We believe that Kroger’s prospects are bolstered by affordable private brands, strong customer analytics, and a growing emphasis on fresh foods, as well as by the convenience of online ordering and curbside pick-up at virtually all of its stores.
The volatile economic environment of the last few years has caused investors to differentiate between business models that are well positioned for the future and those that face significant challenges. We believe that Kroger will be a survivor.
Kroger is gaining market share. It was gaining share before the COVID-19 crisis and said that it has gained share during the pandemic, with help from attractive prices. The company continues to use “big data” to drive promotions and merchandising decisions.
On October 14, Kroger announced plans to acquire Albertsons Companies, a large supermarket chain with more than 2,000 stores in 34 states and the District of Columbia. Banners include Albertsons, Safeway, Vons, Shaw’s, Acme, and Jewel-Osco.
The deal will give Kroger a bigger market for its own-brand products and alternative revenue streams, such as in-store advertising. The combined company will have almost 5,000 stores, 4,000 pharmacies, and approximately 2,000 gas stations. We believe that the proposed acquisition of Albertsons is likely to boost earnings if it is completed.
While we expect the deal to be beneficial, significant M&A was not part of our investment thesis for Kroger, and we are generally not fans of big acquisitions. The transaction is likely to face substantial scrutiny from regulators.
Meanwhile, KR repurchased about $1.2 billion of its stock in FY21. The company purchased about $1.6 billion of its stock in FY22. Over the last five years, Kroger has increased the dividend at a compound annual rate of 16.5%.
In June 2022, it raised its quarterly dividend by 24% to $0.26 per share. Our FY23 dividend estimate is $0.94 and represents 23% of our FY23 adjusted EPS estimate, which should be sustainable. Our FY24 dividend estimate is $1.06. We expect Kroger to pay a dividend if the merger with Albertsons is completed.
We believe Kroger is taking the right steps to defend and increase its market share. The company has a track record of using technology to stock its shelves with the right merchandise and offer the right promotions.
At 16-times our FY24 EPS estimate of $4.08, the shares would be worth about $65. Using our five-year growth rate estimate of 6%, a 25% dividend payout, and a 7.75% cost of equity, followed by a steady-state growth phase with 3% growth, a 75% payout, and a 7.5% cost of equity suggests a fair multiple of 17.
Based on the company’s recent resilience, we might be able to justify a lower cost of equity. The counterpoint is that the margin structure is very low, the company does have debt and pension obligations, and interest rates have risen.
Using similar assumptions and our earnings estimates to analyze Kroger with a dividend discount model also puts the value of the shares at $64, which remains our target price.