Undervalued Dividend Growth Stock of the Week: Kroger Co. (KR)

There are a lot of get-rich-quick schemes out there.

Just watch some of those cringe-inducing late-night infomercials that come on.

Or listen to a telemarketer tell you all about some game-changing real estate opportunity.

I think a lot of these ideas should be renamed “get-poor-quick” schemes.

Personally, I prefer to get rich slowly but surely.

I’ve amassed a real-life, real-money portfolio that’s now well into the six figures… at just 34 years old.

This portfolio was through the power of patience, persistence, and perseverance… not a get-rich-quick scheme.

I’ve simply lived well below my means for six years and invested much of my excess savings into high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.

Sure, it didn’t happen overnight. And it definitely wasn’t easy.

But the money is just as real as if it were to land in my lap quickly.

Moreover, I didn’t have to take huge risks to get here.

I’m investing almost exclusively in large, blue-chip companies that sell product and/or services to people, other businesses, or governments all over the world.

And because these products and/or services are in demand, lots of profit flows.

As demand and pricing increases, so does the profit.

Since there’s only so much cash flow a company can profitably and efficiently reinvest back into the business, many companies end up sending a good chunk of their profit back to shareholders via a dividend.

This dividend income is wonderful by itself – after all, it’s a completely passive source of income that requires nothing from a shareholder other than to continue holding shares.

It’s the easiest “paycheck” you’ll ever receive.

But it gets even better when you see those dividend payments growing year in and year out.

Some of the companies on Mr. Fish’s list (and in my own portfolio) have been increasing their dividends for more than five straight decades.

Just imagine what you have to get right as a business in order to be able to write bigger checks to all of your shareholders for more than 50 years in a row!

In my view, dividend income is a good “litmus test” for a wonderful business.

Don’t tell me how great your business is; show me.

I’m a huge fan of dividend income. The dividends that my personal portfolio generates for me covers a significant percentage of my core personal expenses at this point in life. When combining that dividend income with other sources of passive income, I’m essentially financially free.

So you can try out a get-rich-quick scheme you see on some late-night infomercial.

Or you can put your capital to work with some great businesses that reward you with growing dividends.

For me, it’s a pretty easy and obvious choice.

However, as great as dividend growth stocks can be, it’s important that one doesn’t go and just buy random stocks at random prices.

You first need to fully analyze a business to make sure you understand the business model and how they make money. You want to make sure there’s some kind of economic moat. And you want to be comfortable with the risks.

But perhaps just as important, you should value a stock before you ever decide to buy it.

See, price is what you’ll pay for a stock. But value tells you what that stock is actually worth.

Value gives context to price. Without knowing value, you cannot possibly know whether or not the price is fair or not.

This is true with just about anything in life, and it’s just as true with stocks.

In fact, it’s even more important to know value when dealing with stocks.

That’s because most things in life have a fixed price.

Your meal at your local restaurant. A new pair of jeans. Etc.

But stocks differ.

Their prices are changing every day, sometimes in quite a volatile manner.

Value arms you with the knowledge necessary to ignore those price changes and focus on what a stock is actually worth.

That’s why checking out fellow contributor Dave Van Knapp’s dividend growth investing lesson on valuation is so helpful.

This guide was specifically designed with dividend growth stocks in mind. And it’s super easy to follow.

Knowing value beforehand gives you a great opportunity to know what you should pay for a stock.

And what should you pay?

Well, there’s no real “right answer”.

But I’d argue that one should aim to pay as far below the estimated fair value of a stock as possible.

Specifically, one should look to buy high-quality dividend growth stocks when they’re apparently undervalued.

Undervalued means a stock is priced less than it’s worth.

And this is a great way to look at buying dividend growth stocks because of the massive inherent benefits.

An undervalued dividend growth stock will come with a higher yield, greater long-term total return prospects, and less risk.

That’s relative to what would otherwise be present if the stock were fairly valued or overvalued.

Price and yield are inversely correlated.

All else equal, a lower price will result in a higher yield.

That higher yield not only impacts your current and long-term income but also your long-term total return prospects, since yield is a major component of total return.

Capital gain, which is the other component of total return, is also positively influenced by virtue of the upside that exists between the (lower) price you paid and the (higher) value of the stock.

While price and value can diverge quite a bit in the short term, value tends to matter over the long run.

This all has the effect of also reducing your risk.

A margin of safety exists when you pay less than that which a stock is worth.

That means a stock’s value could drop to the price you paid before you’d be looking at the possibility of an investment that’s worth less than you paid.

If a stock is worth $50 but you pay $40, you have a $10 per-share margin of safety.

So a lot of things would have to go wrong for the value of the company to drop by $10 per share.

But even if it did drop $10 per share, you’d still be looking at an investment that’s worth what you paid.

Compare that to the investor that paid fair price or higher for a stock, with no margin of safety.

These benefits are exactly why I’m always on the lookout for a high-quality dividend growth stock that appears to be priced less than it’s worth.

Well, I may just have stumbled upon one.

And I’m going to share it with you readers…

Kroger Co. (KR) operates more than 2,600 supermarkets across 35 states, in addition to multi-department stores, convenience stores, pharmacies, jewelry stores, fuel centers, and food processing plants.

This is one of the largest supermarket chains in the US. We’re talking about more than $100 billion in annual revenue here.

But size hasn’t impeded their growth – the company has driven growth in its identical supermarket sales for 49 straight quarters, which is remarkable.

You know what else is growing?

The company’s dividend.

They’ve increased their dividend to shareholders for 11 consecutive years now.

And it’s not just growing but growing quite aggressively – the five-year dividend growth rate stands at a very impressive 15.2%.

In fact, the company just recently increased its dividend by more than 14%, so there’s not much of a slowdown occurring here.

captureWith a payout ratio of just 22.4%, there’s still plenty of room left for future dividend increases.

The only real issue I see with the dividend metrics is the yield.

At 1.52%, there’s not much current income to be had.

But I think any investor looking at this stock has to be comfortable with the growth potential rather than what it’s going to be spitting out in terms of dividend income tomorrow. It’s really a long-term play.

And that yield, while low, is still higher than the stock’s five-year average yield of 1.4%.

With a low payout ratio and a very high dividend growth rate, we’d expect that the company has generated some pretty strong underlying growth.

That expectation isn’t far from reality.

We’ll get a look at the last ten years for top-line and bottom-line growth, before comparing that against a near-term forecast for profit growth. This will tell us where the company’s been and where it might be going, which will help us later value its stock.

Kroger has increased its revenue from $66.111 billion to $109.830 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 5.80%.

Meanwhile, their earnings per share expanded from $0.77 to $2.06 over this period, which is a CAGR of 11.55%.

Great stuff here. Even though the bottom line hasn’t grown as fast as the dividend, an extremely low payout ratio 10 years ago has allowed Kroger to increase its dividend a bit more aggressively.

A substantial share buyback program accounts for much of that excess EPS growth. Kroger reduced its outstanding share count by more than 32% over the last decade, which is phenomenal.

Looking out over the next three years, S&P Capital IQ believes that Kroger will compound its EPS by an annual rate of 11%, which would be right in line with what we see above.

The one major glaring issue I see with the company’s fundamentals lies in the balance sheet.

Surprisingly, Kroger carries quite a bit of debt on its balance sheet.

The long-term debt/equity ratio is 1.34 and the interest coverage ratio is a little over 7.

These are metrics that I find slightly troubling; however, Kroger has operated with an elevated debt level for many years now. Thus, I suspect changing this is not a priority for management, nor do I believe it’s going to cause any near-term issues. Rising interest rates could cause that interest coverage ratio to become more pressured, though.

Profitability is pretty characteristic of the business model. Retailing in general is known for thin margins, and grocers in particular face margin pressure.

Over the last five years, Kroger has averaged net margin of 1.44% and return on equity of 27.26%.

The former is acceptable, while the latter is rather excellent. However, the debt level should be taken into account when looking at ROE.

Other than the balance sheet, Kroger operates a high-quality business across the board.

And their various banners appear to have some modicum of customer loyalty, which can be difficult in this industry.

Banners like Ralphs and Fred Meyer are known for quality merchandise and good service, and that’s in addition to the namesake banner.

What’s particularly appealing about this stock at this point in time, though, is the valuation.

The stock is down almost 25% this year, and the valuation is now more appealing than it’s been in some time.

The stock trades hands for a P/E ratio of 14.81, which is markedly below the stock’s five-year average P/E ratio of 17.0. That P/E ratio is also well below the broader market. And the yield, as noted earlier, is higher than its own recent historical average. Investors are also paying less for the company’s cash flow than they have, on average, over the last five years.

So the stock does appear to be at least modestly undervalued. What, then, is a good estimate of its intrinsic value?

I valued shares using a two-stage dividend discount model analysis. The two-stage model accounts for the low yield and high growth rate. I factored in a 10% discount rate. I then assumed a 14% dividend growth rate for the first 10 years and a long-term dividend growth rate of 7.5%. That initial growth rate is in line with the most recent dividend increase, and below the five-year dividend growth rate. With a very low payout ratio and strong EPS growth, I think this is conservative. The DDM analysis gives me a fair value of $38.37.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.

My valuation method gave me an output that would indicate this stock is definitely undervalued. But what about other methodologies? What might they say? Well, we’ll next compare my analysis to that of some professional analysts that have taken the time to value Kroger’s stock.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates KR as a 3-star stock, with a fair value estimate of $32.00.

S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates KR as a 4-star “BUY”, with a fair value calculation of $39.20.

Even Morningstar’s more conservative number would indicate the stock is at worst fairly valued. But I like to average these three numbers out so as to blend these different perspectives and methodologies together, which should help improve accuracy by removing the power of outliers. The averaged valuation is $36.52, which means this stock is potentially 16% undervalued right now.

scBottom line: Kroger Co. (KR) is one of the country’s largest supermarket chains, yet being big has not really slowed the firm down. The low payout ratio and strong underlying profit growth should allow for plenty of huge dividend increases for years to come. And with the possibility of 16% upside on top of that, this could be one of the better opportunities available in an expensive market.

— Jason Fieber

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