Core Concepts: Consumer Plays

Shopping in the Grocery Aisles

Grocers compete in a market where demand is constant, but their sector has undergone massive upheaval over the past 15 years. Leaders such as Kroger (KR) and Safeway (SWY) are facing multiple problems, like severe price competition and additional capacity from Wal-Mart (WMT) and Costco. Also, Whole Foods (WFMI) has been gaining market share with its natural foods model.

The financials of Kroger and Safeway provide ample evidence of serious operating issues. Kroger's operating margin has been on the decline, slipping from 7.4% five years ago to 5.5% today. Safeway's operating margins have declined from 10.4% five years ago to 6.3%.

For every $1,000 of sales, then, Kroger is generating $55 in operating cash profit, down from $74 five years ago. That's a 26% decline. Safeway generates $63 in operating cash profit for every $1,000 in sales. That's down from $104 five years ago and represents a 39% decline.

The stocks of Kroger and Safeway are valued at about 18 times earnings. Because these are not compelling growth stocks, buyers of these stocks must be expecting margin expansion. That's a high-risk, low-probability bet, given the steady deterioration in operating metrics over several years. A methodical, long-term margin decline suggests that secular pressures, not cyclical forces, are at work.

In recent months, specialty grocer Whole Foods has stumbled badly, with lower sales comparisons and disappointing earnings. But bargain-hunters shouldn't get too excited by the stock's 40% decline over the past year. This is a case of an overvalued stock falling to reasonable levels, not to the bargain basement.

By the way, struggles at Whole Foods may have been the impetus for the recent $18.50-per-share cash offer for key competitor Wild Oats (OATS). I highlighted Wild Oats in multiple columns a few years ago, and Whole Foods' offer is consistent with my previous calculation of Wild Oats' value.

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