While they're increasingly shopping online for electronics and other home supplies, people aren't skipping their supermarket shopping trips. Kroger (NYSE: KR), one of the biggest industry players, just revealed accelerating sales growth and rising market share as part of its surprisingly strong third-quarter results.
The news helped send the stock 25% higher in the month of November (though it has trailed the market by a wide margin so far in 2017). Let's look at why investors might expect more gains ahead.
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Solid quarterly results
Kroger's comparable-store sales improved by 1.1% in the third quarter, and while that figure was below the 5% rate that shareholders witnessed as recently as late 2015, it was good news for two reasons. First, it marked the chain's third consecutive quarter of improving growth trends. Comps slipped into negative territory at the end of 2016, but they've now been positive for two straight quarters.
Second, the 1.1% increase outpaced the guidance that management issued back in October calling for comps of between 0.5% and 1%. The expansion pace also translates into modest market share gains against rivals like Wal-Mart (NYSE: WMT) and Target (NYSE: TGT), which have both been slashing prices and pouring resources into upgrading the in-store shopping experience. The initiatives are paying off for the entire industry, with Wal-Mart, Target, and Kroger each posting rising customer traffic and increased spending per visit.
Kroger's profitability remains lower than Wal-Mart, its main competitor. Gross profit margin, though, didn't plunge in the third quarter and in fact it expanded slightly. That means the retailer isn't being forced to take losses to protect its market share. On the contrary, operating margin held steady at 2.7% of sales last quarter.
CEO Rodney McMullen and his team still predict that earnings will decline this year, mainly due to cost cuts that they see as a critical tool for defending Kroger's leading industry position. The company's early outlook for the next fiscal year leaves the door open for a modest profit expansion, but one that's far from the 8% to 11% rate that shareholders had counted on before the recent downturn in the business.
Yet Kroger is aiming to generate solid financial returns over the next three years as it adjusts to changing customer demands. Executives believe they can double free cash flow between now and 2019 while boosting operating margin. Yes, earnings will be held back by price cuts and investments in growth initiatives like the e-commerce sales channel and Kroger's in-store grocery brands. But looking past the flat profit profile, shareholders should see the retailer's business strengthening across important metrics such as free inventory management, cash flow, and operating margin.
Those improvements won't mean much if Kroger can't also expand its sales base. The company believes that it can do this by competing in the prepared foods and home delivery businesses, which together could double its addressable market to $1.5 trillion.
Before it can really attack that large, profitable niche, Kroger needs to reestablish its core grocery business with consistently market-beating growth. The retailer met that goal in the third quarter and predicted another expansion pace improvement in the current quarter. Continuing on this track could brighten the profit picture beyond the tiny uptick that management has predicted for 2018. And given the 25% drop in the stock since the start of the year -- and its price-to-earnings ratio of 16 compared to Wal-Mart's 26 -- Kroger shares are primed for more gains into the start of the new year.
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