Brokers like a balanced portfolio. They like clients to own set percentages of various market sectors, and they often urge them to “re-balance” after prices change, dropping what has worked for what might work next.
If you take advice from one of these people, you may have been told to sell some Amazon.com, Inc. (NASDAQ:AMZN) and buy some Kroger Co (NYSE:KR).
After all, the broker might say, AMZN is becoming a very big piece of your portfolio. The two companies are roughly the same size. Kroger is well-run. Amazon has to fall eventually.
If you took this broker’s advice last year, you may now feel like firing your broker. Over the last year Amazon shares are up over 60%, while those of Kroger are down nearly 20%. Since splitting 2:1 in July of 2015, Kroger shares have fallen by nearly one-third, from $38.20 down to $29.90 as of the close on September 27.
What’s going on?
Software Scales for AMZN Stock
Even in 2013, Amazon was mainly valued as a retailer, a Kroger competitor. What investors have realized since then is that it’s a software company.
Software scales, especially in the age of the cloud, and AMZN is, of course, the leading provider of cloud services. It’s also a leader in delivery infrastructure and warehouse infrastructure, with a unique ability to “break bulk” — turn pallets of merchandise into single-unit lots — without the “shrinkage” of people taking stuff off the shelves and moving it around.
But it’s mainly valued as a software play. Its cloud revenues keep accelerating, and should hit $10 billion this year. That makes Amazon Web Services a $100 billion business just by itself.
Then add roughly 63 million AMZN Prime members, paying about $100 per year for the privilege. That’s $6.3 billion in revenue the company gets for doing nothing, which is also worth 10 times revenue.
As a result, Amazon remains on track to grow another 20%-plus this year, over last year’s $107 billion in sales, and to do so with increased margins, thanks to AWS and Prime. That’s a Price/Earnings multiple of over 200, a price/sales ratio of close to 4, and the ceiling remains unlimited.
People Do Not Scale for KR
Kroger isn’t doing anything wrong. After registering over $109 billion in sales for 2015, the Cincinnati-based mega-grocer is on track to do the same again.
Kroger’s problem is that people don’t scale. People have to turn warehouse deliveries into store displays. People have to manage those products through the distribution cycle. Growth comes from opening or expanding stores — revenue doesn’t just appear.
After beating earnings estimates for the second quarter, however, Kroger guided toward lower profits — $2.10 to $2.20 per share instead of the consensus estimate of $2.21. Revenues for the quarter came in slightly below estimates, at $26.57 billion, because gasoline prices remain low. Kroger sells a lot of gasoline — it owns convenience stores as well as supermarkets.
Kroger is in short a typical mass-market retailer, turning each $1 of earnings into a penny or two of earnings. Wal-Mart Stores, Inc. (NYSE:WMT) has similar results. So does Target Corporation (NYSE:TGT).
Not only do a merchant’s own employees have to work hard to make sales, but so do customers — driving to the stores, pulling products off shelves and lugging the results back home.
The reason given by analysts for Kroger’s recent poor performance is that shares rose quickly in 2013-2014 and it’s now consolidating, catching up with itself. It has now caught up all the way to a price-to-earnings multiple of 14, well below the average stock, and the 12 cent quarterly dividend now yields 1.6%.
But I think that’s an excuse. The real reason for Kroger’s poor performance is its scaling problem, a box it can’t seem to get out of.
Software Beats People
The most important investing truth of this decade is simple. Software scales where people do not. For society, this is a problem, because software isn’t people.
But if you’re an investor, you take this lesson and invest in software. I don’t think Kroger is going away by any means. But its stock is not worth a premium, and management’s basic, blocking-and-tackling strategies won’t make it worth a premium.
This will remain the case until Kroger can do something magical with software. Tell that to your broker next time you see her. And adjust your portfolio accordingly.
Dana Blankenhorn is a financial journalist who dabbles in fiction, his latest being The Reluctant Detective Travels in Time. Write him at danablankenhorn@gmail.com or follow him on Twitter at @danablankenhorn. As of this writing he owned shares in AMZN and KR.
