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The Best Grocery Store Stocks: Deep Industry Analysis

Published by Bob Ciura on June 28th, 2017

2017 is shaping up to be a tumultuous year for the grocery industry.

Grocery stocks across the board are falling, with the exception of Whole Foods Market (WFM), which recently agreed to be acquired by e-commerce giant Amazon (AMZN).

With a competitive force as strong as Amazon, even the biggest U.S. retailers with a grocery presence—Wal-Mart Stores (WMT), Target (TGT), Costco Wholesale (COST), and Kroger (KR)—are under assault.

These stocks remain attractive for dividend growth investors.

Wal-Mart and Target have dividend yields of 2.7% and 4.7%, respectively, and both stocks are members of the Dividend Aristocrats.

The Dividend Aristocrats are a group of 51 stocks in the S&P 500 Index, with 25+ years of consecutive dividend increases.

You can see the entire list of 51 Dividend Aristocrats here.

Meanwhile, Costco and Kroger are members of the Dividend Achievers list, a group of stocks with 10+ years of consecutive dividend growth.

You can see the entire list of all 264 Dividend Achievers by clicking here.

These retailers are all making progress to better compete with Amazon.

In the meantime, investors can collect their dividends, while they wait for the turnarounds to materialize.

This article will discuss the enormous pressure facing the U.S. brick-and-mortar grocers, and the actions being taken to compete with the 800-pound e-commerce gorilla, Amazon.

Wal-Mart and Target Feel The Heat

There are two major challenges facing the grocery industry.

First, is deflation. The cost of groceries is falling, which is eroding margins in an already low-margin industry.

The second pressure facing grocers is e-commerce competition. Internet-based grocery is nothing new, but Amazon represents the strongest player yet.

At this point, Wal-Mart has proven to be best-equipped to successfully fend off Amazon.

This is largely because of Wal-Mart’s massive scale, which allows it to not only compete on price with Amazon, but also compete in e-commerce, Amazon’s home turf.

Wal-Mart’s huge store count, consisting of more than 11,000 stores, along with its distribution network, provide it with prodigious cash flow.

Such strong free cash flow provides it with the financial flexibility to invest heavily when necessary to compete, by lowering prices and building its e-commerce platform.

For example, Wal-Mart’s free cash flow rose more than 30% in the most recent fiscal year, to $21 billion. Free cash flow has risen at a high rate, over the past several years.

WMT Cash Flow

Source: Raymond James Institutional Investors Conference, page 5

And, Wal-Mart’s e-commerce growth exceeded 60% last quarter. This led to 1.4% domestic comparable sales growth for the quarter.

On a constant-currency basis, total sales rose 2.5% last quarter, year-over-year.

Wal-Mart’s earnings-per-share of $1.00 last quarter came in at the high end of its guidance, and was a 2% year-over-year increase.

While this might not sound like much, it represents the first quarterly earnings-per-share increase for Wal-Mart in more than two years.

Wal-Mart’s main rival in the deep discount space, Target, is really struggling.

In early 2017, Target announced it would need to invest heavily to better compete on price, in order to protect market share.

Its updated guidance for 2017 rattled investors’ nerves, as Target unveiled it would spend $2 billion to turn itself around.

The investments will include store redesigns, investing in e-commerce, and lowering prices.

As a result of this investment, the company forecasts earnings-per-share to decline 16%-24% this year.

The problem for Target is that, unlike Wal-Mart and Costco, it hasn’t carved itself a sustainable niche.

Target isn’t the low-cost leader like Wal-Mart, nor has it mastered the membership model like Costco.

And, Target is trying to compete in grocery, but hasn’t found success there either, which is only going to get more difficult with Amazon’s pending acquisition of Whole Foods.

Target’s future success may hinge on its ability to redevelop existing stores, and build new store concepts, to better appeal to consumer preferences.

Fortunately, the company is making big investments in these areas.

Target is planning more than 100 store renovations this year, which the company believes will result in as much as a 4% sales boost per store.

By 2019, Target is planning to redevelop more than 600 stores, or approximately 33% of its total store count.

Next, Target is building small-store formats, designed to help penetrate densely-populated urban markets and large cities.

It has only around 30 of these stores now, but Target plans to have more than 100 small stores in operation by 2019.

TGT Small Stores

Source: Q4 Earnings Presentation, page 77

Target’s ability to compete with Amazon is helped by its nationwide distribution and store network. It can use these stores as fulfillment centers, to allow it to compete in e-commerce.

This has already paid off, as Target’s digital sales rose more than 20% last quarter.

There is reason to believe Target could be successful, as its first-quarter earnings were better than the company had anticipated.

Adjusted earnings-per-share, which excludes non-recurring costs, fell 6.1% to $1.21. However, this was well above the company’s guidance, which called for adjusted earnings-per-share in a range of $0.80-$1.00.

Comparable sales declined a modest 1.3%, driven by small declines in store traffic and basket size.

This is a relatively small decline, which should not be too difficult to recover from, as long as conditions do not deteriorate further.

Target has a more difficult path ahead than Wal-Mart, but the stock compensates investors for this with a dividend yield 200 basis points higher than Wal-Mart’s.

Plus, Target should be able to continue increasing its dividend each year.

On June 14th, it raised its dividend by 3.3%. The new dividend rate of $2.48 per share still represents just 59%-65% of the company’s projected 2017 adjusted earnings-per-share.

With the company likely to distribute less than two-thirds of its adjusted earnings-per-share this year, there should still be room for dividend growth in the years ahead.

And, when it comes to these kinds of turnarounds, there is a precedent of success—Wal-Mart embarked on a similar path a few years ago.

In 2015, Wal-Mart warned investors it would need to spend as much as $10 billion to improve employee training and wages, renovate its stores, and invest in e-commerce.

Its turnaround is ongoing, but the results are starting to materialize.

Target can only hope its own turnaround is as successful, but it similarly has a strong brand, a nationwide store network, and sufficient financial resources.

Even The Mighty Costco Is Not Immune

It wasn’t too long ago that Costco was generating sales growth well ahead of the pack. While Costco remains a highly successful company, even it is not immune from Amazon.

Costco’s sales growth has slowed significantly over the past several years:

This adds fuel to the bearish argument, that Costco could see falling membership—a key driver of profitability—if Amazon is able to succeed in grocery delivery.

Fortunately, Costco’s growth has re-accelerated so far in fiscal 2017.

Last quarter, comparable sales increased 5%. Earnings-per-share increased 28%, year-over-year.

Over the first three quarters of fiscal 2017, comparable sales rose 3%. If the trend continues, Costco could put up its best comps performance since 2014.

In the same period, earnings-per-share rose 12%, a very strong performance in a highly challenging year.

Costco should be among the most resilient retailers when it comes to the Amazon threat. That is because Costco has developed a high level of brand equity with its customers.

Costco’s membership renewal is at 90% in the U.S. and Canada.

Much of Costco’s growth is driven by membership fees, which allow the company to keep prices low.

There is a fair amount of risk that Costco could lose members, if an Amazon Prime membership costs less, especially if Amazon Prime members are given free grocery delivery.

However, one factor that could help Costco retain market share, is its aforementioned brand strength.

Costco has a popular lineup of signature products under the Kirkland brand.

Discount Retailers Pivot Toward The Future

It used to be, that discount retailers like Wal-Mart, Costco, and Target were the ones under-cutting the competition on price.

Now, they are being disrupted by a similar force.

Amazon is doing to the big-box discount retailers, what the discount retailers did to mom-and-pops over the past several decades.

It is easy to see why so many brick-and-mortar CEOs must be extremely frustrated.

After all, how does a company—whose shareholders have become accustomed to high levels of profits and regular dividends—compete with a company that doesn’t have to obey the traditional laws of economics?

Amazon’s investors do not require the company to make a profit. In fact, it seems investors prefer the company to continue losing money, if it results in market share gains and high revenue growth.

Of course, this could all change—low interest rates have, historically, fueled speculative stock market bubbles before, such as in 1999-2000.

As interest rates rise, investors (even Amazon’s) may begin to demand a real economic return from their investment.

But until then, Wal-Mart, Costco, and Target will have to contend with a fierce competitor that is willing and able to sell at or near cost.

Kroger Bends, Doesn’t Break

There is arguably no grocer with more to lose right now than Kroger, the largest supermarket chain in the U.S.

Kroger stock has been stuck in a persistent downtrend since the start of 2017. Shares have lost approximately one-third of their value year-to-date.

Things started deteriorating for Kroger when it released disappointing first-quarter earnings. Then, conditions got even worse when Amazon announced its pending acquisition of Whole Foods.

The big fear surrounding Kroger is that it will be left behind, in the coming new age of grocery delivery, and even further downward pressure on grocery prices, thanks to Amazon.

While the news flow certainly seems to be against Kroger, now might actually be a buying opportunity.

That’s because Kroger is still a highly successful company, with more than 2,200 stores in the U.S.

Through its constant focus on low prices, and a high-quality signature brand, Kroger has attained excellent household loyalty over the years.

KR Loyalty

Source: 2016 Investor Presentation, page 18

In fiscal 2016, Kroger’s total sales increased 5.0%. Excluding fuel, total sales rose by 6.7% for the year.

Comparable-store sales increased 1% in 2016. And, 2016 marked the 12th year in a row in which Kroger increased its domestic market share.

Kroger had earnings-per-share of $2.05 in fiscal 2016. This was down less than 1%, which was disappointing, yet still a strong performance, given the persistent challenges in the grocery industry.

The company is off to a good start to 2017— first-quarter sales increased 4.9% year-over-year.

Going forward, Kroger should be able to retain its market share, because it has invested significantly in building its own digital platform.

The company has aggressively expanded its ClickList service, which gives customers the ability to order online and pick up items in-store, to more than 600 locations.

It also invested in Lucky’s Market, a specialty natural and organics store, which has more than 20 locations.

These investments have fueled Kroger’s growth to start 2017. Total sales increased 4.9%, to $36.3 billion.

And, Kroger is a very shareholder-friendly stock.

It returns a great deal of cash to shareholders each year, through dividends and share repurchases, both of which will become more effective now that the share price is down.

On June 22nd, Kroger increased its dividend by 4%, and also approved a new $1 billion share repurchase.

Since 2006, Kroger has increased its dividend at a compound annual rate of 13% per year.

Thanks to its declining share price, Kroger’s dividend yield has reached 2.1%.

And, its share repurchases will be even more accretive—the recently-approved $1 billion buyback represents nearly 5% of Kroger’s market capitalization.

So, all things being equal, Kroger’s earnings-per-share could increase 5%, just from share repurchases.

With the stock trading for a price-to-earnings ratio of 11, based on projected 2017 earnings, the stock could be significantly undervalued.

The Amazon-Whole Foods deal seemed to terrify Kroger investors, but Whole Foods simply doesn’t have the scale to challenge Kroger.

Whole Foods has just 440 locations in the U.S.

And, there is little overlap between Kroger’s and Whole Foods’ customer base, and geographic location of their stores.

Niche Grocers Are Sprouting Growth

While big-box grocery stores struggle, niche players have found success, especially in areas like natural and organics.

One example is Sprouts Farmers Market (SFM).

Sprouts Farmers Market is a health-oriented grocery store, which specializes in natural and organics.

It offers a wide range of products, including fresh produce, bulk foods, supplements, meat and seafood, deli, baked goods, dairy, and more.

Sprouts operates more than 260 stores across 15 U.S. states, predominantly in the Southwest and Southeast.

Sprouts credits its success to a multi-faceted management philosophy, which is to focus on healthy foods, while providing value to customers.

These principles have resulted in excellent growth over the past several years.

From 2011-2016, Sprouts grew sales by 19% per year.

SFM Sales

Source: May 2017 Investor Presentation, page 4

In 2016, Sprouts generated sales of $4.0 billion, up 13% from the previous year. Comparable-store sales increased 2.7%.

Earnings-per-share were flat last year, as the company continued its aggressive investments in new store openings.

The company expects continued momentum in 2017. Sales are expected to increase by 12.5%-13.5% from 2016.

Sprouts expects to open 32 new stores this year.

It is off to a good start to 2017—first-quarter sales increased by 14%, as comparable store sales rose 1.1%.

Comparable-store sales growth has slowed lately, but the company is still growing comps. This is an impressive accomplishment by itself, given the escalating competition and deflationary pressures facing the grocery industry.

SFM Deflation

Source: May 2017 Investor Presentation, page 14

In fact, Sprouts’ comparable-store sales have increased for 40 consecutive quarters.

The company expects 4.8%-9.6% earnings-per-share growth in 2017.

Sprouts has deployed a differentiated business model to win market share. First, it offers a non-traditional product lineup—it does not carry most national brands.

It also employs a farmers’ market-style store layout, with a heavy focus on produce, and an open store layout with low-profile displays. This helps keep operating costs low.

A focus on profitable growth has led to significant earnings growth in recent years. For example, Sprouts’ net income rose by 22% per year, from 2013-2016.

Last quarter, Sprouts generated a strong return on invested capital of 12.4%. Diluted earnings-per-share increased 10% from the same quarter in 2016.

And, its stores appeal to modern consumer preferences. Most Sprouts stores are small, with an average of 30,000 square feet.

This allows for a faster, more convenient shopping experience. The concept has worked very well, especially in densely-populated, urban areas.

Future growth will be fueled by new store openings.

The company plans to open 30 new stores each year. It has maintained an aggressive pace of double-digit store growth on a percentage basis, over the past five years.

The Grocer Most At Risk

One stock investors would be wise to steer clear from in the grocery industry is SUPERVALU (SVU).

SUPERVALU operates grocery stores under the Cub Foods, Shoppers Food & Pharmacy, Shop ‘n Save, Farm Fresh, and Hornbacher’s banners

At its core, SUPERVALU represents the grocery model of old.

It can’t compete with Wal-Mart and Target on price, which means it almost certainly won’t be able to compete with Amazon’s looming grocery service.

Unlike Costco for example, SUPERVALU does not have a loyal customer base. It stands to reason SUPERVALU will continue to cede market share to competitors that offer more popular products, at lower prices.

And, it has a very weak e-commerce presence, which means it won’t be able to compete in grocery delivery or in-store pickup.

With this as a backdrop, it is hardly surprising to see that SUPERVALU shares have lost 35% of their value year-to-date.

SUPERVALU has pinned its hopes on its wholesale business, which accounts for more than 1,900 of its 2,363 total stores.

The company is accelerating investment in this segment through acquisition. For example, SUPERVALU recently acquired wholesale grocery distributor United Grocers, for $390 million.

However, this strategy has not led to tangible results thus far.

SUPERVALU’s total sales have declined 6% since 2015.

On the surface, SUPERVALU looks strong—overall earnings-per-share soared in fiscal 2017, to $2.43, from $0.66 in fiscal 2016.

However, the increase in earnings last year was due entirely to the sale of the Save-a-Lot franchise. Meanwhile, the continuing business segments continue to deteriorate.

For example, the retail business posted a 5.8% decline in comparable-store sales last quarter.

As a result, last fiscal year, diluted earnings-per-share from continuing operations fell by 67%.

The prolonged decline has left SUPERVALU with a damaged balance sheet as well. The company ended last quarter with cash and cash equivalents of $332 million, along with $1.26 billion of long-term debt.

Long-term debt fell from $2.19 billion at the same point last year, but even so, SUPERVALU has a long-term debt-to-equity ratio of 3.3, which puts its future viability in jeopardy, particularly as the competitive threats will only worsen from here.

SUPERVALU offers investors little reason to buy the stock—sales and earnings are declining at an alarming rate, and the company hasn’t paid a dividend since 2012.

Final Thoughts

The grocery industry is changing like never before. Deflationary pressures are hurting companies across the industry, and Amazon represents a truly disruptive force.

Now that Amazon has come to an agreement to acquire Whole Foods, it is likely the company will accelerate its grocery delivery.

In addition, if Amazon is able to significantly lower Whole Foods’ notoriously high prices, it could represent a real threat to the entire grocery industry.

As a result, investors need to tread carefully. It is best that investors stick to the best-in-class dividend payers, like Wal-Mart, Target, Costco, and Kroger.

These stocks have decades of experience in the retail industry. They have proven the ability to navigate difficult waters before, and adapt to changing conditions when necessary.

The grocery industry is evolving; the key players are differentiating themselves.

Bulk buying shoppers looking for low prices and novelty will choose Costco.  Shoppers looking for low prices (without a membership) on the ‘normal’ big brands will choose Wal-Mart, or perhaps Target.

Shoppers looking for a mix of the traditional food brands as well as organics will choose Kroger.

The high-end organic grocery experience belongs to Whole Foods, with Sprouts also competing and growing rapidly in the health/organic grocery sector.

Amazon will likely take the lion’s share of the online grocery experience, depending on how well they integrate Whole Foods into this experience.  Wal-Mart will also own a sizeable share of this market with its convenient order online, pick up in store option that benefits from the company’s tremendous amount of locations.

In the final analysis, one thing is true.  We will always be buying groceries.  Where and how we do this will change, but different people will prefer different stores based on their own personal preferences.  The forces of competition will better satisfy more consumers while forcing specific companies to focus on their core competencies and niches.  No one company will ever dominate all of grocery.

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