Supermarkets, in general, are not considered particularly attractive investments these days. They're not exactly sexy businesses, they exhibit low profit margins, and they must constantly contend with Wal-Mart (NYSE:WMT) and its "lowest prices all the time" attitude. The squeeze on profits is inexorable.
Over the past three years, for example, the S&P 500 has outperformed supermarkets by about 15 percentage points, despite companies like Pantry (NASDAQ:PTRY) and Village Super Markets (NASDAQ:VLGEA) turning in superb performances over that same time frame. You still had to contend with companies like Winn-Dixie going bust and Pathmark (NASDAQ:PTMK) losing three-quarters of its value.
As supermarkets turn from "defensive" stock (everyone's got to eat, even in a recession) to investing pariahs (Wal-Mart will eat their lunch), perhaps it's time to consider them as investments again. Can Kroger (NYSE:KR) or Safeway (NYSE:SWY) be a viable investment for the future?
Cleanup in aisle 12
Out of all the players in this space, I like Kroger as a long-term bet, even though the elephant in the room, Wal-Mart, still poses a threat to profits and margins. The company is the largest pure-play in the supermarket industry, with more than 2,500 stores operating under names like Kroger, Fred Meyer, Ralphs, and Dillons. It also runs nearly 800 convenience stores (Kwik Shop and Quik Stop) and more than 400 fine jewelry stores, as well as 42 food-processing plants. Despite being larger in terms of size (in both store count and market cap) than either Safeway or even SUPERVALU (NYSE:SVU), its price-to-earnings ratio is less than either, and it sells at a price-to-sales discount as well.
Although those numbers suggest that growth expectations for Kroger are lower, analysts actually peg its long-term growth rate at 9%. Safeway and SUPERVALU's rates are similar, at only 10% and 9.5%, respectively. The much larger Kroger's ability to hold its own against smaller, supposedly more nimble competitors suggests a possible discount here.
Sales grew 7% last year for Kroger, and they rose more than 8% in the first quarter of this year. They're expected to grow by nearly 6% in the coming quarter, which the company will report on this week. For the year, analysts are expecting sales to grow by about 7%, which would include fuel sales, while Kroger's expects non-fuel supermarket sales to grow by about 3.5% for the year. It began paying a quarterly dividend of $0.065 earlier this year, representing a nice return to shareholders of the nearly $1 billion in owner earnings it generated last year.
Indeed, with the Food Institute projecting that supermarkets will lose market share to supercenters and mass retailers by 2013, Kroger's proven ability to grow competitively has made it one of a handful of premier grocery chains. Adopting strategies that differentiate it from the other players, or even co-opting best practices from their stores -- for example, offering a greater selection of organic and natural produce - could help it ensure that it will continue to meet the challenges the industry as a whole faces.
Foolish final thoughts
Although the conventional wisdom correctly states that supermarkets generate low profit margins, Kroger's net margins (1.6%) compare favorably with Village Super Market (1.6%), Safeway (1.5%), and SUPERVALU (1%). Wal-Mart, given both the variety of products it stocks and its larger pricing efficiencies, rings in at 3.2% net margin. Of course, thin margins leave little room for error when trying out new approaches.
Kroger's stock trades near its 52-week highs, and I would prefer to buy it at a discount. While I find the company compelling enough, I think that it's currently fairly priced. I'd rather wait for the market to enter one of its manic moods and offer us Kroger at a sale price. If it were to dip down to the mid- to high teens, I think that would be an opportunity to go shopping.
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Fool contributor Rich Duprey owns shares of Wal-Mart but does not own any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.
