Over the last three years, I’ve used economic uncertainty – first from a year-long trade war through 2019, and then of course the COVID-19 pandemic starting in 2020 – as the basis for a lot of the analysis, and certainly some of my own investments in the marketplace. I think that when economic conditions become more difficult, defensive positioning by focusing on industries that are traditionally less sensitive to the cyclicality of economic health makes sense. It’s a strategy that has helped me make a number of useful investments throughout the past three years.
I expect that the need for defensive positioning is going to continue to be a theme as we move into the holiday season and into 2022. While I’m not calling for a bear market, and I’m not saying that we are doomed for another economic drawdown, there are some critical signs that the inflation is becoming a concern – even while coronavirus continues to be a big concern throughout the world. Countries in the E.U. are imposing fresh new lockdown requirements in an effort to limit the spread of the disease during the coldest part of the year, and infections and hospitalizations remain high throughout the United States. Health systems are being forced continue a long-term, exhausting trend of running at or near maximum capacity that is putting a big strain on health workers – and while I don’t think this reality has been reflected in an economic sense, I also think it is an undercurrent that will see its own economic reckoning.
Another factor that is having a direct impact on inflationary pressures comes from what is broadly described as “supply chain problems.” There are multiple layers that are playing a role in supply disruptions. For one, a shortage of semiconductor products and goods that started with the trade war and has yet to be resolved has impacted the ability of businesses to implement technological services and solutions that are needed in their own operations. Another element is a residual effect of the pandemic and is reflected by the reality that many industries continue to deal with labor shortages as they struggle to recruit workers. Many of those jobs are in areas that saw steep layoffs during the early stage of the pandemic, with many of those businesses now trying to get their operations back on track to meet increasing consumer demand – but in many cases are still running well below pre-pandemic staffing levels.
The impact of these pressures is increasing costs throughout the economy, including for normally defensive industries and sectors. In the Consumer Staples sector, the Food Products industry is one that I like to pay particular attention to. That’s because Food is just a regular part of daily life – and grocery shopping is just another chore that everybody has to get out of the way to keep pantries and fridges stocked. The early stages of the pandemic created big increases in food storage and home consumption; but an increasing number of indicators now suggest that the eat-at-home trend has not only started to level out, but it has lapped pandemic demand levels, suggesting that it has gone as far as it could.
I think a better explanation for the industry’s bearish shift has more to do with issues throughout the supply chain that started during the pandemic and have finally begun to bleed into consumer prices. Labor issues are increasing costs for a lot of companies in this industry, as they are forced to invest in raising wages to attract and keep workers. Labor costs, along with higher supply and basic costs now being passed on to the consumer, which makes it harder for the average American family to make their food budget stretch.
Kroger Company (KR) is the largest traditional food retailer in the United States, and a company that I’ve kept an eye on for some time. After following a strongly bullish trend for most of this year, the stock peaked at around $48 at the beginning of September; but the inflationary pressures I just described have pushed the stock sharply lower, finding short-term trend support at around $38.40 in mid-October. It has started to show some increasing bullish momentum, including a surge yesterday that now has the stock sitting at around $42.50.
KR has been among the most proactive in the entire Consumer Staples industry over the past couple of years, investing heavily in alternative revenues streams like Kroger Personal Finance and Kroger Precision Marketing, building localized, automated warehouse facilities throughout the U.S. and online shopping and curbside delivery that is now in place in 95% of its coverage area. Many of these initiatives have yielded positive results on the company’s earnings reports, and have enhanced the company’s ability to compete against larger rivals like Wal-Mart and Target Stores. I think the stock could give a bullish investor good reason to adding KR to a diversified portfolio, with the current bullish bounce lending weight to a growth-oriented investor’s strategy; but that begs the question, are the company’s fundamentals also strong enough to say the stock is a useful value? Let’s dive in and take a look.
Fundamental and Value Profile
The Kroger Co. (KR) manufactures and processes food for sale in its supermarkets. The Company operates supermarkets, multi-department stores, jewelry stores and convenience stores throughout the United States. As of February 3, 2018, it had operated approximately 3,900 owned or leased supermarkets, convenience stores, fine jewelry stores, distribution warehouses and food production plants through divisions, subsidiaries or affiliates. These facilities are located throughout the United States. As of February 3, 2018, Kroger operated, either directly or through its subsidiaries, 2,782 supermarkets under a range of local banner names, of which 2,268 had pharmacies and 1,489 had fuel centers. As of February 3, 2018, the Company offered ClickList and Harris Teeter ExpressLane, personalized, order online, pick up at the store services at 1,056 of its supermarkets. P$$T, Check This Out and Heritage Farm are the three brands. Its other brands include Simple Truth and Simple Truth Organic. KR has a market cap of $31.9 billion.
Earnings and Sales Growth: Over the last twelve months, earnings increased by about 9.6%, while sales improved by 3.91%. In the last quarter, earnings declined nearly -33% while revenues also decreased by nearly -23.3%. Like most Food retailers, KR operates with razor-thin margins, as Net Income was about 0.87% of Revenues for the last twelve months, but strengthened somewhat in the most recent quarter to 1.47%.
Free Cash Flow: KR’s free cash flow is healthy, at $1.92 billion over the last twelve months. That marks a small decline from $1.98 billion in the last quarter, but more significantly free cash flow was $4.1 billion in the quarter prior. The current number translates to a free cash flow yield of 6.31%.
Debt to Equity: KR has a debt/equity ratio of 1.36. This is higher than I usually prefer to see, but isn’t unusual for Food Retailing stocks. The company’s balance sheet indicates that operating profits are more than adequate to repay their debt, and is a sign of strength, with $3.28 billion in cash and liquid assets, up from $2.7 billion earlier this year, against $12.6 billion in long-term debt. Their long-term debt is a reflection of the capital-intensive investments in itself the company has made to streamline its operations, modernize and automate its own supply chain, and to stay competitive in its market.
Dividend: KR pays an annual dividend of $.84, which marks an increase from $.64 per share in early 2020 and $.72 per share earlier this year. The current payout translates to a yield of about 1.96% at the stock’s current price. The increasing dividend should be taken as management’s confidence in their operating model and ability to keep the business growing in the long-term.
Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but I like to work with a combination of Price/Book and Price/Cash Flow analysis. Together, these measurements provide a long-term, fair value target around $44 per share. That means that even though KR is still more than -15% below its 52-week high, KR is only somewhat undervalued, with just about 5% upside from its current price, and a practical bargain price at around $35.
Technical Profile
Here’s a look at the stock’s latest technical chart.
Current Price Action/Trends and Pivots: The chart above displays the last year of price movement for KR. The stock’s upward trend began in December 2020 at a low point around $30, peaking at the beginning of September at $48. From that peak, the stock dropped to about $38.50 in mid-October, but has picked up bullish momentum from that point, hitting a peak early this month at around $43 before dropping back to support at the 38.2% retracement line at the end of last week. The stock has bounced off of that current support, at $41 and is nearing immediate resistance at the recent, $43 peak. A push above $43 could see short-term upside near to the stock’s September high between $47 and $48, while a drop below support at $41 should find next support at around $39, where the 50% retracement line currently sits.
Near-term Keys: KR’s drop in September and early October helped to make the stock far more interesting as a potential value play than it has been for most of the summer; however for practical purposes it won’t really offer a compelling value proposition unless it continues to drop to about $35 per share. That means that the best probabilities to work with this stock lie with short-term, momentum-based trades. You could use a push above $43 as a signal to buy the stock or start working with call options, using $47 to $48 as a good bullish profit target. A drop below $41, on the other hand would act as a strong signal to consider shorting the stock or buying put options, with a practical bearish profit target sitting at next support around $39 per share.