Will Amazon-Whole Foods Kill Kroger?

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Kroger

The future of Kroger has been put into question by Amazon’s recent deal to acquire Whole Foods. Jeff Bezos immediately declared there would be a reduction in prices at Whole Foods to put an end to the running “Whole Paycheck” joke and to gain market share against their competitors. Bloomberg is reporting the price cuts increased traffic 25% to Whole Foods.

This is terrible news for grocers and one of the reasons Kroger’s stock is down over 40% year-to-date. Did the value of Kroger really decrease from a $31 billion company to a $18 billion company in a matter of months? That’s what the market is telling us but the market is not always right. Here are a few points to consider.

Disclosure: I am long Kroger shares

Why Kroger Stock Is Down

Kroger shares are down about 10% following the release of their Q2 2018 earnings report last week. While earnings were in-line with analysts estimates at $.39 for the quarter, they were down 19% from the same quarter in the prior year. Most importantly, management announced they would no longer provide longer term earning guidance which spooked investors further. On a positive note, same-store sales excluding the sale of fuel rose 0.7% which beat expectations.

Kroger Stock Chart

Kroger’s stock chart over the past year looks like a disaster. The stock price has hit a new 52 week low today following the earnings announcement. At a 40% price discount from where the stock started the year, it might seem like a good time to buy but the stock continues to struggle to find a bottom. RSI is at 31 so it’s not quite oversold at this point. Maybe $20 will be the magic number where the stock will find some support. You would have to go back to 2014 to buy Kroger shares below $20.

Kroger Fundamental Stock Analysis

Looking at the fundamentals of Kroger we see that the multiples are nearing levels not seen since 2014.

The trailing P/E multiple at 12.43x has not been this low since 2015 and the EV/EBITDA multiple at 6.09x hasn’t been this low since 2014.  That makes Kroger one of the 50 lowest P/E ratios and one of the 20 lowest EV/EBITDA ratios in the S&P 500. Just looking at the ratios is not enough, what’s going to change the story here? Here are a few reasons Kroger can co-exist with Amazon/Whole Foods.

#1 – Grocery Will Be Slower to Adapt to Online Shopping

This just may be my own personal preference when it comes to grocery shopping but I like to physically see the fresh foods I purchase before I buy them. Produce and meat especially. I am pretty particular when it comes to buying meat that looks fresh – which is one of the reasons I avoid shopping for meat at Wal-mart. I have heard they have made improvements but in the past I have bought meat that had already started turning brown. Not very appealing to say the least!

Not to mention, when it comes to fruit and veggies, most folks like to check the firmness of certain items such as avocados, tomatoes, or cantaloupes.

There are companies such as Blue Apron and Hello Fresh that are penetrating the on-line grocery market by providing the ingredients for ready-to-cook meals at home. These kinds of services will help hasten grocery’s transition to online shopping but I still believe people will want to shop for food in the store for a long time to come.

Are we just going to become a reclusive society and never buy things in the stores? I think people will still enjoy getting out of the house to shop – but we should certainly see a reduction in square footage at stores.

#2 – Kroger has a Broad Footprint

Kroger has nearly 2,800 supermarkets, 784 convenience stores, and 319 fine jewelry stores. Kroger also owns Vitacost.com which sells vitamins and supplements online. Whole Foods is much smaller at only 456 stores – most of which are in suburban areas. There are still plenty of rural areas across the country that shop at one of Kroger’s stores without access to Whole Foods for 100+ miles. In fact, Whole Foods revenue of $15.7B in 2016 only accounted for about 4% of the total super market revenue in the United States. Teaming up with Amazon does give them a larger platform to reach new customers but they have a lot of work to do to really penetrate this market.

Over time, sure, more boxed or non-perishable food items will be purchased online but the need for local, same-day access to fresh food will always be in demand.

#3 – Whole Foods was not a Good Deal for Amazon

Whole Foods cost Amazon over $13b which was financed through the issuance of debt. What did Amazon get for $13b? A company earning $1.2B in EBITDA per year. The first thing they did was slash prices so unless the lower prices lead to enough demand and increase in sales to offset the lower profit margins, EBITDA will also decline.

This is the same playbook Amazon has used against other retailers. They care less about making money than they do about making sales and gaining market share.

Then there’s going to be supply issues. If Amazon wants to expand access to Whole Foods across the country through distribution centers or whatever means they decide on – they will need to establish relationships with suppliers. Meat, produce, dairy, ect. I worked for Target before and a good bit of they groceries stocked in Target are stocked by the suppliers/vendors themselves.

The quote below from this article describes exactly some of the issues Whole Foods and Amazon are facing as they try to gain market share in terms of supply.

If a company wants to purchase 1mm widgets they can find a factory that already has supply with excess inventory if needed (or can ramp up) and negotiate a price. Simple construct for this example. Now: want to buy 1mm pounds of meat?

If there’s some available on the spot market, fine. If not? What are you going to do – make it?

You can – but – that takes well over a year. And here’s the other key – 1mm pounds how often? Daily? Weekly? Monthly? And if you begin buying all the “spot” available? Guess what? Prices may go up for you – and not your competition. For your competition may already be locked into long-term contracts. And what can be even more baffling to the uninformed is this: All your competitors will have it, as in product – and you won’t. Maybe at any price.

Again, it’s a different business. And in the end it took them (Walmart) years with a lot of painful trial and errors as to try to innovate pricing and suppliers for differentiation. Today, if you look at meat prices from their cases comparing to any other (in my opinion) they’re basically right in line with any other national retailer. You don’t see any “WOW!” type price discrepancies unless, it’s a sale item.

This isn’t going to be a matter of just slashing prices, gain customers, and kill the competition. Lots of work must be done to establish relationships with regional suppliers of meat, produce, dairy, and eggs – the type of items that drive people into the stores that need to be fresh. Is Amazon also going to pay more to purchase these products from suppliers than other grocers?

Conclusion

The stock chart says now is not the time to buy Kroger but after the stock fell close to 30% in a matter of 2 days I couldn’t resist adding the largest U.S. grocery chain to my portfolio. The short-term outlook doesn’t look great but I am in it for the long haul. Markets change and if the Amazon/Whole Foods merger doesn’t work out as smoothly as expected, then maybe investors will be buyers of Kroger again.

 

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