Ultimate Deserted Isle Stock
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In a late 2009 CNBC interview, Warren Buffett was asked to identify one economic indicator that would be considered most relevant for evaluating the state of the overall economy if he was stranded on a deserted island for a month and had no access to market information. Buffett’s answer (“rail card loadings”) has little in common with the subject of this particular article, but the question proposed to the value investing guru proposes an interesting parallel topic – what individual metric is best used to isolate companies that are inherently “safe” over the long run? If an investor had to choose a small portfolio of stocks prior to being placed into a similar deserted island scenario, can the stock selection criteria be boiled down to one particular calculable metric?
Different investors have their own unique set of tools that are utilized when determining the intrinsic worth of a particular company. However, one particular, although generic, metric – value creation – is by far the best indicator of companies that present, on average, the most attractive buy-and-hold investment opportunities.
Among several other popular worldwide brand names that are on the forefront of daily market happenings – including, for instance, Wal-Mart (NYSE: WMT), Coca-Cola, and McDonald’s (NYSE: MCD) – Kroger (NYSE: KR) can also be considered a long-term value creator that has an extremely limited likelihood of losing significant market share over the next half decade. (A prior study of the best value creating corporations in the DJIA can be viewed here.)
The corporation has once again proven its value creation abilities with its most recent annual filing. Likewise, trading at 5.1x enterprise value, Kroger may be slightly more expensive than other players in the field – SuperValu (NYSE: SVU) and Safeway (NYSE: SWY) trade between 3.8x and 4.7x EV – but the stock truly represents an attractive investment, even for a person who might be stranded on a deserted island for the next several years.
Fiscal Year 2011 Highlights
- Customer Loyalty
Kroger is one of the rare corporations that are characterized by impressive customer captivation abilities. Part of its ability to attract and retail a wide base of loyal customers is attributable to the inherent makeup of its industry – people tend to find and stick to one particular grocer in their town – but is also due to its huge investment in customer loyalty initiatives. Close to fifty percent of all US households currently carry a Kroger (or one of its regional supermarket brands) loyalty card, and these “loyalists” spend around $0.50 of every food dollar at a Kroger grocery outlet. One must consider all of the individual food stimuli to which consumers are exposed to fully appreciate this statistic – on the commute to work people stop at places like Starbucks or McDonald’s for coffee and breakfast items, during work hours there is always the temptation to leave the brown bag at home and grab take-out, and restaurant spending during weekends is near an all time high.
The corporation, taking an almost Amazon.com–like approach, has drastically improved its advertising strategy above and beyond the traditional use of local newspaper inserts. Instead, because so many customers are utilizing its loyalty program cards on a daily, bi-weekly, or weekly basis, Kroger is constantly flooded with sales data that can be used for targeted advertising. As is well understood, targeted ads are not only more effective, but the effectiveness tends to drive down the per person advertising cost because fewer ad exposures need to be sent to a given consumer to elicit a purchase response.
Having such a large nationwide footprint, this gives Kroger a huge advantage compared to other companies that may be profitable, but are limited to their own regional markets – i.e. Publix in the Southeastern US and Price Chopper in the Northeast.
The loyalty program, as well as the company’s deep entrenchment in several different US markets, has lead to extremely impressive same store sales increases over the past several years. Even without the boost from fuel sales – more than 40% of Kroger’s grocery stores also contain fuel pumps/convenience stores – comparable store sales increases have averaged 4% Since Q1 2008.
Figures on a Year 1 quarter versus Year 0 quarter basis. i.e. Q1 2011 vs. Q1 2010.
- The Negatives are not too Negative
As if the grocery industry was not difficult enough, with the large degree of fragmentation and the many different food choices consumers have that can substitute a traditional grocer’s offerings, the industry is currently experiencing an additional squeeze due to higher fuel and food costs. Although people do need to eat, grocers nationwide are still seeing decreased traffic and less spent per visit as consumers are limiting their visits and budgeting more carefully. Such products that tend to be limited during these times of downturn are normally the higher margin “luxury” (of sorts) items like beer/wine/spirits, certain more expensive pre-made foods, and excess beauty/toiletry items (makeup, for instance).
Kroger’s gross margins of 20.9% in the most recent year, when compared to average historical gross margins near 25%, not only expose the corporation’s limited ability to pass on rising food costs to consumers, but also shows the impact of its fuel operations. Fuel has come to represent nearly 15% of the Kroger’s revenue stream, which is up from an average of around 6% in the 2006 fiscal year. Although the corporation is undoubtedly selling fuel in higher volumes due to the increase in the number of fuel stations and the increase in the loyal customer base, the larger portion of the higher sales figures simply represents the increase in fuel prices over the same time period. Retail fuel sales naturally have lower margins than certain food products, especially value-added items like bakery goods and pre-made foods (many Kroger locations have ready-to-eat foods like salad bars, etc.). Higher fuel sales as a percentage of income, coupled with the lower margins on the product, have acted to limit the corporation’s overall profitability over the past several years.
There are, however, several intangible positives that come with the operating of fuel centers in addition to the core grocery segment. First, fuel centers act to make the locations even more of a “destination.” Consumers, no matter how much they dislike purchasing gas, have to on a daily, bi-weekly, or weekly basis depending on driving habits. Having the increased level of traffic, even if it is for lower margin products, will undoubtedly lead to a certain level of subsequent grocery item purchases as people decide to stop in the convenience store for quick food/drink items, or simply decide to finish grocery purchasing chores on that particular visit.
Likewise, the increased level of store visits tends to boost top-of-mind awareness and (whether consciously or unconsciously) acts to boost store loyalty. Consumers always look to make purchase decisions easier – especially with the increased amount of advertising stimuli that are being shot their way on a daily basis. Having a one-stop-shop for fuel and grocery items in inherently more convenient for most consumers and tends to increase their reliance on such a shopping outlet. Kroger’s move into the retail fuel sector will pay off exponentially throughout the long run, as an increased amount of long-lived customers will be attracted. Each of these loyal customers comes with a very attractive present value – the total value of all of their future grocery/fuel purchases (over one year, five years, maybe even ten years?) when discounted to present day.
- Value Creation
Despite the increased fuel and food costs, as well as the lower-margin fuel products representing a higher level of the corporation’s revenues, the company is still creating value for shareholders. This holds true even though average operating margins have fallen by more than 100 basis points over the past five years and the company’s total net asset base has remained relatively stable over the same time period. In essence, the company has had troubles in growing its shareholder’s equity base, and the returns on those net assets have diminished. How is this value-generative?
Sales in milions, residual earnings explained in footnote
Kroger has unlocked superior shareholder value creation through the strategic, and smart, buying back of company shares on the open market. There is an inherent right and wrong way to buy back shares – an investment made at fair value will only earn at the required rate of return. Investors need to always be aware not just if companies are buying back shares, but at what market value the shares are being purchased.
Enterprise multiple calculated using each quarter's median market price
Over the past five years, Kroger has purchased nearly $5 billion worth of shares at an average enterprise multiple of 5.5x. The company has definitely taken advantage of its rather stagnant share price over the time period, and this has not only led to improved earnings per share generation, but even more importantly, residual earnings per share generation. Residual earnings take into account the firm’s cost of capital requirements, and only measures earnings above and beyond this charge (see footnote).
As depicted, sales have experienced steady increases since late 2006, and despite the large dip in residual earnings generated in 2010, the excess earnings per share have, on average, increased by more than 15% per year over the past five years.
Although Kroger’s share price has remained relatively stable over the past several years, its ability to improve its core business through the building of its captive customer base, as well as its ability to improve shareholder value creation despite the headwinds faced in the grocery industry, should lead to above average stock performance in the long run.
Kroger, once again, represents one of the few companies that an investor can purchase and forget (even while on a deserted island). Investors should continue to seek out companies that have higher than average value-creating abilities. Simply boosting sales over the long run is but one of the many drivers that controls excess earnings generation – also look for improved efficiency (gross and operating margins) as well as strategic (and smart) share buybacks made at attractive market valuations.
*Footnote: Net operating assets (NOA) = (Total assets - financial assets) - (Total liabilities - financial liabilities). Return on net operating assets = (Post tax operating assets) / (NOA). Residual earnings = (RNOA - Cost of Capital Requirements) * NOA.
gibbstom13 has no positions in the stocks mentioned above. The Motley Fool owns shares of SUPERVALU INC. Motley Fool newsletter services recommend McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.