KR could rebound and rise more than 25%

June 7, 2018

KR could rebound and rise more than 25%

We’ve watched volatility in the broad market increase significantly this year compared to last year, and some of that was a reflection of uncertainty about the economy’s health and sustainability moving forward. Those are conditions that usually give investors a reason to look for more conservative, defensive types of investments, and in the stock market, one of the sectors that usually provides that comes from the Consumer Staples arena. These are businesses that consumers tend to use just about every day in some context or another. Pharmacy companies, grocery stores, and food processors are just a few examples of the kinds of stocks you’ll find in this sector.

Traditional Consumer Staples stocks, like Campbell Soup Company (CPB), The Kraft-Heinz Company (KHC), and General Mills Inc. (GIS), which you might think of as natural leaders in this space, have been under a lot of pressure for more than a year, sitting in long-term downward trends that have gone in the opposite direction of the broad market over that time. Many of them are actually down 20% or more in this year alone – a fact that works directly counter to the defensive-oriented logic I just applied and which also seem to fly in the face of general economic health nationwide. As of the end of April, the food component of the Consumer Price Index (CPI) has risen modestly over the trailing twelve months, which implies the companies that make those products should be seeing gains, or at the bare minimum, holding their values as well. So what gives?

Over the last couple of weeks, I’ve noticed an increasing amount of talk centering on changing consumer behaviors and buying patterns. One of the big trends that economists seem to be keying on is the rise of the Millennial generation as a dominant market demographic. The data points to the fact that Millennials have different preferences than their parents or grandparents do when it comes to basic necessities. Instead of deferring to established, well-known brands, they often opt for organic products from smaller, less visible companies. When they do shop for bargains, they are showing a preference for convenience and ease in the transaction – such as ordering online and having it delivered to their doorstep – over loading the kids in the minivan to make a trip to the grocery store.

Millennial preferences are just one example of what I think is a broader shift in consumer trends. If you make a trip to just about any “big box” store – Walmart (WMT), Target (TGT), Costco (COST), whatever – you’ll notice that just about every single one of them is making changes to make the shopping experience easier, more convenient, and less time-consuming. Amazon’s (AMZN) recent acquisition of Whole Foods wasn’t just about muscling into another already-crowded market space, it was also a recognition of the trend I’m referring to, and the opportunity that exists for the companies that understand what it means for the future and can adapt their businesses for it.

The Kroger Company (KR) is one of the most well-established, nationwide names in the grocery business, and they’ve held up well for decades even as companies like WMT have pushed their way in and changed the competitive landscape of their industry. Not only am I willing to bet there is a Kroger-owned grocery store close to where you live, I’m also going to go out on a limb and say that you probably visit that store a handful of times every month at least. That is the kind of “stickiness” that analysts like to point to when they look for companies that will generally hold up in a troubled economy. This is a company that has faced challenges from competitors large and small and manages to find its own way to survive. The stock is another example of a major underperformer, having declined more than 50% in value since the beginning of 2016 and still facing considerable near-term price pressure from that long-term downward trend. Even so, their fundamentals are pretty solid, and there is a pattern emerging with this stock that looks promising for near-term growth.

Fundamental and Value Profile

The Kroger Co. (Kroger) manufactures and processes food for sale in its supermarkets. The Company operates supermarkets, multi-department stores, jewelry stores and convenience stores throughout the United States. As of February 3, 2018, it had operated approximately 3,900 owned or leased supermarkets, convenience stores, fine jewelry stores, distribution warehouses and food production plants through divisions, subsidiaries or affiliates. These facilities are located throughout the United States. As of February 3, 2018, Kroger operated, either directly or through its subsidiaries, 2,782 supermarkets under a range of local banner names, of which 2,268 had pharmacies and 1,489 had fuel centers. As of February 3, 2018, the Company offered ClickList and Harris Teeter ExpressLane, personalized, order online, pick up at the store services at 1,056 of its supermarkets. P$$T, Check This Out and Heritage Farm are the three brands. Its other brands include Simple Truth and Simple Truth Organic. KR has a current market cap of $20.1 billion.

  • Earnings and Sales Growth: Over the last twelve months, earnings increased by more than 18%, while sales grew a little over 12%. It’s hard for a company to grow earnings faster than sales, and generally not sustainable over time. Initially, however it is a good sign that management is doing a good job of maximizing their business operations.
  • Free Cash Flow: Free Cash Flow is healthy, at about $740 million over the past twelve months. This is a number that has declined by about 50% over the past two quarters, but appears to be related more to seasonal cycles this business works with than any other fundamental factor.
  • Debt to Equity: the company’s debt to equity ratio is 1.74, which is a fairly high number under most circumstances, but which is also roughly inline with the industry average.
  • Dividend: KR pays an annual dividend of $.50 per share, which translates to an annual yield of 2.03% at the stock’s current price.
  • Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods uses the stock’s Book Value, which for KR is $7.83 per share. At the stock’s current price, that translates to a Price/Book Ratio of 3.18. I usually like to see this ratio closer to 1, or even better, below that level, but higher ratios in certain industries aren’t uncommon. The Food & Staples Retailing industry’s average is 2.7, putting KR bit above its counterparts. The stock’s historical Price/Book Ratio, however is 4.9, significantly above its current level. The stock would have to rally to about $38 per share – more than 50% above its current price – to reach par with its historical average.

Technical Profile

Here’s a look at the stock’s latest technical chart.

  • Current Price Action: Over the last week or so, KR has mostly hovered in a tight range between just a little above $24 on the low end and its current price at about $25. Since hitting a 52-week high at around $31 in late January, the stock followed the rest of the market lower (although it experienced a much more severe decline than even most stocks in the Consumer Staples sectors). Once it found a bottom in early March, the stock has stabilized, and even started to follow a modest upward slope from that point.
  • Trends and Pivots: I’ve drawn two trend lines on this chart to illustrate the pattern that I think provides the opportunity that is worth watching. The dotted red line traces the stock’s pattern of declining pivot highs since late April, while the dotted green line traces the pattern of increasing pivot lows. This creates a wedge pattern that should translate to a significant break out of that wedge. The closer the diagonal lines that trace these pivots gets to each other, the more likely that break becomes. Considering the wedge pattern against the longer downward trend that began in January suggests that the breakout will most likely occur to the upside.
  • Near-term Keys: Watch the stock’s movement carefully over the next week or so. A move to $26 would mark a big bullish breakout and should give the stock plenty of room to rally to about $31 per share, which should be a no-brainer for a good bullish trade, either by buying the stock or working with call options. On the other hand, a break below $24 could see the stock drop as low as $20 per share, which might offer an attractive bearish trade, either by shorting the stock or using put options.