Growth investing leans heavily on the idea that stocks tend to follow the direction of their previous trends.
That may just be a nerdy way to say that the longer a stock has been going up, the more likely it is to keep going up. It is also why growth investors shun stocks that are at or near historical lows resulting from downward trends. Value investing, by contrast, holds that all trends are finite; every upward trend is doomed to fail at some point, and every downward trend is destined to recover. It also means that stocks that have been going up, and that are attractive to growth investors usually draw no more than a shrug from value seekers.
The reality that all trends eventually fail makes logical sense, but it’s actually is a contrarian, counter-intuitive idea for many to apply in making investment decisions. That’s because it means that value investors aren’t afraid to buy a stock when the rest of the market is staying away. Sometimes, it means buying a stock at what the bargain hunter has decided is a useful, “good enough” price, and then watching the stock drop even more. That is also a hard thing for a lot of investors to endure, and it is why being a successful value investor requires discipline as well as patience.
Over the last three and a half 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, and certainly all of the past year’s focus on inflation, interest rates, and war in Ukraine as the basis for a defensive approach to a lot of the analysis I’ve done. I think that when economic conditions become more difficult, positioning defensively 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 conservative, useful investments since 2018. I also believe that, with global inflation still high, and Fed chair Jay Powell telling Congress this week that interest rates will remain elevated, and continue to go up, the need to remain conservative and defensive will continue to be a smart approach for the rest of the year. I also think it means that stocks in the Food Products industry will continue to be a useful place to keep your money working for you.
The caveat to looking for investments in Food Products stocks is that not all stocks are created equal. Not only do not all companies share the same kind of fundamental strength, it’s also true that not all Food Products stocks might offer a good value. That’s an important distinction to make, because just as a stock in a new, long-term upward trend typically outpaces the underlying company’s fundamental strength, stocks in downward trends aren’t categorically driven by fundamental weakness.
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. This is a stock that followed a strong upward trend through 2021 to a peak in April of 2022 at almost $63 per share. From that peak, the stock dropped into a clear downward trend that bottomed in October at around $42 and has hovered near that level for most of the past four and a half months. Following their latest earnings report, the stock has picked up quite a bit of bullish momentum to its current price a little above $47.
KR has been among the most proactive innovators in the entire Consumer Staples industry over the past few 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. They also represent significant capital investments that have only just begun and that management has signaled will continue for at least the next couple of years. I think the stock’s fundamentals could give a bullish investor good reason to add KR to a diversified portfolio; but that begs the question, is it also a good value? Let’s dive in and take a look.
Fundamental and Value Profile
The Kroger Co. (KR) is a food retailing company that owns and operates supermarkets, multi-department stores and fulfillment centers throughout the United States. The Company manufactures and processes some of the food for sale in its supermarkets. The Company operates approximately 2,800 owned or leased supermarkets, distribution warehouses and food production plants through divisions, subsidiaries, or affiliates. These facilities are located throughout the United States. The Company also owns store equipment, fixtures, and leasehold improvements, as well as processing and food production equipment. The Company offers personalized, order online, pick up at the store services and also provides home delivery services. In addition, the Company also retails products online. The Company’s brands include Private Selection, The Kroger, Big K, Check This Out, Heritage Farm, Simple Truth and Simple Truth Organic. KR has a market cap of $33.9 billion.
Earnings and Sales Growth: Over the last twelve months, earnings increased by 8.9%, while sales improved by 5.37%. In the last quarter, earnings improved by 12.5% while revenues also rose, by 1.83%. Like most Food retailers, KR operates with razor-thin margins, as Net Income was about 1.51% of Revenues for the last twelve months, and narrowed slightly in the most recent quarter to 1.29%. From an operational standpoint, that leaves little to no room for error.
Free Cash Flow: KR’s free cash flow is healthy, at $1.3 billion over the last twelve months. That marks a decline from $2.6 billion a year ago, and $1.95 billion in the quarter prior. The current number translates to a modest free cash flow yield of 3.9%. The declining free cash flow pattern confirms the weakness reflected by the narrowing of Net Income over the last quarter.
Debt to Equity: KR has a debt/equity ratio of 1.26. This is higher than I usually prefer to see, but also isn’t unusual for Food Retailing stocks. The company’s balance sheet indicates that operating profits are adequate to repay their debt, and is a sign of strength, with about $2 billion in cash and liquid assets (versus $2.1 billion in the quarter prior), against $12.5 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. I take the decline in Net Income, Free Cash Flow and cash over the past year as a reflection of cost increases that KR has actively chosen not to fully pass to their customers, and that could act as a headwind to profitability this year.
Dividend: KR pays an annual dividend of $1.04, which marks an increase from $.64 per share in early 2020, $.72 per share at the beginning of 2021 and $.84 to start 2022. The current payout translates to a yield of about 2.22% at the stock’s current price. The increasing dividend over the last two years should be taken as a sign of 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 $51 per share. That means that KR is modestly undervalued, with 7.64% upside from its current price.
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 red diagonal line marks the stock’s downward trend from a peak at around $63 in April of last year to its October low at around $42; it also provides the baseline for the Fibonacci retracement lines shown on the right side of the chart. After staging a temporary rally to about $50 to start December, the stock dropped back again and began to settle into a consolidation range through February. The top of that range was about $45, which now marks current support after the stock broke above that range following the latest earnings announcement. Immediate resistance is expected at around $50, where the last major pivot high occurred in December, and inline with the 38.2% retracement line. A push above $50 could see additional upside to about $52 where the stock peaked in early September of last year, while a drop below $45 should see the stock retest its yearly low between $43 and $42 per share.
Near-term Keys: KR’s break above the top of its consolidation range this week is an interesting set up for bullish-focused investors. It could offer an interesting, momentum-based signal to consider buying the stock or working with call options, with an attractive near-term target at around $50. A drop back below $45 could be a signal to consider shorting the stock or buying put options, using $42 as a reasonable profit target on a bearish trade. While the stock is undervalued at its current price, the value proposition isn’t high enough at this price to make it a great bargain. I think it’s a smart idea to tuck this one away in a watchlist for now and come back to it again later.
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