The Kroger Company. (NYSE:KR) rebounded strongly as expected from the pullback around $42. As of today, KR is struggling to clear its March high and in my view opens up an opportunity to lock in some profit and patiently wait for its removal. The company continues to improve its digital ecosystem, as mentioned in my last post on Kroger, however, due to temporary headwinds, I updated my DCF model. My revised valuation still offers 20% upside potential, however, the overall bearish sentiment outweighs the current yield and that’s why I’ve sold some of my total positions and am looking for another entry point , as discussed in this article.
KR remains one of the world’s largest food retailers with 5-year revenue growth of 3.64% CAGR, still faster than its peer Walmart Inc. (WMT). Although the company is experiencing uncertainties related to excessive inflation, it has managed to deliver positive results, especially on its operating margin of 2.7% recorded in fiscal 2021 compared to 2.4% in fiscal 2021. 2020. Additionally, KR’s gross margin decreased to 22.01% from 23.32% last year. the year, due to the increase in fuel sales in supermarkets, as we will see later in this article. Further investigation into the origin of these cost savings reveals that a surprisingly large part is due to the drop in OPEX, which is the result of numerous store closures, closures of food production plants and the layoff of more than 40,000 employees.
Kroger currently has 420,000 employees (vs. 465,000 last F2020) working in the company’s 2,726 supermarkets (vs. 2,742 registered supermarkets last fiscal year), 33 food production plants (vs. 35 food production plants in F2020) and 1,613 fuel centers. A decrease in its human resources is somehow wise as there is an ongoing labor issue in California that plans to strike for a pay rise. On the other hand, I find it intangible from the company’s point of view, as it turns to automation and technological advancement, improving its digital ecosystem which can further support the growing demand of the company. In fact, the company has reassured its investors that KR is still capable of delivering a total shareholder return of 8% to 11%.
As we look to 2022, we are confident in our ability to continue to differentiate ourselves, serve our customers in new and exciting ways, and continue to change the definition of what it means to be a grocery retailer without ever losing sight of what is most important to our customers. And when we do, we have a clear path to achieving our commitment of 8% to 11% total shareholder return over time for our shareholders. Source: Call for Q4 2021 results
Additionally, management has planned to increase its CAPEX budget to $3.8 billion to $4 billion in fiscal 2022, which should accelerate the company’s long-term growth. Then we can probably see other catalysts for improving its digital economy. In April 2022, KR launched a collaboration with Bed Bath and Beyond Inc. (BBBY) to improve its online services, promoting an improved overall customer experience.
When it comes to its digital sales on a yearly basis, it’s down 3% from its last fiscal year, but it’s still showing exceptional growth on a two-year stack basis of 113%. On the plus side, total KR fuelless sales of $122,293 million, up 0.1% year-over-year and a remarkable 13.76% on a two-stack basis years compared to $107,487 million in fiscal 2019, imply a strong and cohesive ecosystem. Another value-added enabler is its growing supermarket fuel, as seen in the image below.
Although fuel prices have increased following the conflict between Ukraine and Russia, the company still produces a higher figure of $14,678 million this year than it did in 2019. This growth is attributed to a fuel efficient reward program in which points accumulated by customers are linked to the company’s online store. In addition, management provided a strong outlook on its fuel sales growth, as shown below:
Customers who redeem Fuel Points spend on average 4x more at Kroger and visit 4x more frequently. Our investment in fuel rewards, which is reflected in our supermarket gross margin, also helps customers maximize their dollars and helped us achieve 5% gallon growth in the fourth quarter, outpacing growth in market. Source: Q4 2021 Earnings Call
Due to rising inflation and rising yields, I have lowered my expectations for the company, however, it still produces 20% upside potential at today’s price. I still used an EV/EBITDA multiple of 10.35x which is still below its counterpart, WMT, which generated an EV/EBITDA ratio of 13.26x. I also updated my WACC calculation which is now at 4.54% and used that as the discount rate to complete my DCF model.
In my opinion, KR remains a solid investment, however, due to its deteriorating ROE trend as shown in the image above, I believe there is no reason to enter aggressively in today’s sentiment.
I completed my DCF model using the best expert forecasts. However, contrary to its current FY2026 consensus estimate of $141.17 billion, which is expected to decline 1.60% year-over-year, I have forecast a flat rate of growth due to strong direction from management. We can also see a solid upward revision to its total annual revenue estimates despite the current headwinds. I projected its operating profit to be 3.1% at the end of the model; this is in line with the company’s long-term cost reduction strategy. In fact, management is targeting an additional $150 million increase in future operating profit. In addition, I have planned an increase in CAPEX expenses, as shown in the image above.
The image below includes my assumptions and the updated WACC calculation that I used as a reference to complete my DCF model.
Revisit the chart
Currently, KR is showing some weakness in the price action and could print a potential double top. With its declining efficiency and macro headwinds, it only makes sense that KR is experiencing a pullback that will open up an opportunity to get it at a better price. Looking at its 50-day simple moving average, we can see a huge price imbalance suggesting KR is heading back to its 50-day simple moving average. Looking closely at its daily timeframe, we can see a huge gap from March 2, 2022, which we can use as a confluence for our target support or buy zone, should there ever be a correction. Finally, its MACD indicator tells investors and traders that KR is still in a strong uptrend, which serves as a good catalyst for a pullback opportunity. If KR is really strong, I expect a pullback of 10%; otherwise, it is likely to experience a deeper setback.
Kroger’s margin and efficiency may be impacted by today’s temporary headwinds, but when combined with management’s guidance regarding continued buybacks and dividend payments aligned with long-term total return for the shareholders of the company, I think it still provides a positive benefit to investors. However, from a short-term perspective, I believe the risk involved outweighs its potential return. KR is trading at logical resistance and taking profit at today’s price, leaving some to ride another wave if it continues to outperform the market, and in my opinion this is the safest plan considering of today’s market sentiment.
Thanks for the reading!