Alongside Vice Chairman and his trusted business partner Charlie Munger, Warren Buffett has reshaped the trajectory of Berkshire Hathaway (BRK.A)(BRK.B) since taking total control over the company in 1965. The company has transformed from a fledgling textile manufacturer into the most powerful investment holdings company on the planet. Including its $157 billion cash balance as of September 30, Berkshire Hathaway’s investment portfolio is worth approximately $513 billion as of November 17, 2023.
Munger has had a significant impact on Buffett’s investing strategy. Rather than buying fair businesses at wonderful valuations that his mentor Benjamin Graham taught him, Buffett shifted gears. For decades now, the Oracle of Omaha has stood by the investment philosophy of buying wonderful businesses at fair or better valuations.
One business that’s right up Berkshire Hathaway’s alley is the well-known supermarket chain Kroger (NYSE:KR). The holding company owns a 7% stake in the retailer worth $2.1 billion. For the first time in over four years, let’s dig into what Buffett and company saw in Kroger and why I still think the stock is a buy.
Kroger’s 2.7% dividend yield clocks in at nearly twice the 1.5% yield of the S&P 500 index (SP500). As a testament to just how cheap we’ll find this stock to be, this above-average yield isn’t due to an elevated payout ratio, either. Kroger’s 24% EPS payout ratio is about a third of the 70% payout ratio that credit rating agencies consider to be safe for the grocery retailer industry.
The company also appears to be in fine financial health: Kroger’s 61% debt-to-capital ratio is just below the 65% debt-to-capital ratio that rating agencies like to see from its industry. This is why the company earns an investment-grade BBB credit rating from S&P on a stable outlook. That implies Kroger is at a still reasonably low 7.5% probability of going bankrupt in the next 30 years per Dividend Kings.
For these reasons, it’s not hard to see why Dividend Kings estimates the risk of a dividend cut from Kroger in an average recession is just 1%.
While Kroger’s sound fundamentals are encouraging, the current valuation is equally enticing. Based on historical dividend yield and P/E ratio, the stock’s historical fair value is $63 a share. That suggests Kroger is 33% discounted relative to fair value from its current $42 share price (as of November 17, 2023).
If Kroger delivers earnings growth in line with the consensus and returns to fair value, total returns in the coming 10 years could be as follows:
- 2.7% yield + 4.8% FactSet Research annual earnings growth consensus + a 4% annual valuation boost = 11.5% annual total return potential or a cumulative 197% total return versus the 9% annual total return potential of the S&P or a cumulative 137% total return
Solid Results For The Second Quarter
According to Kroger, the average person makes 221 decisions related to food each day. The company’s 2,700-plus supermarkets and multi-department stores in 35 states and the District of Columbia make it a leading option for consumers who want fresh and affordable food choices. Kroger’s most well-known store banners include Pick ‘n Save, Metro Market, and the eponymous Kroger. This extensive presence of iconic stores throughout the United States coupled with its growing private-label business makes the company interesting.
Kroger’s sales decreased by 2.3% year-over-year to $33.9 billion for the second quarter ended August 12, 2023. A sales decline is never what investors want to see from their investment holdings. But these results are far from discouraging.
It’s not a secret that although fuel prices remain elevated compared to where they were a few years ago, they are much lower than they were in Q2 2022. This was behind the overall decline in Kroger’s sales during the second quarter. Factoring this out of the equation, sales would have grown by 1% in that period.
Last September, Kroger announced that it was ending its pharmacy provider agreement with Express Scripts. This was due to what the former called an unsustainable drug pricing model. When excluding this impact on Kroger’s pharmaceutical business from results, sales would have increased by 2.6% for the second quarter.
The company’s operating loss per share was $0.25 during the second quarter. But backing out a $1.4 billion charge from the company’s settlement for its alleged role in the nationwide opioid crisis and merger costs with Albertsons (ACI), adjusted EPS was $0.96. This was up 6.7% over the year-ago period.
Kroger’s financial position was robust as well. As of August 12, the company’s net total debt to adjusted EBITDA ratio was 1.3 (financial info sourced from Kroger Q2 2023 Earnings Press Release). However, it is worth noting that upon the closing of its merger with Albertsons expected in early 2024, leverage will be going up beyond Kroger’s targeted ratio of between 2.3 and 2.5. The good news is that with $1 billion in expected annual cost efficiencies and aggressive deleveraging, the company thinks it can return to its targeted leverage ratio within 18 to 24 months of closing.
The Dividend Has Room To Run
Having hiked its quarterly dividend per share by 107% in the past five years to the current rate of $0.29, Kroger has been a phenomenal dividend growth stock. The merger with Albertsons will surely slow this dividend growth rate for the foreseeable future.
But make no mistake about it, Kroger is a free cash flow machine that can afford to balance debt repayment and a growing dividend. This is because Kroger has generated $2.4 billion in free cash flow through the first two quarters of this fiscal year. Against the $376 million in dividends paid during that time, that’s just a 15.6% free cash flow payout ratio (details according to page 5 of 39 of Kroger’s 10-Q filing). This is why I would be surprised if dividend growth wasn’t at least in the mid- single-digits annually for the next two to three years before accelerating again.
Risks To Consider
Kroger is a great business, but it still has risks that investors should be aware of before buying.
As is the case with mega-mergers, caution is always warranted. That’s because even deals that make sense on paper such as this one with Albertsons don’t always pan out. On the small chance that Kroger can’t realize its cost synergies as expected, the deal may not create value for shareholders.
Another risk to Kroger is that it contributes to several multi-employer pension plans. If investments within these pensions don’t live up to expectations, the company could have to make additional contributions to fund any shortfalls. That could weigh on Kroger’s financial results.
Summary: Kroger Is A Buffett-Owned Bargain
For dividend growth investors who can handle its risk profile, Kroger could be a smart buy. The company’s 9.6 blended P/E ratio is far below the normal P/E ratio of 13.3. If Kroger grows as expected in the next two years and returns to fair value, it could produce 19% annual total returns through early 2026.
That’s more than double the 8.8% annual total returns that are expected from the SPDR S&P 500 ETF Trust (SPY) in that time. This is why I believe shares of Kroger are currently a buy.