Kroger Buy Recommendation

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Presentation on Kroger (KR) PT - $27

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  • 1. The Kroger Co. (KR):DISCUSSION MATERIALSAndrew Boone

2. 1 Investment Merits Kroger private label brands provide a competitive advantage Additional fuel centers will increase customer traffic Best in class super market with most defensive positioning Superior data management Improved market share Buy: Price target of $xx.xxMERITSFALL 2011 3. 2 Kroger Co. Overview2 year price historyMiscellaneous considerations Market characteristics Kroger Co. accounts for COGS using FIFO Enterprise value: Market cap: $13.05bn 52 week high: $25.85 (7/20/11) 52 week low: $20.53 (12/10/10) Vol.: 3.067mm Next earnings date: December 1st Dividend yield: 1.9%OVERVIEWFALL 2011 4. 3 The Kroger Co. isStores Different Business Lines % of Traditionally cater to customers in a 2.0-2.5 mile radiusStores revenueTotal Supermarkets2,460 94.0% At the end of 2010, Kroger had 1,014 fuel centers attached to a supermarketCombination Food & DrugStore 2,128 Kroger operates more than 40 manufacturing plantsMulti-Department Stores125Marketplace Stores61 361 jewelry stores (149 in stores & 212 in shopping malls)Price Impact Warehouses146Convenience Stores 7845.0% Product of the 1999 takeover of Fred Meyer JewelersJewelry Stores 3610.5%Other* N/A0.5% Historically, 95% of revenues come from supermarketsOVERVIEWFALL 2011 5. 4 Kroger has historically beenStores2007 2008 2009 2010 Stores Stores Stores Stores Total Supermarkets2,4862,4822,4682,460 Combination Food & Drug Store 2,1832,1692,1432,128 Multi-Department Stores123124125125 Marketplace Stores35 43 53 61 Price Impact Warehouses145146147146 Convenience Stores 782771777 784 Jew elry Stores394385374 361Different Business Lines Combination Food & Drug Complete supermarket & pharmacy Multi-Department Combo store with apparel & food departments Marketplace Combo store with additional living and home goodsOVERVIEW Price Impact Warehouse No frills, low cost shopping FALL 2011 6. 5 Investment Merits Kroger private label brands provide a competitive advantageMERITSFALL 2011 7. 6Kroger does a cost analysis for each private label goodand manufactures 40% of these productsPercent of consumers who agreed with the following statements about private label goods (Source: Mintel) Store brand products are of better quality today than they were five years44.0% ago I compare the ingredients listed in store brand products with the name brand42.0% versions I would recommend a store brand product39.0% I purchase store brand products only because I want to save money but Id35.0% rather purchase name brands I dont feel like Im giving anything up (e.g. flavor, quality, prestige) by using34.0% store brands I trust the ingredients of name brand products more than store brand 23.0% I think its worth paying more for name brand products 19.0%U.S. private label sales (Source: Mintel)70,00012.0%60,00010.0%50,000Sales8.0%($mm)40,0006.0%30,0004.0%20,000AnnualPRIVATE LABEL2.0%Growth %10,000 00.0% 2005A 2006A 2007A 2008A2009A 2010E 2011E 2012E 2013E 2014E FALL 2011 8. 7Unemployment has shackled consumer spending and willkeep consumers watching spending US unemployment (source: Bureau of Labor Statistics) Private label as % of US supermarket sales Jan. 2008-Sept. 2011 (Source: Nielsen, Credit Suisse)PRIVATE LABELFALL 2011 9. 8Three tiered branding structure provides exposuresshopping demographics Best quality brand Private Offers 1,000 Private Selection ItemsSelection Better tier 13 new categories Banner Brands Moderation Pillar allows shoppers an easy way to find healthy items Good tier Value Basic products priced to fit in budgets Brand 27% of grocery sales were from Private label units sold haveprivate label goods in 2010, fromincreased to 35% of all groceryPRIVATE LABEL2007 numbers of 26%sales in 2010, from 32% in 2007 FALL 2011 10. 9Kroger manufactures 40% of their own products:vertical structure improves logistics and marginsLaborManufacturing facilities 99.8% of shoppers buy a corporate brand 18 dairiesproduct every 12 weeks 10 deli or bakery plants Big K cola received new packaging andadded Ralphs as a distribution line 5 grocery plants Kroger does a price analysis when deciding 3 beverage plantswhether to manufacture or outsource 2 meat plants 2 cheese plantsPRIVATE LABELFALL 2011 11. 10 Investment Merits Additional fuel centers will increase customer trafficMERITSFALL 2011 12. 11 Same store sales have been buoyed by the addition of fuel sales but still have room to growSupermarket and fuel center units 3,000 45.0% 2,500Total41.2%40.0%supermarkets 2,000 36.2% 35.0%Attached fuelcenters 1,50031.5%30.0% 1,000Percent ofsupermarkets28.0%with fuel 25.0%500 centers 0 20.0%20072008 20092010 Fuel provides virtually no margins but as gas Kroger loyalty points allow shoppers to gain prices remain high, it drives consumers tofurther discounts as they spend more dollars take advantage of the Krogers low fuel priceson grocery sales - $100 spent on groceriesFUEL CENTERS and shop for groceries at the store allow for a $.10 discount per gallon of gas FALL 2011 13. 12 Same Store Sales show Kroger continuing to winSame Store Sales (Source: Factset) 12.0% 10.0%8.0%6.0%Kroger4.0%Safeway2.0%SuperValu0.0%Wal-Mart (2.0%)20062007200820092010 Costco (4.0%) (6.0%) (8.0%)Percent of stores with attached fuel centers (Wal-Mart and SuperValu do not disclose fuel center count) 70.0% 65.0% 60.0% 55.0% 50.0% 45.0%Kroger 40.0%Safeway 35.0% 30.0%Costco 25.0%FUEL CENTERS 20.0% 15.0%2008 2009 2010FALL 2011 14. 13 Investment Merits Best in class super market with most defensive positioning Superior data management Improved market shareMERITSFALL 2011 15. 14Exclusive DunnHumbyUSA partnership allows Krogerinsights into consumer trends Customer Loyalty Card Program 50% of US households have a Kroger Base capital projects on feedbackloyalty card received from DunnHumby to ensure that Kroger remains client focused 90% of purchases at stores use a loyaltycard Weve been doing this for, I dont know, I guess six years now and if you look at the trend over time, weve had tremendous improvement in terms of being able to engage with the customer in a way that they appreciate and need better and better. And its something that every quarter we get better but were constantly working with dunnhumby and our merchandising teams to figure out how to even get better from where we are. - Kroger Management Team (2011 Q2 earnings call)BEST IN CLASSFALL 2011 16. Superior market share allows for superior economies of15scale and lower prices that continues to drive consumersto Kroger units Weighted Average Market Share (Source: Metro Market Studies)30.0%27.0%24.0%21.0%18.0%15.0%Kroger SafewaySupervalu (Excluding Save-A-Lot)Average basket size for Kroger is 14% lower than Safeway, 18% belowBEST IN CLASSHarris Tweeter, and only 6% more expensive than Wal-Mart*FALL 2011 *Source: Wall St. Research 17. 16Discounted Cash Flow (avg of two methods $27.03)Perpetuity Sum 25,046.2 Debt 6,962.0 Assumptions Cash 643.0 Growth 4.0% Pension Underfunding 973.0 Gross margin75.4% Equity Value17,754.2 OG&A step$550.0 Price per share $29.73 CapEx as % of 2.6%Multiples sales Depreciation as % Equity Value 21,803.4 11.8% Debt6,962.0 of beginning assets Tax33.0%Cash643.0 Shares 597.1Pension Underfunding973.0 Equity Value 14,511.4 Price per share $24.30 Discount RateDiscount Rate 12.5%11.5%10.5%10.0% 9.5% 8.5% 7.5%6.5%12.5%11.5%10.5%10.0% 9.5% 8.5% 7.5% 6.5% Terminal Multiple Terminal Growth 1.5% $12.02 $15.12 $18.95 $21.22 $23.79 $30.07 $38.54$50.48 4.50x $16.09 $17.67 $19.36 $20.25 $21.16 $23.10 $25.17 $27.38 2.0% $13.41 $16.85 $21.14 $23.70 $26.63 $33.88 $43.86$58.41 4.75x $17.25 $18.90 $20.66 $21.59 $22.55 $24.57 $26.73 $29.05 2.5% $14.94 $18.76 $23.60 $26.52 $29.87 $38.32 $50.26$68.31 5.00x $18.40 $20.12 $21.96 $22.93 $23.93 $26.04 $28.30 $30.72 3.0% $16.63 $20.91 $26.38 $29.73 $33.61 $43.57 $58.07$81.04 5.25x $19.55 $21.35 $23.27 $24.27 $25.32 $27.52 $29.87 $32.39 3.5% $18.51 $23.32 $29.57 $33.44 $37.98 $49.87 $67.84$98.01 5.50x $20.71 $22.57 $24.57 $25.62 $26.70 $28.99 $31.44 $34.06VALUATION 4.0% $20.61 $26.06 $33.24 $37.77 $43.14 $57.57 $80.40 $121.78 5.75x $21.86 $23.80 $25.87 $26.96 $28.09 $30.46 $33.00 $35.73 4.5% $22.98 $29.18 $37.53 $42.88 $49.34 $67.19 $97.15 $157.42 6.00x $23.01 $25.02 $27.17 $28.30 $29.47 $31.93 $34.57 $37.40FALL 2011 18. 17Comparable companies* The Kroger Co. Fiscal EnterprisePrice / EPSEnterprise Value / Company Name PeriodValue LTMFY1 NTMSales EBIT EBITDA The Kroger Co. (kr-us) 08/2011 19,557.7 11.9211.74 10.96 0.22x 8.6x5.0xPeer Summary Analysis Mean -73,637.812.07 12.49 12.000.36x 11.1x15.9xMedian-21,472.611.96 11.39 10.610.32x 10.7x 9.0x Peer Universe (4 comps) Costco Wholesale Corp. (COST)04/2011 32,074.625.38 21.03 20.70 0.38x13.5x 10.0x SUPERVALU, Inc. (SVU)06/20118,384.8 (1.05)6.156.09 0.23x- 40.9x Wal-M art Stores, Inc. (WM T)07/2011243,221.211.64 12.22 11.49 0.57x10.7x8.0x Safeway, Inc. (SWY-US) 06/2011 10,870.712.29 10.579.73 0.26x 9.2x4.7xVALUATION Source: FactsetFALL 2011 *Downloaded 10/10/2011 19. Supervalu (SVU) Good The bad Heavily levered Cheap (6.1x NTM EPS)SVUSWYKR $1.87bn goodwill impairment madeDebt5,553.0 4,490.0 7,662.0numbers seem much worse at a superficialLTM Interest 535.0286.8449.0levelEBITDA1,833.0 2,366.0 3,716.0 Has experience improving margins, howeverEBIT 894.01177.62,200.0this may be due to a smaller reinvestmentin stores they halved CapEx from FY2009 Debt/EBITDA 3.0x 1.9x 2.1xyet developed 132 new stores in FY2011EBIT/Interest 1.7x 4.1x 4.9x Pension plan Plan assets are as of February 26th, 2011 - Plan at Feb. 27, 2010S&P 500 is down 9.5% over this time frame Total pension assets$1,896.0Total PBO2,663.0 A 25bps reduction in the discount rateUnderfunded status (767.0)would increase pension expense by$10mmDiscount rate6.0% Discount rate derived by AA corporate Expected return on assets7.8%% in equities 53.5%VALUATION% in P/E & real estate10.8%% in fixed income 35.6%FALL 2011 20. Safeway (SWY) The Good Safeway has produced superior marginsThe bad Heavily leveredSafeway trades at 12.3x LTM EPS (11.9x KR)SWY SVU WMT COST KRand at 9.7x NTM EPS (10.9x KR) and 4.7x EV/EBITDA (5x KR)Gross FY028.3% 22.5% 24.7% 12.8% 20.3%Debt to EV is .46x for Safeway (.38x KR)Gross FY-1 28.6% 22.4% 24.8% 12.7% 21.2%KR should trade a premium because of theirEBITDA MarginID sales. While SWY has better margins, I 5.8% 4.9% 7.3% 3.7% 4.5%FYObelieve the most price conscious shopper isEBITDA Marginbeing driven to KR stores (average KR 6.4% 5.4% 6.9% 3.6% 4.8%FY-1 basket is 14% cheaper*) The Bad Safeway has been consistently produced disappointing identical store sales 3.0%8.0% 2.0%6.0% 1.0%4.0% 0.0%2.0% Kroger(1.0%) 0.0% Safeway(2.0%) (2.0%) SuperValu(3.0%)(4.0%) (4.0%) Wal-Mart(5.0%) (6.0%)VALUATION (8.0%)2006 2007 2008 2009 2010 FALL 2011 *Source: Wall St. Research 21. Wal-Mart (WMT) The Good EM growth WMT vs. KRNew sq ft (mm) in FY12 Wal-Mart had a massive price roll back last Sub-Saharan Africa 17.2spring that did not effect KR same store LatAm13.2sales at all. Asia8.2 Same store sales for WMT have not Other 4.3exceeded 1% in 10 consecutive quarters WMT trades at 8x EV/EBITDA (5x KR) &The international segment accounted for 26.1% 11.5x NTM EPS (11x KR). With its superiorof FY2011 net sales margins & better ID sales it should receive apremium The Bad - We are seeing the maturation of WMT for the US segment No where else to grow3850180380016037501403700365012036001003550Stores - End of Year803500Net Opened Stores603450403400335020VALUATION33000FY2007FY2008 FY2009 FY2010 FY2011FALL 2011 22. 21RisksIncreased margin pressurePension Obligation KR is subject to union labor. SWY, COST and SVU do Pension short fall was $973mm at January 29th,as well but WMT does not2011 KR will renegotiate contracts with workers in Discount rate was 5.6%. If the discount rate was toCalifornia, Memphis and West Virginia over thebe lowered by 1% it would increase PBO by $342mmremainder of 2011 Kroger investments more aggressively with their KR has successfully passed along price increases to pension assetsconsumers. However, management specificallychose to contract gross margins. Margin Poor performance will squeeze profitabilitycontraction may hamper financial performance Similar to SVU but better capitalizedHigher hurdles Pension asset allocation 2010 KR has experienced higher hurdles due to superiorGlobal equity securities 22.1%historical numbers Emerging market equity securities 9.4% Multiples may contract if past growth is not Investment grade debt securities 12.2%maintained High yield debt securities 13.6% Much of the historical growth has been due to Private equity6.3%KRs ability to pass through inflationary pressure Hedge funds23.1% Real estate 2.4% Other10.9%RISKS FALL 2011 23. Amazon (AMZN):Everyones retailerAPPENDIX 24. 23Real growth vs. nominal growth8.0%6.0%NominalSameStore Sales4.0%2.0%Real SameStore Sales0.0%(2.0%) 2006 2007 2008 2009 2010REVENUEFALL 2011 25. 24Discounted Cash Flow ($27.03)In Millions2008 2009 2010 2011 2012 2013 2014 2015 2016 2017TVRev$76,148.0$76,733.0$82,127.0$88,548.2$92,090.1$95,773.7$99,604.6 $103,588.8 $107,732.4 $112,041.7 $115,402.9COGS58,012.0 58,429.0 63,354.0 69,082.2 71,767.4 74,638.1 77,623.6 80,728.5 83,957.7 87,316.0 89,935.5 Gross Margin 18,136.0 18,304.0 18,773.0 19,465.9 20,322.7 21,135.6 21,981.0 22,860.3 23,774.7 24,725.7 25,467.5 Gross Margin23.8%23.9%22.9%22.0%22.1%22.1%22.1%22.1%22.1%22.1%22.1%SG&A14,229.0 14,527.0 14,948.0 15,516.0 16,066.0 16,616.0 17,166.017,716.018,266.0 18,816.019,366.0Depreciation 1,443.01,525.01,600.01,746.01,662.31,748.31,835.5 1,924.1 2,014.52,106.9 2,106.9Operating Profit 2,464.02,252.02,225.02,203.92,594.42,771.32,979.6 3,220.2 3,494.23,802.8 3,994.6EBIT Margin 3.2% 2.9% 2.7% 2.5% 2.8% 2.9% 3.0%3.1%3.2% 3.4%3.5%One time items (12.0)(1,161.0) (43.0) 0.00.00.00.0 0.0 0.00.0 0Tax 717.0532.0601.0658.6856.2914.5983.31,062.7 1,153.11,254.9 1,318.2NOPAT1,735.0 559.0 1,581.01,545.31,738.31,856.81,996.3 2,157.5 2,341.12,547.9 2,676.4Working Capital (259.0)73.0 370.0(508.0) (83.7) (87.0) (90.5)(94.1)(97.9)(101.8)0Depreciation 1,443.01,525.01,600.01,746.01,662.31,748.31,835.5 1,924.1 2,014.52,106.9 2,106.9CapEx (2,149.0)(2,297.0)(1,919.0)(1,634.0)(2,394.3)(2,490.1)(2,589.7) (2,693.3) (2,801.0)(2,913.1) (2,106.9)Free Cash Flow770.0(140.0) 1,632.01,149.3 922.5 1,027.91,151.6 1,294.2 1,456.71,639.9 2,676.4Present Value Multiplier 0.980.85 0.77 0.700.640.58 0.53 0.53 49.1 780.8790.9805.5 823.0 842.1861.8 20,093.1REVENUEFALL 2011