News of Warren Buffett's purchase of $549 million of Kroger (KR -0.75%) stock helped lift the supermarket's shares over 5% last week as investors rushed to follow him.
His track record certainly makes a strong case for copying his every move, but even Buffett expresses regret over purchases he's made. Last year, for example, he admitted to paying too much for Kraft back in 2015, saying as good as the business was, sometimes "you can pay too much for a wonderful business."
That's why, even with Buffett's success, investors shouldn't blindly mimic his every move. So let's see whether his assessment of Kroger is good for you.
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Doubts around growth
Prior to Buffett's investment, Kroger stock had been down about 4% over the past year, compared to a 22% gain for the broad market as Wall Street saw price competition from Walmart (WMT -0.08%) and Aldi creating headwinds. Meanwhile, the company also needed to continue investing in online infrastructure to stave off Amazon (AMZN 3.43%).
It had stable consumer demand in its favor, along with a low inflation environment, but profits will be pressured as Kroger builds out its automated warehouses in partnership with online grocery delivery company Ocado. It plans to build 20 fulfillment centers over time, and three are expected to be operational next year, but that may be too little, too late.
Kroger itself was more hopeful. Comparable-store sales excluding fuel rose 2.5% last quarter, which CEO Rodney McMullen noted was "the strongest since we started Restock Kroger, and gross margin rate, excluding fuel and pharmacy, improved slightly," even as costs as a percentage of sales were reduced.
Restock Kroger is the grocery store's aggressive three-year plan to optimize costs, retain employees, and modernize company practices.
The outlook for the coming year was also optimistic, with management forecasting comps in fiscal 2020 growing more than 2.25%, suggesting it was time the Restock Kroger initiative began delivering incremental value to shareholders as promised. It also authorized a new $1 billion stock buyback program to replace the existing one that still had $546 million remaining on it.
With these two competing visions, which one is right?
Under attack from all sides
Obviously, Buffett sides with Kroger's management, but there's a lot behind both arguments.
Kroger is the largest pure-play grocery chain with around 2,800 stores, but Walmart is the largest retailer and has a 21% share of the market with Kroger coming in second at 10%. Costco, with a 5% share, follows in third place.
While the threat posed by Amazon in the physical retail space has diminished considerably over time, as sales from its stores continue to decline and its latest grocery store concept is uninspiring, the growth of online grocery sales remains challenging nonetheless.
Like Walmart, Kroger is leveraging its extensive physical footprint to scale up its presence, and third quarter digital sales grew 21% over the year-ago period, but that's down from 60% a year ago, and off from the 31% gain it registered in the second quarter. In contrast, Walmart notched 41% growth in the fiscal third quarter and 35% growth in the fourth.
Kroger is expected to report its fourth-quarter earnings on March 5. Management said it expects digital growth to moderate going forward as it laps the Home Chef acquisition and focuses on Ship, its ship-to-home service.
The Ocado partnership is also expensive for Kroger, costing about $55 million for each fulfillment center built. It may have done better by targeting microcenters instead that are cheaper, quicker to build, and can be more readily located near stores and customers.
A better opportunity ahead
Kroger remains a solid business and is improving its operations. On the surface, it appears Buffett has acquired a 2.3% stake in a large grocery chain trading at a fairly attractive valuation. Perhaps not the bargain that he's been historically known for, but trading at 13 times forward earnings estimates and a small fraction of its sales, Kroger is a discounted stock.
The question is, can the company overcome the headwinds competitors are creating for it in both the physical and online retail landscape, or will Buffett be bemoaning having overpaid for Kroger in a few years' time?
I'm not sold yet that Kroger won't face more turbulence over the next year or so, meaning that there may be an opportunity to get an even better price on the grocer's stock than what Buffett paid.
