Warren Buffett is one of the most followed stock-pickers around, but he hasn't been doing much as of late. In its most recent filing, Buffett conglomerate Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) reported no consequential new stock picks last quarter among Berkshire's top 25 stocks. In fact, Buffett was a net seller.
However, Buffett and/or his lieutenants, Todd Combs and Ted Wechsler, did make a notable increase in one stock. Many peg this holding as a "boring," old-school company. Yet there's nothing boring about this stock's 49% rise in 2021, good for the second-best return among Berkshire's top 25 holdings.
While Buffett typically looks for beaten-down shares of bargain-priced companies, Berkshire still appears optimistic, adding 21% to its position in the second quarter, even as the stock rose. As it reports earnings this Friday, now may be a good time to look at this overlooked consumer staple.
Kroger stock has surprised to the upside
It may be surprising that grocery chain Kroger (NYSE:KR) is doing so well this year. After all, last year gave the company a huge windfall as people stocked up on groceries during the onset of the pandemic and ate at home at an above-average rate for the remainder of the year. After profits soared in 2020, things are normalizing in 2021. Last quarter, Kroger's same-store-sales actually fell 4.1%.
So how is Kroger's stock doing so well? Well, as with everything in the market, a stock's movement in the short-term is largely about beating expectations. Every analyst and investor knew that last year's huge revenue and profit surge was unsustainable. But perhaps it was more sustainable than some may have expected, as Kroger handily beat earnings and profit expectations back in June.
Kroger delivering on promises
Kroger has been in a multiyear digital transformation effort, and it's executing admirably. The company's digital sales grew 16% last quarter following a 92% surge a year ago, for a two-year growth rate of 108%. That helped overall same-store sales beat expectations, even though they fell. Of note, two-year "stacked" same-store-sales were still up 14.9% relative to 2019, and that 7%-plus annualized growth is very good for a mature grocery store.
Importantly, digital sales also give Kroger the opportunity to sell digital advertising on its app and website. Digital ads are part of Kroger's "alternative revenue streams" it's developing, which includes other services such as Kroger personal finance. As those familiar with FAANG stocks know, digital ads are a highly profitable business. Given that grocery in general is a low-margin business, digital ads can really move the needle for Kroger even at relatively small revenue numbers, and the company reported "record growth" in these alternative profit streams last quarter.
Cost cuts offset investments
As part of its transformation, Kroger is investing heavily in technology. One example is the deployment of its first two Ocado automated warehouses this year in Ohio and Florida. These automated warehouses use a heavy amount of technology and will enable Kroger's new direct delivery business.
On the flip side of these technology investments, management has also been able to use technology to cut costs. In fact, on the conference call with analysts, CFO Gary Millerchip said the company was on track to deliver $1 billion in cost savings for the fourth consecutive year, and that he expects more cost savings in the future, saying that "we continue to identify new opportunities, and we still believe that [...] as it's become a core competence in the company to finding those areas to improve efficiency, we'd expect that to offer opportunities into the future for sure."
Worried about inflation? Kroger should do just fine
One of the concerns in the market today is cost inflation, which is plaguing businesses across the spectrum. However, since people need to eat, and grocery stores are among the lowest-cost food options around, Kroger should be able to pass along cost increases just fine.
In fact, CEO Rodney McMullen said Kroger operates best at around 3%-4% inflation:
[T]ypically our business operates the best when inflation is about 3% to 4% and we have a meaningful amount of fixed cost. And the -- when inflation's at 3% to 4%, that gives you leverage on those costs. And the inflation of 3% to 4%, customers don't overly aggress -- react to that inflationary environment, either. [...] And one of the last comment[s] I would make is it is -- the important part of having such a strong Our Brands program and our own manufacturing plants, if we have inflation that is not driven by true cost changes, what always happens is Our Brands gain significant share at the expense of some of those national brand players as well.
Basically, Kroger's management seems to think 4% inflation is about where price increases may affect customer behavior. But below that, if Kroger's costs go up 4% and it raises prices 4%, the company will receive more dollars of gross profit, even if its margin doesn't change. And since Kroger also has a significant amount of fixed costs that won't necessarily go up with inflation, those gross margin dollars should fall straight to the bottom line.
And of course, Kroger has done a fantastic job of developing its own private label brands, which are generally lower-cost alternatives to national CPG companies. If inflation starts to bite, price-sensitive consumers may merely trade down to Kroger's private labels, which means more sales margin going to Kroger.
Kroger has a lot of hallmarks Buffett looks for
Pricing power, a necessary product, a cheap stock price and shareholder returns are all hallmarks Buffett seeks in his investments. At the time Berkshire took a stake in Kroger in late 2019, the stock was trading at a P/E ratio just over 10 -- much cheaper than the market. While grocery is competitive, Kroger is also well established throughout the country, and mere physical distance was bound to keep Kroger's customer base at least somewhat intact. Yet the company's solid execution on its multiyear modernization plan is now bearing fruit, providing upside potential. Finally, management just authorized another $1 billion share repurchase program and increased the dividend by 17%, the company's 15th consecutive year of increases.
Despite Kroger's recent run, the stock still trades only around 15 times this year's adjusted earnings estimates. That's still a below-market multiple. So for defensive investors looking for a dividend growth stock that can thrive in both inflationary and COVID-affected times, joining Buffett in Kroger could be a wise portfolio move.