EUR 850.00 For Business Accounts Only

Morningstar | KR Updated Star Rating from 07 Mar 2019

We plan a high-single-digit percentage cut to our $31 fair value estimate for narrow-moat Kroger in the wake of the company's fourth-quarter earnings and underwhelming guidance announcement. While we still believe the firm's transformation effort will stabilize performance, the results validate our skepticism regarding management's plans to boost FIFO operating profit by $400 million from fiscal 2017 to 2020 (to $3.5 billion). Our long-term forecast, for low-single-digit top-line growth and fairly flat adjusted EBITDA margins (4.4% in fiscal 2018) on average over the next decade, remains. We suggest investors await a more attractive entry point despite the high-single-digit dip in the share price after the news.

For fiscal 2018, Kroger saw a 1.2% sales decline on 1.8% identical sales growth (excluding fuel), leading to adjusted diluted EPS of $2.11. Our forecast was more optimistic at a 0.7% shortfall, 1.8% growth, and $2.15, respectively. For fiscal 2019, Management targets 2%-2.25% identical sales growth (excluding fuel) and adjusted diluted EPS of $2.15-$2.25, lagging our 2.5% and $2.36 expectations (excluding forecast share repurchases).

Kroger's earnings performance came despite a banner year for fuel sales, with its margin per gallon up 22% to $0.25. While fuel sales are low margin relative to the rest of Kroger's business, we think the strong results mask the degree of the firm's shortfall versus our overall revenue and EPS expectations. As we anticipate fuel margins to normalize, we expect Kroger will have a steeper hill to climb despite space optimization, alternative income stream and omnichannel development, and cost-reduction efforts that have started to mature. That said, we anticipate Kroger's initiatives will leave it better positioned to face an intensely competitive grocery landscape, fueling price reductions while preserving margins and returns to a greater degree than its less advantaged, smaller peers.

We were not surprised by Amazon's announcement that it will open a chain of physical grocery stores more broadly oriented than its Whole Foods banner. The news reinforces our view of the intensely competitive landscape for grocers, as evolving customer expectations and behaviors necessitate rapid innovation in omnichannel solutions. While we expect midscale and smaller grocers to struggle, we remain optimistic that Kroger's size, purchasing power, vast array of customer data, and emerging alternative profit streams can offset the pressure. Still, while many of the new products (such as data analytics tools built on Kroger's purchasing data and targeted toward consumer packaged goods manufacturers) are high margin, we anticipate the benefits will have to be reinvested in the supermarkets amid relentless price pressure. The steady results should still allow returns on invested capital to comfortably exceed Kroger's capital costs (by roughly 200 basis points) for at least the next decade, consistent with our narrow-moat view, which is predicated on the notion that Kroger enjoys scale-related benefits that should allow it to weather the competitive storm better than virtually all other traditional grocers.