- Kroger remains a recession and COVID-19 resistant investment.
- Kroger’s online ordering services have room for improvement, but can act as a growth driver for the long-term.
- The company’s strong cash flow growth is a positive to grow the dividend.
Kroger (KR) operated 2,757 total food stores in 35 states as of March 25, 2020. The company owns the following brands: Kroger, Dillons, Smith’s, Food 4 Less, Fry’s, King Soopers, Food’s Co., City Market, Owen’s, QFC, Pay Less, Gerbes, Fred Meyer, Pick ‘n Save, Jay C, Harris Teeter, Ralph’s, Copp’s, Mariano’s, Metro Market, and Baker’s.
The company has a few different store formats. The combo store is a standard grocery store format with food, pharmacy, pet centers, fresh seafood, and produce. The multi-department stores are combo stores with the addition of apparel, home furnishings, outdoor living, electronics, toys, and auto products. Marketplace stores are smaller than the multi-department stores and offer grocery, pharmacy, health & beauty, expanded perishables, and some general merchandise. Kroger’s low-price warehouse stores are similar in size to combo stores and offer groceries and health & beauty items at low prices.
Kroger also partnered with Ocado (OTCPK:OCDGF) to operate automated customer fulfillment centers [CFCs] for its online business. Check out this link to see an automated CFC in action. Kroger operates six of these automated CFCs and has plans to open three additional ones. The three new facilities are expected to be operational in 2021.
Kroger has an advantage for being an essential business, which has the company performing well during the COVID-19 pandemic. Kroger achieved a 19% sales increase for Q1 FY21 with a 92% digital sales increase. The company responded to the pandemic effectively by offering online sales with delivery services. Kroger has a good chance to continue its steady growth by improving/growing its online business and by opening new stores in strategic areas.
Kroger has a recession-resistant business due to the essential nature of groceries being needed on a regular basis regardless of the economy’s health.
- Kroger benefits from being the largest grocery chain in the United States. This allows the company to benefit from economies of scale by making large purchases from suppliers to get volume discounts.
- Kroger has a customer loyalty program that offers personalized rewards. There is a fuel points program where customers earn 1 fuel point for every $1 they spend in stores. Fuel points add up to allow customers to get discounts on fuel. The company also has a debit card and mobile payments program, where customers can earn double rewards when using the card and app together. These programs encourage repeat business.
- The automated Ocado CFCs increase fulfillment productivity for the online business. The online business is important not just during the pandemic but also for the large number of aging baby boomers, retirees, and busy working people who may enjoy the convenience of obtaining their groceries via home ordering.
- High return on equity [ROE] of 23%. This is higher than the sector median of about 9%. The strong ROE allows Kroger to generate cash internally.
- Strong operating and free cash flow growth:
|FY19||FY20||Trailing 12 months [TTM]|
|Operating Cash Flow||22%||12%||42%|
|Free Cash Flow||600%||11%||92%|
source: Seeking Alpha
- The strong free cash flow growth gives Kroger the ability to increase the dividend on a regular basis.
Some of Kroger’s weaknesses can be improved upon, while others are the nature of the business.
- Grocery stores are a low-margin business. Kroger’s gross margin is 23% and the net income margin is only 1.66%. These margins are lower than the sector median GM of 34% and net income margin of 3%. The low net income margin is the result of having high selling, general, and administration expenses [SG&A].
- While Kroger has a strong ROE, the return on invested capital [ROIC] of 6.7% and return on assets [ROA] of 4.5% are not as strong. The ROIC and ROA are also lower than Kroger’s 5-year average ROIC of 32% and ROA of 5.9%.
- The online customer experience has room for improvement. There have been complaints about order accuracy, issues with items being out of stock, and having a long wait time for deliveries.
- Kroger has a high amount of debt at $20.6 billion as compared to just $425 million in total cash. The current ratio of 0.83 shows that Kroger has 1.2x more current liabilities than current assets. Currently, the high debt is not an issue because of the company’s strong cash flow growth. However, if the cash flow weakened significantly, the high debt could be an issue.
Kroger can implement strategies to improve and grow the business.
- Expansion in current regions where Kroger operates: The company can find strategic locations to open new stores in states/areas where they already operate. This can be existing buildings where a previous business failed or new construction in a new commercial development.
- Expansion into new regions: There may be opportunities to open stores in states/regions where Kroger does not yet have a footprint.
- Improvement of ROA and ROIC: There is an opportunity to increase the single-digit ROA and ROIC to be more in-line with the double-digit returns of Kroger’s ROE.
- Acquisitions of other grocery chains: Kroger can keep its eye out for strategic acquisitions. This can be a chain of stores that is already successful to operate under the existing name or struggling chains that can be rebranded into Kroger’s successful format.
- Improving and growing the online business: The three new Ocado CFCs which are slated to be operational in 2021 is a step to improve the online business. Kroger should also look into improving the website/app customer experience to ensure that the ordering process is optimized. Order accuracy and clear communication for customers should be emphasized for this process.
Kroger faces a few threats that can have a negative impact on the business.
- Competition is always a significant factor that can impact the company. The grocery business is highly competitive with many national and local businesses competing on selection, services, and price. Price wars for goods/services can reduce already thin margins in the grocery business.
- Kroger competes with large companies such as Albertsons [Safeway] (ACI), Walmart (WMT), Costco (COST), Target (TGT), Publix, Ahold [Giant/Peapod] (OTCQX:ADRNY), Aldi, Lidl, and others. The company also competes with smaller regional chains at the local level. Increased competition can limit the ability of Kroger to grow market share.
- So far, COVID-19 had a positive effect on Kroger’s business with the company showing increases in sales. However, unexpected circumstances could arise with the pandemic. For example, a high-profile outbreak among store employees could scare customers away. Or outbreaks in the distribution/fulfillment side of the business could limit the company’s ability to effectively get products to consumers on a timely basis.
- Government regulations/taxes/tariffs could be implemented that are unfavorable to Kroger’s business. One or more of these could make the cost of business more expensive and reduce margins.
- A high-profile sickness outbreak such as salmonella or listeria related to Kroger’s food or brands could cause customers to shop at competing stores.
Kroger’s Long-Term Outlook
The grocery market is always likely to be competitive with many national and regional chains competing on price, quality, and service. Kroger found a way to be successful in the face of high competition. The company achieved this with competitive prices, strategic acquisitions, quality food selection/service based on customer demand, a customer loyalty program, and a growing online business with automated CFCs.
Watch for Kroger to continue to grow the online business with the three new automated CFCs planned for opening in 2021. Also, watch for new store openings and any strategic acquisitions that could help drive growth.
The company’s cash flow growth will help Kroger increase the dividend on a regular basis. The essential nature of the grocery business provides the company with a certain level of safety to successfully withstand recessions.
Our SWOT analysis (Strengths, Weaknesses, Opportunities, Threats) is meant to serve as a baseline for doing research on companies that we might invest in at certain prices. As Warren Buffett has repeated many times, only by getting to know a company’s business, can we start to understand whether or not to invest our hard-earned money.