Expect Kroger to Track Market

We believe the combination of rising food prices, rising gas prices, and market share gains should help boost Kroger Co.'s (KR - Analyst Report) top line in the first quarter. However, we don't expect higher sales to translate into higher profit, due to continued pressure on profit margins. We maintain our Hold rating as the stock looks fairly valued at current levels.

Kroger's bull story is supported by its solid top-line growth, operating cost controls, and improving financial health. Several years ago, Kroger implemented a strategy to attract customers with lower prices. This strategy has been the main driver behind its solid sales growth over the last few years. Kroger has used the cash flow generated from its solid sales growth and steady operating margins to improve its balance sheet and return value to shareholders.

However, we remain concerned with Kroger's contracting gross margins, inflationary pressures, and labor issues. The company's sales growth improvements have come at the cost of its gross margins.

What's more, we don't believe Kroger will able to reverse its gross margin deterioration because the highly competitive environment in the grocery business. The business has simply become too price sensitive. This environment is also making it difficult for Kroger to pass along higher product costs, which could pressure sales or hurt gross margins.

Kroger shares are trading at 14.8x our fiscal year 2008 EPS estimate and 13.6x our fiscal year 2009 EPS estimate. We think this valuation is fair and believe the stock's performance over the next six months will track the return of the S&P 500. As such, our target price is $29, or about 15x our fiscal year 2008 EPS estimate.

Read the full analyst report on KR