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Kroger (KR) is on the Hedgeye Consumer Staples SHORT bench.

HEDGEYE OPINION

Kroger reported lackluster figures today, as the business continues to struggle through a deflationary environment, resulting in tighter margins and decreased ROIC; and adding to the headwinds are increased competition and continued pressure from their multiemployer pension plans (MPP). Kroger is in a position where they are destroying shareholder value with the hopes of moving the company and the brand forward. With sales, margins and returns all decelerating, the company is not adjusting to the new operating environment.  In addition, Kroger has its hands tied with its MPP’s which are increasingly impactful to the business. In order to add relevant value to the business, management will have to be smart in reallocating savings to value-added areas that improve the experience for consumers.

ID SSS came in at +0.1%, after trending at +0.5% near the end of the quarter, missing FactSet estimates of +0.5% and gross margin was 22.2% versus FactSet 22.2%. EPS was $0.41 for the third quarter, matching FactSet estimates. For the remainder of the year, the Company narrowed their EPS guidance to a range of $2.10 - $2.15 (excludes the $0.07 charge from 2Q), down from their prior guidance of $2.10 - $2.20.

The next big data point for the company will come when management outlines its official guidance for FY17.  Management has alluded that FY17 will be the second year in a row that it will not hit its long-term EPS guidance of 8-11%.  Without significant changes to the operating environment it will be difficult for the company to get the low end of the range over the next couple of years; if ever!   

Our bearish bias to KR is tempered by our bullish bias to the grocery retail space.  We expect the entire grocery space to trend upward as we enter a reinflationary environment. However, of all of the names in the space, Kroger faces the most fundamental issues, the most important of which is their multiemployer pension plan obligation, followed by their tightly wound business model. Their MPP obligation will continue to be a drag on the business, and there are many aspects of the financials that are not sustainable.  We will provide further detail of this in a more detailed note that is forthcoming. 

 

NOTABLE COMPANY THOUGHTS

“It’s worth noting, over a longer time horizon we do expect our net total debt to EBITDA ratio to grow if we continue to successfully negotiate restructuring of troubled multiemployer pension plan obligations to help stabilize associates’ future benefits,” (Michael Schlotman, CFO).

HEDGEYE After taking their $0.07 EPS charge in relation to the restructuring of certain MPP obligations last quarter, the company appears to be giving us a heads up that there is more coming down the pike.

“When we take on additional debt to fund these obligations, this reduces the off balance sheet amount of estimated multiemployer pension plan obligation,” (Michael Schlotman, CFO).

HEDGEYE – Surprisingly, the Company provided much more MPP information than they have on previous calls. Such information further solidifies our SHORT bias.

“As expected, deflation persisted during the third quarter, and as we’ve said before, transition periods created a difficult operating environment. This is the third time we’ve had such deflation in 30 years and in previous instances, deflation lasted from 3-5 quarters in a row…We are in the middle of the cycle right now,” (Rodney McMullen).

HEDGEYE This statement mirrors the guidance provided prior to the call, with KR expecting the operating environment in the first half of 2017 to be “similar to today.”

On their approach to e-commerce: “Where we’re situated, our customers live within two or three miles of the store. They more regularly shop in. It’s extremely convenient for them to order online and make that stop by the store on their way to and from either work or daily activities,” (Michael Schlotman, CFO)

HEDGEYE When pressed on whether they would pursue home delivery, as some competitors have done, management did not take the bait. According to management, ClickList has allowed them to gain share while offering added convenience to their customers.

 

QUICK COMPS

  • Revenue: $26.56B vs FactSet $26.33B
  • 3Q EPS:$0.41 vs FactSet $0.41
  • IDs (ex-fuel): +0.1% vs FactSet +0.5%
  • Gross Margin: 22.2% vs FactSet 22.2%
    • Ex-fuel: -5bps
    • OG&A: 16.7% vs FactSet 16.5%
      • Operating expenses ex-fuel: +19bps (15bps of this is related to depreciation increases in capital program)
      • Operating Margin: 2.7% vs FactSet 2.7%

KR | 3Q16 EARNINGS NOTE | SOMETHING HAS TO GIVE  - Chart 1

 

OUTLOOK

Q4 Guidance:

  • Company expects slightly positive identical supermarket sales growth (ex-fuel).

 

FY16 Guidance:

  • Adjusted EPS $2.10 - $2.15 vs FactSet $2.13 (prior guidance of $2.10 - $2.20).
  • Expected capital investments $3.6B - $3.9B.

 

FY17 Guidance:

  • The Company is completing its business plan process for 2017 and will provide specific 2017 guidance in March.
  • KR anticipates both positive identical supermarket sales and net earnings per diluted share growth (excluding the 53rd week).
  • Net earnings will likely be below the low end of the company’s 8-11% net earnings per diluted share long-term growth rate guidance.
  • KR expects the operating environment in the first half of 2017 to be similar to today. The second half of 2017 should show improvement as the company laps current figures.
  • The Company is committed to achieving a net earnings per diluted share growth rate of 8-11%, plus a growing dividend.

Please call or e-mail with any questions.

Howard Penney

Managing Director

Shayne Laidlaw

Analyst