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How The Kroger Co. Is Investing Up to $3 Billion Annually in Its Future

By Nickey Friedman – Oct 27, 2014 at 7:20PM

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Based on its past, $3 billion could go a long way in creating shareholder value.

Source: The Kroger Company.

With its fiscal second quarter reported in September, The Kroger Company (KR 1.06%) celebrated its 43rd quarter in a row of positive identical-supermarket sales growth, notching 4.8% growth in the metric, excluding fuel. Based on the continued growth of sales at existing stores, who can blame management for wanting to invest in new stores? And that's exactly what it's doing.

Better to build
According to S&P Capital IQ transcripts CEO Rodney McMullen in the most recent conference call stated,

"Our customers don't want to compromise by choosing retailers who do well in only one or two areas. In short, customers are looking for a food retailer that can offer it all. And that is Kroger's sweet spot. That is exactly where we've positioned ourselves to win. It is where we are winning. And it is where we intend to continue to win."

One thing you might wonder, is why doesn't Kroger use the same $3 billion to pay down debt instead of growing its business? Kroger's interest expense eats up a decent chunk of its pre-tax earnings every month. However, a quick study of the debt situation shows the maximum interest rate on its debt is 7.5%, and the company gets much more than that as a return on its investments.

As of last quarter, the return on invested capital, or ROIC, for the trailing four quarters was 13.6% compared to 13.5% for the trailing four quarters a year ago. As long as the return from investing in new stores outweighs the interest on the equivalent amount of debt, it makes more sense to delay paying down debt, because in the long run, Kroger should ultimately generate more cash flow and reduce its obligations more quickly.

It's not magic, though
Keep in mind that 13.5% or 13.6% return on investment doesn't automatically happen, but is the result of time and excellent execution. For example, during the first quarter conference call, CFO Mike Schlotman mentioned, "As we increase capital investments, it will be more difficult to grow ROIC in the near term. However, as these investments mature, we expect them to be accretive to ROIC." It sounds like initially, new stores have a smaller return than average, but over time, they have a larger return than average.

McMullen explained Kroger's strategy of going after "fill-in" markets. Fill-in markets are geographic areas where the company already has strong sales but believes there is more opportunity to take even more local market share by opening more stores in the same vicinity.

The fill-in market stores are seeing exceptionally high ROICs, according to McMullen. He hasn't shared specific details yet other than the company is "very pleased" with the initial results.  The plan is to go after these opportunities more aggressively. After 43 quarters in a row of growth in identical-supermarket sales, it shouldn't come as much of a surprise that many of these locations could use another sister store somewhere else in the neighborhood.

A long track record of growing sales at existing stores, plus plenty of opportunity for new stores, plus potential for even better long-term return for new stores equals substantial potential for overall sales and profitability to explode much further than it already has for Kroger. While Kroger is busy investing in value-creating opportunities that should easily pay off, it's clear the companies massive investments are well spent.

Nickey Friedman has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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