EUR 850.00 For Business Accounts Only

Morningstar | Sluggish 2Q Profitability Doesn't Alter Our Long-Term Outlook for Kroger

Our $31 fair value estimate for narrow-moat Kroger should fall by the midsingle digits after we trim our near-term targets in the wake of second-quarter results. However, we still expect the firm's transformation effort will yield improved long-term profitability versus fiscal 2017's 1.7% operating margin. As we expect slow first-half profitability gains are a result of transitory and timing-related factors, our long-term forecast for low-single-digit revenue growth and operating margins over the next decade is intact. While our take on the valuation implications of Kroger's quarterly results is more conservative than the trading reaction to the news (we believe partly because we had been somewhat more pessimistic about fiscal 2018 revenue and adjusted EPS than prevailing sentiment), we still suggest investors await a more attractive entry point.

In the quarter, revenue rose 1.0% on 1.6% identical-supermarket sales growth (without fuel). For the first half, sales increased 2.4% against 35 basis points of operating margin expansion (to 2.4%), with top-line results ahead of our 0.5% estimated full-year decline but profitability short of our 60-basis-point targeted uptick. Management maintained its fiscal 2018 EPS target at $2.00-$2.15 against our $2.10 expectation.

We attribute the profitability shortfall to transitory and timing-related factors. We concur with management's indications that price cuts and space optimization efforts that were pulled forward likely weighed on earnings, but we expect such initiatives to boost future results. With customers increasingly demanding an omnichannel experience including a high-quality in-store environment and numerous order-fulfillment options, we applaud management's focus on bolstering its delivery, click-and-collect, and ship-to-home offerings. Still, we believe competitive dynamics will limit Kroger's long-term operating margins to the low single digits even after the investments bear fruit.

We are intrigued by management's recent announcement that it will be making some of its Simple Truth private-label offerings available on Tmall in China. While we do not anticipate the move will have a meaningful impact for years until its presence is established, and ongoing trade policy concerns threaten to upend the nascent effort, we believe it will serve as a test of the degree to which the brand (which now accounts for $2 billion in annual revenue out of Kroger's roughly $122 billion) can develop stand-alone equity. Assuming management is not distracted from its numerous challenges in its home market (particularly intensifying competition, the consumer's ongoing channel shift, and tight margins), the offering could presage new alternative revenue opportunities.