Does the Sell-Off in Grocery Stocks Present a Buying Opportunity for Kroger?

Now that Amazon's (AMZN -1.82%) acquisition of Whole Foods Market is complete, it's not a bad time to take stock of how this merger and other recent industry trends are affecting Kroger (KR 1.22%), the nation's largest conventional grocery chain.

In this segment from Industry Focus: Consumer Goods, the team tackles a listener question on whether Kroger's recent swoon represents a buying opportunity. To gain some perspective on the grocer's challenges and what lies ahead, tune into the video below.

A full transcript follows the video.

This video was recorded on Sept. 5, 2017.

Vincent Shen: Mat has been investing since 1999, when he first bought stocks with some student loans. Unfortunately, he lost 60% in just 12 weeks. I'm very glad that didn't scare him off. Mat asks, "Does the sell-off of grocery stores present a buying opportunity for Costco and Kroger?" In the past month, Kroger, Costco, and Wal-Mart shares have all pulled back. We bang on this drum a lot -- Fools, remember not to put too much weight into short-term share price moves. But there's no denying that the threat that Whole Foods poses now is much larger with the backing of Amazon, even for some of the country's biggest retailers that I mentioned. Let's start with Kroger, which is down about 10% in the past month. Asit, are you as bearish as the rest of the market seems to be on this company right now?

Asit Sharma: Vince, I'm not so bearish on Kroger, but I am cautious. But first things first, Mat, wow, you use leverage to invest in stocks but not in a very conventional way. I'm very impressed by that. Maybe you got more out of your investments than you did your education. I don't know, sometimes I feel, looking back, it's 50-50.

But to Kroger, Kroger is interesting. It's one of the largest global food retailing companies, food grocery chains. It has 2,800 locations across the United States in 35 states. But it's a conventional grocer. It's not a discounter, and it's not a high-end grocery like Wegmans or Whole Foods. So it's in an unfortunate position just now. I know on this show, I believe you and Dan have talked about the onset of Aldi, which is going to spend $3.5 billion -- this is a German discount chain which will ramp up from 1,600 stores to about 2,500 stores by 2022. German grocery Lidl, I hope I pronounced that correctly, is also establishing a beachhead on the East Coast. They will have 500 locations in the U.S. very soon. Wal-Mart this year said that they are going to reaffirm their everyday low pricing philosophy in light of this discount competition.

And here's Kroger, which had some problems before the Amazon-Whole Foods merger was even announced. Really briefly, those problems started about a year-and-a-half ago in that Kroger was one of the first chains, because of its breadth and scale, to experience grocery deflation. There are two types of deflation. There is cost deflation, that's when farmers have bumper crops and they can offer their goods at lower prices to grocery stores; and there's retail deflation, which is when, those groceries, instead of taking the profits that the farmers give them, they pass it on in the form of price discounts and promotions to get an edge on the competition. So, Kroger and the rest of the industry has been embroiled in a slow-burn of both cost and price deflation. They're starting to compete with each other as they get savings from farmers. 

So Kroger had this problem. And I think, Vince, in some notes that you and I traded, I pointed out the year before, on Dec. 29, Kroger stock peaked at $41.50 per share. And it's down over 50% since then. There are two reasons to be cautious -- the price deflation that Kroger is undergoing, and this increased industry competition that it's also exposed to being in the middle, not a discounter and not a high-end store. What are your thoughts about it, Vince? 

Shen: I'd say that, for Mat, what you mentioned in terms of its position and the increasing competition, that's the big takeaway. This is an $800 billion industry. It's massive. And the companies involved are all dumping billions of dollars themselves to reinvest in the pricing and expand and remain competitive. In that environment, Kroger does lack a bit of that edge or that competitive moat that a lot of Fools like to see in a company. They've acquired other chains in the past. I think they've done a good job increasing their scale and purchasing power. But if I told a regular Kroger shopper that Whole Foods now offers a majority of the items on their shopping list at equal or better prices, I think a lot of them would go to see what the hubbub was all about. That's another thing -- it's not like Amazon only has that one option with Whole Foods in that it can only compete on price. It can offer so many things in terms of, they're already releasing some of their smarthome speaker offerings at Whole Food stores, they can also bring in some of the benefits of a Prime Membership to increase how attractive it is to go to a Whole Foods.

Sharma: Yeah. The reach of Amazon is really interesting, because you may have read articles in the news that, Whole Foods only has 460 odd locations between the U.S. and U.K. and Canada, most of those in the U.S. But what you mentioned, Vince, is very interesting, if Amazon starts activating its Prime members. And nobody knows how many Prime members there are. Bloomberg cited estimates last week that there are over 80 million Prime customers, about a quarter of the U.S. population. If that's true, and Amazon starts incentivizing Prime members to buy Whole Foods items online, they can cut into store traffic, and they can cut into the average basket size at places like Kroger, even if there's not a Whole Foods in proximity anywhere near a Kroger. And that's a really surprising and interesting aspect of this deal that none of us really saw coming a few months ago. I want to add one more thing on what exactly Amazon and Whole Foods just did starting Monday. The items that they lowered prices on are core staples. They're organic eggs, beef, fish. These are items you buy every day, they're not exotic items. And this is a G-rated show, so I'll put it this way: that kicks Kroger right in the place where it hurts most, because Kroger is experiencing this core deflation in its staples, these very items. So that's going to hurt Kroger's margins. 

In terms of valuation, Mat, Kroger does look attractive on paper. On this show, I always talk about the forward P/E ratio -- what a stock sells for versus a year's worth of earnings if you look out. Kroger currently trades at around 11 times forward earnings. That's half of what most grocers trade at. Most grocers trade at above 20 times forward earnings. But it's a hard call. Kroger's management has said that they are going to stand by price as one way to keep their customers. And that sounds to me like not the greatest strategy. Although, we should mention that they have introduced a lot of other innovations into their business.

Shen: Yeah. I think some investors were actually pretty concerned based on the news coming out, in terms of comments from the CEO and what they said about their insistence on potentially fighting on the pricing side, what kind of damage that does in terms of their profitability and how sustainable that really is long-term.