Cobas AM: Nueva Gestora de Francisco García Paramés

Fair Value and Profit Drivers 2020/09/22

We are lifting our valuation for Kroger to $33 per share from $31.50, reflecting strong first-half growth (17% identical sales expansion, excluding fuel) and a time value of money-related adjustment. Our valuation implies forward fiscal 2021 enterprise value/adjusted EBITDA of 6 times and adjusted P/E of 12. While identical sales growth should cool from its first-half pace considering the easing of shelter-in-place orders in the second quarter, we still anticipate 13% expansion for the full year (though our estimate is up from an earlier 9%, considering continued high infection rates heading into the cold and flu season). We suspect that increased use of delivery and click-and-collect will limit the benefit of cost leverage despite the sharp growth (2.9% forecast fiscal 2020 operating margin versus 2.3% in fiscal 2019). Longer term, we anticipate identical sales growth excluding fuel stabilizing at a little over 2%, near our expectations for food inflation despite intense competition forcing prices lower. We anticipate the firm’s plans to curb square footage growth will persist, averaging yearly expansion of less than 10 basis points over the next decade. Combined, retail sales, excluding fuel, should see a 2% average yearly uptick over the next 10 years, near our normalized expectations for fuel revenue (though year-to-year gasoline and diesel performance varies considerably with commodity volatility and consumers' driving habits). Together with faster-growing offerings such as digital coupons and data analytics, we expect 10-year compound average revenue growth of nearly 2.5%. Despite building operating leverage, cost-saving efforts, and lucrative data-related sales, we anticipate the need to keep prices low in light of intense competition will keep operating margins fairly steady at around 2.4% on average long term, with diminishing gross margins offset by leverage over operating, general, and administrative expenses. The firm’s initiatives should leave it better suited to maintaining margins and adjusted returns on invested capital (8.5% forecast long term) in a highly competitive environment. While Kroger will likely pursue partnerships and bolt-on acquisitions, we do not incorporate such deals into our valuation because of their uncertain nature and timing. Instead, we anticipate that Kroger returns excess capital to shareholders, with dividends and stock buybacks accounting for around 35% of operating cash flow by the end of our explicit forecast.