CFA Challenge Student Research - DoYouBuzz · 2014-05-13 · CFA Challenge Student Research Jan 6th...

CFA Challenge Student Research Jan 6th, 2014

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THIEBAUT Tiphaine [email protected] Retail Food Industry Jan 6th, 2014 Ticket: KR Recommendation: HOLD Price: $ 39,70 Target price: $ 44,35

Sources: Ycharts.com – 4-traders.com Highlights

Kroger is on a roll; striking the right balance between planned gross margin sacrifice and sales growth...

• Fundamentals and valuation forecasted established a Target Price of $44,35 – Recommendation HOLD: Kroger share price has outperformed since 2012 and is expected to continue its growth with an upward potential of 11,71% versus current share price.

• The retailer’s 40th consecutive quarter of positive store sales which is an un-matched achievement in the sector. This means Kroger has been enable to take market share from its competitors and it has been doing so continuously for a decade.

• Kroger in the conquest of the United States with the cover of 31 states and is fast-expansion growths will allows to Kroger to cover all the US area in the near future.

• Need of diversification: the international presence from its competitors could be a real threat if Kroger is not well managing its business and strategy of continuing expansion within the US.

• Sensitive margins trend … lightly and slightly... Kroger known since 2005 a deterioration of its gross margin over time with since 2012 a little improvement. It means that competition has forced the company to lower prices that it cannot control costs.

All these events gave significant result for abnormal return on 5 days windows basis around announcements. Sources: Yahoo Finance.com

CFA Challenge Student Research Jan 6th 2014

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Business Description History

The Kroger Co. was founded in 1883 by Bernard Henry Kroger in Cincinnati (Ohio) and has been quoted in 1902 on the NYSE under the code KR. Kroger Company is an American retailer; it is one of the world's largest grocery retailers and the second largest food retailer and largest operator of traditional supermarkets in the US with 2424 stores nationwide. During the 1930s, frozen foods and shopping carts were introduced, and the Kroger Food Foundation invented a way of processing beef without chemicals. In 1946 the company changed its name from The Kroger Grocery and Baking Company to The Kroger Co that it means a new period of growth. In 1960 the company began its expansion into the drugstore business, with an eye on the potential for drugstores built next to grocery stores. By 1962, Kroger had also gone into discounting which are strategically located stores that aggressively merchandised goods on a low margin basis with minimum service. Kroger has always been a massive group especially in 1972, where it became the first grocery retailer in America to test an electronic scanner. Technology continues to play an important role in Kroger’s store operations today. Kroger pioneered QueVision, an innovative faster checkout program that has reduced the time customer’s wait in line to check out. Not only, Kroger is a pioneer launching new technologies improvement but also it is important to measure that Kroger reached significant synergies from its acquisition for its expansion.

Activities

Kroger operates over 2,424 supermarkets and also manufactures and sells food under 36 of its own brands. Kroger’s major products are bakery, banking, beer, dairy, deli, frozen foods, gasoline (at select locations), general merchandise (such as apparel home fashion, furnishings electronics automotive, toys and fine jewelry), liquor (at select locations), meat, pharmacy, fresh seafood, organic product, pets food and wine. Kroger Co has multiples divisions banner companies, which include Kroger, City Market, Dillons, Jay C, Food 4 Less, Fred Meyer, Fry’s, King Soopers, QFC, Ralphs and Smith’s. Kroger believes strongly in maintaining local banners where appropriate. Of these stores, 1,169 have fuel centers. Kroger does not breakdown sales per unit. There are four main types of stores:

- Combination Stores is Kroger’s primary format and draws Customers from a 2 -2,5 mile radius and offers them the advantage of “one-stop shopping” in convenient locations. The majority of Kroger's supermarkets are combo stores with a full selection of food and pharmacy products. They offer a wide of food product as well as specialty departments like bakeries, delis, and organic food sections.

- Multi-Department Stores are more significantly larger than combination stores. It is a collection of several stores under one roof. Kroger operates a number of multi-department stores in the Pacific Northwest and Alaska under the banner Fred Meyer. In addition to groceries, these stores sell apparel, furnishings, electronics, automotive products, toys, and jewelry. Many contain fuel centers.

- Marketplace Stores: are smaller than multi-department stores. Kroger operates marketplace stores in Arizona, Ohio, and Utah. These stores are smaller versions of its multi-department stores. The main difference is that marketplace stores don't contain apparel sections.

- Price-Impact Warehouses offer basic grocery items featuring everyday low prices, with a high concentration of corporate band products, in a low cost structure environment. Kroger's price-impact warehouses are the size of a combo store and offer a "no-frills, low cost" experience for grocery, along with health and beauty items. The company operates these stores in California, Illinois, and Nevada.

In addition, Kroger operates (either directly or through its subsidiaries) through: ü 786 Convenience stores though 15 states and are usually attached to fuel stations and offer different assortments of

food items. ü 328 fine Jewelry stores: These jewelry stores are usually located in either grocery stores or shopping malls. Jewelry

Stores of Kroger are the fourth largest fine jewelry retailer in the United States. ü Pharmacy stores and Fuel centers: both are linked with some combo stores, Multi-department stores, and marketplace

stores ü 37 Manufacturing plants (Approximately 40% of corporate brands sold in the stores) including dairies, bakeries,

beverage plants, and meat plants.

Geographical Positioning In 1912, Kroger made his first long-distance expansion, buying 25 stores in St. Louis, Missouri. The Kroger Grocery and Baking Company soon began to expand outside of Cincinnati; by 1920, the chain had stores in Hamilton, Dayton, and Columbus, Ohio. Throughout the Depression, Kroger maintained its business with 50 supermarkets of its own in 1935. In 1946, the company moved into Texas, Minnesota, and California. Annual sales grew as small neighborhood stores were replaced with larger supermarkets. Between 1948 and 1963, the number of supermarkets in the


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country nearly tripled. As competition in the industry grew increasingly fierce, Kroger joined with six other firms to found the Top Value Stamp Company. In 1983 Kroger merged with Dillon Companies, Inc. and began operating stores coast to coast. That same year, the company acquired the Kwik Shop convenience store chain. In 1999 Fred Meyer brought to Kroger 800 grocery stores located in 12 western states, a good geographic fit given Kroger's presence primarily in the Midwest, South, and Southwest. At the end of FY 2012, The Kroger Co. (either directly or through its subsidiaries) operated 2,424 supermarkets in 31 states under two dozen banners. On the last October 2013 Kroger acquired 212 Harris Teeter supermarkets by an acquisition. Corporate governance

David.B.Dillon, a 37-year Kroger veteran, who has been serving as Chief Executive Officer since 2003, will retire as CEO on January 1, 2014, while continuing to serve as Chairman of the Board. Mr. Dillon will serve as Chairman through December 31,2014. R.McMullen, Kroger's President and Chief Operating Officer, will become CEO on January 1, 2014. McMullen joined Kroger in 1978 on a part-time basis on a stock crew and has been President and Chief Operating Officer since 2009 and a Director since 2003. Shareholder structure Kroger is predominantly owned by institutional and managers of mutual funds, who owns 81% of total

outstanding shares. The insiders and the company hold 6% of shares. The remaining 13% of shares are either owned by the employees of form part of the free float and are currently traded on the NYSE. The main shareholder of the company is The Fidelity Management and Research Company which held 28 171 182 shares (5.44% of shares held). Dividend Policy The dividend per share ($0.15) remained the same after four consecutive quarters. This is a quarterly dividend. Nevertheless, the Board of Directors has authorized a 10% dividend hike, to $0.165 per share and it will be paid

on Dec. 1 to shareholders of record on Nov.15 2013. Capital Investment Total capital investments for 2012 were $2.1 billion, excluding acquisitions. About 51% of Kroger’s 2012 capital dollars were used to build, acquire, expand or complete major remodels of food stores.

The balance was allocated among minor remodels and the company’s other operating and administrative segments (such as convenience stores, jewelry stores and manufacturing facilities). The % of capital investment allocation is:

• 50,6% in Major Supermarkets (including real estate) • 21,8% in Minor Supermarkets • 14,5% in supermarket supports (Technology and Logistics) • 2% in other retail (Convenience & Jewelry stores, including real estate)

• 11,1% in other (Lease Buyouts…) Business Strategy Affection development of core activity …

• Customer at the 1st plan: thanks to its own brand strategy, Kroger can meet, understand and respond to the needs of its customers.

• Vertical Integration through a continuing growth: Kroger uses both vertical integration and outsourcing. Approximately 39% of the corporate brands sold are produced in Kroger's manufacturing facilities. The remainder of corporate brands is outsourced to other manufacturers. By producing their own products retailers can control product quality by directly influencing ingredients and recipes and can directly address the needs of shoppers and moreover, to make some economies of scales.

• Supplementary synergies: Launching organic products and presence in pharmacy services such as a specialist, little

clinics.

… Allows Kroger to strengthen is domestic situation


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Smart driving of its growth model …

• Very well involvement by acquisitions and mergers: Mergers have played a key role in Kroger’s growth over the years. In 1983 Kroger merged with Dillon Companies, Inc. and began operating stores coast to coast. That same year, the company acquired the Kwik Shop convenience store chain. A year later, Kroger formed a nonunion grocery wholesaler for Michigan called Food Land Distributors with Wetterau. During 1994, Kroger spent $534 million on the expansion, which included 45 new stores, 17 expanded stores, 66 remodeling, and the acquisition of 20 stores. From 1995 to 1997, $600 million was to be spent each year on expansion projects. Overall, this would be the largest capital expansion in Kroger history. The biggest merger in Kroger’s history came in 1999, when the company teamed up with Fred Meyer, Inc. in a $13 billion deal that created a supermarket chain with the broadest geographic coverage and widest variety of formats in the food retailing industry. On the last October 2013, shareholders of Harris Teeter Inc. have approved a $2.5 billion acquisition offer from the KR Co., moving the Cincinnati-based retail giant one step closer to gaining more than 200 new stores. Its shareholders voted in favor of KR’s offer to pay $49.38 for all shares in the Charlotte, N.C. The acquisition would give Kroger a stronger foothold in the Southeastern U.S., where Harris Teeter has 212 stores and more than $4.5 billion in revenue.

• Established Organic Growth: Kroger is continuously investing by high level of capital to modernize its structure

and production. Capital Investment reflect its strategy of growth through expansion as well as on self-development, ownership of real estate and technology improvements.

… Ranking Kroger at the head of a controlled growth with an intense penetration into domestic US segments 21th century acquisition strategy …

.

... allowed Kroger, beside its twelve subsidiaries, to develop very aggressively its conquest into the domestic US area. Industry Overview and Competing Positioning

The retail grocery sector is a highly competitive and concentrated industry. Kroger’s main peers are Safeway,

Supervalu, Whole Foods, Wal-Mart, Costco and Target. These are relatively large companies that control the majority of the market share in the retail grocery industry. Each firm in the industry offers almost identical products. In order to be successful and capture market share, Kroger administers the strategy of cost leadership through economies of scale and scope, low-cost distribution, efficient production and minimizing research costs. Kroger’s creates a competitive advantage by their ability to differentiate themselves and it differentiates from competitors but excelling in product quality, product variety and customer service. In the Grocery Industry the stores have three different types of products to sell to customers in perishable foods, non-perishable foods and non-food items. Kroger buy their products from wholesale distributors or manufacturer.

• Competition with tremendous firms

-Consumer’s centric position: Kroger has outpaced peers like Safeway and Supervalu in recent years by becoming more value-oriented ahead of the recession and implementing a rewards program to appeal to cost-conscious consumers. Kroger’s competitive strategy is to operate as a high volume low cost operator that is able to sell at relatively low prices and still generate good financial returns based on their low cost structure. Supporting this is a marketing strategy of focusing on the customer. Kroger refers to this as their “Customer 1st” strategy, which has four elements: people, products, shopping experience, and prices. This focus is the element that is most responsible for the company’s success. Their intensity on being competitive with prices drives sales and results in economies of scale that enable the company to offer lower prices without negatively affecting financial returns. The company seeks to offer prices that are as low or lower than other traditional grocers. Also, the company provides a competitive advantage in understanding the needs of customers, which in turn is used to drive higher sales.

-The strength of Private Label: Kroger offers the broadest assortment of private label products sold by any of the traditional grocers (about 12,000 private label brands in each supermarket). In the fourth quarter of last year private label represented 27% of the company’s grocery sales and 35% of grocery unit volume. This relatively high proportion of private label sales


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also contributes to the company’s low cost structure.

-A discount position: Kroger’s strategy of being a high volume low cost operator has been working well for them. This is borne out by the fact that for the last several years the company has been generating identical store sales, which are notably better than the other two large traditional grocers, Safeway and Supervalu. It is also illustrated by the company financial returns, which are well in excess of their cost of capital. Kroger’s relatively large size and economies of scale should enable the company to continue generating strong financial returns. The company seeks to offer prices that are as low or lower than other traditional grocers. Kroger is far cheaper than its smaller rivals in large part because it is a less "hot" stock in the marketplace and represents a lower growth ratio. For investors, this marks a lower valuation in the face of a more traditional company.

-Conquest of the US: Kroger has the strategic advantage of its location base that is unparalleled in the industry. This places Kroger in a position to continue to drive incremental sales and increase earnings. Kroger has a network of over 2,424 locations across the United States places the company at a strategic advantage against its smaller rivals due to its ability to adapt its current stores to meet the needs of customers who might otherwise go to Whole Foods, The Fresh Market, or another specialty food-retailer. For investors, this marks a company that has proven for 36 straight quarters that it can grow identical supermarket sales through continuing to innovate and use its strategic advantage: its location base.

-Sensitive its customers by social behavior: Kroger is fully engaged in the social serving community partners with largest contribution of foods and funds, supporting women’s health, military. Kroger is continuously minimizing its impact on the environment achieving total energy reduction of 32.7%, its partnership with WWF (World Wildlife Fund) and 21 of its 37 manufacturing plants have achieved “Zero waste”. Its social responsibility is directly impacting on the customers feeling committed and engaged when they come to purchase to Kroger Supermarkets.

• Few firms dominate rather than the others lead a competitive war

ü Threat of new entrants: LOW -Economies of scale: Retail grocery industry has high economies of scales due to the

large retail grocers having tremendous buying power and efficient distribution systems that allows them to reduce prices.

-First mover advantage: New entrants can have a competitive advantage because they can set industry standards and establish exclusive agreements with suppliers and they can gain a first mover advantage by providing differentiating products.

-Legal barriers: New entrants need to be aware with legal requirements to insure a smooth entrance into the industry.

ü Threat of substitute products: LOW

-Performance and relative price: Most retail grocery stores specialize in selling two types of products. Indeed, because the customers relate the value of the product about to its popularity, so we pick up known brands that tend to be higher in price and off-brand product to be cheaper. That is why they produce both in order to response to the market demand. Nevertheless, competition is intense and grocers have difficulty to raising prices.

-Buyer’s willingness to switch: Consumers tend to have different needs and whether or not it is a high price brand product or a cheaper off brand product, they have a full range of products to pick and choose from due to their shopping course.

ü Bargaining power of suppliers: MODERATE

-Price sensitivity: Suppliers engage a competition’s price with other companies for the same product. Popular brands allow suppliers to charge retail grocers higher prices due to consumers demand for these products. Nevertheless, retail grocers also compete with each other on price for to get product at the lowest cost from suppliers and large retailers have substantial buying power in the industry and suppliers cannot afford to be price sensitive if they want to sell their products.

-Relative bargaining power: Suppliers have a high relative bargaining power when they sell a specialty product that buyer cannot find anywhere. But the industry has a lot of retail grocers and substitute suppliers are available and consumer demand is high for many popular brand name products that these suppliers produce.

ü Rivalry among existing firms: HIGH

-Concentration: Retail grocery industry is very concentrated (about 120 000 stores within the US). Within this industry very concentrated, each year the firms are able to increase their sales growth but slowly and moderately. It means the consumers having many shopping alternatives and the industry have reached excess capacity (Supply > Demand) and limited demand is due to a slow US population’s growth (near 2%/year)

-Exit barriers: Retail grocery store industry doesn’t face to high barriers because the majority of companies own and operate their stores and distributions centers and there are no costly regulations leaving the industry.

-Differentiation: Companies need to differentiate themselves by offering a unique product mix or more services such as gasoline stations (such as Kroger) or online ordering.


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ü Bargaining power of buyers: HIGH -Price sensitivity: Consumers choose what they want to allocate as money to the different products. That is why

many retailers, such as Kroger, carry its many of its own name brand products that people typically wish to buy and at cheaper and affordable price.

-Relative bargaining power: Most of grocers carry the same products and consumers lose no money by purchasing their products at different store location. Financial Analysis

The company is rated Baa2 at Moody’s Investors Service, the second-lowest investment grade, and an equivalent BBB at Standard & Poor’s and Fitch Ratings. Kroger has a market capitalization of 21.5B. KR has 40 quarters in a row positive sales illustrates that it is an improvement to grow. Notice that Kroger defines a supermarket as « identical » when it has been open without expansion or relocation for five full quarters.

Balance Sheet

Few more signs indicate that Kroger is managing its balance sheet very conservatively; its total debt as a percentage of total capital was reduced during the last twelve months while its cash on hand grew. Total debt now represents 63.38% of total capital compared to 67.22% a year earlier, while the company had $1.10 billion in cash on hand last quarter, 12.73% more than it did at the end of the year earlier quarter. These developments enhance the company's substantial flexibility in pursuing future growth opportunities and improve total returns to its shareholders.

§ A high level LT debt burden:

The total LT Debt of Kroger is 7.9billion, which it represents approximately 40% of its total debt accounts. Related to the total debt of the grocery industry ($36.1billion), Kroger represents 22% of the total debt within the sector. Nevertheless the firm continues its debt strategy with the decreasing of $525M from a year ago. The current position of long-term debt has decreased because of its recent financings and its net total debt to adjusted EBITDA ratio has declined to 1.86x compared to 2.08x a year ago. Kroger has not been repurchasing as many shares as he originally expected at the beginning of the year (purely because of the Harris Teeter merger).

This lower ratio shows the flexibility to finance Harris Teeter transaction and KR are now well positioned to reestablish and maintain its targeted 2x to 2x Net total debt to EBITDA ratio in line with its long-term strategy (approximately within 18 months after the Harris Teeter’s transaction closes). For now, the debt growth is sustainable but the company’s Debt to Equity ratio is 1,86x, which is 50% higher than its peers. Kroger has been borrowing aggressive to finance its growth and as a result, may experience a burden

of additional interest expense. The examination of near-term assets and liabilities shows that, even though there are not enough liquid assets to satisfy current obligations, operating profits are more than adequate to service the debt. We expect Kroger to continue the cautious management of its debt.

§ The weakness of the operating cycle:

Kroger has working capital of -1,84 billion. This is 310.37% lower than the sector, and 364.4% higher than that of grocery stores industry. Kroger met some trouble paying back its creditors in the short-term. Accounts Receivables are among the industry's worst with 3.83 days worth of sales outstanding. This implies that revenues are not being collected in an efficient manner but within this industry, the firm is operating in cash basis. Last, inventories seem to be well managed as the Inventory processing period is typical for the industry, at 24.94 days.

§ Embellishment of the ROE:

In FY 2013, Kroger ROE has improved from 15.18% in FY 2012 to 34.94% by increasing its operating and asset efficiencies as well as by taking on more debt (high financial leverage) and also due to net income growth. This means that Kroger is well using its investments funds to generate earnings growth. The retail sector has a ROE of 16.53%.

Income Statement

§ Consistent Earnings over the years: The company has outperformed over the last 3 years with an earnings growth rate of 14% and a sales growth rate of 8% which means that Kroger’s stock reflect a high quality earnings. Kroger is increasing its supermarket sales growth expectations (excluding fuel) to approximately 3% to 3.5% for FY 2013. Total sales (including fuel centers) climbed 3.4% to 30,043M from the prior year last quarter. It is the KR’s 40th consecutive quarter of positive identical sales: a strongest indication of how Kroger is connecting with its customers. Kroger is maintaining its growth objectives for its net earnings to a range of $2,73 to $2,80 per diluted share for the FY 2013. This is consistent with its long-term growth rate guidance of 8% to 11% (excluding the effect of Harris Teeter merger and Tax benefits). Kroger can greatly improve its long-term economic image.

§ Continuing enhancement of margins: Kroger’s Net Income grew up leading to an improvement in Company's Net Profit Margin to 1.87 % (against 2.62% of the


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retail sector’s Profit Margin). Kroger invest heavily in R&D and Sales, General & Administrative Exp. and has some difficulties to controlling its costs about its pricing strategy. The Operating Income grew by 116,2% in FY 2013 to 2,76M while revenue increased by 7.06% putting an Operating Margin equal to 2.86% which is rated below average Operating profit of the sector (5,03%). Although Kroger is below the average of the sector, this one improves the margins as one goes along. But Kroger needs to be watchful regarding the repayment of its debts and payment of its fixed costs. The EBITDA of Kroger grew by 51.4% in FY 2013 to $4,42M this led to an improvement in the firm’s annual EBITDA Margin to 4.56%. Also, Kroger has a good ratio EV/EBITDA compared with its competitors. It means that this company cost 3 times its EBITDA, when this ratio ranges from 5 to 31 for the other companies. Kroger has increased its Gross Profit Margin to 20.56% in last Quarter (compared to 22.79% of the retail sector). Despite a strong overall profitability record, based in large part

on a strong return on shareholder equity, the Kroger’s operating margins are weak and trail its peer average. That is why, it is essential in this business and competitive environment that Kroger holds and manages its margins fairly stable to limit their decline, so it could run toward a good future stability.

• Impressive EPS growth over one year Kroger’s annual EPS from continuing Op. for the FY 2013, more than doubled to 175,26% to $2,78 from $1,01 achieved a year ago. Indeed, Kroger’s growth rate for EPS improved from -42,29% decline in the FY 2012. It reflects perfectly the outperformance of the value of the firm’s stock. Statement of Cash Flows

Kroger has generated an average of 2.136B in cash flow a year over the past 10 years or the life of the company. During FY 2013, Kroger plans to use CF from operations to maintain its current investment grade debt rating, repurchase shares, pay dividends to shareholders and fund capital investments. Also, the net CF from Operating and investing activities enable, partially, to solve the L-T debt.

• Company’s Cash Flow very well managed The Kroger’s cash flow grew considerably in its latest quart to $1,62 billion (+ 552,02%) from $248 million reported a year ago. Kroger’s Cash Flow was 39,73% higher than the FY 2012, a nice increase but quite lower than the current pace. We expect this upward trend should boost its margins and overall profitability in the next few quarters.

§ Accumulative CAPEX trend: KR saw improvement in CAPEX growth trend, posting cumulative 12 months CAPEX growth of 8.97% year on year and higher than company's average -6.56%. Company had second best Capital Expenditures growth in Grocery industry. Indeed, KR spends large amounts of capital (2.06B) buying new equipment or investing in new facilities to stay competitive. Over the LT, those costs may have to be fuelled by debt.

§ Good dividend history: Even if Kroger has not consistently paid dividends over the past 10 years of the life of the company Kroger has distributed dividends for the past 6 years. Its dividend yield is 1.67% for the FY 2012 and the dividend paid per share increased to $0,165, this led to improvement in dividend payout ratio to 25% for the last quarter 2013 and 18,05% for the FY 2013. Nevertheless, the payout ratio fells compared to one year ago (FY 2012 payout ratio: 42,57%) due to an excessive increase of EPS by 174,26%.

§ Strong history of stocks buybacks: Kroger has a strong history delivering increased value for shareholders in the form of stock buybacks with in FY 2012 7,59% of shares bought backs and during the last quarter of FY 2013, Kroger bought back 3,6M common shares for an amount of $148M. These have helped Kroger increase each shareholder’s relative ownership stake in the company, due to fewer shares out and holding the same number of shares. Over the last four quarters, Kroger has returned more than 752M to shareholders through share repurchase and dividends as a result of its strong financial position. Kroger intends to continue its quarterly dividend and share repurchase program while managing FCF to reduce the leverage taken on form the merger of Harris Teeter. Although, the ratio will increase at the time the merger closes, Kroger expects to allocate some FCF to debt reduction to reestablish and maintain its 2x – 2.20x net debt to EBITDA ratio over 18 months. Valuation

In our valuation, we totally use four different valuations: a DCF model (FFCF and OFCF), a comparable analysis and a dividend discount model. These methods take current market information as well as forecasts into account. We value Kroger at a target price of $44,35 by applying the mean between the DDM and FCFF models.

• DCF Valuation


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The DCF model allows calculating the intrinsic value of the company as well as displaying its ability to generate cash flows. Because Kroger’s strategy is the expansion overall the country, its growth is in a large share, the result of abundant mergers. We used to calculate a target price by the both, OFCF and FCFF methods, the Cash Flows projected on the next 6 years horizon plus a terminal value (2013 to 2019). We determinate a Weighted Average Cost of Capital of 9.80%.

FCFF: Free Cash Flow for the Firm The FCFF reflects the real cash flows value of the company and accounts for future LT-growth. By the FCFF we can better emphasized on CAPEX generated by the intensive investments of the firm. This approach gives a target price of $42,05. We expect in our calculation, the compound annual growth rate (CAGR) during the next 10 years to be about 6% representing the annualized 10 gains that Kroger will earn over its investment. Nevertheless, the forecast about Kroger Company has

estimated a growth of a CAGR to be 12% between 2013 and 2015 because Kroger is launching organic products and it will be very profitable.

Forecast: sales Growth by 5,6% driven by the merger In the past, Kroger has been able to maintain its sales momentum despite consumer caution and overall sluggish economy. Kroger benefits of its customer 1st strategy by cutting costs and reinvesting the savings into lowering prices on some items that is lead to improve and build customer loyalty and boost the sales. Looking forward 2014, the projected revenues of Kroger are based on several ways. Firstly, Kroger will plan to invest to meet its customer’s health and wellness needs (Pharmacy and Little Clinic businesses) to continue to earn market’s part and to boost sales. Then, corporate brands will continue to gain market share (now representing about 26,1% of total units sold). At the same time, Kroger will plan to continue increasing capital investment over time. That is why, we expect for Kroger a 2,8% of sales growth rate for 2014 (and time to be set up with Harris Teeter merger). For 2015, 2016 and 2017 we can forecast a sales growth rate to 5,6% mainly due of the effects and benefits of the merger. As a defensive industry, food sales are not to tend to change with the economic cycle, so our projected sales are expected to show a continue growth over time and to converge to a long-term growth rate of 3% starting in 2018. Moreover, the firm will plan to raise its capital by some share buyback programs.

Forecast: Improving EBIT margin from 2015 due to better costs efficiency From historical years ended, EBIT Margin is fluctuated around a range of 1,4%-3,4%. It is due to its several mergers, which show how Kroger Company has grown over time. It is significant to notice Kroger knows how to ally at the same time the high cost if an acquisition while continuing its policy of decreasing costs. For the projected years, EBIT Margin are expected to turn around 2,9%-3,2% from 2014 to 2017 and then increase and stabilize from 2018 to converge to 4,0%. Kroger needs to increase its EBIT Margin if it wants to be profitable in regard to its operations, especially for its external growth and conquer into a very competitive industry.

Forecast: An important increase CAPEX until 2017 before to coming back to stable level of investment Depreciation is increasing significantly because during the last few years, Kroger had literally increased capital expenditures and financial borrowings in order to generate an aggressive external growth. Indeed, thanks to its aggressive growth plan,

describing the company’s outlook following the last acquisition of Harris Teeter Supermarkets, Kroger is in accord with its major goal: to continue to earn market share gains in order to keep its competitive advantage within the domestic US country. In our forecasts, we set the CAPEX by considering the growth rate of sales in order to follow its aggressive plan and to be consistent with its available resources. Also, Kroger will add square footage in markets where it believes its business model is already resonating with customers and thanks to its future better presence, Kroger will can grow its market share and its ROIC. Nevertheless, from 2018, we forecast Kroger will reduce its CAPEX as far as its strategy of expansion will be well settled and where, it will be time for Kroger to focus more in the repayment of its debt.

Forecast: Net Working Capital is increasing negatively as a sign of business efficiency As a result of its expansion and its high CAPEX, Kroger cannot easily to collect cash but generates cash very quickly and needs to have a low inventory. It is also due to the reflection of its increase of borrowing. That is why, we expect for Kroger a highly negative increasing of NWC until 2019. Then, Kroger will has to probably increase NWC by negotiating with its suppliers. By a result of the increase of NWC, Kroger’s ROC is decreasing despite the light increasing of its margins to 7,01%. But Kroger is using its resources efficiently, notably for its expansion growth. Kroger increased its ROIC recording a 13,42% ROIC this year compared to 13,34% a year ago. As Kroger increase capital, it will be more difficult to grow ROIC in the near term. However, as these investments mature, we expect them to accredit to ROIC.

OFCF: Operating Free Cash Flow The OFCF giving us the amount of Cash Company generated form the revenues it brings in (excluding cost associated with investments). It is important to distinguish the difference between OFCF and FCFF in the case of Kroger to highlight the weight, which it gives for its external growth. OFCF model is less appropriate here, but in terms of comparison, this model is interesting. The target price from this model is $36,52.

• Comparable Company analysis:

After trying to select a peer group company as similar as possible to Kroger we saw that there are no directly comparable firms to Kroger. Indeed, Wal-Mart and Costco are significantly huger but they reflect with consistency the US Retail Industry. Also, these firms are all subject to the same external factors.


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To determinate the Kroger’s current value, five valuation metrics were examined: EV/EBITDA; EV/Sales; EV/EBIT; trailing P/E; forward P/E and MBR. Then, we applied the mean and median of these valuation ratios, but at the end, we will retain the median, a more robust statistic than the mean. Also, for to have two approaches value of the current value share price of Kroger, we took for the 1st calculation an average of a price on 6months-base and for the 2nd calculation, the price on the Nov. 25th 2013 for to have a better point of view. Peers group comparison- 6 months price average

Peers group comparison- Price at Nov 25th, 2013 By the comparable method, our results varied. Indeed, by taking separately each metrics, we saw that the range is large. The forward P/E indicates a $49,27, which is overvalued, but with the outperformance of the firm, it should be realistic for the future overview. The EV/EBITDA, the EV/EBIT and MBR ratios all showed that Kroger’s observed share price, in a range of $31,10 – $36,98, was undervalued. For 2014, with the median first, we found a target price given by our 2 comparable methods (6months base and price: Nov 25th) is $43.05, which is fairly valued. It was computed by taking the average of our 5 valuation metrics. Then, with the mean, we did the same method and we found a target price of $44,96, which is overvalued. Notice, that we decided to retain the median ratios average for our comparable method, so the $44,96 target price. This estimated price shows an upward potential to the current stock level of $42,56. Kroger’s P/E ratio is on average at 13,41 and is expected to reach 14,3 at the beginning of 2014. Both share price and EPS are expected to grow next year, however since Kroger shares is outperforming the market, P/E ratio should slightly decrease at the end of 2014 until 2018.

• DDM: Dividend Discount Model This approach gives a target price of $46,65. For this model, we made some estimates in order to have a fair value of the stock. We projected our model over 5 years. Our first forecast is that we applied an unchanged cost of equity of 9,82%, which is calculated according to the CAPM model. Then, Kroger is currently paying a dividend of $0,165 per share (that is represent $0,5 for the FY2013). 2014 EPS is projected at $2,81 implying a payout ratio of 20,94%. We expect a long term to continue and dividend will eventually grow with the effects of Harris Teeter merger, few years after the setting up of this acquisition. The Kroger’s ROE of 35,54% and payout ratio give us a retention rate of 79,06%, so an implied growth rate (ROE*Retention rate) of 28,09%. This growth rate is strongly affected by the merger, which will lead to offer more value to the shareholders. Even though Kroger has a good history of paying six consecutives years of dividend increases, our model is based on estimates and we have to be prudent on the process due to the impact of the economic downturn. Valuation summary:

In the final valuation process, we choose to overweight by adjustment of both of the FCFF and DDM models (representing both 80% of the final price). Indeed, as we said, these models both reflect at best the intrinsic value of the company but also, its strategic choices. While OFCF don’t take into account the capital investment, the FCFF allows having an unbiased overview of the specific plans and strategy of Kroger. By applying the mean of the FCFF ($42,05) and DDM ($46,65), we estimate the Kroger’s share value today at $44,35, thus reflects in a fair way the actual market price. The OFCF method ($36,52) is weighted at 5% of the final price, the comparable method ($43,05) at 10% and the DDM method ($46,65) at 30%. In our judgment, there will be further upside potential as long as the acquisition and growth strategies perform well.


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Investment risks

As companies in the retail food industry, Kroger is exposed to a several number of risks. Kroger tries to manage each risk with high-end solution, however some risks cannot be avoided and need to be closely monitored. Market risks

• Competition risks Kroger competes against specialty stores and e-commerce businesses. Since few recent years, retailers are competing on the basis of low prices that took an accelerating pace. These competitors may have a really impact in terms of market share. Although Kroger has a strong dominant localization over the US country, the international presence of its peers could be harmful for the future expansion.

• Unseasonable whether risks The retail food industry is highly correlated with the consumers ‘tastes and expectations, which is strongly reliant on the sales growth. Indeed, Kroger has to plan its sales based on seasonal merchandise trends but if seasonal whether patterns change unexpectedly, demand for certain merchandise could decrease, potentially resulting in reduced sales and excess inventories.

• Interest rate risks Kroger has a high debt burden and a high outstanding borrowing level to the banks. Although, Kroger is endeavoring to reduce its bank borrowings and other debt through various means, its bank borrowings and other debt may increase further in conjunction with its growth strategy. If short or long term interest rates rise, the resultant increase in borrowing costs could adversely affect the firm’s operations, financial condition and earnings.

• Consumption tax hike risks Many states provide exemptions for some specific types of goods and not for other types. Certain types of foods may be exempt, and certain types taxable, even when sold in a grocery store for home consumption. Other things being equal, if consumption tax raise, personal consumption can temporarily fall or to be switch to food of first necessity which is not concerned about taxes.

• Real Estate price appreciation risks Kroger acquires and leases real estate in its retailing and development operations. If real estate prices rise, Kroger’s expenditures would increase. Additionally, if the risk of owning real estate increases due to amendment of laws related to real estate or changes in accounting standard, the firm earnings could be affected.

• Liquidity risks The inability to meet funding needs at an affordable price and if the markets went haywire tomorrow and Kroger could no longer borrow at 6% and investors instead demanded 30%n it would make no sense for Kroger to issue bonds. In consequences, Market liquidity would have dried up and the stockholders would have to be worry about Kroger coming up with enough cash to wipe out all its debt. Also, it is the inability to meet cash obligations when payment is due. Strategic risks

• Quality and food safety risks Consumer concern about food safety and quality assurance became intensified over the years due to of several cases (avian influenza or horse meet crisis for example) and food contamination is actually a really worry to the consumers. Kroger has to be vigilant to its 40 manufacturing plants and need to deploy strong safeguards to ensure food safety and security. If Kroger fails for any reason, the trust of consumers could be fully affected and sales to decline highly.

• Inventories risks If a supplier is late on the delivery of a product or if the product cannot be suitably stored by for lack of square or of means (lack of installations, cold rooms…), the effects for the company could be considerable as a loss if its brand image. Indeed, if the consumer cannot find its product in store, he will switch to another supermarket.

• Integration risks Driven by its subsequent external growth, Kroger’s ability to convert acquisition into efficient organic growth entities depends on its potential to yield the expected return on the investment. Catalysts: -Sovereign debt ceiling crisis in US and government shutdown impact. -Hostile takeover: there is no assurance about antitakeover measures that will be legally valid or effective as a defense. -Corporate Social Responsibility in response to a heightened focus from a variety of stakeholders on how businesses manage social, ethical and environmental risks throughout their supply chains, companies are looking closer at their relating practices. -External competition from Europe’s retail food industry and their occidental products and way of consumption.


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Investment Summary We initiate coverage on The Kroger Company with a HOLD recommendation, as we believe that admittedly, its dominant position among the nation as the largest grocery retailers enables Kroger to sustain top-line growth, expand store base and boost market share. We also believe FY 2013 present enormous opportunities to increase supermarket sales, alleviate gross margin pressure and improve operating margin. In our view, Kroger’s long-term earnings per share growth rate target of 8% to 11% seem achievable. However, soft economic recovery may affect consumer-shopping pattern. Moreover, higher debt-to-capitalization ratio of 63,4% may hinder financial flexibility. That is why, currently, we believe in our HOLD recommendation on the stock. Kroger manages revenue by diversification…

• Geographical domestic diversification: Kroger revenue is spread on the overall US territory operating with its four formats stores. (Combo-stores – Multi-department stores – Marketplace stores – Price impact warehouses).

• Product diversification: Kroger generates revenue thanks to its 3 types of products: Private Selection (Best quality) – Banner brand (Good and healthy items) – Value brand (basic low prices products).

• Customer diversification: Near of 39% of customers would recommend the store brand product to their close relations. (Source: Mintel 2011)

… And investing in US area with a unique goal: to cover all the US area…

• Major Capital Projects: Management continues to deploy intensive capital to concentrate more on remodels, merchandising and other viable projects. These include nearly 40 to 50 major capital projects comprising opening new stores, expansions and relocations and 130 to 160 remodels.

• Expansion strategy by acquisitions: Kroger remains optimistic about its acquisitions of Harris Teeter that would boost the company’s sales. It will provide Kroger with an opportunity to expand its footprint in high-growth markets including Delaware, Florida.

…. In order to attract the shareholders confidence.

• Shareholder friendly moves: Kroger is actively managing its capital, returning much of its free cash flows to shareholders via share buybacks and dividends. Kroger last raised its quarterly dividend by 30%. The company expects to enhance shareholder’s return buy approximately 10% to 13,5% in the long run, including 2% to 2,5% through dividend.

But Kroger needs to have a disciplined business attitude because…

• Consumers may tread to cheaper brands: the recent economic downturn and heavy job losses have transformed the way consumers used to shop. Cash-strapped consumers are now prioritizing their purchases, trading down to cheaper brands and shopping for groceries at very low price leaders like Costco or Wal-Mart. We believe Kroger has to be much more vigilant about its marker share, and should make enough effort to retain customers, otherwise that may affect its top-line performance.

• Competitive pressure: The grocery business is highly fragmented and Kroger faces intense competition from big

players in respect to price, aggressive store expansion and promotional activities to drive traffic/ this may dent company’s sales and margins.

• Higher Debt-to-Capitalization ratio: Kroger is reflecting a debt-to-capitalization ratio of 62%, which is

substantially higher, and could adversely affect the company’s credit worthiness and make it more susceptible to the macro-economic factors and competitive pressures.

• Failure to renegotiate contracts: Most of Kroger’s employees are protected by more than 300 collective

bargaining agreements with the unions. Should the company fail to renegotiate new contracts on their expiration with the unions, it could lead to work stoppages and operational disruptions.

… That is why Kroger has to be vigilant for to well-manage its future improvement.


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Appendix Table of Contents

1. Business Description

a. Fig 1: Subsidiaries of Kroger b. Fig 2: The 47 Manufacturing plants ‘location c. Fig 3: Geographical positioning ‘map of Kroger and Harris Teeter d. Fig 4: Shareholder’s structure & Corporate governance

2. Industry Overview and Competing Positioning

a. Fig 1: Key Value Drivers b. Fig 2: Porter’s Five Forces Model c. Fig 3: SWOT

3. Financial Analysis

a. Fig 1: Income Statement b. Fig 2: Balance Sheet c. Fig 3: Statement of Cash Flows d. Fig 4: Key Financial Ratios e. Fig 5: Altman Z-Score f. Fig 6: ROE Analysis g. Fig 7: Sales and sales growth h. Fig 8: Operating and Profit Margins i. Fig 9: CAPEX j. Fig 10: Pharmacy and Fuel Sales k. Fig 11: Current assets l. Fig 12: Peer Group Net Debt/EBITDA m. Fig 13: Peer Group EV/EBITDA n. Fig 14: Kroger Leverage (Debt/EBITDA)

4. Valuation

a. Fig 1: WACC b. Fig 2: OFCF c. Fig 3: FCFF d. Fig 4: Comparable Valuation e. Fig 5: DDM


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Business Overview Figure 1: Subsidiaries of Kroger Company and their locations Source: Kroger Fact Book 2012 At the end of Fiscal 2012, Kroger operated (either directly or through its subsidiaries) 2,424 supermarkets, 1,169 of which had fuel centers. Approximately 45% of these supermarkets were operated in Company-owned facilities, including some Company-owned buildings on leased land. And 53% of the convenience stores operated by subsidiaries were operated in Company-owned facilities.


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Figure 2 : The 47 Manufacturing Plants of Kroger Co. Source : Kroger Fact Book 2012


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Figure 3: Geographical positionning Sources : Kroger Fact Book 2012, Harris Teeter.com

Figure 4: Shareholder’s structure & Corporate governance Source: Yahoo finance.com


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Industry Overview and Competing Positioning Figure 1: Key Value drivers of Kroger Source: Kroger.com Checklist analysis of the four key value drivers:

• Innovative Value: “QueVision Technology” -Reduce the time shopping experience by its new technology that can speed the checkout line to 26sec’. -Complete before the year’s end the installation of overhead infrared sensors in all its 2,424 supermarkets because results were immediate and boost sales-per-unit have really improved. -Fire upward the whole opinion of the store’s performance in the next months thanks to this technology deployed.

• Customer Value: “Aggressive growth plan through its Customers 1st Strategy” -Appraise the store’s performance with its own program “Shopper experiences” based on the customer’s feedback. -To cut-down high expenses research cost thanks to its unique Customer Data Research based in personal customer’s information -Adopt a Consumer-Centric-Approach by understanding the emerging and new needs of its customers by launching organic products.

• Margins Value: “A real enhancement” -Kroger’s Net Income grew up leading to an improvement in Company's Net Profit Margin to 1.87% à controlling its costs about its “low” pricing strategy. -Enlargement of its Operating Margin putting at 2.86% è more ability and flexibility for the payments of fixed costs (such as interest debt) -Increase of its Gross Profit Margin to 20.56% and an improvement in the firm’s annual EBITDA Margin to 4.56% è allow to Kroger in this business and competitive environment to manage and doing a good future stability holding its margins fairly stable.

• Shareholders Value: “Raising for Dec, 1.2013 its quarterly dividend by 30%” -Increase of shareholders’ return, but also boost earnings per share and raise the market value of the remaining shares -Kroger bolster investors' confidence on the stock, thereby persuading them to either buy or hold the scrip instead of selling them. -Kroger remains confident of its potential growth, suggesting enhanced value for shareholders. Indeed, Kroger expects to generate shareholder returns of 10% to 13.5% over the long run. Value driver’s Conclusion: KR earns a Value Creation TM rating of excellent à the firm will continue to expand and generate economic value for its shareholders => improve its sales-unit growth over the next 12months from its first objective: the satisfaction of its customers.


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Figure 2: Conclusions of The Porter’s Five Forces Model – Retail Grocery Industry Sources: Kroger.com, Supermarketsnews.com Threat of new entrants: LOW

à We can say new entrant face many different challenges and they can be very effective if they establish a healthy relationship with the suppliers with exclusive access. They must have differentiated product or provide specialty services and they can offer attractive services such as take-out orders, loyalty cards, prepared foods and internet shopping.

Please, note that grocers within the industry already have a strong and smooth relationship with their suppliers and it will be a disadvantage for the new entrants.

Threat of substitute products: LOW

à Substitute products are not a major threat to the retail industry because the quality of substitutes available is low and majority of retailers carry the same general products.

Bargaining power of suppliers: MODERATE

à Bargaining power of suppliers is very important in the determination of the final price system. The power is moderate because both suppliers and retailers need of each other to be profitable. It depends of two major factors: how big the retail grocer is and how popular the brand the supplier is selling.

Rivalry among existing firms: HIGH

à Industry very concentrated and majority operate their own stores and distribution centers and this increase the firm’s fixed coast in the industry because companies accrue maintenance and overhead cost. Nevertheless, fixed costs are offset by variable cost of goods sold. COGS are the second highest cost retail grocery. Indeed, grocery stores need to move large quantities of products (to be different) in order to be profitable in this low margin industry; leading to high inventory turnover and an increase in variable cost in the industry.

Bargaining power of buyers: HIGH

à The main power that the consumers have is the price sensitivity of products within the stores and the relative bargaining power that consumers have over the variety of stores. Retailers have to follow a low cost approach to be attractive. It is important to notice that buyers affect the nature of company’s business strategy (differentiation strategy or low cost approach).

To conclude we can say that the retail grocery industry is a very mature market involved in intense competition. Large retail grocers have a competitive edge in the industry due to their efficient distributions place and their purchasing power. Companies deal with critical issues such as slow growth, high concentration, lack of opportunities to differentiate product offerings, low consumer switching cost and a high excess capacity. Small grocers can be effective if they develop a niche product.


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Figure 3: Details of SWOT Analysis Sources: Kroger.com, Fact Book 2011 – Fact Book 2012

SWOT

Strengths Weakness -‐ Strong vertical integration -‐ Three categories of product -‐ Launching Organic Product -‐ Customer Service Focus

-‐ Workforce Unionization -‐ Legal issue -‐ Risk of Food Contamination -‐ Lack of ecommerce

Opportunities Threats -‐ Strategic expansion plan -‐ An unique “Walk-in-Medical”

Clinics -‐ Very strong external growth -‐ One-stop shopping

-‐ Low marginal profits -‐ High Debt weight -‐ Obscure Confidence Trend Index -‐ International presence -‐ Cyclical cost of petroleum

Strengths

-‐ Strong vertical integration of the business: Kroger operates around 40 manufacturing plants for processing, packaging and manufacturing private label products. These manufacturing capabilities allow for more efficient quality control and efficient distribution to stores.

-‐ Three axes of product: Kroger offers products sold in three categories: premium (high grade), brand (medium grade) and budget (low grade) and it allow to customer to select multiple product classes. This branding approach enables the company to meet the demands of its customers and offer them savings opportunities that are not given by other brands.

-‐ Launching Organic Product: Kroger is trying a new organic food program “Organics for Everyone” introducing a wide variety of organic products. Kroger wants to capture the customers who are becoming more health conscious with its fat-free and cholesterol reducing products.

-‐ Customer Service Focus: Kroger has a solidity customer loyalty through its own corporate brands providing a key competitive advantage. About 14,000 of its own corporate brands are sold in each of its stores.

Kroger also have developed a customer service training programs to improve upon their “Customer 1st Strategy” and a unique program “Secret Shoppers” allows them to evaluate their store performance from the shopper’s perspective.

Weaknesses

-‐ Workforce Unionization: Kroger’s unionized workforce puts it at a competitive disadvantage when compared with its peers Wal-Mart, Costco or Safeway. Its competitors enjoy lower labor costs and other operating efficiencies.

-‐ Legal issue: Kroger has faced a relatively long list of legal issues stemming from its acquisition of Fred Meyer and Ralph’s Grocery and using illegal hiring practices in theses chains.

-‐ Risk of Food Contamination: the corporate profit of the company can easily be threatened if any of the forty manufacturing plant, especially that of milk and cheese, gets contaminated. As such sensitive operations are very difficult to be maintained hygienically and are very costly.

-‐ Lack of ecommerce: Kroger operates just as a caterer for meal already made and customer cannot pass an order to grocery products.

Opportunities

-‐ Strategic expansion plan: Kroger is completely focused in domestic markets with a goal to cover maximum locations with a mission a reduction of operating cost. This strategy help the company enhance its in-store store productivity and to penetrate new markets. Kroger has leverage synergies across the country (East and West) thanks to its solid implantation within the states and its multiple formats stores.

-‐ An unique “Walk-in-Medical” Clinics allows a strong positioning to Kroger in the market where the others supermarkets retailer are not present. Kroger’s clinic is able to diagnose and treat common illnesses thanks to licensed nurses and physician assistants; and not just to deliver prescriptions as CVS or Walgreen.

-‐ Very strong external growth as a result of its many mergers over the time. -‐ One-stop shopping for some Kroger’s supermarkets, fuel center and pharmacies in order to have an incentive in the

competition with Wal-Mart and also, making solution for customers 24 hours needs. Threats

-‐ Low marginal profits due to an increasing transportation costs and high inflation rates -‐ High Debt weight: The debt of the company rising to almost $8 billion is again a sizeable threat. A large

percentage of debt has gone toward the implementation of its restructuring, remodeling and new store opening projects.

-‐ Obscure Confidence Trend Index: The slumping economy continues to have a negative impact of consumer expenditures.

-‐ International presence of its peers


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-‐ Cyclical cost of petroleum can be impacted real growth sales of Kroger which own 1,161 fuel centers

To conclude, Kroger is a well-established organization with a culture of both innovation and customer service/loyalty programs. The well-defined values of the organization help to maintain a strategic edge by offering a well-managed brand image. While the company is not without its external threats, a long standing history of 140 years of operation have proven that this company has the flexibility and know-how to maintain its market share without compromising its values, and in some cases perhaps increasing them. Financial Analysis Figure 1: Income Statement Source: Yahoo Finance.com


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Figure 2: Balance Sheet Source: Yahoo Finance.com


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Figure 3: Statement of Cash Flow Source: Yahoo Finance.com


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Figure 4: Key Financial Ratios Sources: Yahoo Finance.com, 4-Traders.com, Nasdaq.com

Figure 5: Altman Z-Score Sources: Yahoo Finance.com, Ycharts.com, and Investepodia.com The Altman Z-Score helps investors to gauge the probability of a company going bankrupt. Generally, firms with a score above 3.00 have a low probability of bankruptcy, and those with a Z-Score of less than 1.81 have a relatively high probability of bankruptcy. Formula: Z = 1.2 x (Working Capital / Total Assets) + 1.4 x (Retained Earnings / Total Assets) + 3.3 x (Earnings Before Interest and Taxes / Total Assets) + 0.6 x (Market Value of Equity / Total Liabilities) + 1.0 x (Sales / Total Assets)


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Kroger has an Altman Z-Score of 5,5 which means that the company is considered to be safe and thus, have relatively remote the risk of bankruptcy. However, there is no single formula that has the power to predict the future but it allows showing the trend of the business over time. About the main peers of Kroger, we can see that the Retail Grocery Industry is approximately into a safe zone. Rather than Supervalu, which has a score very low. Kroger has a lower Probability of Bankruptcy regarding to the grocery stores industry.


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Figure 6: ROE Analysis Sources: Yahoo.finance.com, Y-charts.com Traditional DuPont Decomposition

We see traditional DuPont formula as a simplified but unrealistic model since it puts operating metrics and leverage under the same comparison framework. -Operating efficiency: Kroger has a low net profit margin. In general firms with low profit margins tend to have high asset turnover. Kroger is a perfect example of a business, which has a low profit margin and driving sales through the roof, as customers are attracted to its stores. Indeed, Kroger is driving its sales with low prices politic. -Asset Turnover: Asset turnover ratio at 4,24 means Kroger is using efficiently its assets to generate sales. In a relatively low margin industry, Kroger has to turn assets over faster in order to generate sufficient profit. -Financial Leverage: Kroger has a high gearing ratio at 4,05. It reflects perfectly the high level of the debt of Kroger and also, the fact that Kroger is getting more financing from outside creditors such as banks and suppliers. Also, it would appear that greater gearing increases ROE, but this must be traded off against higher financing costs which reducing profit.


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Figure 7: Kroger’s sales and sales growth Sources: Nasdaq.com, Ycharts.com, Yahoo Finance.com Figure 8: Kroger’s Net Profit Margin & Operating Margin Sources: Nasdaq.com, Ycharts.com, Yahoo Finance.com


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Figure 9: Capital Expenditures Forecasts Sources: Nasdaq.com Figure 10: Historical Pharmacy and Fuel Sales Sources: Kroger Fact Book 2012

Figure 11: Kroger Current Assets Sources: Nasdaq.com


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Figure 12: Kroger Versus its main Peers: Net Debt/EBITDA Sources: Ycharts.com and Yahoo Finance.com Figure 13: Kroger Versus its main Peers – EV/EBITDA Sources: Yahoo Finance.com, Ycharts.com


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Figure: Leverage (Debt/EBITDA) Sources: Ycharts.com and Yahoo Finance.com


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Valuation Figure 1: Weighted Average Cost of Capital Sources: Yahoo Finance.com, CSIMarkets.com, Y-charts.com, and Kroger.com Guidelines: Approach: To determine the cost of Kroger’s equity, we used the CAPM Model and for to calculate the cost of debt, we took the weights of debt and multiplied it by the respective rate. -So, we calculated a Kroger’s WACC by weighting the costs of debt and equity capital corresponding to their market value. Variables related to the WACC include: the cost of debt capital (Kd), the cost of equity capital (Ke), the book value of the debt (D), the market value of equity (E) and the relevant tax rate (τ). Using the CAPM model required us to research information to find risk free rate, market risk premium and relevant tax rate on the disclosures and financials of the firm. -Our beta of 0,62 is the unleveraged beta of the firm based on the FY 2013. -The tax rate of 37,5% is the effective tax rate for 2013 of the firm. -The risk free rate of 3% is the effective 10 Year US Treasury Bond (Sources: http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/) -The Risk Premium is based on the retail Food industry of the FY 2013.

WACC = (E / (E+D))*Ke + (D + (D+E))*(Kd*(1-τ))


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Figure 2: OFCF: Operating Free Cash Flow Source: Yahoo Finance.com, Damodaran.com

Figure 3: FFCF: Free Cash Flow to the Firm Sources: Yahoo Finance.com, Damodaran.com


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DCF Guidelines: -Our DCF Model provides an estimation of the enterprise value one year ahead from now. -This estimation is obtained by discounting all the future OFCF and FFCF generated each year by the company’s level of WACC (Weighted Average Cost of Capital) calculated above at 9,80%. -The g growth rate is expected to be 3% according to our calculation with the consideration of the ROE and Payout Ratio. -We suppose that WACC is > to g. -The discounted Factor is calculated as 1 / (1+WACC) ^ (number of periods out from the current year) -The OFCF are given by the after-tax EBIT, the Net Working Capital change and the Net Fixed Assets change. -The FCFF are given by the after-tax EBIT, the Net Working Capital Change and the Capital Expenditures minus the depreciation. -The tax rate of 37.5% is given by the Kroger’s financials. -EBIT depends on revenues. -To estimate sales growth, we took in consideration the time of the setting up of the Harris Teeter margin for 2014. Then, the firm should benefit of this acquisition with an expected growth rate of 5,6% of growth sales and to converge to stable 3% L-T growth rate starting in 2018 considering the economic downturn. -Administrative expenses are calculated by EBITDA minus Gross Profit -Gross Profit is calculated by sales minus COGS -CAPEX are based on the consideration of the growth rate of the sales plus the expected future projects and investments of the firm. -Net Working capital is linked to revenue and is expected to grow up negatively and considerably according the forecasts. (Seeking Alpha, Last Call Conference).


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Figure 4: Method of Comparable – Analysis Sources: Yahoo Finance.com, Nasdaq.com, and Ycharts.com Guidelines: By this method, we calculated ratios using numbers that are provided by each peer company’s annual reports. This ratios we used include: forward price to earnings, trailing price to earnings, Enterprise Value to EBITDA, Enterprise Value to Sales, Enterprise Value to EBIT and Book Value to Market Value. As you could see in our analysis, this method has generated somewhat fluctuating share prices. Also, we found some extreme values. Theses one are not take into account in our calculation of the Target Price. These valuations are used for simplicity and more thorough analysis (as FCFF, DDM) is necessary using the Intrinsic Valuation of the firm. As we said in the report case, we took two-approaches value of the current value share price of Kroger. For the first one, we selected the all company’s price over the last next 6 months for to have an approach less biased. The second one is just based on the price of the day (the day is consideration is the Nov 25th, day of our calculation work). 1- There, the prices are based on an average of 6 months share price

2- There, the prices are based on the Nov 25th. 2013


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For 2013, the average price given by our 2 comparable methods according to the price-base (6months base and current price: Nov 25th) is 43.05$. (36,98 + 63,68 + 31,10 + 49,27 + 34,21) / 5 = 43,05

• The red values are extremes values and they are not take in consideration in our valuation


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Figure 5: DDM – Dividend Discounted Model Sources: Damodaran.com, Yahoo Finance.com, Ycharts.com Guidelines: By the DDM, we calculated the value of the firm for the shareholders through the expected dividends discounted back to the present. This approach is more precise than using the Method of Comparable. Assumptions: -We are assuming that the stock’s dividend growth rate will be at a constant rate over time -The constant growth rate will continue for an infinite period -The required rate of return (k) is greater than the infinite growth rate (g).


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Reference Page Company’s web sites: www.krogerco.com www.safeway.com www.walmart.com www.supervalu.com www.wholefoods.com www.target.com www.costco.com www.thefreshmarket.com http://www.walgreens.com http://www.familydollar.com http://fr.delhaize.be http://www.cvs.com Financial web sites: www.finance.yahoo.com http://ycharts.com/ http://csimarket.com/ http://www.nasdaq.com/ http://www.4-traders.com/ www.investopedia.com http://www.advfn.com/exchanges/NYSE/ http://www.bloomberg.com/ Business web sites : http://www.retail-business-review.com http://supermarketnews.com/ http://www.foodretailworld.com Damodaran Online Home page Books and Press revue:

-‐ Vernimmen 2011 – Finance d’entreprise – Edition Dalloz -‐ Gestion de Portefeuille et marches financiers – Pascal Alphonse, Michel Levasseur – Edition Pearson -‐ CFA level I – Book 3 – Financial Reporting and Analysis -‐ CFA level I – Book 5 – Fixed Income, Derivatives and alternatives Investments -‐ Wall Street Journal -‐ Kroger Fact Book 2012 -‐ Kroger SEC Filings -‐ End of Q3 FY 2013 Earnings Call transcripts

CFA Challenge Student Research - DoYouBuzz · 2014-05-13 · CFA Challenge Student Research Jan 6th...

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Transcript of CFA Challenge Student Research - DoYouBuzz · 2014-05-13 · CFA Challenge Student Research Jan 6th...