Kroger Outperforms, Stays a Hold

Kroger Co. (KR - Analyst Report) reported better-than-expected results for the first quarter but maintained the high end of its fiscal 2008 EPS guidance. We are increasing our sales and earnings estimates to reflect the upside in the first quarter.

The combination of company’s low prices and private-label brands are leading to market share gains and driving the company’s results. Still, we remain concerned with Kroger’s contracting gross margins and rising food and energy prices that could cause consumers to trade down from Kroger stores. The stock looks fairly valued at current levels. We maintain our Hold rating.

We expect further operating cost improvements that should enable the company to generate an operating margin of 3.34 percent in fiscal 2008 and 3.41 percent in 2009. Kroger has also 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, inflationary pressures, and labor issues continue to be our concerns. Not only has the business become too price sensitive, most of Kroger’s workforce is represented by a labor union, which could put upward pressure on wage expenses.

Kroger shares are trading at 14.5x our fiscal year 2008 EPS estimate and 13.1x 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