Feb. 16, 2020, 10:32 a.m. EST

Why Kroger Looks So Valuable to Warren Buffett, Even in the Age of Amazon and Walmart

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By 24/7 Wall St.

When it comes to ranking the greatest investors, Warren Buffett has ranked among the best investors of the modern era and he has previously held the title of being the world's wealthiest man on paper. And when it comes to conglomerates, his Berkshire Hathaway, Inc. (NYSE: BRK-B) is the largest of them all with a $555 billion market cap. This is why investors praise and follow the moves of Buffett and any of the portfolio changes inside Berkshire Hathaway's vast capital that is invested in public stocks.

Investors get to see the portfolio changes of Mr. Buffett and Berkshire Hathaway every quarter in the vast slew of 13F filings with the Securities and Exchange Commission. At the end of 2019, Berkshire Hathaway's equity portfolio was valued at a whopping $242 billion. One of the top changes, aside from selling some key bank holdings, was that Warren Buffett's portfolio managers purchased approximately $550 million or so worth of shares in The Kroger Company (NYSE: KR).

Warren Buffett has praised Jeff Bezos and Amazon.com, Inc. (NASDAQ: AMZN), and Berkshire Hathaway even owns close to $1 billion worth of Amazon shares. With the rise of the so-called "Amazon Apocalypse" and "Retail Armageddon" some investors would wonder why on earth Buffett would want to or allow his portfolio managers to risk over $500 million in a grocery store chain.

This is where investors need to understand that Buffett has historically been a deep value investor. The notes inside the actual 13F filing show that the entities under the Berkshire Hathaway umbrella that own the Kroger shares are Warren E. Buffett himself and National Indemnity Co. After Kroger shares popped at the start of November, Kroger spent the rest of the fourth quarter trading mostly between $27 and $29. It is possible that the purchases were made back when Kroger was trading under $25 at the start of the fourth quarter, but Buffett probably wouldn't care if his purchase price was 10% higher or 10% lower in his own long-term value hunt.

It turns out that Kroger would fit into the acquisition patterns of companies that Berkshire Hathaway has rolled into its conglomerate structure. Despite the grocery store dilemma of operating on razor-thin margins, Kroger has the fortitude, size and merchandising that can survive in good times and bad times. Kroger is also likely to withstand the rise of Amazon's Whole Foods, and the $13.7 billion that Jeff Bezos paid for Whole foods compares to a current market cap of $ 22 billion for Kroger. And unlike the big-box retailers, shoppers do not have to pay an annual fee to buy groceries there.

Kroger is not en expensive stock compared to the stock market as a whole. Its valuation when Buffett bought the shares was likely 12 to 13 times expected earnings, handily lower than the 15 to 20 times expected earnings for most other S&P base economy companies.

It also turns out that Amazon decided years ago that it was not going to let Whole Foods run away with the rise of organic and natural foods, particularly after Whole Foods gobbled up its smaller rival of Wild Oats for less than $1 billion more than a decade earlier. Kroger began to have more private-label offerings that come with higher margins than its traditional name-brand lines. Kroger also began to increase its own offerings of organic and natural foods, and if you compare the prices of any of those branded organics and naturals that are identical down to the same SKU numbers it turns out that Kroger is almost always selling it far cheaper than Whole Foods.

Another thing helping Kroger out is that the modern era and the rise of online and omnichannel trends has not destroyed the grocery store model. Grocery chains like Kroger have adapted their model to include an in-store pharmacy and Kroger has many Starbucks stores inside its own store. Kroger has gone with pre-prepared foods for on-site or takeout dining, and it turns out the rise of the so-called "meal kits" that get delivered to your home have been able to be copied on-site and never became large enough to threaten the grocery store model.

Another issue which protects the grocery store model is that they allow for online shopping direct or through third parties, and shoppers can pre-order and pick the order up themselves if they choose to or they can opt for delivery in many locations.

Let's just assume that Warren Buffett wanted to acquire Kroger outright to fold it into the Berkshire Hathaway umbrella. One area that Buffett could maybe lower costs is in the distribution model via rail (it owns BNSF) and with other trucking activities the company already has. Berkshire Hathaway could also perhaps remove the layers of profits that Kroger would have to pay out if it brought many of the vast insurance payments the company has to make under Berkshire Hathaway's insurance operations (and don't forget about the Berkshire health care venture with Amazon and JPMorgan).

Kroger generates over $120 billion revenue at this point, and the wide array of grocery store offerings has somewhat of a recession-proof model if you look at the base sales rather than its premium sales. Kroger can scale up or scale down its premium products at premium prices based on the economy.

Kroger was $40 stock at the end of 2015. It has traded as low as $20 for a very brief period since then (2017, and almost that low again in mid-2019). It's 52-week range is $20.70 to $29.97. Despite the $28.23 closing price on Friday being above the $27.95 Refinitiv consensus analyst target price, Buffett likely owns the stock lower and Buffett professes that he doesn't really care about sell-side analyst research reports and their target prices.

It would be easy to point out that Kroger has faced rising competition over the last two decades from Walmart, Costco, and others. Even the dollar-stores have gotten into food sales. Buffett and his team likely feel like the major growth and impact from those food selling rivals has largely been felt.

It would be hard to determine when exactly Team Buffett bought the Kroger shares because Kroger trades millions of shares per day. That said, looking for volume spikes in the last quarter might pinpoint when the purchases were made. The 18.94 million shares owned by Berkshire Hathaway is close to four days worth of trading volume, so Berkshire Hathaway either averaged in over a time period or larger chunks of shares were purchased on days when they figured they would create the least price swing and without telegraphing "Buffett is accumulating Kroger shares!" to the market.

It's very possible Buffett bought the shares at lower prices earlier in the fourth quarter and that they averaged up later in the quarter. This is still also not even quite 2.5% stake, so Berkshire Hathaway could (or even could have already) buy another 50 million shares before running into the SEC's 10% ownership threshold.

Warren Buffett and his portfolio managers probably are betting that the grocery store model won't be all that different a decade from now. Maybe the number of cars used to get the grocery are less, and maybe the way people actually order their groceries may change. There may be fewer cashiers and their may be more robots inside the stores. That said, Buffett and his team are betting that Kroger will still be a top grocery destination in the years ahead. It's probably a safe bet that food won't be going out of style, even if some food trends rise and fade away in time.

Many investors consider themselves to be so-called "whale chasers" where they also get to invest in the same great companies as investment gurus. That's the case here in Kroger, and it seems easy enough to wonder why Kroger was purchased for a stake. Now the question comes down to whether or not a $22.6 billion market cap is big enough for that elusive "whale of a deal" Buffett says he's always looking for.

This blog is reprinted by permission from 24/7 Wall St, © 2007 24/7 Wall St., LLC All rights reserved.

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