Summary
- We like both Kroger and Walmart better than the overall staples sector.
- Investors should take a look on hold both, especially given the market uncertainties ahead.
- Although our personal style is to hold a concentrated portfolio and we limit our holdings to one per sector typically.
- And you will see the key reasons that made us favor Kroger includesits more compressed valuation, higher total shareholder yields, and better growthpotential.
- Kroger's automatic fulfillmentcenters, combined with loyalty programs, provides a strong catalyst to fuel growth.
Thesis
I have been a long-term bull on Kroger ( KR ) and started arguing for it back in June 2021 when near a price level of around $39. Since then, the stock has delivered a total return of more than 26% against the backdrop of a 6% loss from the S&P 500. I've also turned bullish on Walmart ( WMT ) this June after its stock price declined by about 20% as you can see from the following chart following weaker-than-expected guidance. As argued in my last article , I see the negative impacts of inflation and fuel costs already fully priced in for WMT after that sharp drop.
Indeed, in their recent earnings reports (FYQ1 2022 for KR and FYQ1 2023 for WMT), both reported strong results on both lines. For KR, its EPS dialed in at $1.45, beating consensus estimates by $0.17. And its revenue dialed in at $44.60B (an 8.0% growth YoY) and beat the consensus estimate by $1.54B. For WMT, its EPS came in at $1.77 (beating consensus by $0.17) and revenue came in at $151.4B (a growth of 8.2% YoY and beating the consensus estimate by $1.40B). Both have also provided strong guidance going forward. And the market responses have been overall positive as you can see from the chart below. Both stocks have been holding well during the market turmoil since their ER. And both have been outperforming the overall market YTD. To wit, KR delivered a total return of 8.2% YTD, outperforming the overall market by more than 17%. Although WMT suffered a total loss of 7.8% YTD, it still leads the overall market by about 2%.
Looking forward, we are still bullish on both of them. You will see the detailed considerations in the next section. For us, they provide anti-cyclical protection and healthy growth prospects to investors at a discounted valuation.
However, if you are like us (who prefer a more concentrated portfolio) and like to pick one out of the two, you will see why we would favor KR over WMT starting in the third section.
Why we like both?
As you can see from the next chart, compared to the staple sector represented by the Consumer Staples Select Sector SPDR Fund ( XLP ), both offer a far superior combination of strong profitability, compressed valuation, and excellent consistency. Note that the chart is based on data provided either from Yahoo Finance or Seeking Alpha based on the price information on August 30, 2022. Given the large volatility in the past few days, these numbers might have changed a bit when you read this article. A few highlights from this comparison:
- KR's valuation is discounted from XLP by almost half. Its price/cash flow multiple is only 44% of XLP and its PE ratio is only 54% of XLP.
- WMT's valuation is close to the sector average in terms of price/cash flow and PE multiples. But its price/book value is discounted by about 18% from the sector yet its ROE is very close to the sector (21% vs 25%).
- Both stocks provide far superior consistency than XLP in terms of dividend payouts, which is the most reliable indicator of owners' earnings in my view. As can be seen from the chart, KR has been increasing its dividend consecutively for the past 15 years at a rate of 12.9% CAGR in the past five years. And Walmart is soon to be crowned a dividend king with already 49 years of consecutive dividend raises under its belt.
A few notes before moving on. First, note that the growth rate for Walmart is a bit lower in recent years, only at a CAGR of 1.9% in the past 5 years. This is one of the key reasons that we prefer KR, as to be elaborated on later. Second, note that the profitability of KR as measured by the net margin is worse than WMT (2% vs 2.7%, or about 26% in relative terms). It is indeed a concern for us, and we will address it more in the risk section. Finally, note that the net margins for both WMT and KR (2% and 2.7% vs 7%) are far lower than the sector average. Investors do not have to be concerned about such comparison as retailers have different normal margins than the rest of the staples sector.
Dividend yield and total shareholder yield
Besides the valuation discount and growth prospects mentioned above, another key reason that we prefer KR over WMT is the total shareholder yield.
The next chart compares the dividend yield between KR and WMT over the past 10 years. As can be seen, on average, WMT has paid a higher dividend yield than KR in the past. KR's dividend yield has been on average 1.67% in the past, compared to 2.2% for WMT.
Although two important observations here. First, KR currently provides a yield of about 1.86%, not only above WMT (1.68%) but also above its historical average by more than 11%, signaling a valuation compression of 11%. In contrast, WMT currently yields 1.68%, about 24% lower than its historical average and signaling a valuation premium.
The second observation involves the total shareholder yield when share repurchases are considered. When the total shareholder yield is considered, the gap in their yields becomes even larger.
The next chart shows their net common buyback yield. For readers new to the concept, the buyback yield is the amount spent on repurchases divided by the market cap of a company (just like dividend yield is the total amount of dividends paid divided by the market cap). As you can see, both have been consistent buyers of their own shares. And both have been relying on share repurchases more heavily than dividends to return capital to shareholders. In KR's case, its average buyback yield has been on average 4% over the past decade, about 2.4x higher than its average dividend of 1.67% as just mentioned. In WMT's case, its average buyback yield has been on average 2.23% over the past decade, also higher than its average dividend of 2.21% as just mentioned.
All told, currently, KR provides a total shareholder yield of about 6.65% (4.79% from share repurchases plus 1.86% of cash dividends). WMT provides a total shareholder yield of about 4.52% (2.84% from share repurchases plus 1.68% of cash dividends) - a quite attractive total yield, but lower than KR by a good margin.
Return projections
Based on the above valuation comparison and business fundamentals, the following charts show a back-of-the-envelope calculation to project their returns in the next 5 years. This is what I call a reality check or a common-sense test. It is an estimate of the growth rate required to deliver a target ROI in the next five years. In particular, the black thick lines mark the growth rate and valuation required to deliver a 10% annual return (1.1^5 = 160%).
The red line shows the returns if their valuation remains constant at their current levels (about 12.4x PE for KR and 20.6x PE for WMT). The blue lines show if their PE expands in the next 5 years to 14x for KR (its average PE in the past decade) and to 22.5x for WMT. WMT is currently trading slightly above its average PE in the past decade (as you can also see from its below-average dividend yield). And the assumed 22.5x PE is about 10% above its historical average PE). And finally, the green lines show the scenario of a PE contraction. For PE, I assumed a contraction to 11.5x, about the average valuation during 2019 - one of its most undervalued periods. And for WMT, I assumed a contraction to 17x PE, about 10% below its historical average.
Under these assumptions, the purple boxes show where I think the most likely return scenarios would be. As seen, KR is projected to provide a far better return (5.9% to 12.5% CAGR) than WMT (3.5% to 11%) even assuming the same growth rates (5% to 7.5% ) are assumed. And next, I will argue that KR has a better growth potential too.
Final thoughts and risks
To recap, I see both KR and WMT as attractive under their current conditions. Especially given the macroeconomic uncertainties ahead, they both offer a far superior combination of strong profitability, compressed valuation, and excellent consistency compared to the overall staple sector. There is nothing wrong with holding both. However, if we have to pick one, we will go with KR (which is what we are actually holding). KR's valuation is discounted from both XLP and also WMT by almost a half by almost all metrics: price/cash flow, PE, and also total shareholder yields.
Finally, risks. There are risks common to both. The development of the COVID pandemic probably is the biggest macro risk common to both, followed by a labor shortage. There are also risks specific to KR and WMT. As aforementioned, KR's net margin is lower than WMT as you can see from the chart below. The profit margins for both have been quite stable with an average of 1.53% for KR and 2.67% for WMT. So WMT's margin is about 1.74x higher than KR. It is a big gap, but it does not make WMT 1.74x more profitable than KR.
For retailers, another important profit driver is asset turnover rates as detailed in my earlier writings . Simply put, if you buy an orange today for $1 and sell it tomorrow for $1.01, your margin is a meager 1% but your ROIC would be an astronomical 365% because of the high asset turnover rates. Here, the asset turnover rate of KR is better than WMT. Currently, KR's turnover rate is 2.87x, about 1.2x higher than WMT's 2.4x, therefore partially offsetting the lag in profit margins. Although KR's long-term average turnover is 3.3x, more than 1.4x higher than WMT's long-term average of 2.3x. So if KR can improve its turnover rates to its historical average or better, its profitability should be on par with WMT.
And I do see good prospects for its turnover rates to improve dramatically in the near future, which is also the reason why I am optimistic about its growth potential. The company continues to build up its e-commerce capabilities. Out of the many initiatives KR has taken on the front, a highlight involves the partnership with Ocado to build automated distribution sheds. Kroger recently (April 2021) began filling orders from its first shed in Ohio, reaching an important milestone in its digital initiative. Admittedly, it is too early to declare victory. But it is an intriguing opportunity, considering the large surge in its digital sales and the fact that 75% of its customers are within a 90-mile radius, i.e., an Ocado shed range. And it is also rolling out its Boost program, a yearly paid membership that offers free grocery delivery and other benefits. I am optimistic that the opening of more fulfillment centers, combined with loyalty programs like its Boost program, should drive sales and reduce the cost of delivery orders at the same time.
For further details see:
Kroger Vs. Walmart: Why We Like Both But Hold Only Kroger