3 Reasons Kroger's Market-Trouncing Run Won't End Soon

Kroger has nearly doubled the market over the last 10 years and has no plans to stop now.

Jul 12, 2014 at 8:00PM

Kroger (NYSE:KR) has been good to investors over the last 10 years, easily surpassing the market's total return.

Kroger Chart

Kroger has the tools to overcome competition and take market share away from Wal-Mart (NYSE:WMT), Costco (NASDAQ:COST), and Safeway (NYSE:SWY), and continue its outperformance of the market. Kroger will achieve this thanks to three key factors: its strong financial position, use of smart acquisitions, and growing geographical reach.

Low profit margin, yet high profitability ratios
Over the last 10 fiscal years, Kroger has averaged a net profit margin of 1.2%. At first glance, this does not appear overly attractive; however, over the same period, Wal-Mart, the largest retailer of the group by sales, averaged 3.5%, Costco averaged 1.8%, and Safeway averaged 1.1%. Because of economies of scale in the industry, these ratios not so coincidentally go hand in hand with the rank of each company by sales.

Businesses typically need to sell either a small number of high-margin products or a large number of low-margin products to earn a solid profit. The grocery retail business falls in the latter of those two choices. A reasonable assumption would be that Kroger's net profit margin will grow to become more comparable with its larger counterparts as the company continues to increase sales.

Though Kroger has slim profit margins, from the standpoint of return on equity invested, or ROE, Kroger is very profitable. Over the same period discussed above, Kroger's return on equity averaged 19.9%, and it has been above 30% in the last two fiscal years. This is very favorable compared to both Costco and Safeway, which averaged 13.2% and 9.5%, respectively, yet falls a bit short of Wal-Mart, which has averaged 21.6% over the last 10 fiscal years.

Kroger's high return on equity helps display how well the company's management can reinvest earnings at a high rate for shareholders.

Industry consolidation
Many times in this industry, it is more profitable for companies to make acquisitions and let synergies take affect rather than build from the ground up to get into new markets. Kroger recognizes this, and making smart acquisitions will be the next key to unlock future growth for shareholders.

Kroger's merger and acquisition strategy is primarily based on in-market acquisitions, or acquisitions of companies that operate in the same nature as Kroger's brands. These acquisitions produce higher returns because of higher synergies in overhead, marketing, and distribution. An example of such a purchase would be the company's acquisition of Harris Teeter earlier this year.

Another recently announced acquisition is the takeover or Vitacost.com (NASDAQ:VITC), an online retailer of healthy living products. Though it may not produce the large and immediate synergies as the Harris Teeter acquisition, the purchase of Vitacost.com gives Kroger more exposure to the e-commerce and healthy living booms, for a relatively small price of $280 million.

Cross-country journey
As of the end of fiscal year 2013, Kroger only has a geographic reach into 34 states and Washington D.C. with 2,640 total stores. This is easily trumped by Wal-Mart, which has nearly 11,000 stores in all 50 states and worldwide. Costco, on the other hand, has a greater geographic reach and greater revenues with only 658 warehouse stores in 43 different states and eight international countries.

This shows how much room Kroger, even as a fairly mature company, still has to grow. Kroger plans to enter different geographic markets by means of acquisition, as touched on earlier. The Harris Teeter acquisition put Kroger into the fast-growing southeast United States marketplace.

As Kroger grows further, we can expect to see the company take market share from its two larger competitors, Wal-Mart and Costco. As said earlier, higher sales should result in higher profit margins as well -- an overall win-win for investors.

The bottom line on Kroger
Kroger reported outstanding first-quarter earnings on June 19, and shares shot up 5% that day; even with that bump in price, the stock still sells at 17 times earnings. This compares very favorably to the market, which is selling at nearly 19 times earnings.

Finding a company like Kroger, that's on solid financial footing, has high-growth prospects, and sells at a discount to the market is a steal for a long-term investor.

With a 1.3% dividend yield, investors can buy a piece of this company and pump dividends back into Kroger shares to cost-average their share price and be very happy for many years to come.

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Jacob Meredith has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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