Market Mad House

In individuals, insanity is rare; but in groups, parties, nations and epochs, it is the rule. Friedrich Nietzsche

Grocery Wars

Surprise; Kroger’s Revenues Growing Faster than Costco’s

Here’s a surprise flash from the front lines of the grocery wars; Kroger (NYSE: KR) is now growing faster than either Walmart (NYSE: WMT) or Costco Wholesale (NASDAQ: COST).

During third quarter 2016, Kroger’s revenues increased by $1.48 billion. Costco’s revenues grew by $880 million in the same quarter and Walmart’s expanded by $770 million. Kroger reported $112.41 billion in revenues in July that grew to $113.89 billion October; Costco reported $118.72 billion in revenues in August that grew to $119.60 billion in November, and Walmart reported revenues of $483.83 billion in July and $484.60 billion in October.

That’s right, Kroger actually added more revenue during third quarter 2016 than either Walmart or Costco. These numbers provided by ycharts show us that Kroger is now growing faster than its two larger rivals.

Kroger’s Expansion is Paying Off

Such numbers indicate that Kroger’s expansion is paying off and the mega grocer is able to hold its own against rivals like Costco. The strategy of buying regional grocery chains; like Roundy’s and Harris Teeter, is enabling Kroger to compete in the big leagues and win.

What’s interesting is that Kroger is pulling this growth off with a very low profit margin (1.47% on October 31, 2016) and a negative free cash flow of -$555 million. The grocer is able to do that by harnessing what’s known as the economy of scale, that is to sell a lot of stuff at very low prices and you make a lot of money.

The economy of scale comes from the 2,778 supermarkets, 1,387 supermarket fuel centers, 784 convenience stores, 2,331 pharmacies and 323 fine jewelry stores that Kroger operates in 34 states. That floor space combined with 38 manufacturing plants gives Kroger the ability to deep discount.

The business model is hardly new, the US Post Office was pioneering it before the Civil War, but modern technology gives retailers the ability to engage in it more efficiently. One example of this is Kroger’s impressive loyalty card program, another is its Clicklist drive up pickup service for groceries ordered online.

The massive size is what allows Kroger to offer low prices and make a lot of money despite the low profit margin. The business model of building up a massive ecosystem to drive deep discounting is the same one that Walmart and Amazon (NASDAQ: AMZN) utilize.

Is Kroger Making Money?

Kroger is making some money, it reported $2.013 billion in net income on September 30, 2016. That number has fallen slightly in recent quarters it was $2.1 billion in second quarter and $2.05 billion in third quarter.

That number does not provide a lot of float, Kroger reported just $374 million in cash and short-term investments on September 30, 2016; even though it reported $4.444 billion in cash from operations and $36.51 billion in assets on the same day. Cash from operations is also down, Kroger reported $5.13 billion in cash from operations in April and $5.033 billion in July.

My guess is the cash from operations has been falling because of food deflation (lower food prices) and lower fuel prices. Food prices fell by 1.5% in June 2016, 1.6% in July and 1.8% in August, Empresa-Journal reported. That hurts companies like Kroger which operate at a very low profit margin.

Kroger might get some relief if fuel prices start going up again in coming months. Unfortunately, falling food prices might eat up any additional revenue from gasoline sales.

Food deflation explains why Kroger has been greatly expanding premium services like delivery, organics and hot entrees which sell at a higher price to its market. It also explains why Kroger is greatly expanding the offerings of dry goods ranging from clothing to furniture that are found in its stores. Some Kroger Marketplaces now have a selection of toys, clothes, housewares, small appliances and clothing that rivals that in a Walmart supercenter.

There are some advantages to food deflation, Kroger might be in a position to acquire some more regional grocers for a good price like it did with Roundy’s. Another advantage is that Kroger is in a position to undercut the prices of discounters like Aldi and Dollar General (NYSE: DG) and steal their customers.

Is Kroger a Good Investment?

Okay so Kroger is in a pretty good position right now but is it a good investment? If you liked undervalued companies the answer is yes, Kroger had a stock price of $35.22 and a market cap of $33.04 billion on December 22, 2016.

Its investors were rewarded with a return on equity of 30.79% on October 31, 2016. They also received a 12¢ dividend on November 10. That dividend increased by 1.5¢ this year, it was 10.5¢ in April 2016.

The company’s dividend has been steadily increasing for some time. Kroger paid a 9.2¢ dividend in 2015, an 8.3¢ dividend in 2014, a 7.5¢ dividend in 2013 and a 5.8¢ in 2012. The company also split its stock last year which lowered the share price but effectively doubled the dividend.

If you are looking for an undervalued retailer, Kroger would be a pretty good choice. It’s also a company that might make more money if Congress goes along with President-elect Trump’s proposed tax cuts.

Kroger’s profits would be higher if corporate tax rates were lowered to 15% or 20% from the present 35% as Trump has proposed, The Cincinnati Business Courier reported. Kroger pays a higher tax bill than many companies because it does almost no business outside the US.

Investors should note that any such tax cut would probably be two or three years away at the earliest, because it would require Congress to change the tax code. Such a change would require legislation and debate; and it would probably face heavy Democratic opposition. Therefore investors should not bank on that tax change, but keep it in mind if they add Kroger to their portfolios.

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