Kroger's Revenue Misses; Is Now The Time To Buy?

Kroger’s (KR)management made two major missteps with the Restock Kroger plans. The first was their overaggressive plans to grow business in an attempt to compete with Walmart (WMT), Target (TGT), and Amazon (AMZN). The second was failing to realize the mistake soon enough. Now, with the competition closing in on all sides, it may be too late for the company to save its position as America’s leading grocery store.

Kroger’s management readily admitted their mistake last quarter when the 2Q earnings report was released. The overreaching problem was a loss of focus due to distractions including the shift toward e-commerce. Regarding the shift to eCommerce, Kroger forced a massive change on both employees and customers that resulted in push-back and a complete rethinking of renovation plans. Where once the company was altering its layout to suit e-customers it is now back on track with the in-store customer-centric approach.

Even though Kroger is back on track the shift will still take time. The shift includes narrowing the focus as well, back to the core product which is grocery. Grocery accounts for 75% of net revenue so any fluctuations there are felt in full when it comes to bottom-line results. The good news here is that only about 20% of the renovations were completed there isn’t too much to be undone.

Mixed Results And Weak Guidance Sends Shares Lower

Based on the 3Q earnings report I’d say Kroger is on the right track but still has work ahead of it. Comp-store sales surpassed expectations by 0.2% but revenue and earnings both fell short of consensus.

Kroger’s revenue grew by 0.5% over the last year to $27.97 billion. The revenue growth is good but not as good as the market expected and tarnished by weak EPS. The adjusted non-GAAP EPS of $0.47 only missed consensus by $0.02, it was the $0.17 miss on GAAP earnings that got the market’s attention.

One reason for the EPS miss was margins. Margins fell on a net-basis and were affected by several factors including tighter margins in pharmacy compounded by an increase in the pharmacy business. Gross margins excluding pharmacy and gas rose slightly but not enough to offset the impact of the two offenders on a company-wide basis.

EPS was also affected by several impairments charges including a non-cash charge related to Lucky’s Market. Lucky’s Market is a small, regional, organic grocer headquartered in Colorado. Due to “portfolio review” Kroger decided to divest itself of the stake and take a loss on the transaction.

The Silver Lining - Free Cash Flow

While Kroger’s revenue and earnings miss are a concern, the news is not all bad. The company reports the strongest comp-store sales since beginning the Restock Kroger Initiative and significant improvement to the balance sheet. Improvements to the balance sheet include an increase in free-cash-flow and reduction in debt, the one fueling the other and both aiding the company’s long-term outlook.

Over the past year, the company has paid down debt by over $1.5 billion while maintaining a healthy dividend. The reduction in debt improved the debt-to-EBITDA ratio to 2.5X from 2.75X and to within the company’s target range of 2.3X to 2.5X earnings.

With debt back within the board’s preferred range the company is able to take on new debt including a share buyback program. The program is to begin as soon as the current quarter and could be worth $1 billion. At current prices that is about 5% of the total market cap and a significant source of support for price action over the next twelve months.

The Dividend - You Can Bank On It

Kroger’s dividend is one income investors can bank on. The stock is only yielding 2.30% at today’s share prices but that is a safe 2.30%. The company is only paying about 30% of its earnings at this time. The majority of free-cash-flow is going toward debt reduction and renovation plans.

I don’t mind the low payout considering the company’s efforts to improve the balance sheet and buy back stock. The 13-year history of distribution increases and 11.5% 5-year compound annual distribution growth rate tell me I can expect future double-digit dividend increases.

The Technical Outlook - The Trend Is Up

Shares of Kroger took a big hit after the release of Q3 earnings, mostly due to an over-inflated market expectation. The bad news is price action may continue to move lower in the near-term. The good news is the trend is still up and supported by Kroger’s fundamental outlook. Although the Restock Kroger program hit a snag the company is working to refocus its efforts and those efforts are paying off. In the meantime, there is a healthy dividend to collect.

Investors looking for exposure to Kroger might want to wait for the market to confirm the bullish outlook. Technical price support is likely to be strong at the $26 level and coincident with the uptrend line. If price action falls below this level Kroger’s pull-back could deepen to the $24 level or lower. Moving forward, resistance is strong at the $27 level. This level is the top of the price-gap which formed earlier this year, now that the gap is closed a move higher is possible. A move above $27 with an end-of-