Since Amazon.com, Inc. (NASDAQ:AMZN) announced it was buying Whole Foods on June 16, 2017, AMZN stock is up 62% through March 20. Meanwhile, Kroger Co (NYSE:KR), the nation’s largest grocery-store chain, has seen Kroger stock drop 3% in the same period.
On a relative basis, Kroger shareholders have got to be kicking themselves for not getting on the Amazon bandwagon.
However, that’s water under the bridge.
If you’re still holding Kroger stock, the big question is whether management should be buying back its stock at distressed prices or putting it to use in some other fashion?
The Five Capital Allocation Levers
CEOs have CEOs have five ways they can deploy free cash flow ways they can deploy free cash flow: Reinvest in the existing business; make acquisitions; pay down debt; pay dividends; and, buy back stock.
So, before we get to share repurchases, let’s go through the other four capital allocation levers.
Reinvest in business: In fiscal 2017, Kroger spent $3.0 billion on its business, $600 million less than a year earlier. It expects to spend approximately the same amount in 2018 as it did this past year.
A major area of investment in 2018 will be the company’s Restock Kroger Plan, which it unveiled last October.
Many of the pieces of Restock Kroger revolve around technology. Whether it be smart pricing to maintain market share or expanding its self-checkout pilot to 400 stores in 2018 to improve the customer experience, Kroger needs to continue investing in its business.
I’m not a capital allocation expert, but if it spent $3.6 billion in 2016, given the competition, it ought to be spending at least that much in 2018 and beyond.
Pay down debt: Kroger finished fiscal 2017 with $15.2 billion in net total debt, $400 million higher than at the end of the third quarter. As a result of a $1 billion contribution to the company pension plan (it made no contribution in 2016), its net total debt increased to 2.65 times adjusted EBITDA from 2.57 in Q2 2017.
Its target is 2.2-2.4 times adjusted EBITDA.
However, thanks to the sale of its convenience store business for $2.2 billion (it will close in the first quarter), Kroger will be able to bring net total debt in line with its target.
Make acquisitions: Except for little deals to complement the digital side of its business, I don’t see Kroger making any acquisitions in 2018. It doesn’t need to add more stores at this point.
Pay dividends: In 2017, Kroger paid out $444 million in dividends, $15 million higher than a year earlier. I’d expect it to pay out no more than $460 million in 2018.
Share repurchases: This is where it gets interesting.
Kroger repurchased Kroger repurchased $1.6 billion of its stock in 2017 of its stock in 2017 at an average cost of $26.22 a share. That’s about 33% more than it’s repurchased annually, on average, over the past five years.
With some of the funds from the convenience-store sale along with some of the tax savings from the corporate tax rate cut already committed to share repurchases in 2018, I’d expect the amount to be higher than $1.6 billion.
Should the Company Buy Back Kroger Stock?
While the repurchase of Kroger stock in such big quantities does suggest management think its shares are cheap, I would suggest at this point, with free cash flow still only $706 million despite a 23% increase year over year, that the company has better things to do with those funds than buying back stock.
So, from where I sit, no price is cheap enough at this point given how much competition it’s currently facing.
Either invest more capital or pay down the debt and keep the buybacks to less than $200 million.
As of this writing Will Ashworth did not hold a position in any of the aforementioned securities.
