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

Are dirty deeds done dirt cheap?

Only AC/DC would know the answer to that question.

But good deeds are definitely not expensive, and they can radically change your life for the better if they’re adapted as part of a holistic lifestyle that prioritizes good habits.

One of the good habits I adopted years ago was to intelligently invest my excess capital (which was generated by another good habit – living below my means) into high-quality dividend growth stocks.

Investing in great businesses can see your wealth and passive income grow exponentially, right before your very eyes.

And great businesses are often separated from the rest of the pack through the paying and habitual increasing of a dividend.

Indeed, you can see what I mean by checking out David Fish’s Dividend Champions, Contenders, and Challengers list, which is an invaluable compilation of more than 800 US-listed stocks that have all paid increasing dividends for at least the last five consecutive years.

Perusing Mr. Fish’s list will show you a “who’s who” of some of the best and most well-known companies in the entire world.

After all, great companies become great by selling products and/or services that the world demands. In the process, they earn a ton of money. This profit routinely grows as the world demands more of said products and/or services. Finally, these companies end up with so much profit, they almost have no choice but to share a large chunk of it with their owners (the shareholders).

What’s really great about this tangible and growing money is that it’s totally passive.

Dividends don’t require any ongoing work on your part.

Buy a high-quality dividend growth stock. Collect growing passive income for the rest of your life, potentially.

And this doesn’t even require much money.

I built my real-life, real-money portfolio in a little over seven years on a decidedly middle-class income, yet this portfolio generates five-figure passive dividend income for me.

Better yet, I expect this passive dividend income to grow faster than inflation for the long run. As such, it’s likely that I’ll be collecting significantly more passive income just 10 years from now, even if I do no more good deeds.

So good deeds not only come pretty cheap, but even just one good deed can reward you for the rest of your life.

Some say it feels good to be bad.

Well, being financially free early on in your life feels better than just about anything else I can think of!

And that’s what dividend growth investing can do for you.

But one needs to take action by saving capital and investing that capital into great businesses that reward you with growing dividend income.

That’s what today’s article is all about.

I’m going to discuss a high-quality dividend growth stock – culled from Mr. Fish’s CCC list – that appears to be undervalued right now, which could be an opportunity to do one good deed and be rewarded for many years to come.

Undervaluation is key, however, due to the inherent benefits that are potentially available to the long-term investor when it’s present.

See, price is what something costs. But value is what you get for your money.

Value gives context to price. Without knowing value, price is practically meaningless.

When price is well below value, you’re paying less than what something is worth. And you’re getting a good deal in the process.

But it becomes a little more than a “good deal” when dealing with undervalued dividend growth stocks.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.

That’s all relative to what the same stock might offer the long-term investor if it were fairly valued (price and value are equal) or overvalued (price is higher than value).

Price and yield are inversely correlated, meaning the latter rises when the former falls. All else equal, a lower price will result in a higher yield.

That higher yield not only positively impacts your current and long-term income, but it also positively impacts total return due to the fact that dividends/distributions are one component of total return.

The other component, capital gain, is also positively impacted by virtue of the “upside” that exists between the lower price paid and higher intrinsic value of a stock.

If a stock is worth $100, but you pay $75, you have $25 worth of possible additional upside that’s on top of whatever natural upside is available as a quality company becomes worth more over time.

The gap closing between price and value will thus result in capital gain, giving your possible long-term total return another boost.

Moreover, that gap serves to provide the long-term investor a margin of safety, reducing risk in the process.

Just in case the investment thesis is wrong, or in case a company does something wrong, there’s “downside protection” that limits possible losses.

That means that there’s a buffer before the investment becomes worth less than one paid.

The greater the gap between price and value, the greater the margin of safety.

As one can see, undervaluation is something to be sought after.

Fortunately, it’s not all that elusive.

There are a number of resources and systems out there designed to help facilitate the valuation process.

One such resource is fellow contributor Dave Van Knapp’s valuation lesson, which is part of a larger series of high-level lessons on the dividend growth investing strategy.

Once you’re able to separate price from value, and once you find a high-quality dividend growth stock that’s undervalued, it’s time to act and do your good deed.

To help you readers narrow the search a bit, however, I’m going to reveal what appears to be a stock that fits the bill…

Kroger Co. (KR) operates more than 2,700 supermarkets across 35 states (and the District of Columbia), in addition to multi-department stores, convenience stores, pharmacies, jewelry stores, fuel centers, and food processing plants.

In an uncertain world, there’s a certain amount of assurance that one has when investing in a grocer, as people will no doubt continue to need food to survive.

And those grocers that provide the best products and experience at the best value will likely thrive well into the future.

Operating as the largest traditional grocer in the country, Kroger has achieved economies of scale that no other rival enjoys.

But it’s not just through sheer size that Kroger has done well, as the company actually manages to register same-store sales growth quarter in and quarter out, indicating a very loyal (and growing) customer base.

However, additional challenges to the business model are fast approaching.

With the outright acquisition of Whole Foods Market, Inc. (WFM) by e-commerce behemoth Amazon.com, Inc. (AMZN), it’s clear that Amazon is attempting to further strengthen its footprint in the grocery space. And since Amazon has e-commerce logistics down to a science at this point, the threat facing Kroger is very real.

That said, Amazon’s e-commerce dominance does not automatically translate perfectly over to grocery delivery, as they’ve found over the last few years.

Their lack of physical space and a good brand that customers value is what prompted the acquisition of Whole Foods in the first place, but it remains to be seen how easily groceries can move over to the digital space.

Meanwhile, Kroger already has the physical space and brand value, so they actually have a head start. But it’s up to them to convert that to a new era in which consumers will likely expect fresh and competitively-priced same-day grocery delivery.

Looking at the dividend and dividend growth, Kroger is certainly already very competitive here.

They’ve paid an increasing dividend for 12 consecutive years.

And the ten-year dividend growth rate stands at an impressive 16.5%.

With a payout ratio of 29.9%, there’s plenty of room where that came from.

Curiously, however, the most recent dividend increase was only a little over 4%.

If that kind of dramatic deceleration continues (rather than being more of a one-off event), the thesis will be changed, but the long-term dividend growth potential is still outstanding, and the company has still demonstrated a willingness to hand out big raises.

Said another way, the wherewithal and willingness for strong dividend growth are both present.

On top of that historical dividend growth, the stock currently yields 2.19%.

That yield might not seem like much, but consider that the five-year average yield is 1.4%.

So there’s a major disconnect between what investors have typically, on average, been willing to accept in terms of yield over the last five years and what they’re accepting today.

That yield is much higher due to the recent precipitous drop in price (price and yield are inversely correlated): the stock is down over 32% YTD.

Much of this drop is due to the aforementioned acquisition of Whole Foods by Amazon; however, Kroger’s core business hasn’t recently been quite as strong as it has been in years past.

But business operations do not appear to be permanently impaired by 32%.

In fact, FY 2017 Q1 results showed guidance for this fiscal year, and Kroger is expecting 0-1% same-store sales growth and roughly flat YOY EPS (using the midpoint of adjusted EPS).

In order to really determine what kind of underlying earnings power Kroger has, which will help us build an expectation around future dividend growth, we’ll have to look at what the company has historically generated in terms of top-line and bottom-line growth.

This will also help us value the business.

So we’re going to take a look at the last decade and what Kroger has done with business growth over that time frame.

We’ll then compare that to a near-term forecast for profit growth.

Combined, this should give us a very good idea as to what kind of growth Kroger is generating, which will help us ascertain a valuation of the business and its stock.

Kroger’s revenue has increased from $70.235 billion in fiscal year 2007 to $115.337 billion in FY 2016. That’s a compound annual growth rate of 5.67%.

That’s actually really solid. I typically look for mid-single-digit revenue growth from mature companies.

Keep in mind we’re talking about rather large numbers here, and it’s hard to move the dial when you’re selling over $100 billion of products.

The bottom line, meanwhile, fared a bit better thanks to significant buybacks.

The company grew its earnings per share from $0.84 to $2.05 over this same 10-year period, which is a CAGR of 10.42%.

That’s a rather outstanding growth rate for EPS, especially considering the size of the company.

Again, buybacks helped tremendously: Kroger reduced its outstanding share count by approximately 31% over this time frame.

The concern I have, though, is that growth has slowed over the last couple fiscal years.

Considering the larger size of the company and additional threats, it seems unlikely that Kroger will repeat that ~10.5% compound annual growth rate in EPS over the next 10 years.

Looking forward, CFRA believes that Kroger will compound its EPS at an annual rate of 8% over the next three years, which isn’t terribly far off from what the company has demonstrated over the last decade.

If that kind of growth manifests itself, Kroger could support like dividend growth without expanding the payout ratio.

But seeing as how the payout ratio could expand a little, it seems highly plausible that Kroger will deliver dividend growth near the double-digit mark over the foreseeable future, even if EPS growth doesn’t quite match CFRA’s forecast.

The one area of the business that could be improved is the balance sheet.

With a long-term debt/equity ratio of 1.76 and an interest coverage ratio of below 7, the balance sheet could stand to be cleaned up.

But profitability is sound and competitive, keeping in mind that this is a low-margin grocery business.

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

Overall, Kroger has done a tremendous job managing both growth and scale, while also juggling size and quality. They’ve obviously kept their costumer base happy, as evidenced by the relatively solid SSS in the face of additional store openings.

But new threats are on the horizon, and recent results have been a little more lackluster than what Kroger has historically generated. So there are some cracks in the armor.

However, it looks like the stock cracks are stronger than the business cracks, leading to undervaluation…

The P/E ratio on the stock is sitting at 13.72 right now, which is a solid discount to the stock’s own five-year average P/E ratio of 17.9. Every other basic valuation metric for the stock is well below its respective recent historical average, while the yield, as noted earlier, is currently substantially higher than what it’s averaged over the last five years.

So the stock does look cheap, but how cheap might it be? What’s a reasonable estimate of its intrinsic value?

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and an 8% long-term dividend growth rate.

Kroger could easily meet – and even surpass – this hurdle when considering the demonstrated long-term EPS growth and dividend growth, as well as the modest payout ratio. And the forecast for near-term EPS growth was also considered here.

The DDM analysis gives me a fair value of $27.00.

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.

In the end, I think this stock deserves a lower valuation than what it commanded five years ago (or even one year ago), but the recent drop in the stock’s price might be a bit much relative to the company’s operations. However, I like to compare my analysis and valuation with that of what professional stock analysts come up with, which adds value and perspective to the piece.

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 4-star stock, with a fair value estimate of $28.50.

CFRA 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.

CFRA rates KR as a 4-star “BUY”, with a fair value calculation of $28.00.

I came in with the lowest valuation, but averaging these three numbers out gives us a more reflective valuation that integrates multiple methodologies and perspectives. That final valuation is $27.83, which would indicate the stock is potentially 22% undervalued right now.

Bottom line: Kroger Co. (KR) is the largest traditional grocer in the country, which confers a number of inherent benefits that can be used to Kroger’s advantage as the grocery business model undergoes changes. Their ability to see their scale as an opportunity and act on that remains to be seen, but the massive drop in the stock’s price in a very short period of time may have led to an opportunity for individual dividend growth investors, with 22% upside on top of a yield that far surpasses the stock’s recent historical average.

— Jason Fieber

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