Saturday, December 29, 2012

Kroger Set For a Good Christmas?

In a recent article I described the fundamental attribution error in investing. In other words, it’s the tendency of investors to over-weigh performance based on inherent qualities of the management and under-weigh the effects of the macro environment. In the case of Yum! the reality caught up (with its fast food sales in China) in a negative way, but with Kroger (NYSE: KR) it got a whole lot better. The US economy is in a multi-track recovery. It’s tough at the value end, but more positive comparisons are starting to drift down the income spectrum. Throw in a better inflationary environment and things are starting to look favorable.

Kroger’s Keeps on Delivering

It gets better.

As discussed in a previous article, Kroger’s management is delivering superb performance within a challenging environment. The good news in the recent set of results is that, according to Kroger, it gained market share in food and despite the continued fall in gross margin, identical supermarket sales growth (ex fuel and pharmacy) was 3.2% in Q3 against 3.1% in Q1 and Q2 respectively. In a sense this is not surprising because Kroger seems committed to driving gross profits via reducing prices for the customer.

Note the sequential improvement in revenues from Q2 to Q3.

The bad news is that the market has largely priced this in. So the conditionality I suggested in the last article was useless. The market moved too quickly.

Revenue growth appears to be back, but the stock is hardly cheap now having put on a nice rise in recent months. This kind of growth is what happens when good management positions a company in a downturn and then benefits when conditions get better.

In addition, Kroger continues to benefit from having taken customers from Walgreen (NYSE: WAG) following the Express Scripts debacle. With a number of competitors increasingly making bullish noises about retaining ‘the departed,’ Walgreen stockholders must be concerned. Indeed, I’m one of them but my suspicion is that it is all in the price, and some.  Just as with Walgreen, Kroger is seeing some pressure on its top line pharmacy sales thanks to increasing generics sales, but this should be more than offset by increased margin.

A Two Tier Market

The US retail market remains in a curious and unusual recovery mode. It is a duality of growth at the discount end as value with the new ‘retail reality’ and at the same time the high end is doing fine with specialty stores like Whole Foods Market (NASDAQ: WFM) continuing to blaze a trail. Indeed Whole Foods argues that only 20% of its customers account for up to 80% of its business. This is unusual for a large retailer but perhaps typical of US income distributions.

Indeed, KR is in on the ‘healthy’ act too with the launch of brands that are free of artificial ingredients and preservatives. I expect more of this to come from retailers in general. It is their business to service their customer’s needs after all.  More color on the composition of its sales was given when Kroger announced that the share of grocery corporate brands declined in the quarter thanks to aggressive competitive activity from national brands. This sounds like a cause for concern for private label manufacturer Treehouse Foods (NYSE: THS), which has had no end of difficulty this year dealing with changing sales channels and customer realignments.

As for the discount stores, the likes of Dollar General (NYSE: DG) continue to aggressively roll out new stores, and competition remains fierce. KR basically said that the value end remains challenging, and I would read this as an indication that customers are still eager to trade down. Therefore, despite some economic improvements, which KR is seeing with customers purchasing more items on their trips, the environment remains favorable for the dollar stores.

Where Next for Kroger?

A combination of moderating inflation, a gradually improving economy and operational excellence should create nice conditions for Kroger to leverage earnings in future. Full year guidance was raised to $2.44-2.46 from $2.35-2.42 and identical same store growth (ex fuel) for Q4 was forecast at 3-3.5%. Growth appears to be accelerating.

With that said, the shares no longer look particularly cheap. Sometimes it can be interminably frustrating waiting for a reasonable price but that’s the way investing is, although my hunch is that Kroger will probably be pulled up by a decent Christmas season for US retail.

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