by MC

Key Points

• Optimization and economies of scale are key to succeed in the grocery store biz
• Bullish Costco and Kroger — bearish Whole Foods and Sprouts Market
• Costco is Best in Class, price currently overvalued and recommend purchasing at $114 or lower

Introduction

Today we take a look at a very un-glamorous, but essential service demanded by consumers…we’re talking grocery stores. Make no mistake though, this is a huge business with an estimated $650 billion in sales last year, but also highly competitive and dynamic given the amount of choices, products, brands, etc. that are thrown in front of customers’ faces everyday.

My interest in this business was piqued the other day as my wife and I were in Costco doing our weekly rounds for groceries. For the longest time I used to wonder what in the heck is so special about that place. She swears that Costco is THE place for groceries because products are cheap, you can buy in bulk and it’s a relatively painless experience (she even finds it fun!). I never understood why this “warehouse” method of selling things appeals to people…but apparently it does and it works…extremely well. So I rolled up my sleeves and started digging in. During my research I came across two primary types of grocery stores:

1. Your typical, no frills, offers-the-most-basic products, warehouse-style grocery store: Kroger (KR) and Costco (COST) AND
2. Your higher end all-natural/organic products grocery store. Whole Foods (WFM) and Sprouts Food Market (SFM).

The first place I went to get some understanding of their performance was their long-term stock price charts. Below is a graph comparing the four companies’ stock prices over the past 10 years:

The bar chart is Kroger (KR), the purple line is Whole Foods (WFM), the pink line is Costco (COST) and the black line is Sprouts (SFM). Over the past 10 years, it appears that KR and COST have outperformed their peers returning to shareholders nearly 200% of their investment since 2007 whereas WFM has only returned 50% and SFM actually losing money for investors. So how do these companies position themselves and what’s their end-game?

Battle of the Low-Margin/High-Volume vs. Organics

Grocery stores do not enjoy high margins. In fact, average gross margins (Sales less Cost of Goods Sold) is 3%. Compare that to a tech company like Apple or a retailer like Starbucks and you’re looking at 40% and 60%, respectively. In my research I found there are roughly only two kinds of grocers that exist: (1) Those that focus on a no-frills experience, but high volumes because their margins are so small and (2) Those that offer an additional value-add through better service and natural, organic, “healthier” products. Nowhere is the concept of economies of scale more applicable than in this industry. Gross margins for grocery markets range between 10% to mid-30’s, however after taking into account operating expenses like utilities, salaries and other admin expenses you’re looking at operating margins of between 3% to 5%. The table below shows all four grocers’ gross and operating margins over the past 10 years:

Grocers like KR and COST have adopted the warehouse business model and have been doing so successfully. With very thin operating margins, they must have an extraordinarily high amount of foot traffic, product sales volume and a large physical presence. If we look at the average square footage per store of each company, they can be broken out as follows:

• Kroger – 62,275 sq. ft.
• Costco – 142,738 sq. ft.
• Whole Foods – 39,224 sq. ft.
• Sprouts – 28,000 ~ 30,000 sq. ft.

Though COST has the largest footprint per store, KR actually has the largest U.S. coverage with 173 MM sq. ft. (~ 4,000 stores) of space spread across 35 states. COST operates 501 stores in the 44 states (over 200 internationally) with 73 MM sq. ft. WFM has 436 stores in the 42 states (and an additional 20 between Canada and the U.K.), while SFM is the smallest player with 217 stores in 13 states with a large focus on the western U.S., primarily California as 42% of net sales originate in that state.

Clearly KR has the most coverage in the U.S. in terms of operating square footage, but COST has the advantage in terms of states covered, followed by WFM and both probably have the most brand recognition nationally. Now let’s dive into some detail about the operational differences between these four competitors and what sets them apart.

How Value is Added and Points of Differentiation

Kroger

Kroger has been around for almost 140 years which makes it the oldest publicly-traded grocer in the country. They  operate 2,778 retail food stores under a variety of local banner names (ie. Ralphs and King Soopers) and roughly 50% of those food stores also operate gas stations. These retail sites are often combo food/drug, multi-department stores, marketplaces or price-impact warehouses. Their products fall under 1 of 3 “Tiered” categories: Premium brand, a banner brand and a value brand. They also have started developing an organic brand to cater to the market’s evolving tastes. KR also operates food production plants ranging from dairy to meats to plants and cheese. KR is essentially trying to appeal to ALL customers and are participating up and down the value chain and are growing through mergers and acquisitions and their “identical supermarket sales” have been impressive, growing 5%+ annually for the past few years. A feat not easily achievable in a market growing only 2% annually.

Costco

Costco’s business model can be summed up in four words: low prices, high volume. Aside from acquiring only items that are high in quality, affordable and fast-selling, another key differentiating factor that COST employs is there regional distribution centers or “depots” (a.k.a. consolidation points). These depots act as a central gathering, storing and distribution point for their warehouses, saving both time and money in terms of transportation costs and enabling them to optimize their supply chain. Furthermore, if you ever walked into a COST, you would notice that it truly is a warehouse and that little money and energy is spent on creating a unique environment. Rather, they focus on a clean, well-lit environment where products are placed in an open space and are easy to find.

Whole Foods Market

One need look no further than its motto to understand WFM’s position: “Whole Foods, Whole People, Whole Planet”. They obviously focus on healthier products and seek to educate the customer in better food choices. They state that they ban more than 120 food ingredients commonly found in other stores, sell food with no artificial preservatives, colors, flavors or high in fructose corn syrup and meat is sourced from animals that have been assessed for animal welfare and have never been given hormones or antibiotics. Additionally, from their 10K: “Our success is measured by customer satisfaction, team member happiness and excellence, return on invested capital, active environmental stewardship, service in our local and global communities, and win-win supplier partnerships…”. While this is all good and probably effective only in good economic times, it seems a bit overly ambitious and vast and, in my opinion, loses site of what really matters to the customer and that is simply value. I will say, though, their customer service and in-store experience is definitely one of the top I’ve ever experienced and I do like the de-centralized store management approach they take. Essentially, each store is sub-divided into teams, providing them annual operating budget to manage as they see fit. If the team’s budget is in surplus at year’s end, the surplus is given back to employees providing the feeling of real stakeholder-ship and incentivizing best practices at the deepest levels.

Sprouts Food Market

I like to think of SFM as the no-frills version of Whole Foods. Their layout is smaller in size, which simplifies the product-finding process. They, like WFM, focus on healthier, organic choices in their stores and aim to achieve a farmer’s market feel with produce sitting at the center of the store with meats, dairy, other perishables and non-perishables sitting at the fringes. Overall I find their prices to be reasonable and shopping experience pleasant. They do state that they have created a culture of customer engagement and seek to interact with customers in store, however, of all the times I have been to Sprouts, I can only recall very few times of being engaged by an employee and it seems the customer has to be the one to initiate contact. SFM is no KR or COST, but it is a nice alternative to the WFM model.

Performance Comparison

At the end of the day though, we must be able to measure the relevant success of each of these companies to not only be able to carry sustainable operations, but also to be able to consistently grow their earnings power over a long period. The table below looks at earnings and dividends paid per share of each company over the past 10 years.

Ignoring SFM for now since they only went public only recently, I’ll point out a few key items.

• KR, COST and WFM have all been able to successfully grow their earnings over the past 10 years and at a healthy rate. Of the three, COST seems to have weathered the 08/09 Financial Crises the best, only seeing a 15% decline in earnings whereas WFM saw a 38% decline in earnings and KR suffered a huge loss due to a “goodwill impairment charge” from the Ralph’s stores in Southern California.
• Consistent dividend payments are key. Dividends usually represent leftover cash from profits not used for incremental expansion and are reserved as a payment back to investors. Analyzing a company’s ability to maintain their dividend, even in the worst of times, helps the investor understand the company’s ability to efficiently manage their own finances. In my mind, a company who either drastically reduces their dividend or completely cancels it altogether is a company who has poorly managed their operations and therefore their finances and profitability. This should raise alarm bells for anyone looking to invest in that particular company and question that company’s ability to thrive in difficult times.

Lastly, we should look at one of the most important metrics and that is return on invested capital. I touched on the importance or ROIC in an earlier blog on energy midstream companies so while I won’t cover it in detail here, I will say that it’s key for a company’s ROIC to not only be increasing over time, but also be increasing with respect to it’s weighted average cost of capital (WACC).

Below is a table outlining each company’s ROIC over time.

KR, COST and SFM have all seen rising ROIC’s for the past several years which is impressive given how competitive the grocery market is. WFM, on the other hand, has struggled to keep their numbers up.

Touching a bit on WACC, KR and WFM generally have a higher WACC since their capital structure is primarily equity based whereas COST’s WACC is about 70% equity, 30% debt, making it’s WACC lower compared to its peers and the one with the most potential to drive additional upside in their stock price should ROIC continue to go higher.

Expectations and Expansions

Share price is a direct result of the market’s expectation of the ability of these grocers to do one simple thing: Increase same store sales growth. Since margins are already so tight and groceries are practically a commodity, this can only be achieved through growing U.S. market share and/or expanding internationally. The grocery market may not be an exciting one, but the service and goods are essential. A study by Progressive Grocer indicates that the supermarket industry is only growing at 2% per year and Natural Foods Merchandiser indicated natural product sales is growing 9% annually.  Regardless of what the pundits say, it’s more important to understand company-specific expectations for growth to better assess their long-term potential. Below is a quick summary of a few key metrics of each grocer’s expectations for 2016 and 2017:

EPS Growth:

• KR – 8% to 11% growth in 2016 with the same expectation for 2017
• COST –  N/A
• WFM – $1.42 for FY 2017
• SFM – N/A

Same Store Sales Growth:

• KR – 2.5% to 3.5% in 2016
• COST – Flat in 2016, the market is expecting the same if not higher for 2017. First quarter 2017 results were up a paltry 1%, however management pointed out online sales were up 7% to 8% year over year and memberships were up which was encouraging and sent the stock higher.
• WFM – -2% to 0% for 2017.
• SFM – 1.3% in the latest quarter, far below their historical growth rate of 5% to 11%since 2011.

ROIC:

• KR – Slightly higher than 2015, so ~ mid-to-upper 13% through 2016 and 2017.
• COST – N/A
• WFM – 11% or greater for 2017.
• SFM – N/A

Best in Class

Given what we’ve just discussed and how competitive this environment is, I’m giving COST my Best in Class designation for it’s low-cost, highly efficient business model that has continuously brought significant value to customers for many years now. KR comes in second place while WFM and SFM face significant headwinds in my opinion. COST and KR’s long history of successful management and low-cost operating style should allow them to prevail over the longer-term no matter what the economic environment and that is what the Perceptive Investor should look for. This movement to natural, organic food might be strong, but it’s young and when touch economic times come back around and  incomes get pinched, customers will go back to the basics and buy the most affordable product they can find. This will be particularly true in a deflationary environment (one in which general prices for goods are falling and consumers will put off purchases as long as possible. From a macroeconomics perspective, we are currently in a low inflationary period and some grocers had even indicated signs of deflation in some of their goods.). Regardless, deflationary or not, people will still need to eat and that’s why both COST and KR will still be the winners when all is said and done.

Conclusion

COST is currently trading at roughly 29x earnings which makes it expensive by any measure, particularly for a grocery store. While COST still has growth potential, I do NOT recommend buying it at current price levels as the market has gotten a overly excited about the stock. My internal model projects COST is actually worth $152, assuming a 10% EPS growth rate. The market is currently pricing it at around 11% growth. That’s not to say it can’t achieve higher growth rates as it had in the past. Should this be the case, assuming a 15% growth rate, the stock could reach $205 a share – upside of 25%.

In the latest conference call  Executive Management did note a few bullish points providing COST some momentum:

• The average age of their membership has come in recent years. Now, they estimate the average age of their members are 4 years below the average age of the U.S. population vs. being 2 years older just previously. They noted their customer base consists of more Millennials and, in my opinion, could be stealing market share from WFM and SFM.
• Membership renewal rates remain strong ~ 90%+ overall and 94%+ for business level members.
• Membership fees from increased members have risen year over year.

Additionally, one should also note that COST opened 29 new stores in 2016 and currently has plans to open 31 in 2017. This combined with the points above should help drive growth.

It appears COST has momentum behind it, however, as a relatively conservative investor I prefer to keep a margin of safety of 75% of a projected stock price to ensure my portfolio can weather any downturns. Consequently, I will be dollar cost averaging my purchases by buying on dips aiming for a $114 average purchase price.