One of the more powerful trends in investing is sticking to must-haves. Generally known as consumer staples, these companies provide products that are needs, rather than just wants.
But one of the more overlooked parts of the must-have industries is food. Specifically, the stores selling food.
Kroger shares are up 47% over the last year while Wal-Mart shares are down 5%. The run by Kroger has been more than impressive, especially given the fact that it’s competing against a non-traditional grocery, Wal-Mart, that sells nearly everything.
The industry is competitive, with grocers competing on price and virtually no switching costs. This, in part, helps keep profit margins for grocers in the low single digits.
Costco (NASDAQ: COST) is also a key player in groceries. Like Wal-Mart and even Target (NYSE: TGT), Costco uses groceries to drive traffic to its stores and then makes money on the sale of other more profitable products. As a result, these diversified retailers generally sell their food goods at a loss, which has been bad news for conventional grocery stores.
Kroger has managed to stave off the big-box store threat given its size. Kroger’s 2,600 stores give it negotiating power in getting volume discounts. It also offers gasoline at over half its stores, which helps drive traffic.
But there could be trouble on the horizon for Kroger and other grocers. The industry might be getting a bit more competitive as two European giants, with large presences in the U.S., are looking to merge. The expected merger of Ahold NV (OTC: AHONY) and Delhaize Group (NYSE: DEG) would create a near $30 billion market cap grocer that would be one of the largest grocery chains in the U.S.
Ahold runs the Stop & Shop and Giant brands in the U.S., while Delhaize operates the Food Lion and Hannaford chains. The idea is that there is money to be saved by combining marketing efforts and distribution networks. This is just the latest in a string of mergers in the grocery industry, including the Safeway (NYSE: SWY) and Albertson’s merger and Kroger’s purchase of Harris Teeter.
Specialty grocers – more specifically, the natural and organic players – have been gaining a lot of traction over the years. The big three remain Whole Foods Market (NASDAQ: WFM), Sprouts Farmers Market (NASDAQ: SFM) and The Fresh Market (NASDAQ: TFM).
However, specialty grocers have really been taking it on the chin. Whole Foods is down 20% year-to-date, as are Sprouts Farmers Market and The Fresh Market.
Kroger recently noted that specialty grocers are still growing market share. Kroger’s CFO, Michael Schlotman, said on a recent conference call, “If I were sitting in their chairs, I wouldn’t necessarily be embarrassed by some of the recent results they’ve had.”
The move toward health and quality make these three grocers enticing. Sprouts Farmers Market and The Fresh Market still have a lot of runway for store expansion. Meanwhile, Whole Foods is finding other ways to grow, which includes opening a chain of stores for budget-focused shoppers.
Whole Foods still enjoys one of the highest profit margins in the entire grocery industry. It has a near-15% return on invested capital, which is an industry top. And if that wasn’t enough, Whole Foods balance sheet is debt-free.
Apart from Whole Foods, The Fresh Market is a top investment pick. Its profit margins are impressive and its return on invested capital is also in the high teens. The beauty of The Fresh Market is that it’s actually cheaper than Kroger.
The Fresh Market trades at a forward price-earnings ratio (based on next year’s earnings estimates) of 16, while Kroger is at trading at a forward P/E of 17.
But the big leg up that Whole Foods has over the smaller specialty retailers is that it offers a 1.3% dividend yield. That also beats the 1% dividend yield that Kroger is offering.
In the end, everyone still has to eat. And while the large grocers are a great way to play this fact of life, it might be the specialty segment of the grocery industry that is most appealing, since it has less competition and more room for growth.
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