Kroger's Guidance Not Looking Too Fresh

In this episode of Market Foolery, host Mac Greer talks with Motley Fool contributors Ron Gross from Total Income and Jason Moser from Million Dollar Portfolio about today's biggest stories in the market. The healthcare space got a little smaller after Cigna (NYSE: CI) snapped up pharmacy benefits manager Express Scripts (NASDAQ: ESRX) for a whopping $67 billion. How likely is the merger to get through without the antitrust boot stomping it out?

Meanwhile, Costco's (NASDAQ: COST) numbers looked pretty good, but the stock went down a bit following the report. Kroger (NYSE: KR) is selling off something big after releasing disheartening 2018 guidance, and the grocery space is getting even more difficult to compete in with (NASDAQ: AMZN) shaking things up. Tune in to find out more.

A full transcript follows the video.

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This video was recorded on March 8, 2018.

Mac Greer: It's Thursday, March 8. Welcome to Market Foolery! I'm Mac Greer, and I'm joined by Jason Moser from Motley Fool Million Dollar Portfolio and Ron Gross from The Motley Fool's Total Income. Gentlemen, welcome! I got choked up there on Total Income, I'm just so touched by you being here.

Ron Gross: You love income.

Greer: I do love income. Don't we all?

Jason Moser: Total Income, it's not just partial income. This is the whole kit and caboodle.

Gross: We go all out for you. the member.

Greer: I don't think partial income ever quite worked for you. I think you're much better on Total Income. OK, on today's show, we're going to talk some Costco, one of my favorite subjects, as you know. We'll talk some Kroger. You're going to have to help me with that. I'm not sure I'm seeing it for the future of Kroger. And we'll get into some Amazon and Whole Foods.

Guys, let's begin with the big deal of the day, Cigna buying Express Scripts in a $67 billion cash and stock deal. Jason, Cigna is a health insurance company. Express Scripts is the largest pharmacy benefits manager in the U.S., which means it negotiates drug benefits for insurance plans and employers. When you look at this deal, two very different reactions playing out right now. Cigna's share price, down around 9% right now. Express Scripts, up around 11%. What gives?

Moser: We see, often times, when acquisitions are announced, the acquirer's stock typically takes a little bit of a hit. The stock of the company being acquired is boosted because of the premium on the deal. I think a lot of that boils down to, the market is telling the acquirer, "The burden of proof is on you to make sense of this deal and show us that it's going to work out." I think it's going to work out in this case, probably, because I think we're in an almost full-on panic mode at this point in the healthcare industry where consolidation is being seen as really the only way to fully compete in what is a very fast changing but very, very big market space. I think these companies are also, in the back of their minds, trying to figure out exactly how they stave off Amazon from jumping in there and competing in one way or another. For Express Scripts holders, I think this is probably a lifesaver right here. The stock had not really done a whole heck of a lot over the last five years. The top line has been stuck in limbo. Being a part of Cigna and something bigger probably benefits both companies.

Gross: I agree with everything you said, Jason.

Moser: Well, thank you!

Gross: Consolidation is definitely the name of the game here. But antitrust scrutiny is really a part of this as well, with Cigna and Anthem being blocked, Aetna and Humana being blocked. So, it's not a given as we consolidate and roll up this industry. But, these deals will get done over time, and consolidation will continue. The trifecta of Amazon, Berkshire and JPMorgan kind of better figure out where they want to play here, because it's going to be slim pickings out there in terms of if you want to buy something vs. just build it. I'm sure there's lots of vigorous discussion going on about where they want to go, but a lot of the good, most obvious acquisitions are being made already.

Greer: Let's talk about that trifecta, Jason. We have this recently announced venture between Amazon's Jeff Bezos, Warren Buffett, JPMorgan's Jamie Dimon. And, as Ron just mentioned, this kind of changes the game a bit. Does this make that venture less attractive? Where do you think this leaves them?

Moser: I don't think so. I think, from the perspective of those three leaders and what they want to do, it's less about figuring out how to fix the current state of our healthcare industry, and more about starting brand-new and building something from the ground up. I don't know that they're going to really look at this sort of landscape today as playing too much into what they're going to try to figure out. They've talked before already, they're going to try to find a CEO first and foremost for this company, for this healthcare venture. Then, from there, it's going to be a lot of trial and error. I don't think they're really letting the current landscape play into it, because the current landscape, any which way you cut it, is kind of broken. And Ron's point about antitrust is spot-on.

The one thing I will say in regard to this deal, I think it probably goes through because this hearkens back to UnitedHealth Group's deal where they bought Catamaran a few years ago. That was a big insurer bringing a PBM into their network, just like this deal is as well. Now, it's also worth noting that Express Scripts is a bigger company than Catamaran was at the time. Either way, I think the deal probably makes sense because there's not a lot of overlap, it's a very complimentary joining of two businesses there. But, regardless of what the landscape looks like there, I think the big three are looking to build something from the ground up, not really worried about today's state.

Gross: We should maybe explain that the Department of Justice gets involved from an antitrust perspective when they think a merger and acquisition is going to harm the consumer, when consolidation is going to harm the consumer. If an acquisition or a merger is what we call vertical, where it's a complimentary business, adding on to a business that somewhat similar but not exact, that typically goes through and is OK. When it's more horizontal, where you have similar businesses combining, and that could potentially hurt prices and hurt consumers, that's where the Department of Justice gets nervous.

Greer: We will keep an eye on it. Guys, let's move on to Costco, one of my favorite subjects. Costco reporting earnings on Wednesday. Ron, when I look at these numbers, same-store sales up 8.4% for the quarter. That seems pretty strong. Online sales up more than 28%. Renewal rates up to 91%. That's a 1% gain. People aren't leaving Costco.

Moser: I think we know what's going on at the dinnertime conversation at Mac's house.

Greer: So, I hear all that and I'm like, certainly this stock is up big today. And yet, shares are down. And when I sift through all this earnings coverage, seems to be a lot of concern still about Amazon and competition.

Gross: Yeah. I will answer your question, if there was a question in there, after you tell me, what percent of your current outfit is Kirkland brand? Be honest.

Greer: OK, I will be honest. I'm disappointing myself, because I'm wearing a Brooks Brothers shirt.

Gross: Oh, they look just like your Kirkland shirts.

Greer: I know. It's still blue. But I've moved away from that.

Moser: High cotton. They're paying you too much.

Greer: Today is unusual, because I'm wearing Levi's jeans, which is really cutting edge --

Gross: We'll have to cut this part out of the show.

Greer: I know. So, only my socks today. Only my socks.

Gross: All right, a little bit. At least it's something. So, to your question, it's a great report. It's one of those times where I say, step back from the stock and just look at the business. As you mentioned, the metrics are really strong. If you owned 100% of this company and it was just your baby, you'd be very pleased with how this quarter went, with sales up almost 11% and net income excluding a tax benefit of 22%, e-commerce, which is very, very important in this world of Amazon, which you mentioned, up 28.5%. It's interesting to note that Costco had to bring prices down to compete with Amazon, and that can usually can take a smack out of margins, take a whack out of margins. But, in this case, Costco has such power to negotiate with suppliers that they were able to mitigate any kind of margin damage there, and you see that showing up in the net profit increase.

Greer: So, why the Wall Street reaction, then?

Gross: It's one of those short-term vs. long-term things. They actually did miss estimates for profit and same-store sales. They missed what analysts thought was going to happen. So, when that happens, you miss expectations, the analysts come out and say, "They didn't do as well as I expected, therefore the stock isn't worth what I thought, because the metrics don't match up with what my guess was for the year." It's a very short-term way of looking at things, but a very normal Wall Street way of looking at things. Not a Foolish way. We go for the long ball here. I'm not pretending there isn't competition here. For a while, even in the last year, we've been a little bit worried about Costco. But good for them. They continue to put up solid numbers.

Moser: I think, maybe, you want to look at, we always talk about Amazon being that competitor to Costco. I think Costco is a very well-run business, it holds irrelevant place in the market today. I think, though, that the market is looking at this from simply the perspective of two membership programs. You have Amazon Prime and you have Costco. Which membership do you think is going to be the more powerful and productive one over the course of the next 10, 15, 20 years? Probably, most people are going to say it's Prime. And it's not really to knock Costco's membership at all, because it's a good one. But, historically, that relationship was really focused on rock bottom prices. We're going to bring you in there and we're going to have everything you want, and we're going to give it to you for the lowest price possible. And what Amazon has done so well is training the consumer to not care as much about rock bottom prices as perhaps we once did.

Greer: I disagree. I think Costco is more about value. Yes, they're competing on price, but I trust Costco. That's why I will pay a premium, even for Kirkland, for their signature brand. At the end of the day, maybe it's not a rock bottom price, but I trust them.

Moser: So, you think Costco has been able to steer away from that, we're going to give it to you at the lowest price possible?

Greer: I think in some cases, they can. I mean, you can go in and buy high ticket items at Costco. But what you're doing, especially with their Kirkland stuff, but, with their other products, as you're saying, I trust them enough, I will buy Kirkland branded stuff, and I will pay more for it than name branded stuff.

Moser: And I think that's good. I think that's something that Costco needs to do. What we've seen Amazon do over the course of its time and growing out that Prime relationship, it's taken the conversation away from being the lowest-priced provider and more about giving you fairly competitive prices, but a really great value in the form of time. We're saving you from having to go out to wherever to get this stuff.

Greer: Convenience.

Moser: Exactly.

Gross: Costco is all about having you trust them that they will get the best value in there, because they need you to keep renewing and paying that annual membership fee, because the vast bulk of their profits come from that membership fee. Amazon is more, in my opinion, about the convenience one gets from continuing to be a Prime member, which is obviously very important to them as well. Those recurring subscription revenues are essential. But, I think they're promising a different thing to the consumer. You'll get fine prices at Amazon, but you won't necessarily get the rock bottom, but oh my gosh the convenience is unbelievable.

Having said that, in this world, Amazon is probably the bigger winner. But I don't think it's a winner-take-all dynamic. I still think there's a place for folks like Costco in the world. The question then becomes, what are you going to pay for the stock in a world where they are perhaps not the winner, but still somewhat relevant? And at 14 times EBITDA right now, maybe close to 30 times earnings, I would be a little bit cautious with Costco.

Greer: OK, that plays into my next question. Over the next five to 10 years, is there room for both Amazon and Costco to be market-beating stocks?

Moser: I would bet against Costco being a market-beater.

Greer: That hurts me a little.

Moser: I just have a hard time seeing the younger generation of consumers finding the value in that subscription. I think what we're going to have to really do is look at, 10 years going forward, how is Costco going to be up to grow that membership base? And, are they going to be able to grow their membership base like Amazon is able to grow theirs? And I just don't think they can for a number of different reasons. We just saw where Amazon is now offering that discounted Prime membership to citizens who are on Medicare or Medicaid. They're figuring out all sorts of different levers to pull with that Prime relationship, but there's still a big global opportunity out there. Costco has the global market, not quite as far reaching as Amazon's, but if you're looking at it over the course of the next 10 years, it strikes me that Prime is going to be the easier winner.

Gross: It pains me to say that Jason is probably right, because I, too, am a big fan of Costco, and I've been a shareholder for a very, very long time, and I will remain one. It might not be a market-beater right now at the entry point where one would be starting from. As I mentioned earlier, the stock is kind of fairly, if not richly, priced. To be a market-beater from this point forward is not the easiest thing to do. If you saw a pull-back of 15%-20% in the stock for whatever reason, whether it was a stock market correction or something specific to the industry, and you were able to get in at that entry point, I would feel much better about it.

Greer: Back to Jason's point, what gets and keeps millennials shopping at Costco? Right now, I'm an Amazon shareholder and I'm a Costco shareholder. I love both of them. If I had to pick between memberships, and it pains me to admit this, I would go Amazon Prime all day long, and I would let Costco go. But I don't have to pick. But, for millennials, what's going to get them into the Costco door, and what's going to keep them? Because I love the treasure hunt, but I get the sense that maybe millennials value convenience over this treasure hunt thing.

Gross: Yep. Millennials also don't always have a ton of money, so value proposition could play in there. Maybe the job market will have to weaken a little bit for value to come back into vogue where millennials will start trying to save a buck rather than just go for the convenience. But, your question is really the answer in that it's not an easy battle for them.

Moser: I think also, it's just the shopping experience alone. I think when you look at the two, Amazon, obviously, you're shopping on your phone often times or your desktop, whereas Costco you're going to the stores. I think from the very beginning, on the behavior side of it, millennial consumers and generations to come are going to be more in line with shopping via mobile devices or with their laptops or whatever, vs. driving to the store to go find something. So, I think right there from the very beginning, it's a big, tall hurdle to clear.

Greer: I'm going to give you two words for Costco: free samples. That may be the answer. I'm not sure. Still working on it.

Gross: [laughs] Duly noted.

Greer: OK, guy., Kroger.

Gross: Woof. As you say, woof.

Greer: Shares of Kroger falling on Thursday after the company reporting fourth quarter earnings. Jason, Kroger is issuing a disappointing profit outlook for 2018. Shares of Kroger down around 12% at the time of our taping here. Is there any hope?

Moser: [laughs] You sound so dire!

Gross: There's always hope, Mac.

Greer: We should point out, when we're talking Kroger, we're also talking Harris Teeter. Kroger owns Harris Teeter.

Moser: It can't come as a shock that guidance for 2018 is going to be somewhat challenged. The grocery space is evolving very quickly, and now we have the competitor there in Amazon/ Whole Foods. Is there hope? I mean, I think you're asking the question, why would I invest in Kroger? Maybe there's hope, maybe there's not. I think the reason why you would invest in Kroger is because this is such a big market. In 2016, supermarket sales came in around $670 billion. Data from the Food Marketing Institute shows on the other side of the coin there that it's not a very profitable industry. You're looking at net margins of around 1%-1.1%.

Greer: Tell me more! [laughs]

Gross: [laughs] Where do I write the check?

Moser: So, it's very difficult to paint this picture of why you need to be investing in Kroger. But, I think one reason might be because of its scale. It's one of the bigger grocery concepts out there. It does own Harris Teeter. There are some positives there, but yeah, absolutely, the outlook has the market spooked.

Gross: I'm a Harris Teeter guy. Jason, you and I both know our way around the kitchen a little bit. And I think Harris Teeter does a great job in terms of offering good produce, good meats, relatively good value. They're beefing up their organic space to compete with those other folks. But, as you said, it's such a tight margin business. It's brutal out there. I will continue, week after week, to buy Harris Teeter.

Moser: It's very brutal. You also have to look at, the No. 1 grocer in the space is Wal-Mart.

Greer: I've heard of them.

Moser: [laughs] Wal-Mart is the leader in the space here. And they're doing a heck of a lot in the grocery side as well, certainly with the meal plans and e-commerce and whatnot. It's just a very competitive space that's not very profitable.

Greer: And let's talk about the competitive space a little bit more. This week, Jason, we learned from Amazon's annual report that Amazon has committed to roughly $22 billion in future food purchases as it really tries to bulk up Whole Foods. The fancy term here is unconditional purchase obligations. You know. UPOs.

Moser: Yes. You're on the hook.

Greer: So, what does that mean?

Moser: Normally, this was a line item in Amazon's 10K that accounted for its digital media. What we've seen here is, that number has gone up exponentially thanks to the Whole Foods acquisition. It just means they're on the hook for buying a lot of stuff for the grocery segment, and it means they're investing a lot in that presence, and they see some potential growth there. That's not a big surprise. Amazon bought Whole Foods because they wanted to get a presence in the grocery segment.

But, what I do think is going to be more interesting, at least to me, is that at the end of trading today, United Natural Foods is going to release their earnings for the quarter, and I'm going to be very interested to see how they respond to this news. United Natural Foods, 35% of their sales come from that relationship with Whole Foods, and they are signed on to be a provider to Whole Foods I think through 2025 now. So, it could be one of those situations where, you have this great partner, and you know that Amazon is going to be spending a lot of money with you in volume, but they're going to be asking a little bit on pricing, as well. Which can certainly play out on the profitability side. It's kind of like those chip companies that are suppliers to Apple. It's great having Apple as your partner, you're going to sell a lot of chips, but Apple is going to command pricing, which really dings those margins. So, we'll have to get their take on the call here after the market closes today.

Gross: If you're someone like Kroger, it's so hard to compete against a company that, in any given short period of time, really doesn't care if it's profitable or not and will do whatever it needs to do to take control of that space. That's brutal to fight against.

Greer: That's tough. OK, guys, as we wrap up, we get to play my favorite game. It's the completely arbitrary desert island question. I think I know how this is going to end up, so we're going to tweak it a bit. For the next five years, you're on a desert island. We have four stocks. We have Cigna, Costco, Amazon, Kroger. I want you to start kicking them off one at a time. What's the first stock you're kicking off? You have to hold one for these five years. What are you getting rid of first?

Moser: What am I getting rid of first?

Greer: Yeah, you don't like it, you don't want it.

Moser: Cigna, Costco... ?

Greer: Cigna, Costco, Amazon, Kroger.

Moser: Well, I'm kicking Kroger off first.

Greer: Kroger. Ron?

Gross: I have to do it, I agree. I don't want to agree, but I do.

Greer: OK. Now we're down to Cigna, Costco and Amazon. Where are you going?

Gross: I'm going to kick off Cigna.

Moser: Oh, I'd boot Costco.

Greer: Interesting.

Gross: That's fair, though, it was close.

Greer: OK. Ron? What are you keeping?

Gross: I have to keep Amazon.

Greer: You have to keep Amazon.

Gross: I mean, I'm traditionally thought of as a value investor around here, but I've owned Amazon, I will continue to own Amazon. They're dominant in so many fields, probably some we haven't even thought of yet.

Greer: Even if they relocate, even if they choose for their second location for the headquarters your front yard?

Gross: No, I'm out then.

Greer: Because it's pretty close to your house, right?

Gross: The proposed site in Maryland is very close to my home, and yes, that would be dicey. But as far as the stock goes, I'm in.

Greer: OK. Jason?

Moser: I love the healthcare market. I think Cigna is going to do very well. But I have to agree with Ron. You need Amazon. This is just the most relevant company of our time.

Greer: OK, we will leave it there. I should mention that all of next week, Market Foolery will be coming to you from South by Southwest in my great state of Texas.

Gross: Nice!

Greer: So, if you're in the Austin area, we're going to have a listener meet up on Monday, March 12. Chris Hill and company will be there. Just email and we'll send you all the details. That's a listener meet up, Monday, March 12, Austin, Texas, South by Southwest. Jason, Ron, thanks for joining me!

Moser: Thank you!

Gross: Thanks, Mac!

Greer: As always, people on the show may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Mac Greer. Thanks for listening! We'll see you tomorrow!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Jason Moser owns shares of Apple and Berkshire Hathaway (B shares). Mac Greer owns shares of Amazon, Apple, and Costco Wholesale. Ron Gross owns shares of Amazon, Apple, Berkshire Hathaway (B shares), and Costco Wholesale. The Motley Fool owns shares of and recommends Amazon, Apple, and Berkshire Hathaway (B shares). The Motley Fool is short shares of Kroger and has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Costco Wholesale and UnitedHealth Group. The Motley Fool has a disclosure policy.