The Next Earnings Blowup
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
There has certainly been a lot of pain and suffering in the supermarket industry with the problems reported at Supervalu. In fact, I have written in the past that the numbers at Safeway (NYSE: SWY) worried me because they look eerily similar to where Supervalu was prior to their dividend cut. One supermarket that seems to be weathering the storm better than the rest is Kroger (NYSE: KR). I'm sure part of the reason has to do with the diversity of the stores the company owns. While the company's over 2,400 supermarkets certainly dominate earnings, they also own nearly 800 convenience stores and over 300 fine jewelry stores as well. While this diversity of operations has helped the company's sales growth, their earnings growth is about to disappear, and I'm not sure that investors realize it.
The supermarket business is difficult, and there is rampant competition. What many people may not realize is just how thin margins have become for traditional supermarket chains. Looking at Kroger versus some of their competition, you can see why this company has an uphill battle to maintain sales growth. Not only does the company compete against traditional grocers such as Safeway, but companies like Costco (NASDAQ: COST), Target (NYSE: TGT), and Wal-Mart (NYSE: WMT), are all heavily investing in taking business from traditional supermarkets. Looking at the operating margin of each of these companies, you can see why Kroger is facing a tough challenge to continue competing in this industry.
Kroger shows an operating margin of 2.46%, which compares favorably to Safeway at 2.38%. Many people believe Costco offers a better value for shoppers, yet still maintains an operating margin of 2.79%. When you look at companies like Wal-Mart and Target, their diversity of selection drives operating margins of near 6% and almost 7.5% respectively. It should be no surprise then, that most of their competition is expected to outgrow Kroger over the next few years. Let's take a look at Kroger's current earnings report and I'll show you where the positives are, and where the one big problem is as well.
In the most recent quarter, Kroger reported sales up 3.9% and strong comparable store sales up 3.6%. Through share repurchases the company managed to grow diluted EPS by almost 11%. Kroger's financial position at first seems impressive, but there's one major concern investors should be aware of. The company repurchased 23.7 million shares at an average price of $22.15 in the most recent quarter. Year-over-year diluted shares are down almost 10% as well. While long-term debt is a concern and has increased as a percentage of total assets from last year, interest costs are actually down 8.5%. In addition, operating cash flow increased slightly, and Kroger generated over $620 million in adjusted free cash flow.
This all sounds like really good news until you look at the company's cash position. At the beginning of 2011, Kroger had over $800 million in cash on its balance sheet. In the last two years, the company has repurchased shares primarily from cash on the balance sheet. As of this quarter, the company's cash balance is down to less than $240 million. The problem is, the company simply cannot continue using cash it does not have to repurchase shares. Think about it, earnings-per-share increased 11%, but what would have happened if diluted shares didn't drop by almost 10%? The simple answer is, earnings-per-share would have barely changed and investors would have been disappointed. With disappointing earnings in the future as a near certainty, investors would be better served to look at one of Kroger's competitors as a suitable alternative.
Given the choice of Kroger's competition, the company that appears the most attractive is Target. I know many investors favor both Costco and Wal-Mart, but both companies sell for a significant premium to their growth rates. In addition, neither one can match Target when it comes to operating margin. When you consider that Target is a dividend aristocrat, has a yield above 2%, and is expected to grow earnings north of 12%, the company offers the best combination of growth and yield. Target has been steadily increasing their grocery selection at their traditional Target stores. The company also is expected to enter Canada next year. It appears growth at this retailer should continue for many years to come.
For Kroger investors, the company's inability to repurchase a significant amount of shares will almost certainly lead to disappointment. I would suggest investors Target a different company if they want exposure to the supermarket industry.
MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Costco Wholesale. Motley Fool newsletter services recommend Costco Wholesale. 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.