The Long and Short
Kroger offers an attractive entry point relative to Walmart
Meredith Contente | December 3, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Kroger Co. (KR) posted third quarter results that came in better than expected due to sustained at home food trends. Momentum witnessed in the quarter provided management with the confidence to raise full year guidance. While management has been known to operate with leverage higher than their target range, KR’s net leverage hit an all-time low in the quarter of 1.68x, and remains well below its target range of 2.3x-2.5x. That said, KR appears to have roughly $4 billion-$5 billion of flexibility on the debt side to pursue acquisitions and shareholder remuneration before hitting its leverage target or affecting ratings. Kroger’s 30-year and 10-year bonds have widened to Walmart during the latest sell-off, creating an attractive entry point for investors who can position for spreads to re-tighten.
Inflation negatively impacted the gross margin as KR chose not to pass through some costs to the consumer. While management was able to offset most of the margin deterioration on the operating side, the ability to do so in 2022 will likely be much harder as comps become more difficult. That said, leverage will likely start to tick up as EBITDA declines and margins contract further, but again KR maintains flexibility within its ratings and target for leverage to rise. KR bonds have recently witnessed some widening in the latest sell-off and as such, its 30-year bonds trade over 60 bp behind Walmart’s (WMT) 30-year paper. The relationship between the two credits has been as tight as 45 bp. Investors should look to trade KR in a range relative to WMT and look to enter this part of curve when KR trades 60 bp or more behind WMT and look to sell when the relationship is closer to 45 bp. In the 10-year part of the curve, investors should look to enter KR when it trades 45 bp or more behind WMT and sell when that relationship approaches 30 bp.
Exhibit 1. KR Curve vs. WMT Curve (Now and 3 Months Ago)
Gross Margin Decline Mostly Offset by Operating Cuts
KR’s 3Q results highlight how inflation is negatively impacting margins as the company’s gross margin contracted 130 bp year-over-year (to 21.7%). Management noted that they chose only to pass through higher costs to the consumer where it made sense with an objective to win long-term customer loyalty. While the gross margin was up 30 bp on a sequential basis, it remains below the 22% threshold that KR has long maintained. KR effectively managed operating costs during the quarter to help offset the gross margin decline, with the EBITDA margin only contracting 20 bp year-over-year (to 5.3%). Management noted that they are on track to deliver $1 billion in cost savings for 2021 but did not mention or discuss a cost savings target for 2022. As we look at street estimates over the next few quarters, operating margins will contract further, to the mid 4% range as comps become tougher and extracting further costs on the operating side becomes harder to execute, particularly as wages need to keep up with inflation.
Private Label to the Rescue
Management did note that the inflationary environment presents a great opportunity for their private label brands as the consumer looks to stretch their budget. It provides the consumer to switch from a national brand to their private label brand without compromising on quality. This would be the best way, in our view, for KR to improve the EBITDA margin as private label brands can carry at least 200 bp or more margin than their branded peers, as there are no advertising costs associated with private label. KR did see its private label penetration increase from 2Q as the rate of inflation increased. Additionally, KR management spent a considerable amount of time on the earnings call discussing its private label brands, more so than usual, which leads us to believe this will be management’s focus in the upcoming quarters. With private label trends expected to improve, KR believes its private label brands such as Simple Truth will become more important to its overall strategy while increasing its competitive moat.
Full Year Guidance Raised Yet Again
This was the first quarter this year that KR witnessed positive same store sales (ex fuel). Year-to-date, we note that same-store-sales (ex-fuel) remains in negative territory at negative 1%. The return to positive same store sales growth in the quarter led management to increase full-year same store sales guidance to a range of -0.4% to -0.2%, which is up from guidance provided last quarter of -1.5% to -1.0%. Additionally, management increased its EPS guidance from the $3.25-$3.35 range to the $3.40-$3.50 range. We note that guidance is now up significantly from the start of the year as management was forecasting same store sales to be down in the 3%-5% range while EPS was expected to be in the $2.75-$2.95 range.