In March America’s largest grocer, Kroger Co (NYSE:KR) reported decent fourth quarter numbers alongside an awful full-year 2018 guide. The bad guide short-circuited what was a multi-month rally in Kroger stock from $20 to $30.
After the Q4 report, Kroger stock dropped to $23. I smelled an opportunity in that sell-off as Kroger’s big growth initiatives, digital and private-label sales growth and cost-savings, were proceeding as planned. Those growth drivers gave the company a solid long-term growth outlook which didn’t seem priced in at $23.
Fast forward a few months, and Kroger is rallying back towards $30.
The big driver? A double-beat-and-raise first quarter earnings report that comprised huge digital sales growth, record private-label sales share, and rebounding margins.
Those are the three big check boxes when it comes to Kroger stock. As such, I think the strong first quarter report paves the way for Kroger stock to break above $30.
Here’s a deeper look.
Kroger’s Growth Narrative
Kroger’s first quarter earnings report was very good.
Comparable sales rose 1.4%. While that is a slowdown from last quarter’s 1.5% rate, this quarter’s 1.4% comp lapped a 1.6% comp in the year ago quarter, versus last quarter’s 1.5% comp lapping a 0.6% comp in the year ago quarter. Thus, on a two year stack basis, comparable sales growth in Q1 was 3%, versus 2.1% in Q4.
In the big picture, then, the comparable sales growth trend is improving.
Sales rose 3.4%, assisted by a boost in higher gas prices. Ex-fuel, sales rose 2.3%, which is still a solid growth rate for a huge grocery chain. Gross margins showed signs of moderating, falling just 13 basis points year-over-year. Meanwhile, operating margins actually rose 100 basis points year-over-year, thanks to improved cost controls which more than offset higher wages.
Looking out, management implied that these good times will keep rolling for Kroger. Comparable sales growth is expected to be between 2% and 2.5% this year, while earnings are expected to come in at $2.08, versus the prior guide of $2.05.
Why are things getting better for Kroger?
Three major reasons. One, digital sales are soaring (up 60% in Q1, against a tough 90% lap last year). Two, private brands are succeeding and creating a healthy moat around the business (private brands achieved highest-ever retail dollar share last quarter). Three, cost saving initiatives are yielding materially positive results, and creating a rebound effect in margins.
All three of these major growth drivers accelerated in Q1. Thus, the long-term growth narrative of Kroger as a sustainable grocery company adapting to today’s omni-channel retail environment by building out digital sales capabilities and enhancing private offerings, has only strengthened.
Kroger Stock Should Break Above $30
Below $30, Kroger stock simply isn’t priced appropriately considering that it will remain America’s largest grocer over the next 5 to 10-plus years.
Thanks to robust digital sales and private brand growth, Kroger is establishing a future for itself as an omni-channel grocer with a big moat. Because of that, comparable sales growth should be able to stabilize around 0-1% over the next several years, and that should flow into 0-1% net sales growth (ex fuel effects).
On the margin side, comparable sales growth stabilization should allow for operating margin stabilization. Operating margins dipped big in 2017, but are already bouncing back, and should have clear runway to 2016 highs of 3% over the next several years.
Assuming that comparable sales growth stabilizes around 0-1% per year and that margins bounce back to 3%, I think that Kroger can net around $3.20 in earnings per share in fivr years. A historically-average 15-times multiple on those earnings implies a four-year forward price target $48.
Discounted back by 10% per year, that equates to a present-day value of just under $33.
Bottom Line on Kroger Stock
Kroger stock is bouncing back thanks to a strong first quarter earnings report which affirmed the company’s staying power as America’s largest grocer. This bounce back will continue into the foreeable future, and Kroger stock will likely break above $30 quite soon.
As of this writing, Luke Lango was long KR.