This Grocer Could Continue To Outperform

Piyush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The general thesis is that grocery stores have steady revenues and consistent profits because “people need to consume.” But, shares of Kroger (NYSE: KR) have risen by around 45% over the last year, yet its shares appear to be undervalued. Naturally, one may question the overly optimistic estimates and conclude that the deal is too good to be true. Yet, here are a few reasons why Kroger appears to be a great investment option, even after its recent rally.

A paradigm shift

It’s a well-known fact that there’s an ongoing shift toward healthier, more nutritional food products. To capture the growing health conscious market, Kroger re-branded and expanded its product lineup of organic foods (Simple Truth and Simple Truth Organic) last year. The company claims these items to be free from the 101 artificial ingredients that are known to be harmful to human health, but are still used by other manufacturers to reduce costs and retain taste.

Its management stated that the company added 588 new products in the corporate brands category last year, most of which include organic offerings. Driven by strong demand for organic products, corporate brands exceeded the company’s internal sales growth estimates by 33%. This is a huge achievement for Kroger, since its corporate brands account for 27% of total grocery department sales.

As a result of these strong sales, Kroger reported fourth quarter revenue of $24.2 billion, which rose by an impressive 12.8%, compared to last year’s quarter. This was partly because the company operated for an extra week. On adjusting for the extra week, its sales were up by 3.7%, while its net earnings rose by 22%, which is nothing short of spectacular.


Kroger isn’t the only grocer that sells organic food items. Shares of Safeway (NYSE: SWY) have risen by nearly 65% over the last six months, mainly due to the recovering traffic and volumetric growth. On a quarterly basis, the grocer derived 45% of its revenue from its loyalty program, while profits surged by 58%. Its shares were upbeat after management released its annual EPS guidance of $2.25-$2.45, which was higher than the street’s estimates.

Another peer, Whole Foods Market (NASDAQ: WFM) is mostly leveraged toward organic foods, and practically introduced organic foods on a massive scale in the first place. The grocer reported over 30% growth in its FY12 EPS, yet its shares have declined by nearly 10% over the last six months. This was because revenue missed the Street’s estimates, suggesting a possible slowdown in its spectacular growth rate. Furthermore, its management lowered guidance for revenue growth to 10%-11% for the remainder of 2013, which was lower than the Street’s estimates.

Shifting focus to Kroger, its management expects to increase identical store sales by 3%, with an estimated EPS of $2.71-$2.79, while analysts estimated an EPS of $2.76, for FY14. That's a huge identical sales growth target, especially since Kroger operates with nearly 3,700 stores, while Safeway and Whole Foods Markets operate with around 1,600 and 345 stores, respectively. JPMorgan has a Buy rating for Kroger with a price target of $35.

Investors’ delight

Kroger has also been returning value to shareholders and, in 2012, returned over $1.5 billion in the form of dividends and share buybacks. At the current price, its shares yield 1.8%, with a modest payout ratio of 18.66%. During the recent quarter, the company repurchased 2.2 million of its shares for $57 million, while an authorized capital of $466 million still remains. This accounts to a pending repurchase of nearly 14 million shares, which, combined by dividend payouts, should boost its annual EPS by 10%-12% (according to management).

Wrap up

At the current prices, shares of Kroger and Safeway trade at a forward earnings multiple of 10 times each, while Whole Foods Market trades at 25 times forward earnings. According to analyst consensus, the annual EPS of Kroger should grow by 8.2% for the next five years, which seems pretty solid by the standards of defensives.

According to a recent report, organic foods have penetrated only 45% of American households, which suggests that there's still a significant upside in store for the entire industry. With that in mind, I believe Kroger is a great income growth stock and deserves nothing short of a Buy rating.

Piyush Arora has no position in any stocks mentioned. The Motley Fool recommends Whole Foods Market. The Motley Fool owns shares of Whole Foods Market. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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