Kroger (KR) has seen rougher times recently. For years, the market has liked the business model of making bolt-on deals which created a grocery and retail empire with over $120 billion in annual sales last year, as shares rose from just $10 in 2012 to $40 merely three/four years later.
Enthusiasm has faded quite a bit, given that growth is slowing down, the company has taken on quite some debt, and the market is nervous about the potential disruptive forces threatening the grocery market as well, certainly after Amazon.com (NASDAQ:AMZN) went after Whole Foods, of course, while pure-play online players have gained room as well, as German discounters make life not easier.
Running multiple labels under one umbrella might not be the way to go forward, according to some investors who have voted with their feet, as shares are now down to just $22 again, warranting an update on the thesis after the company has completed its first out of the three years under its "Restock Kroger" transformation program.
The Current Business
Kroger managed to grow identical sales by 1.8% last year, with reported sales down slightly to $121.2 billion as a consequence of the sale of the convenience store business. The company reported flattish operating earnings of $2.6 billion on this revenue base. After accounting for $620 million in interest, and a nominal amount in pension plans, the company earned $2.11 per share from its operations, which quite simply tells us that shares trade at just 10-11 times earnings.
The modest valuation is a direct result of the debt load, modest identical sales growth, and other challenges faced by the business. Ending the year with $429 million in cash and equivalents, Kroger operates with $15.2 billion in debt and lease obligations, for very steep debt levels. With reported EBITDA of $5.3 billion, leverage ratios come in at 2.8 times, which is suboptimal in a time of dividend commitments (albeit relatively modest) and net investments required to be made into the business.
Fortunately, the company was and still is seeing 2019 identical sales up between 2.00 and 2.25%, with adjusted earnings seen at $2.15-2.25 per share, while capital spending targets are set at $3.0 billion, compared to $2.5 billion in D&A charges in 2018. While the company touts achievements like 58% growth in digital sales, reality is that this comes from a fairly low base.
It should be said that management is trying to pull a lot of levers with partnerships, of which the partnership with Ocado (OTCPK:OCDGF) looks particularly interesting, of course, with multiple high-tech customer fulfillment centers being announced and started construction on already. This comes as the initial deal with Ocado has been signed little over a year ago by now.
Reality is that investors were not really convinced with the 2019 outlook and 2018 results, as shares have come under continued pressure, and this has not changed following the release of the first quarter results. Crucial identical sales growth slowed down to 1.5%, with digital sales up 42%. With digital hitting a $5 billion run rate in 2018, that suggests about 4% of sales are generated online. Assuming 42% growth on $5 billion in sales worked down to about $2 billion, suggesting that all of the identical sales growth and some more is driven by e-commerce growth.
While management is sticking to the full year guidance, it goes without saying that risks to this guidance have gone up. While the company touts a relatively big improvement in leverage ratios to 2.5 times, this is mostly a seasonal effect, of course.
The issue with a net debt load of $13-15 billion (depending if you look at Q1 or the full year results) is that the business reports adjusted earnings at about $1.6-1.7 billion a year, as the huge EBITDA numbers (inflated by large deprecation charges as this is an asset-heavy business) reduce the reported leverage ratios. At the same time, it means that actual time needed to earn this money is much longer than the leverage ratios suggest. This comes as the ratio of net earnings to EBITDA is much lower in the case of Kroger compared to some other companies.
Still Not Pulling The Trigger
Following the big reset in the stock in 2017, with shares having falling towards $20 at the time, investors have seen a nice rebound during last year's summer, as shares rose to $30 on the back of the outlined initiatives and some early results. Following the release of the first quarter results, it becomes clear that 2019 will become another year of struggles with adjusted earnings in the first quarter down a penny to $0.72 per share. Furthermore, stiff competition will not be alleviated anytime soon, while a tight labour market is not helpful either for such a labour-intensive business.
While the business looks very cheap based on the earnings power, reality is that leverage is still high, and real struggles continue to be apparent despite large net cash investments into the business. For now, I see the argument for a value investor, given the earnings power and dominant position, but before value becomes apparent (mostly has to come from re-rating of valuation multiples in my eyes), note that this requires a lot of hard work with a fair deal of uncertainty whether this can be achieved and when.
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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.