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One of the biggest mergers of 2017 came on June 16, when e-commerce titan Amazon (NASDAQ: AMZN) announced it would acquire specialty grocer Whole Foods Market (NYSE: WFM) for $13.7 billion.
The news carries major implications not just for the two companies involved, but the entire grocery industry. Share prices of all major grocery stocks, including Kroger stock, crashed on the takeover announcement.
Kroger (NYSE: KR) in particular has had a very rough year. Kroger stock has lost one-third of its value year-to-date, and the Amazon-Whole Foods deal only added to shareholders’ misery.
However, investors should view the merger in the proper context. It will likely have a minimal impact on Kroger. That’s why the best way for investors to play the Amazon-Whole Foods deal might be to buy Kroger stock.
Kroger is Down, Not Out
Kroger has suffered alongside other grocers this year, due to industrywide challenges. Specifically, deflation in the price of groceries has caused margins to contract, which is especially painful, because grocery is already a low-margin business.
Because of this, Kroger lowered its 2017 earnings forecast at the beginning of the year. The company now expects full-year GAAP earnings of $1.74 to $1.79 per diluted share. Adjusted earnings, which excludes non-recurring expenses, is forecast in a range of $2 to $2.05 per diluted share. Previously, management guided to adjusted earnings of $2.21 to $2.25 per diluted share.
This is a significant reduction, and is largely the result of falling grocery prices. However, sales are expected to hold up — Kroger sees the potential for flat to 1% growth in comparable-store sales this year, a key metric that indicates sales at stores open at least one year.
There is another major reason why Kroger’s earnings are expected to be much lower than originally anticipated. That is because the company is investing heavily in technology. These are necessary investments to adapt to a changing retail landscape.
Kroger shares sank on the news of Amazon’s acquisition of Whole Foods because of the intensifying competitive pressure in the grocery industry. Investors fear that Amazon could use Whole Foods as distribution points for its grocery delivery service, which could disrupt traditional brick-and-mortar supermarkets.
However, these fears are largely unfounded, which makes Kroger a compelling bargain at its depressed share price.
Kroger Isn’t Going Anywhere
It is understandable for Kroger investors to be terrified of Amazon. In theory, what Amazon did to department stores, it could conceivably do to grocery stores as well. But in reality, there is very little overlap between either the geographic location of Kroger’s and Whole Foods’ stores, or their respective customer bases.
Whole Foods caters to affluent customers, primarily millennials, in densely-populated urban centers. These markets are much more receptive to grocery delivery, which explains Amazon’s takeover offer. At the same time, Kroger is not in these markets, and its customers are primarily older, and more price-sensitive.
Amazon is paying a huge amount — nearly $14 billion — to buy Whole Foods, which has approximately 440 stores in the U.S. Meanwhile, Kroger’s market cap is barely above $21 billion, and it has more than 2,000 stores in the U.S.
Either Amazon is grossly overpaying for Whole Foods, or Kroger is massively undervalued. The latter seems to be more convincing.
Even with its reduced guidance, Kroger shares trade for just 11 times forward earnings guidance. And, there is still potential for Kroger’s future earnings to grow. The company is making huge investments in grocery pickup through its ClickList offering. That service is now available in more than 600 locations. This could help it continue to take share from its major competitors like Safeway and SUPERVALU (NYSE: SVU). In fact, Kroger has taken market share in the U.S. for 12 consecutive years.
Kroger Stock is a Buy
Kroger stock is suffering from deteriorating sentiment, but the fundamentals remain intact. The company grew sales last year, and will likely grow sales this year. Its long-term guidance calls for 10% earnings growth each year, which is attainable, especially since its strong cash flow is being deployed to repurchase shares.
Kroger recently announced a dividend increase, and a $1 billion share buyback, which represents nearly 5% of the market cap. As a result, Kroger stock looks attractive on valuation and for its dividend growth.
Disclosure: The author is personally long KR.