2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Deutsche Bank Research
Rating Company Date Hold Kroger Co. 2 July 2018 Coverage Change North America United States Reuters Bloomberg Exchange Ticker Price at 29 Jun 2018 (USD) 28.45 Consumer KR.N KR UN NYS KR Price Target 30.00 Retailing / Food & Drug Chains 52-week range 31.34 - 19.94 Waiting for the Dinner Bell; Resuming coverage of KR with a Hold Valuation & Risks Paul Trussell, CFA We are resuming coverage of KR with a Hold rating and a $30 PT. We believe Research Analyst management is taking important strategic steps to extend market share gains and +1-212-250-8343 position the company for long-term success, most notably with Kroger Restock, which is gaining traction in early quarters, and the Ocado partnership. We are Tiffany Kanaga modeling KR comps ahead of Walmart U.S. by 3Q18 for the first time since Research Analyst 2Q16, which should help KR narrow the P/E multiple discount vs. WMT back +1-212-250-1724 toward historical averages. However, we also acknowledge significant investor skepticism given increasingly tougher ID sales compares as the year progresses Gabriella Carbone as well as multi-faceted margin pressure. Net, we think valuation at current levels Research Associate appropriately balances the bull and bear cases, and remain sidelined until we see +1-212-250-8274 more improvement in fundamentals or a better entry point. Damon Polistina Opportunities Ahead: Several Reasons Why Some Investors Might Take a Bite Research Associate (Pages 9-16) +1-904-645-1624 On the bull side, we see a number of positives supporting ID supermarket sales growth including a thriving private label program (over $20B in sales), fast- Krisztina Katai growing natural/organic offerings (up double-digits in 1Q), strong online growth Research Associate (up 66% in 1Q and over 90% in 2017) being bolstered by Ocado, Home Chef, and +1-212-250-0590 Nuro over time, Restock Kroger gaining traction, and better frozen food industry trends. Higher prices at the pump (up 21% YOY) are a benefit to fuel sales. Lastly, Price/price relative full-year earnings guidance looks potentially conservative in light of cost control 60 tailwinds: KR posted 25% EPS growth in 1Q with a clean sales and OG&A driven 40 performance, but the high-end of the full-year plan implies that 2Q-4Q EPS will be 20 up only a combined 4% YOY (ex. 53rd week). Given a low buy-side bar reflecting a 0 history of misses vs. initial full-year plan, we believe simply executing against the 2016 2017 2018 midpoint of $2.00-$2.15 guidance (DB $2.14, Street $2.11) would trigger multiple Kroger Co. S&P 500 INDEX (Rebased) expansion from today's 12.3x into the mid-teens, representing what would in that case be a well-deserved premium vs. the long-term historical average of 12.5x. Performance (%) 1m 3m 12m Absolute 16.1 18.8 22.4 Risks Ahead: Many Good Reasons to Be Excused from the Table (Pages 17-32) S&P 500 INDEX 1.1 2.9 12.3 The bears, in turn, have several points behind why they anticipate a full-year ID Source: Deutsche Bank sales miss vs. 2.0%-2.5% guidance (DB 2.1%, Street 1.9%), including a lack of Stock & option liquidity data food inflation, tough center store trends, pharmacy sector headwinds including Market Cap (USD) 23,793.5 AMZN jumping into the game with PillPack, and ongoing challenges in the Shares outstanding (m) 836.3 traditional grocer channel overshadowing KR's market share gains. Lower gas Free float (%) 100 margins, labor/wage/pension investments, freight, and price investments in a Volume (29 Jun 2018) 1,989,366 competitive space all create margin pressure, while the Ocado partnership carries Option volume (und. shrs., 1M avg.) 95,905 meaningful execution risk. Lastly, with the 1Q beat, the trading multiple has Source: Deutsche Bank elevated back above the long-term average despite all these concerns plus rising
Deutsche Bank Securities Inc. Distributed on: 02/07/2018 05:30:12 GMT Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 091/04/2018. 7T2se3r0Ot6kwoPa 2 July 2018 Retailing / Food & Drug Chains Kroger Co. debt leverage ratio levels (2.43x today) heading above the 2.3x-2.5x target range with increased borrowings to fund Ocado and Home Chef, and tax payments related to the gain from the sale of the convenience store business unit.
$30 PT Based on 13x 2019E EPS; Improving Comp vs. WMT Suggests a Smaller Multiple Discount Ahead On an EV/EBITDA basis, our valuation translates to a 7.1x target multiple compared with a 6.0x 10-year average. We think a modest premium is warranted by robust online sales with potential acceleration through the Ocado partnership, partly offset by capital requirements and execution risk as well as continued price investments to defend share in the challenging conventional grocer channel. Additionally, we note that the spread between KR and WMT's trading P/E multiples has narrowed from a peak nine turns in November to 4.6x today (5.1x QTD average), but KR's discount is still much larger than the 10-year average of 1.6 turns, and we attribute much of the narrowing to WMT's slowing digital growth contrasted with KR's amped-up efforts. We see a fair correlation over time (0.66 since 1Q13) between the total comp spread vs. the average multiple spread for KR vs. WMT. This correlation strengthens considerably to 0.90 when considering comp on a three-quarter lag (e.g., comparing the 2Q17 comp spread vs. the 1Q18 average multiple spread). With KR's comp meaningfully catching up to WMT's in 4Q17 and 1Q18, and modeled to meet and then surpass it in 2Q18E and 3Q18E (for the first time since 2Q16; see Figure 7), we expect KR's multiple discount to likewise narrow significantly over the course of 2018. Correlation analysis suggests that the average multiple spread should trend toward 3.6x over the next four quarters, improving from 5.9x in 1Q18 and 7.6x in 4Q17. We have a six turn spread between our target multiples today (19x for WMT vs. 13x for KR), also suggesting either upside to KR (less likely, in our view) or downside to WMT (more likely).
Forecasts and ratios Year End Jan 30 2018A 2019E 2020E 2021E 1Q EPS 0.58 0.73 – – 2Q EPS 0.39 0.38 – – 3Q EPS 0.44 0.46 – – 4Q EPS 0.63 0.56 – – FY EPS (USD) 2.04 2.14 2.31 2.45 P/E (x) 12.8 13.3 12.3 11.6 Source: Deutsche Bank estimates, company data
Page 2 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Table Of Contents
Summary of Estimates and Valuation...... 4 We Arrive at a $30 PT Based on 13x Our 2019 EPS Forecast of $2.31...... 4 Improving Comp vs. WMT Suggests a Smaller Multiple Discount Ahead...... 5 Sensitivity Analysis...... 6 Opportunities Ahead: Reasons to Like the Stock...... 9 Scale from National Footprint...... 9 Thriving Private Label and Natural/Organic Offerings...... 10 Strong Online Growth...... 11 Data-Driven Business Model through the Loyalty Program...... 12 Restock Kroger Gaining Traction...... 12 Better Frozen Food Industry Trends...... 14 Higher Prices at the Pump...... 15 Conservative Guidance Allowing Further Beat & Raises...... 16 Low Buy-Side Bar with Poor Investor Sentiment...... 16 Risks Ahead: Reasons to Avoid the Stock...... 17 Traditional Grocer Share Loss...... 17 Lack of Food Inflation...... 19 Tough Trends in Center Store...... 20 Tougher SSS Compares vs. Guidance Calling for Acceleration...... 21 Lower Gas Margins...... 22 Pharmacy Sector Headwinds...... 23 Price Investments in a Competitive Space...... 24 Freight Still an Issue...... 25 Ongoing Labor/Wage/Pension Investments...... 25 Ocado Execution Risk...... 25 Elevated Trading Multiple...... 28 Rising Debt Leverage Ratio Levels Above the Target Range...... 31
Deutsche Bank Securities Inc. Page 3 2 July 2018 Retailing / Food & Drug Chains Kroger Co. Summary of Estimates and Valuation
We Arrive at a $30 PT Based on 13x Our 2019 EPS Forecast of $2.31 (Street $2.25)
Figure 1: Summary of Estimates vs. Consensus and Guidance 2Q18 ID Sales ex. 2018 ID Sales ex. 2019 ID Sales ex. Price Target 2Q18 EPS Fuel 2018 EPS Fuel 2019 EPS Fuel Deutsche Bank Consensus $30 $0.37 1.8% $2.11 1.9% $2.25 2.0% Below consensus of 2.0%-2.5% with Guidance $0.40 at the time of $2.00-$2.15 updated definition 1Q18 earnings of ID sales
Source: Deutsche Bank estimates, Company Filings, Factset
Figure 2: Condensed P&L P&L 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18E 3Q18E 4Q18E Supermarket sales ex. fuel $91,310.0 $96,900.0 $29,941.0 $22,701.0 $22,597.0 $25,659.7 $100,898.7 $30,669.7 $23,291.2 $23,229.7 $24,430.9 $101,621.5 $103,526.9 $105,442.2 Fuel sales 14,804.0 13,979.0 4,702.0 3,621.0 3,872.0 3,975.8 16,170.8 5,220.6 3,961.1 3,887.6 3,623.7 16,693.0 17,485.8 17,835.5 Other sales 3,716.0 4,458.0 1,642.0 1,275.0 1,280.0 1,395.5 5,592.5 1,639.7 1,006.3 1,013.1 1,127.6 4,786.7 5,160.9 5,799.8 Total sales 109,830.0 115,337.0 36,285.0 27,597.0 27,749.0 31,031.0 122,662.0 37,530.0 28,258.6 28,130.4 29,182.2 123,101.3 126,173.6 129,077.5 Cost of goods sold 85,496.0 89,502.0 28,281.0 21,609.0 21,532.0 24,240.0 95,662.0 29,362.0 22,253.7 21,941.7 22,849.7 96,407.1 98,983.2 101,325.8 Gross profit 24,334.0 25,835.0 8,004.0 5,988.0 6,217.0 6,791.0 27,000.0 8,168.0 6,005.0 6,188.7 6,332.5 26,694.2 27,190.4 27,751.7 OG&A 17,946.0 19,067.0 5,993.0 4,523.0 4,708.0 4,999.0 20,223.0 6,122.0 4,640.6 4,769.2 4,769.0 20,300.8 20,706.9 21,162.4 Rent 723.0 881.0 270.0 225.0 196.0 220.0 911.0 276.0 230.0 199.9 224.4 930.3 947.0 964.1 D&A 2,089.0 2,340.0 736.0 562.0 573.0 584.0 2,455.0 741.0 567.6 578.7 589.8 2,477.2 2,514.3 2,552.1 Operating income 3,576.0 3,547.0 1,005.0 678.0 740.0 988.0 3,411.0 1,029.0 566.8 640.8 749.3 2,985.9 3,022.2 3,073.1 Net interest expense 482.0 521.0 177.0 138.0 136.0 148.0 599.0 192.0 170.0 170.0 170.0 702.0 694.5 677.0 Income before taxes 3,094.0 3,026.0 828.0 540.0 604.0 840.0 2,812.0 837.0 396.8 470.8 579.3 2,283.9 2,327.7 2,396.1 Tax expense 1,045.0 1,013.0 288.0 189.0 215.0 279.0 971.0 219.0 79.4 94.2 115.9 508.4 512.1 527.1 Net income 2,034.7 2,029.0 540.0 353.0 397.0 561.2 1,851.2 626.0 318.4 378.7 465.4 1,788.5 1,820.6 1,874.0 Operating EPS $2.08 $2.12 $0.58 $0.39 $0.44 $0.63 $2.04 $0.73 $0.38 $0.46 $0.56 $2.14 $2.31 $2.45 Diluted shares outstanding 980.3 956.1 925.0 905.0 893.0 884.0 903.2 846.0 833.8 832.1 828.9 836.3 787.5 764.0
Sales and Margin Analysis 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18E 3Q18E 4Q18E ID supermarket sales ex. fuel 5.0% 1.0% (0.2%) 0.7% 1.1% 1.5% 0.7% 1.9% 2.1% 2.3% 2.5% 2.1% 2.0% 2.0% Supermarket sales ex. fuel 5.8% 6.1% 1.4% 2.5% 2.5% 10.8% 4.1% 2.4% 2.6% 2.8% (4.8%) 0.7% 1.9% 1.9% Fuel sales (21.5%) (5.6%) 20.5% 4.3% 15.2% 22.7% 15.7% 11.0% 9.4% 0.4% (8.9%) 3.2% 4.7% 2.0% Other sales 11.5% 20.0% 40.7% 35.8% 11.2% 16.2% 25.4% (0.1%) (21.1%) (20.9%) (19.2%) (14.4%) 7.8% 12.4% Total sales growth 1.3% 5.0% 4.9% 3.9% 4.5% 12.4% 6.4% 3.4% 2.4% 1.4% (6.0%) 0.4% 2.5% 2.3% 22.2% 22.4% 22.1% 21.7% 22.4% 21.9% 22.0% 21.8% 21.3% 22.0% 21.7% 21.7% 21.6% 21.5% OG&A as % of sales 16.3% 16.5% 16.5% 16.4% 17.0% 16.1% 16.5% 16.3% 16.4% 17.0% 16.3% 16.5% 16.4% 16.4% EBIT margin 3.3% 3.1% 2.8% 2.5% 2.7% 3.2% 2.8% 2.7% 2.0% 2.3% 2.6% 2.4% 2.4% 2.4% Tax rate 33.8% 33.5% 34.8% 35.0% 35.6% 33.2% 34.5% 26.2% 20.0% 20.0% 20.0% 22.3% 22.0% 22.0% EPS growth 16.9% 2.2% (17.1%) (17.6%) 8.4% 18.8% (3.9%) 25.0% (2.1%) 2.4% (11.6%) 4.8% 8.1% 6.1%
Source: Deutsche Bank estimates, Company Filings
We arrive at our $30 PT based on 13x our 2019 EPS forecast of $2.31 (Street $2.25). Our target multiple is slightly above the 10-year historical average of 12.5x. On an EV/EBITDA basis, our valuation translates to a 7.1x target multiple compared with a 6.0x 10-year average. We think a modest premium is warranted by robust online sales with potential acceleration through the Ocado partnership, partly offset by capital requirements and execution risk as well as continued price investments to defend share in the challenging conventional grocer channel.
Page 4 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 3: Forward P/E Figure 4: Forward EV/EBITDA
20.0x 9.5x
9.0x
18.0x 8.5x
8.0x
16.0x 7.5x
7.0x
14.0x 6.5x 10-Year Average: 10-Year Average: 6.0x 12.5x 6.0x
12.0x 5.5x
5.0x
10.0x 4.5x
4.0x
8.0x 3.5x Jun-08 Jun-10 Jun-12 Jun-14 Jun-16 Jun-18 Jun-08 Jun-10 Jun-12 Jun-14 Jun-16 Jun-18
Source: Deutsche Bank, Factset Source: Deutsche Bank, Factset
Improving Comp vs. WMT Suggests a Smaller Multiple Discount Ahead
The spread between KR and WMT's trading P/E multiples (using consensus) has narrowed from a peak nine turns in November 2017 to 4.6x turns today (5.1x QTD average), but KR's discount is still much larger than the 10-year average of 1.6 turns. We attribute much of the narrowing to WMT's slowing digital growth contrasted with KR's amped-up efforts including the Ocado announcement, and we see a fair correlation over time (0.66 since 1Q13) between the total comp spread vs. the average multiple spread for KR vs. WMT. This correlation strengthens considerably to 0.90 when considering comp on a three-quarter lag (e.g., comparing the 2Q17 comp spread vs. the 1Q18 average multiple spread). With KR's comp meaningfully catching up to WMT's in 4Q17 and 1Q18, and modeled to meet and then surpass it in 2Q18E and 3Q18E (for the first time since 2Q16), we expect KR's multiple discount to likewise narrow significantly over the course of 2018. Correlation analysis suggests that the average multiple spread should trend toward 3.6x over the next four quarters, improving from 5.9x in 1Q18 and 7.6x in 4Q17. We have a six turn spread between our target multiples today (19x for WMT vs. 13x for KR), also suggesting either upside to KR (less likely, in our view) or downside to WMT (more likely).
Deutsche Bank Securities Inc. Page 5 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 5: KR vs. WMT Forward P/E Multiple Figure 6: Spread Between KR and WMT's Forward P/E Multiples
23.0x 5.0x
21.0x
19.0x
17.0x 0.0x
15.0x 10-Year Average: 13.0x (1.6x) (5.0x) 11.0x
9.0x
7.0x Jun-08 Jun-10 Jun-12 Jun-14 Jun-16 Jun-18 (10.0x) KR WMT Jun-08 Jun-10 Jun-12 Jun-14 Jun-16 Jun-18
Source: Deutsche Bank, Factset Source: Deutsche Bank, Factset
Figure 7: KR vs. WMT Comp and Multiple Spreads 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18E 3Q18E KR Comp 2.4% 1.7% 0.1% (0.7%) (0.2%) 0.7% 1.1% 1.5% 1.9% 2.1% 2.3% Walmart U.S. Comp 1.0% 1.6% 1.2% 1.8% 1.4% 1.8% 2.7% 2.6% 2.1% 2.1% 2.0% Comp Spread (bps) 140 10 (110) (250) (160) (110) (160) (110) (20) 0 30 Average Multiple Spread 0.2x (1.5x) (2.7x) (0.9x) (2.3x) (4.8x) (6.7x) (7.6x) (5.9x) NA NA
Source: Deutsche Bank, Company Filings, Factset. Note: KR redefined ID sales ex. fuel starting with 1Q18 to be more inclusive of company business units, including Kroger Specialty Pharmacy and ship-to-home solutions (1Q18 was 1.9% under the new methodology vs. 1.4% under the old one). The company intends to use this calculation going forward as a more appropriate measure to track Kroger's performance as it redefines the grocery customer experience, and to be more comparable with how peers report
Figure 8: KR vs. WMT Comp Spread vs. Multiple Spread Figure 9: Comp Spread on a Three-Quarter Lag (0.90 (0.66 Correlation) Correlation)
600 4.0x 600 4.0x 500 500 2.0x 2.0x 400 400 0.0x 0.0x 300 300 200 (2.0x) 200 (2.0x) 100 (4.0x) 100 (4.0x) 0 (6.0x) 0 (100) (6.0x) (100) (200) (8.0x) (8.0x) (200) (300) (10.0x)
(300) (10.0x)
2Q15 4Q13 4Q16 3Q18
2Q13 1Q14 3Q14 1Q15 4Q15 2Q16 1Q17 3Q17 1Q18 4Q18 2Q19 1Q13 3Q13 2Q14 4Q14 3Q15 1Q16 3Q16 2Q17 4Q17 2Q18 1Q19
1Q18
4Q17
3Q17
2Q17
1Q17
4Q16
3Q16
2Q16
1Q16
4Q15
3Q15
2Q15
1Q15
4Q14
3Q14
2Q14
1Q14
4Q13
3Q13 2Q13 1Q13 Comp Spread (bps) - 3-Quarter Lag Multiple Spread Comp Spread (bps) Multiple Spread Likely Multiple Trajectory
Source: Deutsche Bank, Company Filings, Factset Source: Deutsche Bank, Company Filings, Factset. Note: 1Q19 and 2Q19 reflect 2Q18E and 3Q18E comp spread
Sensitivity Analysis
Below we have performed a sensitivity analysis around 2020 ID supermarket sales (assuming a ramp in 2019 to that figure) and 2020 EBIT margin as compared with 2.8% achieved in 2017 and 2.4% forecasted for 2018 (also assuming a ramp in 2019). We see ~32% upside from current levels to $38 (last seen in 2016) in a scenario with a 3% comp and ~20 bps of EBIT margin expansion leading to
Page 6 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co. approximately $2.75 in earnings power and a 15x target multiple. Conversely, we see 25% downside to $21 (just above lows seen last fall) in a scenario with a flat comp and ~20 bps of EBIT margin compression leading closer to $2 in earnings power and an 11x target multiple.
Figure 10: 2020E EPS Sensitivity to ID Sales and EBIT Margin ID Supermarket Sales $ 2.45 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 2.18% $2.12 $2.14 $2.16 $2.17 $2.19 $2.21 $2.23 2.28% $2.25 $2.27 $2.29 $2.30 $2.32 $2.34 $2.36 2.38% $2.38 $2.40 $2.42 $2.44 $2.45 $2.47 $2.49 2.48% $2.51 $2.53 $2.55 $2.57 $2.59 $2.61 $2.63
EBIT EBIT Margin 2.58% $2.64 $2.66 $2.68 $2.70 $2.72 $2.74 $2.76
Source: Deutsche Bank estimates
Figure 11: PT Sensitivity to 2020E EPS and Target Multiple 2020 EPS $ - $2.12 $2.23 $2.33 $2.44 $2.55 $2.65 $2.76 11.0x $21 $22 $23 $24 $25 $27 $28 12.0x $23 $24 $25 $27 $28 $29 $30 13.0x $25 $26 $28 $29 $30 $31 $33 14.0x $27 $28 $30 $31 $32 $34 $35
Multiple 15.0x $29 $30 $32 $33 $35 $36 $38
Source: Deutsche Bank estimates. Note: We have applied a 10% discount factor
Figure 12: Upside/Downside to PT vs. Current Stock Price 2020 EPS $ - $2.12 $2.23 $2.33 $2.44 $2.55 $2.65 $2.76 11.0x (25%) (22%) (18%) (14%) (10%) (7%) (3%) 12.0x (19%) (15%) (11%) (6%) (2%) 2% 6% 13.0x (12%) (7%) (3%) 1% 6% 10% 15% 14.0x (5%) (0%) 4% 9% 14% 19% 23%
Multiple 15.0x 2% 7% 12% 17% 22% 27% 32%
Source: Deutsche Bank estimates
Deutsche Bank Securities Inc. Page 7 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 13: KR Stock Price (Last Five Years)
$45
$40
$35
$30
$25
$20
$15 Jun-13 Jun-14 Jun-15 Jun-16 Jun-17 Jun-18
Source: Deutsche Bank, Factset
Page 8 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co. Opportunities Ahead: Reasons to Like the Stock
Scale from National Footprint
We see KR as the only truly national traditional grocer in a fragmented market, As a testament to its scale, KR's floral shops with nearly 2,800 retail food stores in 35 states and $101B in 2017 supermarket ring up enough annual business to make the company the world's largest florist sales (ex. fuel). The company's footprint has been stitched together through a series of mergers, with the largest being Fred Meyer in 1999, a $13B deal generating economies of scale in purchasing, manufacturing, information systems, and logistics. More recently, in 2014 KR acquired Harris Teeter (200 stores in the Mid-Atlantic region and D.C.), and Vitacost.com (one of the largest pure e-commerce companies in the nutrition and healthy living market). In 2015, KR acquired Roundy's, adding Pick ‘N Save, Metro Market, and Mariano’s stores in Wisconsin and Illinois under its umbrella. In June, KR completed its purchase of Home Chef, a meal kit provider, expanding the company's online presence.
Today, the company operates under nearly two dozen banners (arguably a bear point, with lack of national recognition for any given banner). Additionally, KR is the only major U.S. supermarket company to operate an economical three- tier distribution system, and the company also runs 38 food production or manufacturing facilities producing private label products (see next point for details). Furthermore, KR has almost 2,300 pharmacies located in its combination food and drug stores.
Lastly, we note that approximately 45% of KR's supermarkets are operated in company-owned facilities, including some company-owned buildings on leased land. Management's current strategy emphasizes self-development and ownership of store real estate.
■ The primary food store format, the combo store (2,347 locations as of 1Q18), draws customers from a 2-2.5 mile radius.
■ Multi-department stores (132 locations) are significantly larger in size than combo stores, and sell a wide selection of general merchandise items such as apparel, home fashion and furnishings, outdoor living, electronics, automotive products, toys, and fine jewelry.
■ Marketplace stores (171 locations) are smaller in size than multi- department stores. They offer full-service grocery, pharmacy, and health and beauty care departments as well as an expanded perishable offering and general merchandise area that includes apparel, home goods, and toys.
■ Price impact warehouse stores (129 locations) offer a “no-frills, low cost” warehouse format and feature everyday low prices plus promotions for a wide selection of grocery and health and beauty care items. The average size of a price impact warehouse store is similar to that of a combo store.
Deutsche Bank Securities Inc. Page 9 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 14: KR's Portfolio of Banners and Companies
Source: Deutsche Bank, Company Website
Thriving Private Label and Natural/Organic Offerings
KR's supermarkets stock over 15,000 KR's own brands, with $20.5B in sales according to the October 2017 Investor private label items on average Conference presentation, are up 37% since 2011 and would be ranked #140 on the Fortune 500 list as a standalone enterprise. KR's own brands are also the largest brands sold in its stores. Approximately 33% of own brand units and 44% of the grocery category own brand units sold in KR's supermarkets are produced in its food production plants, which include 17 dairies, ten deli or bakery plants, five grocery product plants, two beverage plants, one meat plant, and two cheese plants.
The company is looking to aggressively grow its three biggest brands: Kroger, Private Selection, and Simple Truth. Management reported "another period of record growth" for own brands in 1Q18, with growth ahead of national brands in nearly every department as well as "significant" market share gains overall. In 1Q18, own brands comprised 28.7% of unit sales and 26.7% of sales dollars. This represents 5.1% sales growth and 3.4% unit growth, led by double-digit growth (again) in the Simple Truth and Simple Truth Organic lines. KR saw $16.7B in natural and organic sales in 2017, including $2B from Simple Truth.
Figure 15: KR's Private Label Brands Are Top Sellers
Source: Deutsche Bank, KR October 2017 Investor Conference Presentation
Page 10 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Strong Online Growth
Digital sales rose over 66% in 1Q, extending the good momentum from 2017's ClickList® Pickup FAQ growth of more than 90%, driven by the ongoing expansion of ClickList, the What is ClickList® Pickup and how does it work? company's delivery initiatives, and ID growth. Digital revenue primarily includes ClickList® is an online grocery ordering revenue from all curbside pickup locations and online sales by Vitacost.com service from Kroger. Now you can shop (which KR acquired in 2014 for $280M). online for the products you need and pick up your order at the store from the convenience KR offers ClickList and Harris Teeter ExpressLane (personalized, order online, of your car! Our associates will even bring pickup at the store services) at over 1,050 of its supermarkets and continues to out your order and load it into your car. How do I reserve a pickup time? increase home delivery service available to customers. This is up from 637 at the You can either reserve a pickup time before end of 2016. The company has aggressively grown its existing seamless coverage adding items to your cart or while you’re to reach approximately 75% of its customers, including its network of ClickList viewing your shopping cart. First, select locations, stores offering home delivery through Instacart and other partners, as a ClickList® Pickup store. Once you’ve selected your store, you will need to select a well as ship-to-home capabilities. KR's goal is to reach 100% of customers with date and time to receive your order. the seamless experience and, over time, to reach nationwide. Your time slot is a one-hour window in which you can arrive to pick up your groceries. Typical ClickList® Pickup hours are from 7am KR acquired Home Chef in June for $200M and future earnout payments of up to 9pm, 7 days a week. Some hours may to $500M over five years contingent on achieving certain milestones. The deal vary by location. Check local store listing for creates another avenue for accelerating digital growth as Home Chef offers in details. store and online meal kits. Home Chef grew 150% in 2017 to $250M in revenue How far in advance can I schedule a pickup time? with two profitable quarters. The acquisition is expected to have no impact You can reserve a timeslot up to three days on 2018 earnings, and to be slightly accretive in 2019. Home Chef employs in advance. approximately 1,000 employees, is headquartered in downtown Chicago, and I’ve placed my order for pickup. What do I operates three DC's in Chicago, Atlanta, and San Bernardino, which reach 98% do when I arrive at my pickup location? When you arrive at your store, follow the of all continental U.S. households within a two-day delivery window. signs to the ClickList® pickup area. Call the number on the sign to let us know On the horizon, KR has a new exclusive partnership with Ocado (announced in you’ve arrived. An associate will bring your May), which we dig into on pages 25-28. KR and Ocado will identify sites for up order out to your vehicle. We’ll load your groceries, and you’ll be on your way in to 20 automated warehouse facilities in the U.S. over the next three years. The minutes! new relationship is not expected to affect KR's EPS guidance range for 2018 and Are there fees for using ClickList®? 2019 as it is already reflected in the company's Restock Kroger plan. The service fee is waived for your first 3 orders! Fees vary by region for ClickList® Pickup. You can find more information Most recently, on 6/28 KR announced a new partnership with Nuro, maker of online at checkout, or visit your local store the world's first fully unmanned road vehicle, to pilot a new delivery experience. for details. Customers will be able to place same-day delivery orders through ClickList and What kinds of products can I buy through Nuro's app, which will be delivered by Nuro's fleet of autonomous vehicles. This the ClickList® service? You can shop for over 70,000 items across will be the first application and deployment of Nuro's hardware and software, the entire store, with more being added all with the pilot market to be announced soon and operations to begin this Fall. the time.
KR's online efforts are led by Group Vice President and Chief Digital Officer Yael Cosset, named to the role in January 2017. Prior to this, he served as Chief Commercial Officer and Chief Information Officer of 84.51° from April 2015 to December 2016. Before joining KR, Mr. Cosset served in several leadership roles at dunnhumby USA from 2009 to 2015, including EVP of Consumer Markets and Global Chief Information Officer.
As announced on 6/27, KR is locating its new digital HQ in downtown Cincinnati. The two-building complex will house approximately 600 employees at first, expected to grow to over 1,000 over the next three years.
Deutsche Bank Securities Inc. Page 11 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Data-Driven Business Model through the Loyalty Program
KR is the largest collector of food purchase data in the country. As management puts it, "Kroger has more data than any of our competitors, which leads us to deep customer knowledge and unparalleled personalization." The company's loyalty program has been a key driver of positive ID sales over time (14 straight years of annual growth). KR has historically discussed (as recently as March 2016) that half of Americans have and use one of its loyalty cards. Importantly, management also noted at a March 2018 investor conference that loyal households have a slightly higher average ticket.
Much of the data analytics is directed by KR's 84.51° business. In April 2015, KR acquired the balance of its 50/50 dunnhumbyUSA marketing partnership with Tesco, forming a new unit called 84.51° (named after the longitude of its Cincinnati HQ near KR's). As part of the agreement, 84.51° has a perpetual license to use dunnhumby's analytical tools.
We expect the 84.51° unit and the loyalty program to continue to contribute to positive ID sales and market share gains through Restock Kroger's data and personalization initiatives, covered in the next section.
Restock Kroger Gaining Traction
Introduced at the October 2017 Investor Conference, Restock Kroger is a three- year plan to create shareholder value by redefining how America eats, as management describes it. KR is making progress along each of the four main drivers:
1. Redefine the Grocery Customer Experience ■ Data & Personalization: KR already delivers over 3 billion personalized recommendations to customers annually. The company is using shopper data to create different experiences for customers.
■ Digital: KR is optimizing the digital experience by placing the customer at the center of everything the company does, providing not only functional information but also inspiration and personalized discovery through recipes and product content.
■ Space Optimization: KR intends to leverage customer science to make space-planning decisions to disrupt the shelf, optimize assortment, and improve in-stocks.
■ Our Brands: Building on 37% growth from 2011 to 2017 (from $15B to $20.5B in annual sales), KR will continue investing to grow its most popular brands.
■ Smart Pricing: KR will continue investing to avoid losing customers because of price. The company has invested more than $4B in price since 2001.
2. Partner for Customer Value ■ Front-End Transformation: The company is redesigning the front-end to maximize stores for self-checkout, include expanding the 20-store Scan, Bag, Go pilot to 400 stores in 2018.
Page 12 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
■ Technology Innovation: KR will continue building its Internet of Things sensor network, video analytics, and machine learning networks and complement those innovations with robotics and AI to transform the customer experience.
■ Alternative Revenue Streams: KR intends to create shareholder value by expanding its alternative revenue streams, including driving media and advertising revenue.
3. Develop Talent ■ Investing in Store Associates: KR plans to invest an incremental $500M in human capital over the next three years (from October 2017). This will be in addition to the company’s continued efforts to rebalance pay and benefits while also focusing on certifications and performance incentives, career opportunities, and training.
4. Live Our Purpose ■ Zero Hunger | Zero Waste: The company successfully launched the plan in September, which aims to end hunger in KR's communities and eliminate waste in the company by 2025.
Due to tax reform, KR has accelerated investments in Restock Kroger. Pull- forward investments began in the last four weeks of 1Q. While the incremental 401(k) contribution match investment was retroactive to the first of the year, costs to support the new associate education program, Feed Your Future, had not begun in earnest as of the 1Q conference call. Investments in wages are rolling as contracts are negotiated, and the education payments will occur over time as associates take advantage of opportunities.
With 1Q results, management noted that "Restock Kroger is off to a great start" and is "especially proud of our team's execution of process changes that led to strong cost controls". Space optimization work is ahead of schedule. KR has approximately 30% of its planned 600 stores completed for 2018. Space optimization remains a near-term headwind to ID sales until late in 3Q18, after which there will be enough completed and maturing stores to offset new ones.
The Restock Kroger plan is being funded through capital investments, cost savings, and FCF. The plan is expected to generate $400M in incremental operating profit by 2020, and generate over $6.5B in FCF over a three-year period vs. $706M in 2017 and $397M in 2016. With 1Q results, management stated that the company is on track to achieve FCF and FIFO operating profit goals as originally laid out.
Deutsche Bank Securities Inc. Page 13 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 16: EBIT Dollars vs. Margin ($M) Figure 17: FCF ($M)
$3,800 3.5% $3,000 $3,576 $3,547 $3,600 $2,500 $3,411 $2,500 $3,400 3.0% $3,224 $3,200 $3,073 $2,000 $2,986 $3,022 2.5% $1,702 $3,000 $1,574 $1,500 $1,263 $2,800 2.0% $1,103 $2,600 $1,000 $706 $2,400 1.5% $500 $397 $2,200
$2,000 1.0% $0 2014 2015 2016 2017 2018E 2019E 2020E 2014 2015 2016 2017 2018E 2019E 2020E
Source: Deutsche Bank estimates, Company Filings Source: Deutsche Bank estimates, Company Filings. Note: Company defines FCF as net cash provided by operating activities minus net cash used by investing activities
Better Frozen Food Industry Trends
We expect KR to benefit from a resurgence in frozen food trends, with the category seeing strong YOY dollar growth trends in tracked channels as highlighted by DB Food Analyst Rob Dickerson. Refreshed brands are gaining traction through innovation highlighting health and convenience, with both pricing and units driving sales growth.
Figure 18: The Frozen Category Has Seen YOY Sales Figure 19: On a Two-Year Stacked basis, Category Sales Growth Accelerate Over the Last Year, led by Conagra, Growth Has Been Driven by Private Label and Pinnacle, Private Label, and Pinnacle and More Recently, Conagra
Source: Deutsche Bank, Nielsen Source: Deutsche Bank, Nielsen
Page 14 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 20: In 2017, Category Growth Was Driven Figure 21: On a Two-Year Stacked Basis, Volume By Pricing, Partially Offset By Volume Declines; So Declines Have Improved Far in 2018, Category Growth Driven By Pricing Has Decelerated, with Volumes Growing Modestly YOY
Source: Deutsche Bank, Nielsen Source: Deutsche Bank, Nielsen
Higher Prices at the Pump
Retail gasoline prices (all grades, dollars per gallon, including taxes) were $2.913 according to the U.S. Energy Information Administration for the week of 6/25, up 21% YOY, which should benefit sales growth through higher dollar sales of fuel as well as potential share gains away from stock-up trip destinations that are more remote (i.e., WMT). KR has 1,522 supermarket fuel centers as of 1Q18, and $15.9B in 2017 fuel sales ex. the 53rd week (13% of total sales; up 13.9% YOY). KR’s supermarket fuel centers were not included in the convenience store business divestiture in April 2018.
Figure 22: Retail Gasoline Prices Figure 23: YOY % Change $4.50 50% 40% $4.00 30% $3.50 20%
$3.00 10% 0% $2.50 (10%) $2.00 (20%) (30%) $1.50 (40%) $1.00 (50%) Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18
Source: Deutsche Bank, EIA Source: Deutsche Bank, EIA
Deutsche Bank Securities Inc. Page 15 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Conservative Guidance Allowing Further Beat & Raises
KR beat the Street by 10c in 1Q (EPS of $0.73 vs. $0.63), but adjusted up the low-end of full-year guidance by 5c, leaving the high-end untouched ($2.00-$2.15 vs. $1.95-$2.15 previously). While we acknowledge healthy skepticism around ID sales plan of 2.0%-2.5% vs. only 1.9% achieved in 1Q and with tougher compares ahead, and a poor track record vs. initial full-year guidance (see below), we believe bulls still see upside to 2018 EPS guidance through Restock Kroger providing improved cost control. KR posted 25% EPS growth in 1Q with a clean sales and OG&A driven performance, but the high-end of the full-year plan implies that 2Q-4Q EPS will be up only a combined 4% YOY (ex. 53rd week), leading some investors to call guidance overly conservative given the multitude of tailwinds already explored in this section (private label, natural/organic, digital, personalization, frozen food, higher gas prices).
KR posted 25% EPS growth in 1Q, but the Figure 24: KR Initial EPS Guidance vs. Initial Street Expectations and Actuals high-end of the full-year plan implies that 2Q-4Q will be up only a combined 4% YOY Year Initial Guidance Initial Street Delta from Midpoint Actual Delta from Midpoint (ex. 53rd week), leading some investors to 2014 $3.14-$3.25 $3.12 $0.00 $1.78 ($1.34) call guidance overly conservative 2015 $3.80-$3.90 $3.72 $0.13 $2.08 ($1.77) 2016 $2.19-$2.28 $2.24 ($0.01) $2.12 ($0.11) 2017 $2.21-$2.25 $2.23 $0.00 $2.04 ($0.19) 2018E $1.95-$2.15 $2.16 ($0.11) TBD TBD
Source: Deutsche Bank, Company Filings, Factset
Low Buy-Side Bar with Poor Investor Sentiment
While bulls may see upside to 2018 EPS guidance as discussed above, we think they are ultimately outnumbered by the bears who maintain a skeptical outlook given a history of misses vs. initial plan, as also discussed above, combined with KR's challenging position in a hated subsector (conventional grocers) being squeezed by high-end natural/organic-centric options on one end (e.g., Whole Foods, Sprouts), discounters on the other end (e.g., WMT, Aldi, COST), and the cloud up above (online siphoning sales from brick & mortar). Short interest sits at 6.1%, a relatively high level for the sector (above SFS 4.5% and SPTN 1.7%). We believe simply executing against the midpoint of guidance, and not even beating it, would exceed average buy-side forecasts and trigger multiple expansion from today's 12.3x on our 2019 EPS forecast (12.6x Street) into the mid-teens, representing what would in that case be a well deserved premium vs. the long-term historical average of 12.5x.
Page 16 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co. Risks Ahead: Reasons to Avoid the Stock
Traditional Grocer Share Loss
Based on annual sales data, we perceive changing consumer grocery habits away from traditional grocers and toward alternate sources including fill-in trips at dollar stores. We have compiled food/consumables sales of major grocery players in 2017 vs. 2012, with the share shift evident away from conventional retailers (category share down ~92 bps over five years), and toward fill-in/online/other players including dollar stores (up ~195 bps), with the dollar stores posting MSD- HSD consumables growth and Aldi up solid double-digits. We expect sales to continue to migrate in the direction of the dollar stores and hard discounters from the traditional grocers as consumers take advantage of improved quality and assortment combined with convenience and value.
We commend KR for having thus far gained modest share, by our math and "I want to be crystal clear, we are gaining by management's commentary (see right; 2017 marked the 13th consecutive market share. But we've also allowed others to gain share more than we would be happy year of gains). We believe the company has executed relatively well in capturing with." share from floundering traditional grocery peers. However, as we see negative – Chairman and CEO Rodney McMullen, sentiment around the conventional channel, including KR, as the food retail space October 2017 Investor Conference becomes increasingly competitive, we consider industry market share shifts as an overall bear point for investors when considering this stock.
Deutsche Bank Securities Inc. Page 17 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 25: U.S. Grocery Landscape – Key Players ($B) 2012 2012 2017 2017 CAGR Big-Box Walmart U.S. $151.0 26% $178.3 25% 3% Sam's Club $31.0 5% $34.3 5% 2% COST $24.4 4% $32.9 5% 6% TGT $14.3 2% $14.4 2% 0% BJ's $7.5 1% $8.1 1% 1% Subtotal $228.2 39% $268.1 38% 3% Traditional KR (incl. HT & Roundy's) $83.1 14.1% $100.9 14.2% 4% Albertsons NA $51.1 7% Publix $23.4 4% $29.0 4% 4% Ahold USA $25.8 4% $26.0 4% 0% H-E-B $19.4 3% $23.1 3% 4% Meijer $14.6 2% $18.9 3% 5% Wakefern $13.6 2% $16.3 2% 4% Whole Foods $11.3 2% $15.5 2% 7% Trader Joe's $10.5 2% $13.6 2% 5% Southeastern $10.0 2% $9.9 1% (0%) Giant Eagle $9.9 2% $8.9 1% (2%) Hy-Vee $7.7 1% $10.0 1% 5% Wegmans $6.6 1% $8.5 1% 5% Delhaize America $18.8 3% $17.4 2% SVU $8.8 1% $2.6 0% SWY $33.4 6% Acquired by Albertsons Subtotal $297.0 50% $351.8 49% 3% Fill-In/Online/Other DG $11.8 2% $18.1 3% 9% 7-Eleven $11.4 2% $16.9 2% 8% Aldi $7.9 1% $16.8 2% 16% Walgreens $7.9 1% $9.6 1% 4% CVS $9.8 2% $8.6 1% (3%) Family Dollar $6.4 1% $8.3 1% 5% Rite-Aid $4.4 1% $4.0 1% (2%) Dollar Tree $3.7 1% $5.5 1% 8% Amazon NA $2.0 0% Big Lots $1.6 $1.6 0% 0% Blue Apron NA $0.9 0% Subtotal $65.0 11% $92.3 13% 7% Grand Total $590.2 100% $712.1 100% 4%
Source: Deutsche Bank, Company Filings, Supermarket News. Note: Estimated where unavailable; represents fiscal year
Page 18 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 26: KR Has a ~6% Share in a $1.5 Trillion Fragmented Food Industry Including Food Away from Home
Source: Deutsche Bank, KR October 2017 Investor Conference Presentation
Lack of Food Inflation
Food inflation has been modest, and flattening in recent months. The Bureau of Labor Statistics reported CPI food at home inflation of just 0.1% in May vs. 0.5% in April and 0.4% in March. In May, meats, poultry, fish, and eggs were up 2.3%, offset by cereals and bakery products down -0.2%, dairy and related products down -0.6%, fruits and vegetables down -0.4%, nonalcoholic beverages and beverage materials down -1.3%, and other foods down -0.4%.
Figure 27: CPI Food at Home Index (YOY % Change) 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% (1.0%) (2.0%)
(3.0%)
Jan-18
Jan-17
Jan-16
Jan-15
Jan-14
Jan-13
Jan-12
Sep-17
Sep-16
Sep-15
Sep-14
Sep-13
Sep-12
May-18
May-17
May-16
May-15
May-14
May-13 May-12
Source: Deutsche Bank, BLS
Moreover, PPI has also flattened in recent months, suggesting even lower levels of CPI ahead. We see a 0.88 correlation between CPI and PPI on a five-month lag.
Deutsche Bank Securities Inc. Page 19 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 28: PPI vs. CPI
25.0%
20.0%
15.0% Weighted-Average PPI May 0.6% April 0.5% March 1.9% 10.0% February 0.8% January 1.4% December 2.3% 5.0%
0.0%
CPI-PPI Spread (5.0%) May (0.5%) April 0.0% March (1.5%) February (0.3%) (10.0%) January (0.4%) December (1.4%)
(15.0%)
Jan-18
Jan-17
Jan-16
Jan-15
Jan-14
Jan-13
Jan-12
Jan-11
Jan-10
Sep-17
Sep-16
Sep-15
Sep-14
Sep-13
Sep-12
Sep-11
Sep-10
Sep-09
May-18
May-17
May-16
May-15
May-14
May-13
May-12
May-11
May-10 May-09
Weighted-Average PPI CPI Food at Home
Source: Deutsche Bank, BLS
Tough Trends in Center Store
As noted by Coca-Cola's Senior Manager of Shopper Strategy and Innovation Ron Hughes, center store contributes 75%-80% of grocery bottom-line profit, but is struggling to resonate with Millennials – 25% of Millennials say the 'center store is a boring part of the store,’ and 23% say, ‘I almost get claustrophobic when shopping center store.’ (as quoted in a 12/18/17 Progressive Grocer article). Center store has lost share to fresh options along the perimeter, and to fresh options and new innovation outside traditional grocers (e.g., meal kits).
Nielsen total CPG sales increased 1.5% YOY in the 4-week period ended 6/16 vs. the 1.6% historical average, composed of a 1.1% increase in average price and a 0.4% increase in units. Nielsen food sales have been softer, up 1.0% YOY in the 4- week period ended 6/16 vs. the historical average of 2.0%, composed of a 1.4% increase in price partly offset by a 0.4% decrease in units.
On a 6-month rolling basis, food price remains modestly positive, albeit slowing as the year progresses, while units have improved but still do not contribute to growth.
Page 20 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 29: Nielsen Food Price Rolling 6-Month Average; Figure 30: Nielsen Food Units Rolling 6-Month Average; % Change YOY) % Change YOY)
7.0 2.0
6.0 1.0 5.0
4.0 0.0 3.0
2.0 -1.0
1.0 -2.0 0.0
-1.0
-3.0
Jul-17
Jul-16
Jul-15
Jul-14
Jul-13
Jul-12
Jul-11
Jan-18
Jan-17
Jan-16
Jan-15
Jan-14
Jan-13
Jan-12
Jan-11
Jul-11 Jul-14
Jul-12 Jul-15
Jul-16
Jul-17
Jul-13
Jan-11 Jan-14
Jan-15 Jan-12
Jan-13 Jan-16
Jan-17 Jan-18
Source: Deutsche Bank, Nielsen Source: Deutsche Bank, Nielsen
Tougher SSS Compares vs. Guidance Calling for Acceleration
We believe bears are rightfully skeptical around ID sales plan of 2.0%-2.5% vs. only 1.9% achieved in 1Q and with tougher compares ahead. As inflation has been moving in the wrong direction recently, with PPI suggesting further backtracking ahead, KR's path to accelerating ID sales must include more growth stemming from demand increases, hardly a given as the Nielsen unit trend has been negative. KR will benefit from moving past space optimization by the end of 3Q, continued digital growth with ClickList expansion, and robust private label and natural/organic trends, but we think the company must also post increasing market share gains and core business growth to meet guidance.
We note that below we include ID supermarket sales as reported, with the new methodology kicking in with 1Q18 (1.9% vs. 1.4% under the old methodology), and we have also provided a separate table with estimated historicals adding 50 bps to each quarter to make ID sales more comparable over time.
Deutsche Bank Securities Inc. Page 21 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 31: ID Supermarket Sales Ex. Fuel Figure 32: ID Supermarket Sales Ex. Fuel with Estimated Historicals Under the New Methodology (Adding 50 bps)
4.6% 5.7% 2.4% (0.2%) 1.9% 5.1% 6.2% 2.9% 0.3% 1.9% 4.8% 5.3% 1.7% 0.7% 2.1% 5.3% 5.8% 2.2% 1.2% 2.1% 5.6% 5.4% 0.1% 1.1% 2.3% 6.1% 5.9% 0.6% 1.6% 2.3% 6.0% 3.7% (0.7%) 1.5% 2.0% 6.5% 4.2% (0.2%) 2.0% 2.0% 5.2% 5.0% 1.0% 0.7% 2.1% 5.7% 5.5% 1.5% 1.2% 2.1%
2-Year Stacked SSS 2-Year Stacked SSS
7.9% 10.3% 8.1% 2.2% 1.7% 8.9% 11.3% 9.1% 3.2% 2.2% 8.1% 10.1% 7.0% 2.4% 2.8% 9.1% 11.1% 8.0% 3.4% 3.3% 9.1% 11.0% 5.5% 1.2% 3.4% 10.1% 12.0% 6.5% 2.2% 3.9% 10.3% 9.7% 3.0% 0.8% 3.5% 11.3% 10.7% 4.0% 1.8% 4.0% 8.9% 10.2% 6.0% 1.7% 2.8% 9.9% 11.2% 7.0% 2.7% 3.3%
Source: Deutsche Bank estimates, Company Filings. Note: KR redefined ID sales ex. fuel starting with Source: Deutsche Bank estimates, Company Filings. Note: We have added 50 bps to historical comps 1Q18 to be more inclusive of company business units, including Kroger Specialty Pharmacy and ship- prior to 1Q18 to approximate the new methodology to-home solutions. The company intends to use this calculation going forward as a more appropriate measure to track Kroger's performance as it redefines the grocery customer experience, and to be more comparable with how peers report
Lower Gas Margins
Gas margins are volatile but have trended lower on average in recent periods, and we have tough YOY compares ahead. The company reported a gas margin of $0.187 in 1Q vs. $0.198 in 4Q and $0.249 in 3Q, or 7.1% in 1Q by our math vs. 8.0% in 4Q and 10.1% in 3Q. Looking at OPIS data, we see margins trending lower in April before ticking up in May and June to date. Assuming a reversion to the mean, we are modeling a gas margin for KR of 6.2% in 2Q18 (down 329 bps YOY) before rebounding to a forecasted 6.8% in 3Q18 (down 334 bps) and 7.3% in 4Q18 (down 76 bps).
Figure 33: Gasoline % Profit Figure 34: Gasoline % Profit on a 13-Week Rolling Basis
12.0% 18.0% 16.0% 11.0%
14.0% 10.0%
12.0% 9.0% 10.0% 8.0% 8.0% 7.0% 6.0% 6.0% 4.0% 2.0% 5.0% 0.0% 4.0%
Source: Deutsche Bank, OPIS Source: Deutsche Bank, OPIS
Figure 35: KR Reported and Forecasted Gas Margins 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18E 3Q18E 4Q18E KR Gas Margin $0.143 $0.198 $0.179 $0.172 $0.171 $0.217 $0.249 $0.198 $0.187 $0.186 $0.201 $0.216 % Profit 7.5% 9.0% 8.2% 7.9% 7.5% 9.5% 10.1% 8.0% 7.1% 6.2% 6.8% 7.3% bps YOY Change 4 53 189 16 (44) (329) (334) (76)
Source: Deutsche Bank estimates, Company Filings
Page 22 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Pharmacy Sector Headwinds
KR posted $10.75B in pharmacy product sales in 2017 (this figure does not include specialty pharmacy sales, which are grouped in "other" sales), representing 8.8% of total sales. The category was up 3.1% for the year, trailing all other categories and the total company growth rate.
Figure 36: Pharmacy Sales ($M) and Annual Growth Rates
$12,000 14.0% $10,752 $11,000 $10,432 12.0% $9,778 $10,000 10.0% $9,032 $9,000 $8,018 $8,073 8.0% $8,000 6.0% $7,000 4.0% $6,000
$5,000 2.0%
$4,000 0.0% 2012 2013 2014 2015 2016 2017
Source: Deutsche Bank, Company Filings
KR has seen pharmacy growth decelerate since 2014, with industry headwinds from reimbursement pressure and the impact of generic introductions. Looking ahead, we expect continued sector headwinds to constrain sales growth. KR is seeing pharmacy inflation of only 1%-2%, as discussed with the 1Q18 conference call, above ~0.5% of the rest of the business but still a relatively low level. Management noted with 4Q17 results that ID and total script count continue to grow nicely, but pricing is a challenge, and GPM has softened.
As a new negative factor in the competitive landscape, on 6/28 AMZN announced the acquisition of PillPack, a pharmacy that provides pre-sorted dose packaging and home delivery. TechCrunch reported a transaction value of just under $1B. As it relates to its own pharmacy strategy, management stated on the 4Q conference call that "it's a very important part of our business" but one where they "don't see us doing anything differently in the near-term" when asked about potential acquisitions.
We do note, as a bull sub-point, that given the 50 bps lift in ID supermarket sales in 1Q18 (to 1.9% from 1.4%) when including other items including specialty pharmacy as opposed to the former methodology, we assume that this business is growing rapidly at the company, in line with industry dynamics. KR acquired Axium specialty pharmacy in 2012, and ModernHEALTH in 2016. Drug Channels Institute estimates KR's specialty pharmacy business at $2.3B in 2017 revenues, up 13% YOY with a 2% share in a fragmented market.
Deutsche Bank Securities Inc. Page 23 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 37: Specialty Pharmacy Market Overview
Source: Deutsche Bank, Drug Channels Institute
Price Investments in a Competitive Space
KR has invested nearly $4B in price since 2001, according to the October 2017 Investor Conference presentation, and management is determined to not lose customers because of price. KR pulled forward price investments in the last four weeks of 1Q driven by tax savings, and the company is "very happy" with the subsequent unit growth and response from customers, especially in its private label brands. Management also stated that elasticity around these investments has been consistent with expectations.
In no small part reflecting price investments, in our view, KR's FIFO GPM ex. fuel contracted 13 bps in 1Q18, extending 2017's negative 19 bps trend. We believe price investments are likely to remain a GPM headwind given elevated activity in a competitive space. On WMT's 1Q18 conference call, its management explained, "We do continue to invest in price in the U.S. business. It's important component of our overall strategy and we expect that to be a headwind to gross margin."
Page 24 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 38: Quarterly GPM Trends (YOY Change in bps) 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 Total GPM (9) (63) (87) (39) 17 (31) (29) (45) (40) FIFO GPM ex. Gas & Acquisitions (2) (13) (5) (22) (45) (30) 30 (31) (13)
Source: Deutsche Bank, Company Filings
Freight Still an Issue
While not specifically cited by management with 1Q results, we believe elevated freight expense in a tight trucking market remains a headwind for KR, like its peers, contributing to the 13 bps contraction in GPM ex. fuel and the LIFO charge in 1Q. There could be a drag on margins until the end of the calendar year, when we lap the initial industry issues. DB Transportation Analyst Amit Mehrotra notes the capacity crunch in the trucking market , with supply constraints due to the driver shortage. Reefer contract rates were up 17.1% YOY in June vs. 15.3% in May, 13.7% in April, and 11.9% in March.
Ongoing Labor/Wage/Pension Investments
As announced in October, KR is investing an incremental $500M in associates in wages, training, and development over the next three years through Restock Kroger. This will be in addition to continued efforts to rebalance pay and benefits, while also focusing on certifications and performance incentives, career opportunities, and training. As a result of investments, management observed with 1Q18 results that they are seeing improvements in retention.
Additionally, we note that a majority of KR's employees are covered by collective bargaining agreements with unions. The company is a party to approximately 360 collective bargaining agreements in total. Upon the expiration of agreements, work stoppages by the affected workers could occur if KR is unable to negotiate new contracts with labor unions. KR has several major negotiations in 2018, including contracts with the UFCW for store associates at Smiths in Albuquerque, Fred Meyer in Portland, and Kroger stores in Richmond and Fort Wayne. The company's financial results continue to be pressured by inefficient healthcare and pension costs, which some of its competitors do not face. KR contributes to several multi-employer pension plans based on obligations arising under the collective bargaining agreements. Over the last four quarters, KR used cash to contribute an incremental $1.2B pre-tax to company-sponsored pension plans and $467M pre-tax to satisfy withdrawal obligations to the Central States Pension Fund. Management believes that the present value of actuarially accrued liabilities in most of these plans substantially exceeds the value of the assets held in trust to pay benefits, and expects that contributions to those funds will increase over the next few years. KR also currently bears the investment risk of two of the larger multi-employer pension plans in which it participates.
Ocado Execution Risk
As part of its home delivery efforts, in May KR announced an exclusive partnership with U.K.-based online supermarket Ocado, bringing that company to the U.S. for the first time. As part of the agreement, KR increased its existing investment in Ocado by 5% in a subscription rights agreement, taking its total investment to more than 6%. KR and Ocado are already working to identify the first three sites in 2018 for development of new, automated warehouse facilities in the U.S., and
Deutsche Bank Securities Inc. Page 25 2 July 2018 Retailing / Food & Drug Chains Kroger Co. will identify up to a total of 20 over the first three years of the agreement. The new relationship is not expected to affect KR's EPS guidance range for 2018 and 2019 as it is already reflected in the company's Restock Kroger plan.
Ocado is a publicly-traded U.K. company (listed in 2010), and the world's largest dedicated online grocery retailer. Established in 2000, the company has developed a unique end-to-end operating solution based on proprietary technology and IP. Warehouse automation within the customer fulfillment centers (CFC's) are a key differentiator for the company. Ocado also uses advanced data analytics and cloud storage to deliver groceries to over 645,000 active customers, and has U.K. household penetration of ~3%. The company notes a typical cost to acquire a customer of £20-£40, average annual customer spend of greater than £2,000, and current operating contribution of over £200, with a payback period of 6-12 months. The retail business is highly cash generative, with CFC's expected to generate nearly £175M of cash flow at maturity.
Figure 39: U.K. Online Grocery Dynamics
Source: Deutsche Bank, Company Presentation. 1) IGD. 2) U.K. retail penetration: Citi Research, IBISWorld, U.S. Census, Euromonitor
Page 26 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 40: Ocado Has ~3% U.K. Household Penetration Figure 41: Ocado Customers Are Very Loyal
Source: Deutsche Bank, Company Presentation. Note: Represents active customer penetration within the Source: Deutsche Bank, Company Presentation Ocado delivery area
While a retailer in its own right, the company also acts as a platform powering six other food retailers: Morrisons, Groupe Casino, Sobeys, Kroger, ICA, and a regional European retailer (not named). As the solutions business scales, Ocado earns higher fees and can generate better returns.
■ Since launching its first commercial partnership in 2014, Morrisons.com sales have grown significantly, according to Ocado. The company announced an extension to the partnership in June 2016 to allow capacity in the Erith CFC, enabling the business to continue to scale alongside customer demand. Additionally, Ocado agreed to provide Morrisons with store picking capabilities, where customer orders are picked and packed directly from their existing stores. Despite expected weaker economies at scale, this alternative picking solution enables full geographical coverage to areas where the current centralized picking capacity does not reach.
■ Ocado's first international partnership with a regional European retailer provides access to the full software platform, know-how, and support services required to build an efficient online grocery business. The partner is initially operating from a manual warehouse, with the option to progress to a full automation solution at a later date.
■ Under the Groupe Casino agreement, that company gains access to the full end-to-end Ocado Smart Platform solution, including the construction of the latest generation automated warehouse, front-end website functionality, last mile routing management, and big data and real time implementation. The agreement provides exclusivity benefits to Groupe Casino in France as long as that company continues to commit to grow online operations over time. As well as some upfront fees, which will enable Groupe Casino's systems and processes to be integrated with the Ocado Smart Platform, fees will be based on the capacity utilization within the CFC and will scale as online operations grow.
■ Ocado partnered exclusively in Canada with Sobeys in early 2018 to launch its end-to-end solution for online grocery services. The first CFC will be in the greater Toronto area, with a build expected to take
Deutsche Bank Securities Inc. Page 27 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
approximately two years. In addition, both companies will consider developing other CFC's in Canada in dense urban areas. Sobeys pays Ocado certain upfront fees upon signing and during the development phase, then ongoing fees linked to installed capacity within the CFC and service criteria.
In 2017, Ocado posted £1.43B in total revenue (excluding the extra week), with 92% derived from the retail business (up 12.4% YOY) and the balance from solutions (up 16.2%).
KR has not provided many numeric details, but at an investor conference in May, management enthusiastically observed that "it's a phenomenal return even if we hit our conservative estimates. But if we were to hit Ocado's estimates on how they think these things could ramp, it's a return that's probably 50% higher than our own expectation of a return."
While we believe KR is making the right long-term strategic decisions in a rapidly- changing retail landscape, and the stock may benefit in the meanwhile from a valuation halo associated with potentially accelerating online sales, we highlight meaningful execution risk around this unique partnership. The arrangement will require balance sheet commitments by KR that may not be met by a necessary level of incremental sales and profits in the foreseeable future, if at all.
Elevated Trading Multiple
With the 1Q beat but what we still view as conservative guidance keeping full- year EPS estimates in check (low-end of the range raised but high-end unaltered; Street now $2.11 vs. $2.07 prior to the print), we have seen the trading multiple expand two turns to 13.0x 2019 EPS, above the 1-year average of 11.7x and above the 10-year average of 12.5x. We still remain below the 3-year average of 14.1x and the 5-year average of 14.2x, which are buoyed by the oil trade in late 2015/ early 2015 and again in late 2015/early 2016, when a dip in prices at the pump to $2 and under spurred optimism around increased consumer spending, and temporarily sent KR's multiple to the 18x-20x range each time. Additionally, KR stands only 1.5 turns below the peer index, above the 10-year average of 2.0 turns, after being meaningfully below the average for much of the past 18 months.
Page 28 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 42: KR Forward P/E (Last 10 Years)
20.0x
18.0x
16.0x
14.0x
12.0x
10.0x
8.0x Jun-08 Jun-10 Jun-12 Jun-14 Jun-16 Jun-18
KR 10Y Average 5Y Average 3Y Average 1Y Average
Source: Deutsche Bank, Factset
Deutsche Bank Securities Inc. Page 29 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 43: KR Forward EV/EBITDA (Last 10 Years)
10.0x
9.0x
8.0x
7.0x
6.0x
5.0x
4.0x
3.0x
Jun-18
Jun-13 Jun-17
Jun-12 Jun-16
Jun-11 Jun-09 Jun-15
Jun-10 Jun-08 Jun-14
KR 10Y Average 3Y and 5Y Average 1Y Average
Source: Deutsche Bank, Factset
Page 30 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 44: KR vs. Peer Index Forward P/E Multiple
24.0x
22.0x
20.0x
18.0x
16.0x
14.0x
12.0x
10.0x
8.0x Jun-08 Jun-10 Jun-12 Jun-14 Jun-16 Jun-18
KR Peer Index
Source: Deutsche Bank, Factset. Peer Index includes CASY, SFM, SFS, SVU, TGT, UNFI, and WMT. Outliers excluded
Figure 45: Spread Between KR and the Peer Index Forward P/E Multiples 4.0x
2.0x
0.0x
(2.0x)
10-Year Average: (2.0x) (4.0x)
(6.0x) Jun-08 Jun-10 Jun-12 Jun-14 Jun-16 Jun-18
Source: Deutsche Bank, Factset
Rising Debt Leverage Ratio Levels Above the Target Range
With 1Q results, KR's net total debt/adj. EBITDA ratio increased to 2.43x on a 52- week basis. The company's target range is 2.3x-2.5x, and management expects the ratio increase throughout the year due to increased borrowings to fund the investment in Ocado, the acquisition of Home Chef, and tax payments related to the gain from the sale of the convenience store business unit.
Deutsche Bank Securities Inc. Page 31 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Figure 46: Net Debt/Adj EBITDA Is Rising Above the Target Range
2.90x 2.83x
2.70x Target Range: 2.65x 2.57x 2.55x 2.3x-2.5x 2.50x 2.50x 2.43x 2.37x 2.33x 2.30x
2.10x
1.90x
1.70x
1.50x 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18E 3Q18E 4Q18E
Source: Deutsche Bank estimates, Company Filings
Page 32 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co. Appendix 1
Important Disclosures *Other information available upon request
Disclosure checklist Company Ticker Recent price* Disclosure Kroger Co. KR.N 28.45 (USD) 29 Jun 2018 7, 8 *Prices are current as of the end of the previous trading session unless otherwise indicated and are sourced from local exchanges via Reuters, Bloomberg and other vendors . Other information is sourced from Deutsche Bank, subject companies, and other sources. For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at https://research.db.com/ Research/Disclosures/CompanySearch. Aside from within this report, important risk and conflict disclosures can also be found at https://research.db.com/Research/Topics/Equities? topicId=RB0002. Investors are strongly encouraged to review this information before investing. Important Disclosures Required by U.S. Regulators Disclosures marked with an asterisk may also be required by at least one jurisdiction in addition to the United States.See Important Disclosures Required by Non-US Regulators and Explanatory Notes. 7. Deutsche Bank and/or its affiliate(s) has received compensation from this company for the provision of investment banking or financial advisory services within the past year. 8. Deutsche Bank and/or its affiliate(s) expects to receive, or intends to seek, compensation for investment banking services from this company in the next three months. Important Disclosures Required by Non-U.S. Regulators Disclosures marked with an asterisk may also be required by at least one jurisdiction in addition to the United States.See Important Disclosures Required by Non-US Regulators and Explanatory Notes. 7. Deutsche Bank and/or its affiliate(s) has received compensation from this company for the provision of investment banking or financial advisory services within the past year. For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at https://research.db.com/Research/Disclosures/CompanySearch Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s) about the subject issuer and the securities of the issuer. In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Paul Trussell
Deutsche Bank Securities Inc. Page 33 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
Historical recommendations and target price. Kroger Co. (KR.N) (as of 06/29/2018) 100.00 Current Recommendations Buy Hold 80.00 Sell Not Rated Suspended Rating
60.00 ** Analyst is no longer at Deutsche Bank
2 1 40.00 3 4
Security price 5 9 8 6 7 10 20.00
0.00 Jul '15 Jan '16 Jul '16 Jan '17 Jul '17 Jan '18 Jul '18 Date
1. 07/14/2015 Buy, Target Price Change USD 45.00 Karen Short** 6. 06/19/2017 Buy, Target Price Change USD 26.00 Shane Higgins** 2. 12/04/2015 Buy, Target Price Change USD 48.00 Karen Short** 7. 09/11/2017 Downgraded to Hold, Target Price Change USD 21.00 Shane Higgins** 3. 06/16/2016 Buy, Target Price Change USD 41.00 Shane Higgins** 8. 12/01/2017 Hold, Target Price Change USD 26.00 Shane Higgins** 4. 09/12/2016 Buy, Target Price Change USD 39.00 Shane Higgins** 9. 03/05/2018 Hold, Target Price Change USD 28.00 Shane Higgins** 5. 03/03/2017 Buy, Target Price Change USD 35.00 Shane Higgins** 10. 03/09/2018 Hold, Target Price Change USD 25.00 Shane Higgins**
§§§§$$$$$§§§§§
Equity Rating Key Equity rating dispersion and banking relationships Buy: Based on a current 12- month view of total share-holder return (TSR = percentage change in share price from current price to projected target price plus pro-jected dividend yield ) , we recommend that investors buy the stock. Sell: Based on a current 12-month view of total share-holder return, we recommend that investors sell the stock. Hold: We take a neutral view on the stock 12-months out and, based on this time horizon, do not recommend either a Buy or Sell. Newly issued research recommendations and target prices supersede previously published research.
Page 34 Deutsche Bank Securities Inc. 2 July 2018 Retailing / Food & Drug Chains Kroger Co.
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Deutsche Bank Securities Inc. Page 39 David Folkerts-Landau Group Chief Economist and Global Head of Research
Raj Hindocha Michael Spencer Steve Pollard Global Chief Operating Officer Head of APAC Research Head of Americas Research Research Global Head of Economics Global Head of Equity Research
Anthony Klarman Paul Reynolds Dave Clark Pam Finelli Global Head of Head of EMEA Head of APAC Global Head of Debt Research Equity Research Equity Research Equity Derivatives Research
Andreas Neubauer Spyros Mesomeris Head of Research - Germany Global Head of Quantitative and QIS Research
International Production Locations
Deutsche Bank AG Deutsche Bank AG Deutsche Bank AG Deutsche Securities Inc. Deutsche Bank Place Mainzer Landstrasse 11-17 Filiale Hongkong 2-11-1 Nagatacho Level 16 60329 Frankfurt am Main International Commerce Centre, Sanno Park Tower Corner of Hunter & Phillip Streets Germany 1 Austin Road West,Kowloon, Chiyoda-ku, Tokyo 100-6171 Sydney, NSW 2000 Tel: (49) 69 910 00 Hong Kong Japan Australia Tel: (852) 2203 8888 Tel: (81) 3 5156 6770 Tel: (61) 2 8258 1234 Deutsche Bank AG London Deutsche Bank Securities Inc. 1 Great Winchester Street 60 Wall Street London EC2N 2EQ New York, NY 10005 United Kingdom United States of America Tel: (44) 20 7545 8000 Tel: (1) 212 250 2500