for online orders could weigh on margins, however. Management stressed that the waivers are only “temporary” in nature, but the (rising) competitive intensity of the grocery industry will likely necessitate maintaining the waivers over the medium to longer term as well.

Nonetheless, the company remains locked into the Ocado partnership, seeing it as additive to the overall digital strategy. The company expects its Ocado partnership to help accelerate efforts to reduce e-commerce fulfillment costs via AI and automation, and, in turn, drive better order fulfillment. In line with the partnership, the company is launching two facilities in the Spring in Ohio and Florida – the Ohio location will be used to provide a read on customers’ response to the new service in Ohio, Indiana, and parts of Kentucky.

Takeaways for Packaged Foods

Kroger’s intention to return to normal levels of price investment should prove largely neutral to the big brands. Importantly, Kroger confirmed that branded products have grown faster than private label brands during the pandemic, but attributed this mainly to a one-off benefit from stimulus payments to low-income consumers. As the stimulus impact recedes, expect consumers to shift back to private label. But any declines for the big brands will likely be gradual, as grocers continue to rely on the big food companies for their flexible supply chains and popular brands.

Another notable takeaway was that shoppers are enjoying cooking from home, trying to eat healthier, and preparing breakfast and lunches for their kids (according to Kroger’s consumer research). This could prove to be a positive tailwind for food companies with meal preparation portfolios like Conagra (CAG), while those lacking healthier offerings could see further declines.

Focused on Reinvestment Amid Pension Pressures

Positively, the company’s capital allocation plan remains intact – even with the excess cash from the COVID-19 boost. The first priority is still reinvesting into the business, which is a positive for future growth. Secondly, management is focused on maintaining the investment-grade debt rating, and finally, returning cash to shareholders (either through buybacks or dividends).

Assuming a dividend growth path in line with historical levels would mean a c. 2% yield for the fiscal year. Combined with gross repurchases of c. $80 million in the second half (in line with the $750 million guidance at the midpoint), this equates to a very decent total shareholder return of c. 5%.

Q1 ’20

Q2 ’20

Q3 ’20e

Q4 ’20e

F2020e

Dividends per Share

$0.16

$0.16

$0.18

$0.18

$0.68

Gross Repurchases ($)

422.0

247.0

40.0

40.0

750

Source: Company Data, Own Estimates

But investors will need to balance the capital return with the continued pressure from health care and pension costs that many grocery peers do not face. As of Q2 ’20, total pension and postretirement benefit obligations totaled $578 million, up c.$96 million on a Y/Y basis.

Q2 ’19

Q3 ’19

Q4 ’19

Q1 ’20

Q2 ’20

Pension and Postretirement Benefit Obligations

482.0

471.0

608.0

591.0

578.0

Source: Company Data

Final Take

Overall, Kroger continues to perform well through the COVID-19-impacted backdrop. While sales growth has been strong, questions remain over the sustainability of current trends, along with the lack of gross margin expansion amid a favorable backdrop. The c. 5% capital return is positive, but questions around its performance next year present near-term risks, while its ability to manage pricing and margins, along with rising pension pressures, cloud the longer-term outlook. At current levels, I am neutral on Kroger shares.

ChartData by YCharts

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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