Boring, Yes. But Kroger Offers Stability, Growth, and Value.

Recommending a long investment in Kroger with a 1 year target of $47. KR represents an opportunity to invest in both stability and growth at an attractive valuation (20% discount to S&P). While the industry has grown annually at 3.2% with only one down year in 10 years (-0.1% in 2009), KR has grown comps for 40 consecutive quarters at 3.8%. This was achieved by management's investment in pricing, which is now competitive with #1 Wal-Mart and 10-15% lower than #3 Safeway. A number of competitors in the space remain challenged, creating an opportunity for KR to continue to gain share and grow EPS over 10% for 3-5 years. This opportunity exists because past earnings growth was muted while KR invested to become a low-price operator and will become apparent as management executes on higher margin opportunities to fill-in market presence and take share.

Attractions:

1. KR's executives are great operators and capital allocators (returned 20% of MV in 3 years) who are compensated by ROIC
2. KR's end market is growing and stable. Food store sales increased ~3% per year over the past 10 years driven by population growth and inflation, and only declined in one year (2009) by -0.1%
3. KR's SSS growth has been consistently positive (40 consecutive quarters), outpacing competitors and food inflation.
4. KR's pricing is competitive with Wal-Mart and better than supermarket peers, creating a virtuous cycle where it generates higher profits that it reinvests into its store, further increasing the gap in pricing and customer experience
5. KR uses the debt markets prudently; benefiting from low interest rates (issued 10 year at 4%). Continuously recapitalizing and buying back shares is optimizing the balance sheet for shareholders
6. KR's real estate has an implied value of 30% of enterprise value. Ownership of locations has increased from 30% to 45%

Risks:

1. Prolonged low or high food inflation
2. Online competitors (Amazon) increasing penetration of non-perishables and expansion of at-home grocery delivery
3. Over expansion from bricks and mortar competition

Market View:
- Negative view is KR is in a bad industry, with low EPS growth ex repurchases, and EV/EBITDA at mid-high end of historical levels
- After reaching $43 in October, KR sold off as retailers expressed caution on the consumer
- CS downgraded target price from $48 (Buy) to $39 (Neutral) due to its forecast of lower than normal food inflation. The next week, the USDA released its inflation forecast of 2.5-3.5% (compared with 2.5% and 0.9% in 2012 and 2013)

Catalysts:

- Management will affirm growth Capex / square footage expansion plans and operating margin targets
- Most of the street has not updated models to include Harris Teeter (consensus $3.12 2014E EPS). This will add $0.06-0.09

Valuation Discussion:

As KR holds operating margins and increases square footage, historical multiples could prove conservative for a company growing EPS at 10%, paying 1.8% dividend, and having below-market volatility. Currently, S&P trades at 17.1x LTM EPS, while WMT and TGT are at 14.2x and 15.1x. For now, modeling 1 year target multiple of 14.7x, similar to P/E multiple reached in October. DCF valuation implies NOPAT/EV of 5.5%, which is supported by 7.4% cost of capital and end market growth of 2.5% (due to food inflation). Implied EV/EBITDA of ~7.2x is at the high end of past 10 years, but reflects that KR margins have now internalized the effects of WMT's expansion. EV/EBITDA for WMT and TGT are 7.8x and 7.1x despite higher mix exposure to online competition.