An Equity Valuation and Analysis of
Kroger Co.
As of November 1, 2007
Brandon Dunn
Cliff Fielden
Trey Keith
Sean Murass
brandon.dunn@ttu.edu
cfielden2@yahoo.com
trey.keith@ttu.edu
murass02@yahoo.com
0
Table of Contents
Executive Summary……………………………………………………………………..……………..4
Business & Industry Analysis…………………………………………………………….………..11
Company Overview………………………………………………………………………….11
Industry Overview……………………………………………………………………………13
Five Forces Model………………………………………………………………………………………15
Rivalry Among Existing Firms…………………………………………………………….16
Threat of New Entrants…………………………………………………………………….24
Threat of Substitute Products……………………………………………….…………..28
Bargaining Power of Buyers…………………………………………………….………..30
Bargaining Power of Suppliers…………………………………………………….…….32
Value Chain Analysis………………………………………………………………………………….36
Firm Competitive Advantage Analysis…………………………………………………………..40
Accounting Analysis……………………………………………………………………….………….47
Key Accounting Policies…………………………………………………………………….47
Accounting Flexibility……………………………………………………………………….55
Actual Accounting Strategy……………………………………………………………….58
Quality of Disclosure…………………………………………………………..……………61
Qualitative Analysis……………………………………………………….…………………61
Quantitative Analysis of Disclosure…………………………………………….………65
Sales Manipulation Diagnostic………………………………………….……..66
Sales Manipulation Chart…………………………………………………………71
Expense Manipulation Diagnostic…………………………………………….72
Expense Manipulation Chart………………………………………….………..79
Potential Red Flags………………………………………………………………..………..80
Undo Accounting Distortions………………………………………………………..…..82
Financial Analysis, Forecast Financials, and Cost of Capital Estimation....83
Financial Ratio Analysis…………………………………………………..……..83
1
Liquidity Analysis……………………………………………………………………84
Profitability Analysis……………………………………………………………….98
Capital Structure Analysis……………………………………….…………….109
SGR/IGR Analysis………………………………………………..……………….115
Financial Statement Forecasting…………………………………….………118
Cost of Capital Estimations………………………………………….………..131
Cost of Equity……………………………………………………………..……….131
Cost of Debt……………………………………………………………..…………135
Weighted Average Cost of Capital……………………………………..…..135
Equity Valuations…………………………………………………………………………..137
Method of Comparables……………………………………………..…………137
Intrinsic Valuations…………………………………………………….………..144
Discount Dividends Model………………………………………...…144
Free Cash Flows Model…………………………………………..…..147
Residual Income Model………………………………………….……149
Long Run Return on Equity Residual Income Model……….152
Abnormal Earnings Growth Model………………………………..155
Credit Analysis……………………………………………………………………………….159
Analyst Recommendation…………………………………………………………..…..161
Appendix………………………………………………………………………….……………163
Liquidity Ratios…………………………………………………………………....163
Inventory Turnover Ratios…………………………………………….………164
Profitability Ratios……………………………………………………….……….165
Capital Structure Ratios…………………………………………………………166
Growth Rate Ratios………………………………………………………………166
Regression Analysis………………………..…………………………………….167
Cost of Debt and WACC………………………………………………………..179
Method of Comparables…………………………………………………….….179
Long Run Residual Income Perpetuity Model…………………………..180
Discount Dividends Model……………………………………………………..181
2
Discounted Free Cash Flows Model…………………………….………….182
Residual Income Model……………………………………..………………….183
Abnormal Earnings Growth Model………………………………….………184
Altman Z-score……………………….……………………………………………185
References……………………………………………………………….…………………..186
3
Executive Summary
Investment Recommendation: Overvalued; Sell 11/01/07
KR - NYSE (11/1/2007):
52 Week Range:
Revenue:
Market Capitalization:
Shares Outstanding:
Percent Institutional
Ownership:
Book Value Per Share:
ROE:
ROA:
$28.20
$21.12 -$31.94
$66,111 M
$20.16 B
$715 M
81%
6.89
22.65%
5.26%
Cost of Capital Est.
Estimated:
3-Month
1-Year
2-Year
5-Year
7-Year
10-Year
R2
Beta
Ke
-0.0078
0.0233
0.0230
0.0227
0.0225
0.0223
-0.7051
-0.724
-0.6997
-0.6980
-0.6974
-0.6964
-1.29%
-1.11%
-0.08%
-1.30%
-1.21%
-0.17%
Published Beta:
Kd(BT):
WACC(BT):
1.05
13.90%
8.50%
WACC(AT): 7.75%
http://moneycentral.msn.com
2002
3.26
Altman Z-Score
2003
2004
3.18
3.17
Valuation Estimates
Actual Price (11/1/2007): $28.20
Financial Based Valuations
Trailing P/E:
$27.79
Forward P/E:
$22.09
P.E.G.:
$18.86
P/B:
$17.07
P/EBITDA:
$45.17
P/FCF:
($41.14)
EV/EBITDA:
$28.36
Dividend Yield
$21.25
Intrinsic Valuations
Discounted Dividend:
$6.82
Free Cash Flows:
$85.37
Residual Income:
$9.03
LR ROE:
$20.48
AEG:
$7.73
http://moneycentral.msn.com
4
2005
3.62
2006
3.81
Industry Analysis
The retail grocery sector is a highly competitive industry. Kroger
Company’s top competitors are Safeway (SWY), Supervalu (SVU), Whole Foods
(WFMI), Wal-Mart (WMT) and Winn Dixie (WINN). Kroger has to compete
against 1,262 super centers, which are a growing trend in the market. The
grocery store industry is highly competitive and profit margins are narrow. Each
firm in the industry offers almost identical products. Firms in the industry must
compete on price. In order to be successful and capture market share, Kroger
administers the strategy of cost leadership. Kroger achieves cost leadership
through economies of scale and scope, low-cost distribution, efficient production
and minimizing research costs. Kroger’s creates a competitive advantage by their
ability to differentiate themselves. In the industry, a customer can walk across
the street and purchase the same products; switching costs are very low. Kroger
differentiates from competitors by excelling in product quality, product variety,
and customer service. If Kroger can correctly utilize these success factors, they
will be able to maintain their domination within the industry and acquire more
market share.
Firms that have established themselves in the market place have
experience difficulties through the year: including, differentiating their products,
decreases in demand, high concentration, high economies of scale, and high
fixed costs. A firm must have a well planned product mix to go with efficient
operations to be profitable. Large companies and chains dominate the industry.
Small grocers can be effective if they develop a niche product or service.
Companies already established in an industry have an advantage over new
entrants due to the large investments that are required to begin operations.
Large economies of scale, first mover advantages, access to distribution
channels, and legal barriers are elements in the industry that new entrants must
evaluate.
5
In the US Retail Grocery Industry the threat of substitute products is
almost non existent. Though there are substitute means of getting food, such as
fast food, restaurants, and convenient stores, the actual products sold within
“grocery” stores usually are the same at all locations. The power with which
buyers have affects a company’s business strategy greatly. It can determine
whether or not they want to compete by differentiation strategy or low cost
approach. The greater power the consumer has, the more the company is driven
towards a low cost approach. The lower the amount of bargaining power, the
more freedom the company has in determining what kind of strategy approach
they wish to take.
Accounting Analysis
The accounting analysis is conducted by analysis to gain an idea of a
companies flexible accounting policies, their actual accounting strategy, and their
level of disclosure. Through this process, we can determine the quality of a firm’s
disclosure, quality of a firm’s actual information, and any possible distortions.
The key material used from the 10-K are the income statement, balance sheet,
statement of cash flows, and the footnotes regarding key accounting policies. A
firm’s key accounting policies should be linked to a company’s key success
factors.
Kroger Co. and the majority of its competitors have key accounting
policies surrounding post-retirement benefit plans and their leases structure.
This is a key accounting policy because a firm can hide the present value of
pension obligations by using an aggressive discount rate. These benefit
obligations can be affected greatly if the discount rate is overstated or
understated. Kroger provides a very thorough disclosure in their 10-K as to how
they assess the discount rates and benefit obligations owed to their employees.
Kroger uses an outside consultant to assess discount rates; eliminating managers
incentives to decrease these benefit obligations. These efforts demonstrate
6
Kroger’s initiative to disclose valuable accounting information; allowing their
financial records to be more transparent. Kroger and its competitors are also
given the choice of accounting for their leased property as either an operating
lease or a capital lease. Capitalized leases are recorded as capital leased assets
and liabilities on a firm’s balance sheet, while operating leases are not. This can
give managers an incentive to reduce their lease obligations and increase
earnings for the period. The majority Kroger’s leased assets are in the form of
operating leases. For example, in 2007 Kroger will have operating lease
payments of $778 thousand compared $57 thousand in capital lease expenses.
Although Kroger uses operating leases on the majority of their leased facilities,
these obligations are not significant when compared to the company’s total
assets and total liabilities. Kroger also showed $649 thousand in operating lease
expenses for the year 2006 (Kroger 10-K). This information is included in
Kroger’s detailed disclosure regarding their lease structures.
The accounting flexibility within Kroger is based on their choice of using
Operating Leases vs. Capital Leases and their ability to influence the discount
rate on their Post-Retirement Benefit Plans. Kroger’s flexibility in these areas
gives them the choice of being more informative to investors or to hide the true
nature of their activities. Kroger does a great job disclosing areas of accounting
flexibility. Kroger’s transparency has improved over the last five years; providing
shareholders with valuable information.
Kroger’s sales and expense diagnostic ratios show there are no major
“Red Flags.” For companies like Kroger, it is very difficult to manipulate sales
because due to technology. Kroger’s expense diagnostic ratios have not
experienced any major changes the past few years and they provide no red flags
to investors. Overall, Kroger does a very good job of disclosing the majority of
their key accounting procedures to their investors and they also continue to
increase the level of their exposure by implementing newly accepted accounting
standards that are recommended by the FASB.
7
Financial Analysis, Forecast Financials, and Cost of Capital Estimations
The Financial analysis of a company is conducted by analyst and investors
to gain insight into how a firm is performing compared to its competitors and the
rest of the industry. This analysis requires the use of financial ratios to evaluate
a company’s liquidity, profitability, and capital structure. These ratios are
compared against other companies in the industry in order to determine
company and industry trends. These trends are used as guidelines in the
forecasting of a firm’s financial statements. A companies cost of equity can be
estimated using a Regression Analysis or the Back Door Method. The cost of
debt is determined by allocating the appropriate weights and rates to debt items
on a company’s balance sheet. Plugging these values into the Weighted Average
Cost of Capital formula will then provide an estimated cost of capital for a firm.
The liquidity ratios provided in the financial analysis for Kroger indicate
that Kroger and the retail grocery industry as a whole are not very liquid.
Kroger’s current ratio and quick asset ratio indicate that the firm does not have a
substantial amount of current assets to pay off their current debt obligations.
Although, due to Kroger’s size and financial health, this should not scare away
investors. Kroger’s profitability ratios indicate that the firm is performing above
its competitors and the retail grocery industry as a whole. Kroger’s high gross
profit margins, net profit margins, and return on equity ratios demonstrate the
Company’s financial strength over the last few years. Kroger’s capital structure
ratios show that the Company has continued to finance the majority of their
capital expenditures through debt. Kroger is able to obtain debt financing rather
cheaply due to their high credit rating.
In our ten year forecast of Kroger’s financial statements, we used trends
that were found in our financial ratio analysis. This required us to make
assumptions for our forecasted financial statements that we felt were
appropriate. A few assumptions we made regarding Kroger’s forecasted financial
statements include: a 6% sales growth each year, an asset turnover ratio of 3.30
8
times, and that CFFO should be forecasted using the CFFO/Sales ratio. These
assumptions allowed us to forecast the remainder of the forecasted financial
statements and a detailed discussion regarding each statement is provided in the
forecasted financials section.
In estimating Kroger’s cost of capital we discovered that the regression
analysis provided us with insufficient data in order for us to determine the cost of
equity for the Company. We used an alternative technique, known as The Back
Door Method, to determine Kroger’s cost of equity. Kroger’s cost of debt before
and after tax was then determined by weighting each debt item and multiplying
it by the appropriate rate. After finding Kroger’s cost of equity and cost of debt
we were then able to calculate the Company’s Weighted Average Cost of Capital.
Valuations
The last step in an equity evaluation is to determine the company’s
appropriate share price and to evaluate whether it is overvalued, undervalued, or
fairly valued. This step requires analyst to use several different methods to
value the equity of a firm.
In our equity valuation of Kroger, we began by using the Method of
Comparables technique to take a quick glance at how the Company’s share price
compared to other companies in the industry. The tailing price to earnings and
Enterprise Value to EBITDA ratios indicate that Kroger’s observed share price of
$28.20, on November 1, 2007, is fairly valued with calculated share prices of
$27.79 and $28.36. The forward price to earnings, price to book, dividend yield,
and price earnings growth ratios all showed Kroger’s observed share price as
being overvalued with share prices of $22.09, $17.07, $21.25, and $18.86,
respectively. The price to EBITDA ratio ($45.17) was the only ratio that showed
Kroger’s observed share price as being undervalued and the price to free cash
flow ratio ($-41.14) was useless in our equity valuation.
9
Our decision regarding the issue of whether Kroger’s share price was
overvalued, undervalued, or fairly valued was based on the Intrinsic Valuation
Models. The discount dividend model generated an implied share price of $6.82
on 11/01/07, indicating that the observed share price of $28.20 is overvalued.
This model is not the most accurate method to calculate Kroger’s share price
because Kroger’s dividends are relatively small and the Company just started to
pay dividends in 2006. The free cash flow model provided us with a share price
of $85.37 for 11/01/07 and indicates to investors that the observed share price is
undervalued. This model is also inaccurate because Kroger’s forecasted free
cash flows are fairly high and when discounted back to the present they
generate a very large firm value.
The residual income model gave us an implied share price of $9.03 on
11/01/07, which shows the observed share price as being overvalued. This
model is known to be the most accurate and we agree because of our confidence
in our forecasted future earnings for Kroger. The long run return on equity
residual income model gave us an implied share price of $20.48 for Kroger on
11/01/07, which also shows that Kroger’s observed share price is overvalued.
This model uses forecasted book value of equity, long run ROE, cost of equity,
and a long run equity growth rate in a perpetuity formula to determine a
company’s share price. The last model we used in our equity valuation of Kroger
is the Abnormal Earnings Growth Model. This model gave us an implied share
price of $7.73 for Kroger on 11/01/07, indicating that the observed share price is
overvalued. This model is also considered to be fairly accurate because it can be
directly linked to the residual income model. After evaluating our Intrinsic
Valuation Models for Kroger, it can be concluded that Kroger’s observed share
price on 11/01/07 is overvalued.
10
Business and Industry Analysis
Company Overview
The Kroger Co. (KR), (or “The Company”), is one of the largest retail
grocers in the nation. The Company was founded by Barney Kroger in 1883 and
was incorporated a few years later in 1902. Barney Kroger believed in his credo
to, “Be particular. Never sell anything you would not want yourself.” Mr. Kroger’s
inspiration still stands strong with Kroger Co. He is still a big part of their
success; achieving 60 billion dollars in sales annually. The Kroger Co.
headquarters are in Cincinnati, Ohio.
“The Kroger Co. operates retail food and drug stores, multi-department
stores, jewelry stores and convenience stores throughout the United States
(OneSource).” Although Kroger is a multidimensional company the main portion
of their sales comes from food products; about 95% of Kroger’s total sales are
associated with food stores that they own.
Kroger Co. spans across 31 states in U.S. with 2,468 supermarkets, 779
convenience stores and 412 fine jewelry stores (10-K). Kroger Co. has multiple
banner companies which include Kroger, Food 4 Less, King Soopers, Ralphs, Fred
Meyer, Smith’s, Baker’s, Fry’s, Dillions, QFC, and City Market. Kroger is a multidimensional company considered to be in the grocery industry.
Kroger’s revenue comes from their customers, who buy their products at
price level. Kroger, who sells these products at the price level, in turn makes the
difference between the price and cost of the product. Operational costs and
distribution costs are two of the costs Kroger can profit from. The market cap for
Kroger is 19.4 Billion, which is larger than Safeway, Supervalu, Whole Foods and
Winn-Dixie. Wal-Mart blows out everyone for market cap however that is
expected since they are a larger firm and compete in different areas, not just
groceries. The graph below represents the price fluctuation over the last five
years of Kroger and its competitors.
11
http://moneycentral.msn.com
The 2006 year for Kroger was quite impressive; growing by 5.6% in their
supermarket sales. Kroger Co.’s market share increased as well (approximately
over 70 points according to their 10-K). They increased on a volume-weighted
basis by 65 points, which is a trend Kroger would like to continue. Kroger has an
increasing trend in net sales trough the past five years. The stock price for
Kroger took a major jump from 2006 to 2007. The chart below shows Kroger’s
total assets, net sales, and stock price over the last five years.
2003
2004
2005
2006
2007
Total Assets
20,349
20,767
20,491
20,482
21,215
Net Sales
51,760
53,791
56,434
60,553
66,111
Stock Price
15.09
18.53
17.1
18.4
25.6
12
Industry Overview
Retail Grocery Industry
Kroger Company
Industry Competition
Rivalry Among Existing Firms
Threat of New Entrants
Threat of Substitute Products
Bargaining Power of Buyers
Bargaining Power of
Suppliers
Competitive Advantage
RETAIL GROCERY INDUSTRY
HIGH
HIGH
LOW
LOW
LOW
HIGH
PURCHASING & DISTRIBUTION
The chart above is an overview of the five forces model and Kroger’s
competitive advantage. The retail grocery sector is a highly competitive industry.
Kroger Company’s top competitors are Safeway (SWY), Supervalu (SVU), Whole
Foods (WFMI), Wal-Mart (WMT) and Winn Dixie (WINN). Kroger has to compete
against 1,262 super centers, which are a growing trend in the market. “WalMart is the leading seller of groceries in the country” (First Research). According
to First Research, the industry has 70,000 grocery stores with 40,000 companies
that operate them. However, the industry is concentrated, with the largest
companies owning 70 percent of the grocery industry market.
In the grocery store industry, the stores have three different types of
products to sell to customers in perishable foods, non-perishable foods, and nonfood items. The larger companies such as Kroger, Safeway, Supervalu, Whole
Foods and Winn-Dixie buy their products from wholesale distributors or from the
manufacturer. The choice depends on the relationships and contracts set in
place.
When firms grow large enough, such as Wal-Mart, they have the ability
to have their own distribution center. The grocery industry’s inventory system is
very similar between all of the firms by keeping track of their inventory using
computers and SKU’s. A growing trend in this industry is that retail grocery
stores are beginning to compete more heavily in their fuel centers. This has led
13
to an increase in their overall profitability due to the fact that being able to fill up
with gas at your local grocery store is convenient for consumers.
14
Five Forces Model
The Five Forces Model is a tool used to analyze the structure and identify
profit potential in a given industry. The analysis will help determine the value
drivers associated with the firm. The model is broken into two separate groups:
Degree of Actual and Potential Competition and Bargaining Power in Input and
Output Markets. The Actual and Potential Competition section of the model can
be further divided into subgroups that include; Rivalry Among Existing Firms,
Threat of New Entrants, and Threat of Substitute Products. These categories
take an in-depth look at the competition in an industry and determine the profit
potential of the industry. Bargaining Power in Input and Output Markets can be
subdivided into Bargaining Power of Buyers and Bargaining Power of Suppliers.
These five forces can help an analyst determine the structure and profitability of
an industry. The chart below is a collection of the five forces in the retail grocery
industry that will be analyzed in detail in the next sections.
Retail Grocery Industry
Rivalry Among Existing Firms
HIGH
Threat of New Entrants
LOW
Threat of Substitute Products
LOW
Bargaining Power of Buyers
HIGH
Bargaining Power of Suppliers
MODERATE
15
Rivalry among Existing Firms
The retail grocery store industry is a very mature and competitive market.
Firms that have established themselves in the market place have experienced
difficulty in differentiating their products, decreases in demand, high
concentration, high economies of scale, and high fixed costs. In this highly
competitive industry, a firm needs to have a well planned product mix to go with
efficient operations to be profitable. Large companies and chains dominate the
industry. Small grocers can be effective if they develop a niche product or
service.
Industry Growth
% Change in Sales Growth
Five Year Industry Growth
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
4.1
4.4
4.1
2.3
0.4
2002
2003
2004
2005
2006
*Statistics are provided by First Research
The chart above is an illustration of the retail grocery industries growth
during the previous five years. Industry growth is a very important component
when determining the level of competition between existing firms in an industry.
When industry growth is fairly stable, firms attempt to take market share from
16
their competitors. When a firm captures more market share they are able to
grow. Firms do not have to fight over market share for them to grow when an
industry is expanding rather quickly. The retail grocery store industry has seen
low to moderate growth over the past five years. For the past five years, the
industry on average has grown at only 3.1 percent a year
(www.firstreasearch.com). The average growth of the industry is about the
same as the average inflation rate on the entire economy. The industry must
keep their growth rate above inflation to maintain the dollar value within the
industry. Although growth rate has been low, the top ten retail grocery
companies have grown at an average rate of 15.31 percent (yahoo/finance.com).
The low average growth rate is a direct result of the high concentration in the
industry.
The retail grocery industry currently has 70,000 operating stores and the
number continues to increase with the vast expansion of supercenters. Wal-Mart
has continued to increase their number of stores throughout the U.S. and has
also increased their same store sales year after year. In 2006, Kroger closed
down more stores than they opened but still managed to increase their same
store sales the last few years. Most firms in the industry are closing down their
weaker locations and investing their assets in store locations that have the most
profit potential. Across the industry, average same store sales have continued to
increase. This can be accredited to the diversification of grocery store. Stores are
starting to offer a wider range of services; such as fuel centers, commercial
banking, prepared foods, gift cards, and many other one stop shopping
amenities. Companies such as Winn-Dixie are having difficulty competing with
super centers like Wal-Mart and Super Target. The struggling retail grocers have
experienced declines in sales and rapid store closings across the country. A
major factor in the limited growth can be contributed to a slow U.S. population
growth of only one percent a year in most areas (www.firstreasearch.com). The
average birth rates are at an all time low. The population flow from integration is
the only factor that is fueling industry growth on a population basis.
17
For firms to grow in this industry it is very important for them to move
large quantities of product. It is crucial to have the right product mix. Large
retail grocers are able to efficiently buy and distribute their products in this low
margin industry. This has made it very difficult for small grocery stores to enter
the market and compete with large retailers on price. A small retailer must find
alternate methods to compete on. Product prices are very important to compete,
but low prices are not a necessity in the industry. In recent years, large retailers
have seen the majority of their growth form the acquisition of small grocery
chains (www.firstreasearch.com). The chart below illustrates the retail grocery
industries percentage of growth in sales over the past five years.
Concentration
To determine whether an Industry is concentrated or not, it is important
to analyze the number of firms in a market and their market share. Firms that
are in industries with high concentration can coordinate and set prices that
others must follow to compete in the market. If an industry has low
concentration there can be extremely high price competition between the
competing firms. The retail grocery industry includes 40,000 companies that
operate 70,000 stores in the United States. The industry has high concentration;
50 of the 40,000 companies hold approximately 70 percent of the market
(www.firstreasearch.com). Although the traditional grocery store industry is
concentrated, firms have had to deal with Mass Merchants and Wholesale Clubs
such as Wal-Mart, Target, Costco and Sam’s Club entering the grocery market
with low price strategies. These Mass Merchants and Wholesale clubs have been
able to take market share; they provide lower prices than traditional grocers.
These industry giants have very efficient purchasing and distribution systems. As
a result, retail grocery stores enter into price competition with these mass
merchants and wholesale clubs; despite that they are in a high concentration
industry. The chart below illustrates the level of concentration in the retail
grocery industry. As can be seen, Wal-Mart has continued to increase their
18
market share in the retail grocery industry. Kroger has also continued to
increase their market share and sales. Unfortunately, they are no longer the
leader in grocery sales. Wal-Mart’s recent conquest of world domination in this
retail industry has caused them to surpass all other competitors; Wal-Mart
surpassed Kroger in 2005.
Grocery Store Market Share
25
% of Market Share
20
Wal-Mart
15
Kroger
Safeway
SuperValu
10
Winn Dixie
5
0
2002
2003
2004
2005
2006
Year
*Statistics are provided by edgarscan.com
Differentiation and Switching Costs
In the retail grocery industry, it is very hard to differentiate yourself from
your competitors because all the firms in this industry sell the same general
products and have equal quality. These products include: perishable foods, nonperishable foods, and non-food items (www.firstreasearch.com). Retail grocery
stores compete on price and increases in price could lead to the potential lose of
customers due to the low switching cost in this industry. Switching cost are the
costs associated with stopping your current operations in an industry and
19
attempting to produce goods and services in a different industry. Switching costs
are high in the retail grocery industry because firms in this market would find it
relatively hard and costly to stop their grocery operations and engage in other
retail activities. Companies wanting to differentiate themselves in this industry
need to select a unique product mix and offer more services such as; online
ordering and gasoline stations.
Economies of Scale
TOTAL ASSETS
2002
2003
2004
2005
2006
Kroger
$20,102
$20,184
$20,491
$20,482
$21,215
Safeway
$16,047
$15,096
$16,377
$15,756
$16,273
SuperValu
$5,896
$6,161
$6,278
$6,153
$21,702
Winn Dixie
$2,790
$2,619
$1,987
$1,608
$1,670
Wal-Mart
$83,451
$94,808
$104,912
$138,187
$151,193
$1,213
$1,521
$1,889
$2,043
$943
Whole Foods Market
*Numbers in Millions
*Statistics are provided by edgarscan.com
The chart above shows Kroger’s and its major competitors total asset
figures from 2002 to 2006. In many industries the size of the company is vital to
their success and profitability. In the retail grocery industry, economies of scale
exist with distribution efficiency and purchasing. By looking at the concentration
of the market, where 50 of the 40,000 grocery companies represent 70 percent
of the market, it is evident that large companies dominate the industry
(www.firstreasearch.com).
Large companies are able to thrive in this market
because they have significant buying power and very efficient distribution
operations. Many of the larger retail grocers own and operate their own
distribution centers (www.firstreasearch.com). These factors allow large retail
grocery stores to charge lower prices than small and midsize companies.
20
Although this is a large firm industry, small companies have and can compete
effectively if they differentiate themselves from larger retail grocery store chains.
Fixed-Variable Costs
The level of competition in an industry can be influenced by the
companies fixed to variable cost. In industries where companies have high fixed
costs to variable costs, they attempt to lower price to increase demand in their
current stores in operation. In the retail grocery industry, the majority of retail
grocery stores own and operate their own stores and distribution centers
(www.firstreasearch.com). This increases firms’ fixed cost in this industry
because companies accrue maintenance and overhead cost. Although fixed cost
can be relatively high in this industry, they are offset by the variable cost of
goods sold. Cost of goods sold (COGS) is the second highest cost retail grocery
stores encounter. Grocery stores need to move large quantities of products in
order to be profitable in this low margin industry; leading to high inventory
turnover and increased variable cost in this industry.
Fixed Assets/Variable Costs
The ratio of fixed assets to variable costs plays a large role for a company
participating within the industry. The chart below shows the fixed asset to
variable cost ratios for Kroger and their competitors.
Fixed Assets/Variable Costs
2003
2004
2005
2006
2007
Kroger
1.10
1.07
1.08
1.03
0.99
Safeway
0.97
0.89
0.92
0.91
0.98
Supervalu
1.09
0.96
0.98
0.80
1.23
* The information comes from each company’s annual 10-K
21
The higher the ratio, the more focused the company is on central items
within the firm. It is harder for them to break from this focal point. The lower the
ratio, the more leeway the company has to go into different areas; they can
distinguish themselves from the industry. If they feel that they are not
successful, they have to sell the assets in that area and invest in other areas and
try to make a profit. This is why companies tend to operate from operating
leases instead of capital leases. It allows them to easily and readily exit the
industry should the company operate poorly.
Kroger operates the majority of their leases on operating leases. This is
why they report their variable costs are close to their fixed assets; explaining
why they have a fixed asset to variable cost ratio of about 1:1. In the grocery
industry, fixed assets and variable costs are close in value. It is important for
Kroger to maintain a ratio above 1:1. A ratio below 1:1 usually means that a firm
is not operating efficiently. Kroger’s ratio has declined over the last five years.
This is a result of their growing operations that increase variable costs and the
lack of investment into fixed assets. Kroger ratio shows consistency and reaches
the desired 1:1 mark. An analyst can see that Kroger is using efficiently using
their fixed assets.
Excess Capacity
Same Store Sales Growth
2002
2003
2004
2005
2006
KROGER
3.32%
3.92%
4.91%
7.30%
9.18%
SAFEWAY
1.36%
2.26%
0.27%
7.24%
4.60%
SUPERVALU
2.38%
1.64%
-3.30%
5.47%
-5.58%
WINN DIXIE
0.78%
-1.30%
-0.04%
-6.69%
1.51%
WAL-MART
14.10%
12.55%
22.59%
9.75%
11.67%
18.40%
Whole Foods Market
*Statistics are provided by edgarscan.com
17.03%
22.78%
21.63%
19.27%
22
The above table gives you the same store sales growth rates for Kroger
and their major competitors. The majority of the companies in the chart above
have been able to increase their same store sales growth year over year. These
already established companies increasing sales growth every year indicates that
the industry has not yet reached excess capacity.
Excess capacity can play a major role in determining the price competition
in an industry. An industry is said to have excess capacity when supply is
greater than demand. When supply is greater than demand, firms inside the
industry tend to reduce prices in order to increase demand for their products and
services. The retail grocery store industry is saturated with large retail stores
and is reaching excess capacity. As a consequence of consumers having many
different shopping alternatives, supply exceeds demand in the grocery store
industry. Limited demand for grocery products can also be contributed to the
U.S. population growing at only 1 percent a year (www.firstreasearch.com). As
a result, many retail grocery companies have been cutting prices and offering
discounts to increase demand in their stores. This makes it very difficult for
small firms to compete because they do not have substantial buying power or
the efficient distribution operations that large firms have.
Exit Barriers
Exit barriers limit a firm’s ability to exit an industry because of the high
cost associated with their departure. Companies that have specialized assets that
can only be used for the nature of their business could experience very high exit
costs. The retail grocery store industry does not face high exit barriers because
the majority of companies in this industry own and operate their stores and
distribution centers. These stores are not considered specialized property and
could be sold along with inventory if a company in this industry decided to exit
the market. There are also no costly regulations regarding leaving the industry.
23
Conclusion
The retail grocery industry is a very mature market that is involved in
intense competition. It is important for firms in this industry to create the right
product mix and establish efficient distribution operations. Large retail grocers
have a competitive edge in this industry due to their efficient distribution
operations and their purchasing power. However, small firms can be competitive
in this industry if they differentiate themselves by selling specialty products,
providing superior quality goods, or by creating specialty services. Companies in
the retail grocery industry deal with many critical issues such as: slow growth,
high concentration, lack of opportunities to differentiate product offerings, low
consumer switching cost, and a market that has high excess capacity.
Threat of New Entrants
Companies experiencing substantially high profits face the threat of new
entrants entering their respective industry. Other firms will attempt to capitalize
on the profits other firms have achieved in the industry. In order to be
successful, new entrants need to evaluate an industry before deciding to enter.
Large economies of scale, first mover advantages, access to distribution
channels, and legal barriers are elements in the industry that new entrants must
evaluate. Companies already established in an industry have an advantage over
new entrants due to the large investments that are required to begin operations.
24
Economies of Scale
TOTAL ASSETS
2002
2003
2004
2005
2006
Kroger
$20,102
$20,184
$20,491
$20,482
$21,215
Safeway
$16,047
$15,096
$16,377
$15,756
$16,273
SuperValu
$5,896
$6,161
$6,278
$6,153
$21,702
Winn Dixie
$2,790
$2,619
$1,987
$1,608
$1,670
Wal-Mart
$83,451
$94,808
$104,912
$138,187
$151,193
$1,213
$1,521
$1,889
$2,043
$943
Whole Foods Market
*Numbers in Millions
*Statistics are provided by edgarscan.com
The above chart illustrates Kroger’s and its competitors total asset number
over the past five years. New entrants evaluate the economies of scale to
determine how competitive and profitable they can be in an industry. Industries
that have large economies of scale make it difficult for new firms to enter the
market because of the high cost associated with startup. The retail grocery
industry has high economies of scale due to the large retail grocers having
tremendous buying power and efficient distribution systems that allow them to
reduce prices (www.firstreasearch.com). As a result, new entrants into this
industry will find it difficult to compete with these large retailers pricing
strategies.
First Mover Advantage
Firms that enter a market early can have a competitive advantage over
firms that enter the market late because they can set industry standards and
establish exclusive selling agreements with suppliers. Companies can also create
a first mover advantage by providing products and services that were not already
available to consumers. In the retail grocery industry, companies are engaged in
intense price competition and they all sell very similar products of the same
25
quality. Given the relatively low consumer switching cost in this industry, it
makes it very difficult to gain a first mover advantage in this market. New
entrants into this market can gain a first mover advantage by providing
differentiating products and services to consumers. New entrants can offer
services such as take-out orders, loyalty cards, prepared foods, and internet
shopping in order to increase their share of the market
(www.firstreasearch.com).
Distribution Access and Relationships
New entrants into an industry often face the critical issue of developing
relationships with their distributors. Existing firms in an industry have an
advantage over new entrants because they have established healthy
relationships with their suppliers.
New entrants are faced with very high cost associated with the
development of their distribution channels. Most firms in the retail grocery
industry own and operate their distribution centers. This is a disadvantage to
new entrants because the cost of establishing distribution centers is very high.
These high distribution startup cost would not allow new entrants to compete
effectively on price with the larger firms in this industry. Superb distribution
access and relationships enables a firm to get their products on the shelves in an
economically efficient manner.
To achieve distribution and access, a company must invest significant
capital and expense dollars to ensure that their information systems and logistics
network operate efficiently. A firm must have sufficient technology systems,
labor forces, warehouse capacity, supply chains, and transportation abilities to
operate a successful distribution. A firm’s logistics network is vital to the
distribution process. An efficient system can eliminate unnecessary setbacks in
the distribution process. Grocery chains distribute their own products throughout
the company’s stores. The grocery stores are able to supply the same products
at a lower cost.
26
Firms in the grocery industry operate their distribution of products on the
same based system. Companies must have different locations that distribute
various products. Firms must operate distribution centers that are close proximity
to their final destination. These locations are for goods that are quick turn and
perishables. Stores usually have separate distribution centers that concentrate on
pharmaceuticals, health and beauty products, and dry grocery products. It is vital
for firms to own and operate an adequate transportation fleet. A company must
run enough trucks to transport needed inventories from distribution centers to
their stores. Distributions processes in the industry greatly differ after the basics.
Firms will implement techniques and strategies such as data warehouses,
expanded software systems, voice-pick technology, label-base picking, real-time
warehouse management, and global positioning systems
(www.firstresearch.com).
Relationships are crucial in a firms’ distribution process. In the industry,
grocery stores buy from manufacturers that use marketing strategies like product
bundling, product lining, and family branding. It is very important to establish a
good and positive relationship with these large manufacturers. A good rapport
with companies, like Proctor and Gamble, can lead to purchase discounts and
cheaper rates on procured items. It is also important to build a connection with
advertising agents and brands that you offer. A company needs every
opportunity to advertise their store name.
Legal Barriers
Legal barriers play an important role when firms are looking to enter an
industry. New entrants into an industry need to be aware of these legal
requirements to insure a smooth entrance into the market. New entrants into
the retail grocery industry would be subject to regulations regarding state health
departments, Food and Safety, and food inspection services of the FDA, OSHA,
and USDA (www.firstreasearch.com).
27
Conclusion
New entrants into the retail grocery industry face many different
challenges along the way to establishing a profitable company. A few of these
challenges include large economies of scale with purchasing and distribution,
costly startup purchases for distribution centers, and food health and safety
regulations by US and state governments. New entrants into this industry can
be effective if they sell specialty products or provide specialty services to help
differentiate themselves from the rest of the market.
Threat of Substitute Products
In the US Retail Grocery Industry the threat of substitute products is
almost non existent. Though there are substitute means of getting food, such as
fast food, restaurants, and convenient stores, the actual products sold within
“grocery” stores usually are the same at all locations. With the exception of Mass
Market Retailers, such as Target and Wal-mart, who sell to all areas of retail, or
Warehouse stores, like Costco and Sam’s club, who sale food in bulk at
discounted prices, you will find mainly the same products with miniscule
variations on their pricing. That is why companies in the retail grocery industry,
whose target market varies from low to high income families, do not perceive
substitute products as a major threat. They carry all of the substitute products
that are offered at other Retail Grocers.
Relative Price and Performance
Consumers tend to relate the quality of the product with the value and
popularity of a brand. The more well known brands usually tend to be higher in
cost due to the popularity of the product. However, an off brand product tends
to be cheaper. Most retail grocery stores specialize in selling both products due
to the fact that their market entails families reaching both ends of the income
28
spectrum. This also increases the chance that a lower income family would
choose a higher priced product or a higher income family would choose a lower
end product due to the proximity of the products being next to each other.
Because of intense competition, grocers have difficulty raising prices. Most
grocers have direct competition in their market area. Overall, consumer food
prices grew 20 percent in the last ten years, but in some years the increase was
just 1 percent. (www.firstreasearch.com)
Buyer’s willingness to switch
Substitute products are a way of life within the Retail Grocery Industry.
You never tend to have on without the other. Consumers tend to have different
wants and needs. For this reason, companies attempt to cater to all of their
different needs. Whether or not it is a high priced named brand product or an off
brand cheaper product, their costumers have the full range of products to pick
and choose from due to their shopping nature. Adhering to all of their different
customer’s tastes and financial problems is the driving factor and motivator for
the way Kroger stocks and sells their products.
Conclusion
Substitute products are not a major threat to the retail grocery industry
because the quality of substitutes available is low. This is why these products do
not pose much of a threat to the industry. The majority of the different retailers
in the market carry the same general products. Due to the many different
choices in food selection, with the exception of specialty type food vendors,
tends to lead to the death of a particular company. With all of the choices within
this day and age, you have to be flexible with what you are willing to sell in order
to compete with the competition.
29
Bargaining Power of Buyers
The power with which buyers have to affect the Retail Grocer Industry
usually affects that company’s business strategy greatly. It can determine
whether or not they want to compete by a differentiation strategy or a low cost
provider approach. The higher the amount of power that the consumer has, the
more the company is driven towards a low cost approach. The lower the amount
of bargaining power, the more freedom the company has in determining what
kind of strategy approach they wish to take.
The percentage of food bought at food stores has been declining for
decades, as changes in lifestyles have caused Americans to turn to other sources
like restaurants, take-out, and convenience stores. Americans buy only 40
percent of their food at food stores, down from 45 percent a decade earlier
(www.firstresearch.com). This has caused the industries growth of prices to
come to a screeching halt. Because of this change in lifestyle, the consumer has
more leeway to pick and choose what it wants when it wants it. This has caused
the Grocer industries growth to slow down immensely. Overall, consumer food
prices have only grown 20 percent in the last decade. (www.firstresearch.com)
Because of the fact that the consumer has so much leeway with which to
choose how to eat, the Grocer Industry has had to almost completely compete
on a low cost approach against its other retail competition. This just shows how
much power the consumer has.
Price Sensitivity
Price sensitivity involves what the average consumer is willing to pay for a
particular product. What the average value of that product is determined by a
number of different things: production costs, labor costs, scarcity, and docking
costs. Since the consumer has to eat everyday, there is a great need for the
Grocer Retail Industry. The basis with which they will choose what to buy will be
30
determined by which company has the product they desire at the price with
which they are willing to pay for it.
Many of the different retailers, such as Kroger’s, Randall’s, HEB, etc., carry
many of the name brand products that people typically wish to buy. They also
each carry their own type of off brand item that is similar to the name brand
item but which they can buy at a cheaper and more affordable price. They also
utilize positioning within their stores to locate both the name brand items and
their low cost version together so that they can choose either brand.
Ultimately it comes down to what the consumer wishes to allocate their
money towards. What products they wish to take home at night. It all depends
on what the consumer desires. However, if any of the companies choose not to
follow this low cost approach, with all of the different options the consumer can
choose for food consumption, they will surely collapse as a company.
Relative Bargaining Power
The consumers bargaining power is determined by the numbers of
consumers relative to the producers, the sheer amount of purchases by a single
buyer, and the alternative “substitute” products available to the consumer. The
problem that most grocers face is the fact that most grocers carry the same
products. The consumers lose no money by purchasing their products at a
different store location. Granted there are a large number of consumers within
an area, still the simple fact that the industry is short on price growth feeds the
fact that the stores must maintain a constant number of consumers at their store
locations. Otherwise these companies are going to decline and eventually fall
suspect to bankruptcy. Therefore the consumer tends to have a higher than
normal level of bargaining power within this industry.
31
Conclusion
Though there are many differing factors that contribute to how much
power a consumer has over the producer, the main two that are dealt with are
price sensitivity of products within the stores and the relative bargaining power
which the consumer has over the stores. If a company truly wishes to compete
and make a profit within this industry, they must take these items into account
and deal with them as they feel is necessary.
Bargaining Power of Suppliers
Bargaining power of suppliers is very important in an industry because it
can determine the structure and pricing of industry products. Suppliers are said
to have high bargaining power when the number of companies in an industry is
relatively small and there are very few substitutes available. Suppliers can also
have the upper hand when the supplier’s product is superior to other products
offered in the market. When suppliers have high bargaining power they can
control industry prices and distribution schedules for firms in their respective
industry. On the other hand, suppliers are said to have low bargaining power
when there are many firms, a variety of substitutes, and companies in the
industry sell similar products.
In the retail grocery industry, the bargaining power of suppliers is
moderate. The majority of grocery stores have their own distribution centers;
therefore they buy their goods directly from manufacturers. These manufacturers
serve as the grocery stores suppliers. The manufacturers in this industry have
some bargaining power because the products they produce are very desirable to
the end consumer. If a retail grocery store does not sell a specific brand, this
could lead to customers using a different store depending on how popular the
brand. For example, Proctor and Gamble sell many different products to retail
grocery stores that are in high demand by consumers. If a retail grocer did not
32
carry Proctor and Gamble products, many consumers would probably elect to use
a different grocer. The reason suppliers have moderate instead of high
bargaining power is due to the issue of manufacturers needing their products to
be on grocery store shelves. Large retail grocery stores are very desirable for
manufacturers because in order to be profitable and increase growth,
manufacturers need to establish lasting relationships with large retail grocers.
The industry as a whole experiences moderate suppler bargaining power
because both retail grocers and manufacturers need each other equally.
Price Sensitivity
Price sensitivity measures a supplier’s/manufacturer’s perception of price
as it increases and decreases in the market. Suppliers want to sell their products
at the highest possible amount that will generate the highest possible return. In
doing so, suppliers engage in price competition with other companies selling
products of the same quality. Suppliers will normally charge higher prices for
specialty products or products that are more popular and generate the most
demand by consumers.
In the retail grocery industry, most grocery stores buy their products
directly from manufacturers who then ship products to the retailer’s distribution
centers. Manufacturers compete directly with one another in price competition in
order to push their product on to the grocer’s shelf. The retail grocery industry
is a low margin industry, which means that they need to move their products
quickly and efficiently in order to be profitable. Retail grocers also compete with
each other on price and getting products at the lowest possible cost from
manufactures allows them to compete with their competitors effectively. Large
retail grocers have substantial buying power in this industry and suppliers can
not afford to be price sensitive if they want their products on display at these
stores.
Quality plays a very important role in the price suppliers/manufacturers
can charge retail grocery stores. Retail stores private label brands are the
33
highest margin products they sell and are the cheapest ones to purchase.
Popular brands allow suppliers and manufacturers to charge retail grocers higher
prices due to consumers demand for these products. These higher prices lead to
an increase in the price grocers charge their consumers.
Relative Bargaining Power
Bargaining power is a major factor in an industry that can determine the
final price of goods and services. The cost associated with not doing business
with a supplier or retailer is a major issue involved in who has relative bargaining
power in an industry. Suppliers have high relative bargaining power when they
sell a specialty product that the buyer can not find elsewhere. This allows the
supplier to charge a higher price for the specialty product because of the
bargaining power they have over the buyer. Also, suppliers have high relative
bargaining power when there are only a few companies in an industry looking to
buy the products they sell and there is a lack of substitutes for their products.
In the retail grocery industry, suppliers have moderate bargaining power
with retail grocery stores. The industry has a variety of grocery stores and
substitute suppliers are available. Suppliers have moderate bargaining power in
this industry because consumer demand is high for many popular brand name
products these suppliers/manufacturers produce. The reason the word
“moderate” is used is because some suppliers/manufacturers have bargaining
power and some do not. The manufacturers that do have bargaining power are
the ones that produce products that are in high demand by consumers. Grocery
stores need these products on their shelves in order to keep store traffic
constant. On the other hand, it is also important for manufacturers to sell their
products to the large retail grocers to increase their profitability.
34
Conclusion
Bargaining power of suppliers is a very important issue that can eventually
determine the distribution system and final price of a product. The retail grocery
industry faces moderate supplier bargaining power because both the supplier
and retailer need one another to be profitable in this industry. The bargaining
power of suppliers in this industry depends on two major factors: how big the
retail grocer is and how popular the brand the supplier is selling. Large retail
grocers have substantial buying power over their suppliers because of the
suppliers need to be associated with the large grocery store. Brand popularity
can also be a major issue due to the fact that consumers have brand preferences
and not carrying a specific manufacturer’s brand could decrease a retail grocer’s
store traffic.
35
Strategies for Creating a Value Chain
The grocery industry is concentrated with numerous competitors. The
ability to have the right mix of products and efficient operations is crucial to an
individual firm’s success. The success of the firm is forged by strategies that
create a competitive advantage in the industry. Formulating a competitive
advantage will create value throughout the firm. The grocery industry primarily
focuses on the strategies of differentiation and cost leadership. Traditional
grocery stores concentrate largely on the strategy of differentiation. However, to
be competitive and thieve in the industry a firm must achieve an adequate level
of cost leadership.
Differentiation
In the grocery store industry, the most important strategy for creating a
competitive advantage is the ability to differentiate. Differentiation occurs when
a firm is able to supply a unique product or service at a cost lower than the price
premium customers will pay. Traditional grocery stores compete directly with
large super center retailers for market share in grocery sales. Retailers, like WalMart, compete primarily on price. Midsized stores differentiate themselves by
focusing on product quality, variety, and customer service.
Superior Product Quality
Superior product quality is crucial in building customer loyalty and store
image. Firms across the industry offer identical retail items day in and day out.
Prices and availability of these products are relatively the same from store to
store. Grocery stores apply the method of corporate branding to achieve product
quality. These private labels are sold at a lower cost but have a higher profit
margin than national brands. Stores must implement strict inspections and
36
specifications when receiving goods from outside manufacturers. Stores closely
monitor beef, pork, poultry, seafood, and other perishable items to ensure
product quality (www.firstresearch.com).
Superior Product Variety
Grocery stores differentiate themselves by establishing greater product
variety. All stores in the industry provide a large percentage of the same
products. Providing a unique product selection can increase customer loyalty and
expand customer base. It is crucial that stores utilize their shelf space to
maximize the variety of products. It is normal for stores to offer products sold in
three quality categories: premium quality, corporate brand quality, and budget
quality. Having this variety of products allows customers to shop towards their
lifestyle and financial situation. Common grocery stores harbor a prepared food
section that provides customers the ability to purchase a large variety of fresh
cooked food. The restaurant and fast food industry cuts into grocery stores
target market. Maintaining a prepared food section, with a variety of foods
identical to restaurant cuisine, will encourage customers to buy in store.
Americans are becoming more health conscious regarding their food selection.
Grocery stores that provide “whole” or organic food products will appeal to
health oriented shoppers (www.firstresearch.com).
Superior Customer Service
Large super centers and warehouse stores often have unbeatable low
prices. These corporations cut costs by allowing customer service deficiencies.
Midsized firms can differentiate themselves by implementing preferable customer
service. Grocery stores typically organize their customer service engagements
similarly. Personnel decisions regarding the hiring of managers and employees
are crucial. Employing smart and friendly employees can dramatically affect a
store’s customer retention rate. It is also important to have adequate staffing.
Stores can gain a competitive advantage by having numerous cashiers and
37
baggage clerks. Customer aid and problem solving services can directly affect
customer loyalty in a positive way (www.firstresearch.com).
Cost Leadership
The grocery store industry is highly competitive and profit margins are
narrow. In order for a firm to be successful it must administer the strategy of
cost leadership. Cost leadership is achieved when a firm supplies the same
product or service at a lower cost. Traditional grocery stores cannot consistently
price match with super centers and warehouses. There are alternative ways a
grocery store can create a competitive advantage using cost leadership. Grocery
stores can achieve cost leadership through economies of scale and scope, lowcost distribution, and minimizing research costs.
Economies of Scale and Scope
Economies of scale characterize a production process in which an increase
in the scale of the firm causes a decrease in long run average cost of each unit.
Basically, a grocery store can afford to sell products at a lower cost if they
purchase more inventories. On the other hand, economies of scope refer to
efficiencies primarily associated with demand-side changes, such as increasing or
decreasing the scope of marketing and distribution, of different types of
products. Grocery stores buy from manufacturers that use marketing strategies
like product bundling, product lining, and family branding. Stores reduce their
prices and establish cost leadership through these activities
(www.wekipedia.com).
Efficient Production and Low-Cost Distribution
Low-cost distribution enables a firm to get their products on the shelves in
an economically efficient manner. A firm must have sufficient technology
systems, labor forces, warehouse capacity, supply chains, and transportation
38
abilities to achieve cost leadership through low-cost distribution. A firm’s logistics
network is vital to the distribution process. An efficient system can eliminate
unnecessary costs. Large chains may leverage their distribution system by selling
to smaller food retailers. Some companies own and operate their own bakeries
and dairies independently. Grocery chains distribute their own products
throughout the company’s stores. The cost of these products are low because
they are not subject to advertising expenses, premiums, mark-ups, or any other
costs associated with branded goods. The grocery stores are able to supply the
same products at a lower cost and create a competitive advantage. It is common
for grocery chains to use “loyalty cards” to target profitable customers. Stores
will exchange detailed customer information for discount cards. Firms are able to
gather valuable customer data without having to spend the time and money to
physically seek it out. These stores will systematically discount certain products
at prices that are below the market price; only card holders qualify. This method
allows customers to purchase products at a discount; enabling the stores to cost
effectively move inventory and seasonal products. (www.firstresearch.com).
39
Firm Competitive Advantage Analysis
The Kroger Co. is the largest retail food company in the United States as
measured by total annual sales. The flagship grocery store is able to excel in the
industry because of a balanced mix between firm differentiation and competitive
cost leadership. The firm’s superior products and efficient operations have
propelled their ability to create and sustain a competitive advantage. Kroger
differentiates itself from other industry competitors by focusing on product
quality, variety, and customer service. Furthermore, The Company establishes
cost leadership through competitive strategies such as: economies of scale and
scope, low-cost distribution, and minimizing research costs.
Historical Competitive Advantage Analysis
Kroger has been the primary leader and innovator throughout the
development of the grocery store industry. The Company originally focused on
basic food retail operations; including dairies, bakeries, and meat shops. Mr.
Kroger quickly realized that it was more profitable operate regular fixtures in the
grocery markets under one roof.
Early Innovations
Kroger was the first grocery chain to consolidate numerous food
departments. In addition, Mr. Kroger recognized the profit opportunities
associated with independently producing and selling products. The Company was
the first grocery chain to manufacture and produce “corporate brands.” Kroger
stores were also the first grocery chain to routinely monitor and test food offered
to the customers. The Company has adapted and grown parallel with the
evolution of the grocery industry. Kroger has always obtained a competitive
advantage over competitors with innovative achievements and successful
40
investments. The Company was the first grocery store to install a product
scanning system for check out and inventory purposes. This revolutionary
innovation dramatically increased store operation efficiency.
Modern Innovations
Kroger was the first American grocery retailer to establish a customer
research and database program. This systematic break through prompted the
development of delis and unpackaged food divisions. Most recently, Kroger
merged with supermarket chain, Fred Mayer Inc., which generated huge
economies of scale in purchasing, manufacturing, information systems, and
logistics. The ability for Kroger realize and execute their corporate agenda has
always put them in a dominant position of power. Historically, Kroger has always
had a competitive advantage in the grocery store industry (OneSource
Information Services).
Differentiation
The Company’s most important strategy for creating a competitive
advantage is the ability to differentiate. Kroger differentiates from competitors by
excelling in product quality, product variety, and customer service.
Superior Product Quality
Superior product quality is crucial in building customer loyalty and store
image. The Company uses the method of corporate branding to achieve product
quality. Kroger’s outstanding private-label products have earned industry leading
market share. Kroger owns and operates private manufacturing plants that
produce high quality goods. “Consumer research, the finest ingredients, and our
rigorous testing produce the quality behind our corporate brand. This is part of
the everyday value that is found in all our products (www.kroger.com).” They
are able to closely monitor the production and distribution of these units. The
41
Company has developed one of the toughest inspection and specification
systems in the industry. Quality beef is ensured by tests such as USDA Choice,
Certified Angus USDA Choice, and Natural Beef Select. Kroger’s pork is 100% allnatural and poultry items are grown locally or organically. Seafood, among
numerous delicate food items, is guaranteed to be fresh. Management performs
a “make and buy” analysis on all corporate branded and procured products. All
items are held to the same high standards. The Company trademark, “Private
Selection,” is a premium quality brand that offers gourmet and upscale items.
The majority of Kroger’s manufacturing plants are located within a 200 mile
radius of end user stores. In the grocery industry, the level of product class is
usually determined by the quality of perishable foods. The Company’s time
efficient system of distribution enables the stores to stock new and fresh
products daily (www.kroger.com).
Product Variety
Kroger differentiates itself by establishing superior product variety. It is
known that every major grocery store will offer a certain range of nationally
advertised products. Kroger gains a competitive advantage by providing a wide
and unique product selection. Kroger offers products sold in three categories:
premium (high grade), brand (medium grade), and budget (low grade). The
variety of product classes enables any type of customer to frequent the stores.
Kroger’s multiple retail formats allows them to meet the needs of virtually every
customer. Kroger is able to gain access to valuable customers with innovations in
specialty foods. Kroger is committed to capturing the customers who are
becoming more health conscious regarding their food selection. The Company
established a new, cholesterol reducing, fat-free line of food products
(www.kroger.com). Corporate brands such as “Naturally Preferred” and “Active
Lifestyle” were established to attract healthy and environmentally concerned
shoppers. “Organics for Everyone” is the marketing tagline for the new organic
food program. Kroger attempts to introduce a wide variety of organic products to
42
a new customer base. These products establish strong customer loyalty and
yield higher profit margins. Kroger’s reputation for superior variety in product
selection is anchored by their prepared food innovation. Quick and easy meals
are becoming more popular to the general American public. Kroger capitalizes on
this opportunity by providing customers the ability to purchase a large variety of
freshly prepared meals and ingredients; shoppers are able to buy restaurant
quality cuisine in the stores. Kroger’s customers have grown more dependent on
these prepared meals; which increases the number of trips a shopper makes
within a normal grocery cycle. This strategy is Kroger’s best effort to compete
directly with restaurants and fast food establishments.
Customer Service
Kroger uses the strategy of superior customer service to establish a
competitive advantage. Any grocery chain can offer a customer various items
within a certain price range. A positive experience for the customer is created
through their interactions with store employees. The feeling the customer has
when they leave the store decides whether or not they will keep coming back.
The Company’s associates crucial key to their success. Kroger provides
competitive wages, high-quality health-care benefits and secure pensions to
recruit the best people available (www.kroger.com). Kroger’s employees are
among the highest compensated in the food retailing industry. The Company
offers more employee benefits than its closest competitors. The Company is able
to keep store employee moral high; reflecting in positive customer relations
activities. They have developed numerous projects and customer service training
programs to improve upon their “Customer 1st” strategy. Kroger’s unique
program, “Secret Shoppers,” allows them to evaluate their store performance
from the shoppers’ perspective. Through this program, The Company is able to
identify problem areas that need improvement. “We carefully consider
opportunities that have the potential to redefine existing operating processes
while materially improving the shopping experience of our customers
43
(www.kroger.com). It is a high of priority that Kroger stores be clean. From the
bathrooms to the aisles, Kroger stores follow a uniform cleanliness program that
is very effective. “Kroger stores have ranked in the top three in sanitary levels in
the last seven years (www.firstresearch.com).” Kroger makes it a priority to have
each store adequately staffed. The Company finishes near the top in check out
efficiency every year (www.kroger.com).
Cost Leadership
The Company is successful in demonstrating cost leadership. Kroger is
highly price competitive within the grocery store industry. Traditional grocery
stores cannot consistently price match with super centers and warehouses.
Despite the odds, Kroger has had a successful track record of competing headto-head against super centers. Kroger uses the methods of economies of scale
and scope, low-cost distribution, and minimizing research costs to gain a
competitive advantage.
Economies to Scale
Kroger is the largest supermarket operator in the United States. In 1999,
Kroger merged with another supermarket powerhouse, Fred Mayer Inc.,
establishing superior economies to scale. The Company’s dominant purchasing
power enables them to buy in large volume. This allows Kroger to receive
purchase discounts and cheaper rates on procured items; resulting in lower
prices throughout the store. The Company maintains positive relationships with
the largest manufactures in the grocery industry. Kroger acquires numerous
products manufactured by a single company; achieving economies of scope
through purchasing product bundles, product lines, and family brands. Kroger
utilizes its size to offer economies of scale that are invisible to the customer.
Kroger leverages its size and centralizes vital functions; such as procurement,
44
accounting, and treasury operations (www.kroger.com). This strategy creates
value for customers and better returns for shareholders.
Low-Cost Distribution
The Company uses efficient production methods and low-cost distribution
to establish cost leadership. The Kroger Co. invests significant capital and
expense dollars to ensure that their information systems and logistics network
operate as efficiently and cost-effectively as possible.
The Company is the only major supermarket with a nationwide three-tier
distribution system. The first tier consists of quick turn and perishables that
service stores within a 200 mile radius. The second tier consists of consolidation
centers that service retail stores. Items at these locations include
pharmaceuticals, health and beauty products, and dry grocery products. The
third tier is responsible for shipping seasonal and promotional products to stores.
The tiered distribution system and network is supported with innovative
technology and more cost-effective store delivery.
“Demand forecasting technology utilizes certain store ordering system
capabilities. This capability enhancement is a reality with the creation of Kroger’s
data warehouse, expanded corporate computing infrastructure, and current
software systems. Voice-pick technology employed in our distribution centers
uses wireless communication and voice picking product versus previous paper
label-bases picking. Our real-time warehouse management system improves
both the speed and accuracy of product assembly and shipping
(www.krogerco.com).” Kroger’s distribution network allows them to deliver their
products in a time and cost efficient manner.
The cost savings through these activities are reflected on the product
prices in the stores. The Company is able to improve distribution utilization and
delivery through its transportation fleet. Kroger is home to one of the largest
trucking fleets in the world. The Company’s transportation capacity maximizes
coordination and utilization throughout the distribution process; enabling them to
45
achieve cost leadership. Kroger has superior corporate manufacturing abilities.
This allows them to serve as a distribution source for other smaller grocery
chains. The Company also avoids profit cutting expenses through corporate
branding. Distribution of their own products throughout the industry causes an
increase their profit margins. “By manufacturing our products, we lower our
costs and pass on savings to our customers (www.kroger.com).”
Minimal Research Costs
Kroger is able to minimize research costs through customer loyalty cards.
The “Kroger Plus” shopper’s card is the mechanism used to deliver valuable
research and customer information. Customers can apply and receive a card in
exchange for personal information. “In fact, approximately 40% of all U.S.
households hold one of our shopper cards (www.krogerco.com).” The Company
is able to receive valuable research within their stores; avoiding high expense
costs associated with customer data research. Kroger has formulated an
extensive collection of consumer data generated from their customer loyalty
cards plus a unique partnership with a data analysis firm called ‘dunnhumby’
(www.kroger.com).” The Company is able to monitor customer trends and
formulate marketing strategies to increase profits. Stores often offer preferable
discounts exclusively to card holders; enabling the stores to effectively move
inventory and seasonal products (www.krogerco.com).
46
Accounting Analysis
The accounting analysis is a tool used to assess the methods and policies
a company uses to report its business transactions. Public corporations provide
financial statements and explanations to shareholders and potential investors
about how their company does business. Although these financial statements
are evaluated by external auditors, they can be manipulated by managers and
make it difficult for investors to truly see the operating efficiency of a firm. The
accounting analysis is used to determine whether a firm’s financial numbers
actually showcase the true identity of the firm. The process involves six steps
that help analysis determine the accounting quality of firm’s financial statements.
These six steps include: Identifying Key Accounting Policies, Assess Accounting
Flexibility, Evaluate Accounting Strategy, Evaluate the Quality of Disclosure,
Identify Potential Red Flags, and Undo Accounting Distortions (Healy).
Key Accounting Policies
The first step in the accounting analysis is to determine the key
accounting policies that are used by a firm. These policies are directly related to
the success factors and risk found in an industry (Healy). When evaluating a
company and its industry it is important to understand the key success factors
that are used in the accounting process.
Firms use their key success factors to gain a competitive advantage in the
industry in which they reside. This is why it is important to understand these key
success factors and how the company accounts for them in their key accounting
policies. Key success factors for companies in the retail grocery industry are
product variety, low cost distribution, and economies of scale.
The retail grocery industry is very competitive, and the majority of
companies in this industry provide the same goods and services. It is important
47
for firms in this industry to differentiate themselves by providing a variety of
quality goods and services at the lowest possible price. Cost leadership in the
retail grocery industry is a very important strategy because of the low profit
margins companies in this industry experience. Cost leadership is achieved when
firms provide quality goods and services at the lowest possible price. The most
successful retail grocers have been able to achieve cost leadership because of
the excellent distribution systems they have established.
Economies of scale are a major factor in the retail grocery industry. Due
to the highly concentrated nature of this industry, it is essential for firms to be
large in-order to compete with their competition. Large retail grocers have an
advantage in this industry because their size gives them the ability to establish
distribution centers, reduce costs, and provide lower cost products and services
with the same quality to their customers. Risk associated with this industry
include: very competitive environment, food safety, labor relations, strategy
execution, and data and technology (Kroger 10-K). These key success factors
and risk are very important in determining the accounting policies used by
Kroger Co. and its competitors in the retail grocery industry.
Economies of Scale
As mentioned in the Five Forces Model, the retail grocery industry is a
highly concentrated industry with the 50 largest companies holding 70 percent of
the market share (firstresearch). This concentrated nature implies that
economies of scale play a major role in this industry and retail grocers must be
large in order to gain market share and survive. Gaining market share requires
companies to increase their sales growth over their competitor’s year over year.
By increasing sales growth and market share, companies can ultimately increase
their size. Economies of scale are important because larger companies can
distribute more products at a lower cost.
48
Kroger's Five Year Sales Growth
2002
2003
2004
2005
2006
$50,100
$51,100
$51,106
$53,472
$57,712
-
-
$2,305
$3,526
$4,455
$50,100
$51,100
$53,411
$56,998
$62,167
Other Sales
$3,700
$700
$3,023
$3,555
$3,944
Total Sales
$53,800
$51,800
$56,434
$60,553
$66,111
Food Stores Sales without Fuel
Fuel Sales
Total Food Store Sales
*Numbers were generated from Kroger’s 10-K and are stated in millions
Since the establishment of Kroger in 1883, the Company has been able to
gain the number one and number two market share positions in 38 of the 44
regions they are located in (www.kroger.com). The chart above illustrates
Kroger’s sales growth over the last five years. As can be seen in the chart,
Kroger has continued to increase their sales growth and obtain market share in
the retail grocery industry. To aid the sales of its grocery stores, Kroger
established gasoline stations at many of their retail locations beginning in 2004.
The section titled “Other sales” in the chart came from convenience store sales
and jewelry sales (www.kroger.com). Kroger’s ability to obtain market share and
increase sales in this industry can be seen through the large number of retail
stores it owns and operates. At the end of 2006, Kroger had approximately
2,468 stores (20 new store openings) operating in 44 different regions
throughout the U.S (Kroger 10-K).
Although Kroger opened 20 new stores in 2006, the Company also closed 60
of its operating store locations. Kroger provides disclosure regarding the closing
costs associated with their stores and recognizes them as a liability on their
balance sheet. Kroger provides sufficient information for an analyst to determine
how they recognize these items in their books. Economies of scale are a key
accounting policy for large companies who are rapidly growing and gaining
market share. For large grocers such as Kroger, it is critical that analysis
evaluate the approach a company takes in determining costs associated with
store openings and closings. During times of rapid growth, information on a
firm’s annual report can become less transparent because it gives managers an
49
incentive to not fully account for costs such as “Opening and Closing Costs”
which can lead to manipulation of liabilities and expenses for that period (Healy).
Post-Retirement Benefit Plans:
An important factor that can influence the quality of companies
accounting policies is their Post-Retirement Benefit Plans. In the retail grocery
industry firms compete in high price competition. Companies need to keep their
costs low to be successful. The low cost strategy can be greatly affected by
firm’s post-retirement benefit plans.
To determine the amount of funds allocated to retirement plans Kroger
Co. matches its discount rate (the discount rate is the rate that produces equal
present value payments) for their benefit cash flows to the required rate of
return for a zero coupon corporate bond based on its year of maturity
(www.Kroger.com). In the year end of 2006, Kroger Co. had a post-retirement
benefit discount rate of 5.90% (www.Kroger.com). The method used to
determine this discount rate was provided by Kroger’s 10-K. “The selection of the
5.90% discount rate as of year-end 2006 represents the equivalent single rate
under a broad-market AA yield curve constructed by the Company’s outside
consultant, Mercer Human Resource Consulting.”
This discount rate is accurate when discounting the projected pension
project liability. Kroger The 5.90% rate is up from the 5.70% rate on year
earlier. “The 20 basis point increase in the discount rate decreased the projected
pension benefit obligation as of February 3, 2007, by approximately $68 million
(Kroger 10-K).” The pension is assumed to have a return of 8.5%. The spread
between the discount rate and expected return is right around the average rate
of inflation. The discount rate selected is good because it correlates with other
market conditions in the industry.
Post-Retirement Benefit Discount Rates can also affect expenses a
company incurs during the year. In Kroger’s 10-K, you can see that a 1%
discount rate change could lead to an increase or decrease of approximately $37
50
million in expenses (Kroger 10-K). So, manipulating benefit obligation liabilities
and expenses can be easily done by increasing or decreasing the discount rate
the company uses to determine their benefit obligations. This is why it is
important to determine the method in which a company decides to account for
its Post-Retirement Benefit obligations.
Post-Retirement Discount Rates
2002
2003
2004
2005
2006
KROGER
6.75%
6.25%
5.75%
5.70%
5.90%
SAFEWAY
6.50%
6.00%
5.80%
5.70%
6.00%
SUPERVALU
7.00%
6.25%
6.00%
5.75%
5.85%
8.00%
6.00%
WINN DIXIE
Statistics were provided by each company’s 10-K
6.00%
6.00%
4.75%
The chart above illustrates Kroger’s and its competitors Post-Retirement
Benefit Discount rates for the last five years. For the most part, the industry has
seen a decrease in discount rates over the past five years. Firms that decrease
their Post-Retirement Discount Rates are practicing a more conservative form of
accounting because they are increasing their benefit obligation liabilities and
expenses and reducing their earnings for the year. The majority of retail grocery
stores in this industry determine their discount rates by matching them to a yield
curve that represents returns on current corporate bonds (Kroger 10-K). As can
be seen in the chart, Kroger Co. and a few of its competitors increased their
discount rates this past year. When firm’s increase their discount rates, they are
using a more aggressive form of accounting that will reduce their benefit
obligations and boost earnings for the current period. This is evident by Kroger’s
0.20% increase in their discount rate that resulted in a $68 million decrease in
their benefit obligations. Kroger’s post-retirement benefit obligations make up a
substantial part of the Company’s long term liabilities with $2.4 billion in benefit
51
obligations and long term liabilities totaling $8.7 billion. This $2.4 billion
represents 27.8% of long term liabilities.
How firms account for their Post-Retirement Benefit Obligations is a key
accounting policy because managers can manipulate discount rates and other
benefit related information. Manipulating these factors can result in a material
change to liabilities, expenses, and earnings for the period. On February 3, 2007
Kroger Co. adopted the Employers Accounting for Defined Benefit Pension and
Other Post-Retirement Plans (Kroger 10-K). This accounting standard requires
companies to disclose their benefit plans on their balance sheets. Kroger’s newly
adopted accounting standards for handling their benefit plans gives their
financial statements more transparency and reduces misleading information of
their financial data.
Operating vs. Capital Leases
In evaluating the quality of a firm’s accounting procedures it is important
to analyze the lease structure a company uses. Company’s can choose to
account for their leased property as either an operating lease or a capital lease.
Firms using the capitalized lease method report leased property as capital leased
assets and capitalized leased liabilities on their balance sheet. This method
provides a more transparent balance sheet for analyst and investors when they
evaluate a firm’s performance. On the other hand, using the operating lease
method allows companies to leave leased assets and liabilities off of their
balance sheet. This can give managers an incentive to reduce their lease
obligations and increase earnings for the period.
Firms in the retail grocery industry have leases on the majority of the
properties in which they operate. These leased properties include retail stores
and distribution centers. A mixture of both operating leases and capital leases
are used throughout the industry; the majority being in the form of operating
leases. Distinguishing between operating leases and capital leases is an
important factor that could lead companies to manipulate costs by not showing a
52
substantial amount of lease obligations on their balance sheets due to the use of
operating leases. Although, Kroger and other grocer’s in this industry do not
experience a substantial amount of operating lease obligations compared to their
other debt obligations. Kroger and the majority of its competitors own most of
the facilities in which they operate. In instances were Kroger and its competitors
have operating leases on their facilities they provide more than adequate
disclosure regarding the obligations they carry. For example, both Kroger and
Safeway disclosed to investors their current operating lease obligations and the
future payments on both their capital leases and operating leases.
Although Kroger experiences flexibility in their accounting policies
regarding operating leases, their obligations under these leases are not
significant enough to concern investors about expense manipulation. Investors
and analyst should still evaluate a company’s use of operating leases even if their
obligations are relatively small. In the section titled “Actual Accounting Strategy”
under the subtitle “Operating Leases vs. Capital Leases” we will discuss and
disclose how much and how significant these leases have on Kroger’s financial
statements.
Merchandising Cost
The retail grocery industry is a low margin industry and the majority of
companies in this market are concerned with keeping distribution costs low. To
help keep costs low, many companies in the retail grocery industry have
established their own distribution centers. As a result of high price competition
and the low margin nature of this industry, an important accounting policy for
retail grocers is how they state their merchandising cost.
Kroger’s merchandising costs include: product costs, inbound freight
charges, warehousing costs, and manufacturing production costs. Merchandising
costs also include the transportation and warehousing costs that are directly
related with the company’s distribution centers. Kroger had merchandising costs
of $50 billion and $45 billion at the end of 2006 and 2005 respectively (Kroger
53
10-K). This is a substantial amount of money that is included in the cost of
goods sold section of the company’s income statement. It is important to
analyze merchandise costs in the retail grocery industry because grocery store
managers want to keep these costs as low as possible. Managers have an
incentive not to include merchandising costs in the period in which it was
incurred to help increase profits and make their company look more profitable to
investors.
Goodwill
The Kroger Company reviews for impairment during the fourth quarter of
each year. The company conducts a review to determine the fair value
associated with goodwill. “Generally, fair value represents a multiple of earnings,
or discounted projected future cash flows, and we compare fair value to the
carrying value of a division for the purpose of identifying potential impairment
(Kroger 10-K).” Managers use their knowledge of the current environment and
future expectations. The Company recognizes goodwill when the carrying value
of these divisions is in excess of their implied fair value. The following chart
shows Kroger’s reported goodwill over the past five years.
Kroger’s
Goodwill
Goodwill
GW Amortization
GW Impairment
2002
$3,594
103
NA
2003
2004
2005
2006
3,575 $3,134 $2,191 $2,192
NA
NA
NA
NA
19
441
943
0
Kroger started recording and accounting for goodwill impairment in 2003.
In previous years, they used a goodwill amortization schedule to account for any
decreases in the value of goodwill. In recent years, Kroger has been able to
maintain the value of goodwill on their balance sheet. Goodwill is listed under
assets on the balance sheet. To measure how much the company values its
goodwill, take the percentage of goodwill to total assets. Kroger’s $2192 million
54
of goodwill represents 10.33% of their total assets. This percentage is relatively
low compared to most other companies. Kroger’s goodwill represents a large part
of their assets, but it does not hold a significant importance among other assets.
Goodwill is the one accounting item that is extremely difficult to value. Kroger’s
small percentage of goodwill assures investors that the large percentage of their
assets have a disc tint and finite value.
Conclusion
In determining a company’s key accounting policies it is important to
understand the key success factors and risk involved in their industry. The retail
grocery industry is highly price competitive and it is important for managers to
keep cost low to allow them to earn a profit on their low margin goods.
Important accounting policies in the retail grocery industry are economies of
scale, post-retirement benefit plans, operating leases, and merchandising cost.
It is critical for investors and analysis to determine the methods managers use to
account for these activities on their financial statements in order to determine
the true value of the firm.
Accounting Flexibility
The next step in the Accounting Analysis is determining the level of
flexibility a firm has in implementing their accounting policies. Accounting
flexibility allows a firm to show their financials in a positive light or to hide the
true nature of their activities. Firms’ accounting flexibility enables them to show
what they what be shown. Accounting flexibility is an advantage of the firm but
can be misleading because the information being shown is only what they
choose to be disclosed. GAAP however has rules which all of the firms must
follow. GAAP creates, “a uniform accounting language and increase the
credibility of financial statements by limiting a firm’s ability to distort them”
(Healy 3-3). Overall, GAAP limits the amount of flexibility the firm and managers
55
can have. A more flexible firm will be able to communicate to investor’s better,
clearer, and more insightful information. The downside is the chance to overestimate and inflate their actual numbers. Kroger’s areas of flexibility are made
up of operating leases vs. capital leases, post retirement benefit plans, and
economies of scale.
Operating Leases vs. Capital Leases
One of the industry’s main flexibility surrounds the decision to use
operating vs. capital leases. Kroger Co. experiences a large amount of flexibility
in their lease structure. The difference between operating leases and capital
leases is how they are accounted for on the balance sheet. Operating leases are
“a lease contract that allows the use of an asset but does not convey the rights
similar to ownership of the asset” (Investopedia.com). Operating leases are also
not capitalized meaning that there is never ownership. If ownership never takes
place, then the operating leases do not affect the balance sheet, only the income
statement because they are recognized as expenses. The majority of firms
choose operating leases because of the no effect on the balance sheet. This can
lead to a false identity for a firm because of the lack of transparency in their
financial statements.
Capital Leases are somewhat different because of ownership. Capital
Leases are “leases considered to have the economic characteristic of asset
ownership” (Investopedia.com). Ownership is the main reason companies
choose to have capital leases. The benefits of having the ownership include the
money back from the interest expense and amortization with depreciation for
every year of ownership. The disadvantage of a capital lease is the risk
associated with ownership. Firms would choose a capital lease if they were likely
to be there for a longer amount of time. Since Kroger uses a mixture of both
capital leases and operating leases they experience a lot of flexibility in this area.
56
Post-Retirement Benefit Plans
Post-Retirement Benefit Plans are another critical accounting policy for
Kroger. Kroger’s Post-retirement benefit plans are made up of important
components such as “the discount rate, the expected long-term rate of return on
plan assets, average life expectancy and the rate of increases in compensation
and health care costs” (Kroger 2007 10-K). The discount rate plays an important
factor in the benefit plans and the overall earnings reported by the firm. The
flexibility of the firm’s ability to alter these discount rates in order to increase or
decrease earnings is an important factor when evaluating a firm. Firms can
choose to increase or decrease their discount rates which would have a major
effect on the companies benefit obligations and earnings for a given period.
These benefit obligations can be affected greatly if the discount rate is
overstated or understated, because of the implications it has on the balance
sheet and income statement. When companies choose to decrease their
discount rates, they recognize increases in benefit obligations and expenses
leading to lower earnings. When companies increase discount rates, they are
recognizing a decrease in their benefit obligations and expenses leading to an
increase in earnings. So as previously stated, manipulating benefit obligation
expenses and liabilities can be easily done by increasing or decreasing the
discount rate and in Kroger’s case these obligations make up 27.8% of their total
long term liabilities.
Conclusion
The accounting flexibility within Kroger is based on their choice of using
Operating Leases vs. Capital Leases and their ability to influence the discount
rate on their Post-Retirement Benefit Plans. Kroger’s flexibility in these areas
gives them the choice of being more informative to investors or to hide the true
nature of their activities. These areas of flexibility may also represent a large
portion of the company’s liabilities and expenses. So it is important for investors
57
and analysis to understand the company’s flexibility in these areas and determine
the quality of disclosure in these accounting policies.
Actual Accounting Strategy
The third step in the accounting analysis involves determining the
company’s actual accounting strategy. When determining a company’s actual
accounting strategy it is important to remember their flexibility in choosing:
accounting policies, accounting estimates, reporting format, and the degree of
disclosure they provide. Companies can use this flexibility to their advantage by
not disclosing information to their investors or they can use the flexibility to
report the true nature of their actions. Two important factors when assessing a
firms actual accounting strategy are the level of disclosure provided by the firm
and if the company uses an aggressive form of accounting or a conservative
form.
Post-Retirement Benefit Plans
Kroger Co. and the majority of its competitors have post-retirement
benefit plans for their employees. Kroger provides a very thorough disclosure in
their 10-K as to how they assess the discount rates and benefit obligations owed
to their employees. Kroger uses a non-contributory defined benefit plan which
includes Qualified Plans and a Non-Qualified Plan (Kroger 10-K). Kroger
determines their benefit obligations by using a discount rate that is equivalent to
the required rate of return on corporate U.S. bonds in the year of their maturity.
In 2006, the Company determined its discount rate to be 5.90%, a 0.20%
increase from the previous year, and they also disclosed that the discount rate
was determined by the Company’s outside consultant, Mercer Human Resource
Consulting. Using an outside consultant to assess discount rates helps eliminate
managers incentives to decrease these benefit obligations. Kroger Co. has
shown a continued decrease in discount rates over the past few years until this
58
year’s recent increase to 5.90%. Although this increase in discount rates will
lower the Company’s benefit obligation, it can be seen that the rest of the
industry has followed the same trend. In their disclosure, Kroger also discusses
the effects of its post-retirement benefit plans on its balance sheet and income
statement with benefit obligation liabilities totaling $2.4 billion and current
benefit costs equaling $149 million at the end of 2006 (Kroger 10-K). The $2.4
billion in benefit obligations represents 27.8% of the company’s long term
liabilities, which is a material amount of money invested in employees postretirement benefit plans.
Kroger Co. has historically used a more conservative form of accounting
when determining its benefit obligations. As previously mentioned, Kroger has
continued to decrease its post-retirement discount rate until 2006. Decreasing
the discount rate will ultimately increase a firm’s benefit obligations and decrease
their earnings. This demonstrates a conservative use of accounting by Kroger in
regards to its post-retirement benefit plans. In 2006, the Company’s outside
consultant increased their discount rate to 5.90% compared to the previous
year’s discount rate of 5.70%. In Kroger’s 10-K, it mentions that an increase or
decrease in the discount rate would affect benefit expenses by approximately
$37 million (www.kroger.com). The increase in post-retirement discount rates
resulted in a reduction in benefit obligation liabilities of $68 million in 2006
(Kroger 10-K). Although the Company showed a decrease in their benefit
obligations, the discount rate was assessed by an outside consultant and the
industry as a whole showed the same increase in these discount rates for 2006.
Kroger Co. also recently adopted the GAAP standard know as the “Employers
Accounting for Defined Benefit Pension and Other Post-Retirement Plans (Kroger
10-K).” This accounting standard requires companies to more thoroughly record
their post-retirement benefit plans on their balance sheet. Kroger’s use of an
outside consultant and its newly adopted GAAP for handling post-retirement
benefit plans demonstrates the Companies use of a more conservative form of
accounting.
59
Operating Leases vs. Capital Leases
In the retail grocery industry there is a mix use of both operating and
capital leases. The majority of these leases are in the form of operating leases,
which can be seen in Kroger’s annual report as it uses more operating leases
than capital leases. Companies choose to use operating leases to avoid the risk
related with owning the property. In 2007, Kroger will have operating lease
payments of $778 thousand compared $57 thousand in capital lease expenses.
Kroger also recorded $649 thousand in operating lease expenses for the year
2006 (Kroger 10-K). This information is included in Kroger’s detailed disclosure
regarding their lease structures.
Although Kroger uses operating leases on the majority of their leased
facilities these obligations under operating leases are not significant when
compared to the company’s total assets and total liabilities. If the operating
leases were converted to capital leases they would only represent 7.50% of the
Kroger’s total current liabilities in 2006. So although Kroger chooses to use
operating leases over capital leases on their leased facilities, their obligations
are not a significant amount that would require further investigation.
Conclusion
When doing the accounting analysis it is important to evaluate the actual
accounting strategy firms implement around their flexible policies. Kroger Co.
experiences the majority of their flexibility in their decisions to use operating
leases vs. capital leases and the discount rate that determines their benefit
obligations. Kroger provides more than adequate disclosure regarding its
operating leases and their post-retirement benefit plans. The company uses a
low to medium form of conservative accounting for both of these accounting
policies.
60
Quality of Disclosure
The quality of disclosure is crucial in determining the level of transparency
and accuracy of Kroger’s accounting reports in their 10-K. To determine the
quality of disclosures, we must analyze the firm’s managerial strategy and
decisions regarding accounting disclosures. Managers have certain required
disclosure obligations, but they retain the ability to communicate their strategic
accounting methods. Managers can either make it easy or difficult for analysts to
really determine the value of a firm. Evaluating a firm’s quality of disclosure can
give investors a more comfortable picture of the firm’s operations and financial
situation. When reading Kroger’s annual report it is obvious that they strongly
believe that their accounting policies are vital in preparing their financial
statements for investors.
Qualitative Analysis
Operating and Capital Leases
Kroger discloses a sufficient amount of information regarding their
commitments and involvements in operating and capital leases. The Company
openly admits to using primarily operating leases in their leased facilities (Kroger
10-K). The footnotes exhibit the structure of a general lease term. They specify
the range of life for a typical lease; including the options for renewal. Kroger’s
10-K thoroughly states certain clauses, various expenses, funding methods, and
other lease concessions. Kroger discloses the calculations to determine minimum
rent expenses and payments for operating and capital leases. The manager’s
discussion notes that Kroger’s fundamental goal is to engage in capital
expenditures and provide growth through expansion and acquisition; they want
to own the real estate for operations (Kroger 10-K). Kroger’s 10-K reveals the
economic consequences and benefits resulting from store closures. They disclose
the calculations of cash flows generated from discontinuing operations. The
61
Company admits that volatile rent expense is the principal factor in closing these
stores (Kroger 10-K).
Post-Retirement Benefit Plan
Kroger does a very good job of showing their current and future benefit
obligations that is owed to their employees. In the industry, the pension plan is
a large liability that affects the cash flows of each firm. It is important that
investors are able to assess the financial consequences of individual pension
plans. “Accounting rules require that firms estimate the value of defined pension
and post-retirement commitments as the present value of future expected
payouts under the plan” (Palepu & Healy). In other words, pension plans
represent a firm’s financial obligation to employees in the future.
Analysis of Pension Discount Rate
Kroger forecasts their pension liability by estimating the discount rate, the
expected long-term rate of return of plan assets, average life expectancy, and
the increasing rates in compensation and health care costs. Kroger does an
excellent job of disclosing their methodology for selecting a discount rate that
accurately reflects the benefit plan’s cash flows. “Benefit cash flows due in a
particular year can be ‘settled’ theoretically by ‘investing’ them in the zerocoupon bond that matures in the same year” (Kroger 10-K). Kroger selected the
discount rate of 5.90% to measure the projected pension benefit obligations for
2006. The Company does a thorough job in determining the expected return on
pension plan assets. Kroger uses historical, current, and forecasted allocations
and returns to estimate the expected return. The Company discloses the
methods used in determining the average life expectancy in the calculation of its
pension obligation. The adjustments made to the 2015 mortality table increased
the projected benefit obligation by $93 million dollars (Kroger 10-K). Kroger’s
10-K has seven full pages of useful information retaining to the pension analysis.
They diligently explain each plan asset, plan liability, expense and costs, discount
62
rate, funding endeavor, and supplemental plan. The pension benefit analysis is
crucial because managers have a lot of flexibility in this area. Kroger makes a
strong effort to disclose each and every aspect of the benefit obligation
calculation.
Disclosure of Inventory
Inventory valuation is another area where managers’ strategic accounting
methods can have a dramatic effect on a firm’s cash flows. Managers can
manipulate the value of total inventory by implementing several different
inventory valuation techniques. In the retail grocery industry, managers use
FIFO (first in first out) and LIFO (first in last out) inventory accounting to
illustrate operations involving inventory. These techniques are irrelevant
when considering the quality of disclosure involving inventory
accounting. Kroger does not fully disclose the method used to calculate their
inventory. We are not able to see the breakdown of inventory into categories or
percentages. However, we do know the average inventory for each year.
Kroger’s inventory turnover rate is consistent and shows steady growth. The
inventory turnover ratio shows how many times a firm’s inventory is sold and
replaced over the year. In the grocery industry, a high inventory ratio is a
positive sign. It shows that a firm’s cash to cash cycle is efficient and that
investments for inventory are repaid in a short period. In Kroger’s 10-K, they fail
to thoroughly explain their activities and the consequences behind their inventory
operations.
Ratio Analysis
The inventory turnover ratio illustrates inventory accounting details.
Kroger’s COGS (cost of goods sold) is about double that of its competitors.
Kroger stores must keep a higher inventory level than its competitors. This
ensures that Kroger stores will not miss any sales opportunities due to lack of
inventory. In the grocery industry, high levels of inventory lead to more lost,
63
stolen, and damaged goods. The high inventory of perishable goods also
exposes Kroger to more loss from spoilage. This explains why Kroger’s inventory
turnover ratio is smaller than its competitors.
Inventory Method Analysis
In the grocery industry, inventory databases and methods tracking
inventory are crucial in the distribution process. These methods often require a
large technological investment and steep learning curves. In the industry, it is
not common for a firm to disclose any data or comments regarding inventory
methods. Kroger elects not to disclose any detailed information in this area.
Kroger’s technology and logistics system is one of top quality in the grocery
industry. Kroger stores preciously manage and track their inventories daily. They
have an exact measurement of their inventories. It is not necessary for Kroger to
release this valuable information to the public. Releasing this information will
expose their strengths and weaknesses within inventory operations; possibly
hurting their bargaining power over suppliers and customers. It will also allow
other firms to capitalize on Kroger’s inventory management breakthroughs.
Kroger can best maintain their competitive advantage by withholding inventory
accounting data. Kroger decision to withhold inventory data is not an act of
secrecy or mystery. The company’s operating structure is balanced between their
corporate office and 17 operating divisions. Kroger’s decentralized structure
delegates each division to have the ultimate authority regarding their inventory
and merchandising decisions. “Divisional managers are able to respond quickly to
changes in competition and customer preferences within each local market
(www.kroger.com).” The Company’s operating goal is to maximize efficiency and
minimize costs. Therefore, to disclose each individual division’s entire inventory
method would be inefficient.
64
Quantitative Analysis of Disclosure
Due to the Generally Accepted Accounting Principles (GAAP) set forth by
FASB, managers overlooking their companies have leeway to make annual
reports appear to the advantage of the manager. It helps managers portray the
company to the best of their ability so that investors will find the company
favorable and choose to invest with them. However, investors and analysts
should pay careful attention to all of the disclosure details involved with these
financial documents, checking for distortions and variations within them. Though
most managers use these filings to better document and disclose their
information, they have certain incentives that may lead them to “doctor” their
findings due to the flexible accounting choices they might have in order to
achieve personal goals.
There are two main forms of action that investors can take in order to
better evaluate these findings. These two techniques are known as the Sales
Manipulation and Expense Manipulation Diagnostic Ratios. In Sales Manipulation
investors can compare the net sales of companies 10-K’s too many different
aspects, such as accounts receivable, inventories, unearned revenue, and
warranty liabilities to determine if there are any irregularities that might point out
distortions that have been made to exemplify a company’s performance.
Investors can also check different Expense Manipulation Ratios such as:
expenses, accruals, and asset turnover over a given time period to check if any
fraudulent activities have occurred. Large changes within all of these ratios tend
to lead to a “problem” within the company that may point out financial problems
or manager’s manipulation of company activity.
65
Sales Manipulation Diagnostic
Looking back from year to year at the financial activities within the
company can help investors check and find any discrepancies within the
company or financial market that are occurring. Comparing net sales with
various other elements of a company’s financial statements enables investors
and analyst to determine if a company’s sales have been manipulated.
Ultimately, it allows investors to gain an understanding about a company’s
activity and about probable investment opportunities.
Net Sales/Cash from Sales
Net Sales/Cash From Sales
1.008
1.006
1.004
1.002
1
0.998
0.996
0.994
0.992
0.99
2003
KR
SWY
SVU
WFMI
WMT
2004
2005
2006
2007
Year
As you can see in the chart above, Kroger and its competitors all have net
sales to cash from sales ratio around one. Taking this ratio of Net Sales to Cash
from Sales gives us an overview of what is actually being received within the
accrual time period. It usually involves around a 1:1 ratio. For the most part,
firms never fully realize this ratio. Kroger mainly receives cash directly from
actual cash payments or through credit or debit card payments that are
financially backed immediately. Kroger recognizes immediate cash payment form
66
customers who use big name credit cards. However, customer purchases using
cards such as a company’s “private” credit card are handled much differently.
These company credit cards act as receivables when issued and the actual
payment comes in the form of payments received at a later date.
For the most part, retail grocers don’t carry private credit cards due to the
risk of defaults on payment; especially since the trend of most grocers has
allotted for gas sales. They alleviate themselves of the risk by paying fees for the
services of major credit and banking companies. For this reason, most retail
grocer companies maintain a close relation to the 1:1 ratio as represented by this
graph. Customer payment defaults are not a significant problem in the industry.
The majority of purchases are on a smaller scale; the percentage of multiple
defaults by an individual is low. Most of the firms’ large transactions occur
between large manufacturers or well-known service companies. The default rate
for the supply side of the industry is almost zero. The net sales to cash from
sales is not a relevant ratio.
Net Sales/Account Receivables
Net Sales/Net Account Receivables
250
200
KR
SWY
150
SVU
100
WFMI
WMT
50
0
2003
2004
2005
2006
Year
67
2007
The retail grocery industry, for the most part, tends to try and keep the
ratio of net sales to account receivables stable due to the fact that they prefer
accepting cash instead of accounts receivable at a later date. The chart above
demonstrates Kroger’s long term strategy of keeping net sales to accounts
receivable stable. The only way this trend is apparent without causing a “red
flag” is when a company is changing their key success factors and going with a
different approach.
With the exception of a few “balancing out” years for Wal-Mart, the retail
grocery industry as a whole has a relatively low ratio of Net Sales to Accounts
Receivables. This is mainly due to the fact that most sales occur by cash means.
By holding no company credit cards, they are virtually free of accounts pending
payments at later dates. Wal-Mart tends to have a higher ratio due to the sheer
magnitude of products and services that they sale. The rest of the retail grocers
tend to show a very consistent pattern of ratios.
Net Sales/Inventory
The chart below shows the ratio of net sales to inventory for the firms in
the industry. The information was gathered from each company’s 10-K from the
last five years.
Net Sales/Inventory
30
25
KR
20
SWY
15
SVU
WFMI
10
WMT
5
0
2003
2004
2005
2006
Year
68
2007
For the most part, Kroger and its competitors have shown the same
steady trend in their inventory turnover the past five years. Each company has a
similar variation of inventory methods; leading us to believe that the inventories
have been soundly kept in respect to net sales across the board. This ratio also
tends to show the grade of performance between how a firm is allocating and
efficiently using their inventories to maximize revenue output. As the graph
details, each company has had a steady flow of inventory in respect to Net Sales.
In the grocery industry, a store has the capability of generating large amounts of
sales in a short period of time. Stores must have the inventory to support the
flow of sales throughout the year. The net sales to inventory ratio shows that
firms in the industry are holding a sufficient amount of inventory to support the
flow of sales.
Net Sales/Unearned Revenue
The ratio of Net Sales to Unearned Revenues is one of the more suitable
and widely used methods managers utilize to obtain a quota. Managers can use
ploys such as recognizing unearned revenues early so that even though they
have not received payments as of yet their overall net income has increased by
that margin. This is a large “red flag” as far as investors should be concerned.
This can seriously understate the level of financial distress that the company is
in. Kroger and its competitors do not experience significant unearned revenue
amounts on their balance sheet because revenue is earned as soon as the
transaction occurs in the checkout line.
Net Sales/Warranty Liabilities
All of the companies included in these ratios do not partake in giving out
company warranties on products or services. All of the products that are featured
within these companies are protected by the manufacturers warranty leaving no
liability with these firms. Therefore you cannot apply this ratio to any of these
industries.
69
Conclusion
In the grocery industry, comparing net sales with other elements of a
company’s financial statements is crucial. Analysts need to be able to determine
the degree at which a firm manipulates sales. In this circumstance, the most
important factors are the amount of cash collected from customers and the
inventory. These two factors are the most relevant in the grocery industry
because they encompass the most basic operations of the business. Grocery
stores live and die by cash sales and inventory levels.
70
Sales Manipulation Diagnostic
KR
Net Sales/ Cash from Sales
Net Sales/ Receivables
Net Sales/ Inventory
Net Sales/ Unearned Revenue
Net Sales/ Warranty Liability
2003
2004
2005
2006
2007
1.0000
76.45
11.59
NA
NA
1.0001
79.81
11.97
NA
NA
1.0002
85.38
11.93
NA
NA
.9997
89.05
12.39
NA
NA
.9986
85.53
13.01
NA
NA
.9989
80.90
12.85
NA
NA
1.0016
93.23
13.52
NA
NA
1.0013
105.67
13.07
NA
NA
1.0000
109.57
13.89
NA
NA
.9989
87.13
15.21
NA
NA
1.0012
40.17
16.03
NA
NA
1.0009
45.21
16.65
NA
NA
1.0024
42.12
16.55
NA
NA
1.0011
45.25
17.83
NA
NA
1.0069
39.09
12.78
NA
NA
.9977
87.33
24.88
NA
NA
.9952
68.58
25.41
NA
NA
.995
59.5
25.27
NA
NA
.9996
70.37
27.02
NA
NA
.9968
67.8
27.51
NA
NA
.9993
144.35
9.28
NA
1.0015
201.59
9.50
NA
.9989
164.13
9.56
NA
.9985
119.98
9.68
NA
.9994
121.48
10.24
NA
SWY
Net Sales/ Cash from Sales
Net Sales/ Receivables
Net Sales/ Inventory
Net Sales/ Unearned Revenue
Net Sales/ Warranty Liability
SVU
Net Sales/ Cash from Sales
Net Sales/ Receivables
Net Sales/ Inventory
Net Sales/ Unearned Revenue
Net Sales/ Warranty Liability
WFMI
Net Sales/ Cash from Sales
Net Sales/ Receivables
Net Sales/ Inventory
Net Sales/ Unearned Revenue
Net Sales/ Warranty Liability
WMT
Net Sales/ Cash from Sales
Net Sales/ Receivables
Net Sales/ Inventory
Net Sales/ Unearned Revenue
Net Sales/ Warranty Liability
This is a formatted readout of the Sales Manipulation Diagnostic which
has been used to create the previous graphs.
71
Expense Manipulation Diagnostic
When investors identify a company’s past performance over several years,
they are able to point out characteristics which allow them to have better insight
into the workings of a potential investment choice. He or she can also compare
their past performances with those of their industry wide competitors. They can
decide whether or not certain anomalies are formed within a certain company’s
accounting activities or whether it is an industry wide situation. Like other
diagnostic ratios, these ratios are run to determine the reliability of a company’s
financial statements. A company with vast fluctuations or imbalances throughout
an expense manipulation diagnostic analysis can determine whether or not they
are reporting realistic financial statements.
Asset Turnover
Asset Turnover Ratio
3.5
3
2.5
Kr
SWY
2
SVU
1.5
WFMI
WMT
1
0.5
0
1
2
3
4
Year
72
5
The chart above illustrates Kroger and other firm’s Asset Turnover ratios
for the last five years. Asset turnover measures a firm’s ability to efficiently use
assets to acquire sales. It determines how much sales revenue a company
generates from its assets (en.wikipedia.org). As you can see in the chart above,
Kroger has experienced little volatility and appears to have a steady ratio. The
Company’s asset turnover ratio is shows a steady increase; there have been no
decreases reported. The Company has produced $3.11 in sales for every dollar of
assets. The competitors are able to manage a high average asset turnover ratio
of 2.5. Most grocery stores have operating leases rather than capital leases.
Operating leases keep assets off the balance sheet. Kroger is the largest store in
their industry. They have more stores that generate the most sales. Firms in the
industry tend to keep inventories low. Stores generate large sales and keep
inventory turnovers high; leading to a higher ratio. Kroger’s asset turnover ratio
would lead an investor to believe that they do not manipulate expenses.
Operating Cash Flow/Operating Income
CFFO / OI
3
2.5
2
Kr
SWY
SVU
1.5
WFMI
WMT
1
0.5
0
2003
2004
2005
2006
Year
73
2007
Above is a diagram of Kroger and its competitors Cash Flow from
Operations to Operating Income ratios. Kroger has experienced substantial
fluctuation in their cash flows and operating income ratio, but has stayed close to
the industry average. The current cash flow from operations to operating income
ratio is 1.05. This ratio illustrates the relationship between the amounts of cash
generated from operating activity and the amount of operating income recorded
on the income statement (en.wikipedia.org). Kroger has experienced some large
fluctuations over the past five years; possibly due to overstating expenses.
Overstating expenses on the income sheet would cause the ratio to increase. In
2005, Kroger’s CCFO/OI ratio declined rapidly; possibly caused by a decrease in
cash flow from operations and an increase in operating income. The Company
has not done a good job of matching cash flows from operations to total income.
As a whole, these industry ratios are declining. It is good to have a lower
CCFO/OI ratio; a declining ratio is a positive. A possible explanation for this is
that firms are generating less cash flow through investing and financing activities
and creating more income through operating activities. If a firm has a high or
increasing CCFO/OI ratio, they can be experiencing a lower income from
operations.
74
Operating Cash Flow/Net Operating Assets
CFFO / NOA
0.45
0.4
0.35
0.3
Kr
SWY
0.25
SVU
0.2
WFMI
0.15
WMT
0.1
0.05
0
2003
2004
2005
2006
2007
The chart above is a diagram of Kroger and its competitors Cash Flow
from Operations to Net Operating Asset ratios. The ratio of changes in
CFFO/NOA uses cash flows from operations to show firm’s return on operating
assets. Kroger’s high ratio relates directly to more cash being generated from a
firm’s total assets. An analyst can determine that they utilize property, plant, and
equipment. Kroger’s steep ratio decline cannot be attributed to a decline in sales,
which would decrease their cash flow from operating activities. Kroger has seen
a substantial increase in sales percentage annually. The Company expensed fixed
assets rather than capitalizing them; increasing their operating assets. Kroger’s
current ratio shows that their operating assets are able to consistently produce
operating cash flows. Investing in operating assets to produce increased cash
flows from operations is not The Company’s strategy. This ratio illustrates that
75
companies are able to manipulate their expenses through the use of operating
and capital leases.
Total Accruals/Changes in Sales
Total Accruals / Change in Sales
0.8
0.7
0.6
0.5
Kr
0.4
SWY
SVU
0.3
WFMI
0.2
WMT
0.1
0
-0.1
2003
2004
2005
2006
2007
Year
The diagram above is a collection of Total Accruals to Net Sales Ratios for
Kroger and its competitors over the last five years. The ratio illustrates how the
total accruals of a firm match a company’s total net income. The ratio takes the
company’s net income less the CFFO and divides by total sales per company.
This ratio can be in indicator whether companies are manipulating expenses in
efforts of overstating net income. A firm could achieve this accounting objective
by increasing sales while holding inventory and depreciation sales constant. In
the grocery industry, in increase in sales usually causes an increase in these
costs.
In 2003 through 2005, Kroger experiences a dramatic decrease of total
accruals/change in sales. The Company rebounds soon after and appears to
76
approach the industry equilibrium. Kroger, including its competitors, will not be
able to easily manipulate this ratio. Sales are recorded simultaneously when the
each product is scanned; therefore, they are difficult to manipulate. Inventory
and depreciation expenses are closely integrated with product sales. Total
accruals divided by the change in sales seen by each firm is the ratio that differs
among each company the most. However, the ratios are on such a small scale
that the differences are minimal. When the ratio is high, we can believe that the
firm is operating efficiently.
Pension/SG&A
Pension / SG&A
0.35
0.3
0.25
Kr
SWY
0.2
SVU
0.15
WFMI
WMT
0.1
0.05
0
2003
2004
2005
2006
2007
Year
Above is a collection of Pension Expenses to SG & A Expenses for Kroger
and its competitors over the last five years. The pension expense ratio compares
the selling, general, and administrative expenses to the Pension expense. The
pension expense reimburses retirees for the service towards their company
throughout their careers. Pension plans net worth and liabilities are constantly
77
changing. These ratios are not reliable when evaluating expense manipulation.
They are should not be significant because they illustrate a lack of consistency.
78
Expense Manipulation Diagnostic
KR
CFFO/OI
CFFO/NOA
Asset Turnover
Total Accruals/Change in Sales
Pension Expense/SG&A
Other Employment/SG&A
2003
1.24
.3296
2.57
.6709
.1434
.0366
2004
1.62
.2100
2.59
.4717
.1781
.0351
2005
2.76
.2084
2.75
-.0393
.2009
.0345
2006
1.08
.1929
2.95
.0692
.2071
.0323
2007
1.05
.1996
3.11
.2163
.2043
.0315
2.14
.1531
2.17
.0021
.0149
.0025
2.8
.1148
2.366
.0020
.0120
.0049
1.89
.1480
2.23
.0044
.0160
.0071
1.54
.1166
2.43
.0303
.0183
.0070
1.35
.1233
2.46
.0112
.0293
.0073
1.02
.2732
3.24
.4670
.2485
.055
1.4
.3844
3.28
.3152
.2784
.0563
1.12
.3509
3.11
.4968
.3078
.0664
1.6
.3044
3.23
.2906
.0813
N/A
.6135
.1796
1.72
.3002
.0459
.0076
1.62
.3554
2.85
.2002
N/A
.62
1.67
.3890
2.63
.2264
N/A
.7031
1.52
.3764
2.54
.1809
N/A
.7761
1.79
.3898
2.48
.1628
N/A
.9310
1.41
.3662
2.74
.2249
N/A
.7512
.9720
.2683
2.38
.5448
N/A
.0311
1.06
.2827
2.40
.5115
N/A
.0294
.8695
.2300
1.28
.6148
N/A
.0278
.9424
.2364
2.24
.5843
N/A
.0263
.9838
.2361
2.28
.3392
N/A
.0337
SWY
CFFO/OI
CFFO/NOA
Asset Turnover
Total Accruals/Change in Sales
Pension Expense/SG&A
Other Employment/SG&A
SVU
CFFO/OI
CFFO/NOA
Asset Turnover
Total Accruals/Change in Sales
Pension Expense/SG&A
Other Employment/SG&A
WFMI
CFFO/OI
CFFO/NOA
Asset Turnover
Total Accruals/Change in Sales
Pension Expense/SG&A
Other Employment/SG&A
WMT
CFFO/OI
CFFO/NOA
Asset Turnover
Total Accruals/Change in Sales
Pension Expense/SG&A
Other Employment/SG&A
79
Conclusion
Though many firms within the retail grocer industry have varying methods
by which they allocate their accounting abilities, the numbers tend to run fairly
evenly across the board. This tells us that the overall market, as a trend, is fairly
even in measure with no one standing out as practicing unfair accounting
measures.
With the exception of large fluctuations in the middle of their total
accruals ratio, Kroger tends to be right on track with most of their ratios. They
seem to be factual and upfront with their practices which lead investors to have
more trust with their reporting methods. However, no one investor should ever
become settled with the way that accounting methods are handled. Though
many good people work on these, humans are prone to being fallible and
creating mistakes by either choice or error. Knowing how to look up past
performances and measure them by ratios helps us stay away from becoming
lethargic with our practices.
Potential Red Flags
Identifying potential red flags is an important step in the accounting
analysis because it probes into the firm’s financials and their business decisions.
Potential red flags are the part of the accounting analysis where questionable
accounting decisions are reviewed and then analyzed. Analyzing some of the
accounting methods is needed because sometimes the numbers become
distorted. The numbers from the previous ratios diagnostics can be a strong
starting point when looking for these red flags. Distorted numbers for the most
part happen for a reason, mainly for the company to become more appealing.
Identifying some of the red flags can save firms from running into future
problems.
80
Diagnostic Ratio’s
After reviewing Kroger’s sales and expense diagnostic ratio’s, there are no
major “Red Flags” that standout. For companies like Kroger in the retail grocery
industry, it is very difficult to manipulate sales because of the new scanning
technology at checkout lines. When consumers buy products they are
automatically scanned and counted as sold. On the other hand, manipulating
expenses in the retail industry can be done fairly easily. Rapidly increasing asset
turnover ratio’s and high pension expenditures to selling, general, and
administrative can be a warning sign to investors. Kroger’s expense diagnostic
ratios have not experience any major changes the past few years and they
provide no red flags to investors.
Operating Leases
Kroger does a good job in their annual report of disclosing information
regarding the areas they experience flexible accounting. Kroger’s use of
operating leases over capital leases in their leased facilities requires a more
thorough analysis of these operating lease obligations. After examining Kroger’s
operating leases it can be concluded that their obligations are not significant
when compared to the company’s current liabilities. Analyst and investors should
be aware of how a company accounts for their leases in order to determine if
there is manipulation involved.
Post-Retirement Benefit Plans
In many cases the way a firm handles their benefit plans can provide a
major red flag to investors. Although this can be a troublesome are for investors
when evaluating a firm, Kroger goes above and beyond GAAP standards for
disclosing their post-retirement benefit obligations. In this disclosure, Kroger
illustrates how they assess their discount rates (outside consultant); their current
and future benefit obligations, and has improved their disclosure methods by
implementing new accounting standards for recognizing these obligations.
81
Therefore, Kroger’s post-retirement benefit plans do not raise major red flags to
investors.
Conclusion
After careful review of Kroger’s manipulation ratios and their financial
statements it can be seen that there are very few red flags for investors.
Kroger’s wide use of operating leases vs. capital leases is the only area that may
cause concerns for investors. Overall, Kroger does a very good job of disclosing
the majority of their key accounting procedures to their investors and they also
continue to increase the level of their exposure by implementing newly accepted
accounting standards that are recommended by the FASB.
Undo Accounting Distortions
When it is decided that there are possible distortions in a company’s
financial statements, it is important for investors and analyst to reevaluate the
impact of these distortions. Kroger’s conducting sales and expense manipulation
ratios for Kroger and its competitors we were able to evaluate the quality of the
Company’s disclosure. Kroger’s financial statements and ratios do not provide
any evident red flags. Kroger also does a very good job of disclosing their
flexible accounting policies that surround its post retirement benefit plans and
operating leases. The Company also continues to increase the quality of their
disclosure by adding recommended FASB accounting policies for their flexible
accounting policies. So it can be concluded that Kroger has no evident potential
red flags needing to be reevaluated.
82
Financial Analysis, Forecasting Financials,
and Cost of Capital Estimation
When attempting to find the value of a company, it is essential for
analysts and investors to collect financial information about the company, its
competitors, and the industry in which the company resides. In this section of
our valuation of Kroger, we implemented several key analyses of the Company
and its competitor’s financial statements. The first area of focus for Kroger’s
evaluation was to conduct a trend and a benchmark analysis using liquidity,
profitability, and capital structure ratios. This required us to obtain the five year
financial statement history of Kroger and its competitors. These ratios gave us
important information about Kroger and the rest of the industry that can be used
in our ten year financial forecast analysis of Kroger. In our forecasted financial
statements we made key assumptions using trends found in our ratio analysis of
Kroger and the retail grocery industry. These trends enabled us to project
Kroger’s future income statements, balance sheets, and statement of cash flows
over a ten year period. The final analyses we conducted consisted of the
estimation of the cost of debt and equity. This required us to collect information
regarding interest rates and pricing data for Kroger. The information allowed us
to compute the cost of equity using the CAPM Model and regression analysis.
Financial Ratio Analysis
Financial ratio analysis uses ratios to measure a company’s liquidity,
profitability, and capital structure. This analysis is broken into two different
sections: Trend Analysis and Benchmark Analysis. Trend analysis is a process in
which an individual firm’s financial ratios are determined over a five year history.
These financial ratios allow analyst to see company trends within their historical
83
financial statements. The Benchmark Analysis is performed by using the same
financial ratios in the trend analysis. These ratios are applied to competitors and
the overall industry to develop industry wide trends. Analysts and investors can
then compare the company being valued with its competitors and the industry.
Both the trend analysis and the benchmark analysis provide helpful information
to individuals trying to evaluate a firm’s historical performance and their
expected future performance. In our valuation of Kroger, we chose to combine
the trend analysis with the benchmark analysis to give us a better idea of how
Kroger compares to its competitors and the rest of the retail grocery industry.
Liquidity Analysis
Liquidity ratios are ratios derived from the company’s balance sheet and
income statement. The primary purpose of the liquidity ratios is to measure the
firm’s ability to turn their assets into cash. These ratios are important in
measuring the ability of a company to meet both its short-term and long-term
obligations (www.creditguru.com). These ratios measure a company’s ability to
maintain a sufficient percentage of cash equivalent assets that are crucial for
paying off the firm’s current liabilities. Liquidity ratios used in Kroger’s financial
analysis include the current ratio, quick asset turnover, accounts receivable
turnover, inventory turnover, and working capital turnover. These ratios help
determine how assets are transformed into cash and generate cash flows.
84
Current Ratio
Current Ratio
3.50
3.00
2.50
Kroger
Safeway
2.00
SuperValu
Winn-Dixie
1.50
Industry Average
1.00
0.50
0.00
2002
2003
2004
2005
2006
Year
Current Ratio
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
0.99
0.91
0.94
1.48
1.08
2003
1.01
1.01
1.08
1.45
1.14
2004
1.01
0.95
1.09
1.44
1.12
2005
0.96
0.87
1.30
3.03
1.54
2006
0.89
0.77
1.44
1.73
1.21
The chart above illustrates the Current Ratios for Kroger and its
competitors over the past five years. The current ratio is calculated by dividing
the firm’s current assets by their current liabilities. This ratio allows analysts to
evaluate a firm’s ability to pay its short-term obligations (investorwords.com).
Basically, the current ratio shows whether or not a company can pay its bills.
Financial analysts favor a current ratio of about 2:1, however; current ratios vary
across different industries.
85
Over the five year period from 2002 through 2006, Kroger has managed a
current ratio of .97; while the industry averaged a ratio of 1.22 (the industry
average excluding Winn-Dixie is 1.01). This means that for every dollar the
company owes, it has .97 available in current assets. In the retail grocery
industry, current ratios are relatively low. Kroger’s ratio is slightly less than that
of its competitors in the industry. A current ratio of less than one usually
indicates that a company will have problems meeting short-term obligations.
Kroger’s current ratio is right below the standard 1:1 ratio, which is nothing to be
concerned about. Kroger has the ability to generate large amounts of cash sales
in a short time period. Analysts are not concerned with Kroger’s current ratio
because they acknowledge the Company’s ability to generate sufficient cash
flows to cover their short-term obligations.
Quick Ratio
Quick Asset Ratio
0.80
0.70
0.60
Kroger
0.50
Safeway
SuperValu
0.40
Winn-Dixie
0.30
Industry Average
0.20
0.10
0.00
2002
2003
2004
2005
Year
86
2006
Quick Asset Ratio
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
0.15
0.13
0.28
0.33
0.22
2003
0.16
0.16
0.33
0.26
0.23
2004
0.23
0.16
0.40
0.20
0.25
2005
0.21
0.17
0.57
0.72
0.42
2006
0.21
0.15
0.75
0.61
0.43
The graph above presents Quick Asset Ratios for Kroger, its competitors,
and the overall industry. The Quick Asset Ratio, or acid-test ratio, is a measure
of a company's liquidity and ability to meet its obligations. “Quick ratio is
obtained by subtracting inventories from current assets and then dividing by
current liabilities.” The Quick ratio is viewed as a sign of company's financial
strength or weakness; higher number means stronger, lower number means
weaker (www.investorwords.com). Items involved in the quick ratio’s current
assets include: cash, cash equivalents, receivables, and short-term investments.
Over the five year period from 2002 through 2006, Kroger has reported an
average quick ratio of 0.192. Over the same period, the industry has achieved
an average ratio of 0.309 (the industry average excluding Winn-Dixie is 0.27).
Kroger’s average ratio shows that they have $0.192 of liquid assets for every $1
of current liabilities. In the grocery store industry, it is common for firms to
operate with a low quick ratio. Supervalu and Winn-Dixie have shown very
volatile increases and decreases over the five year period. Their quick ratios are
dramatically larger than Kroger Co. These sharp increases could be explained by
a decrease in liabilities from store closings and pension fund cut backs. The high
ratios could also be an effect of cash generated from the selling of assets or
cutting back on inventory volume. Kroger’s quick ratio is at the lower end of the
industry average, but does not fall too far off the industry mark. Investors should
not be alarmed by the Company’s poor quick ratio performance. The low ratio is
a direct result of Kroger maintaining very large inventories. Their stores operate
mostly on leases which would explain why their current liabilities are high.
87
Kroger’s quick asset ratio has shown a growth of 40% during the five year
period.
Accounts Receivable Turnover
Accounts Receivables Turnover
120.00
100.00
80.00
Kroger
Safeway
SuperValu
60.00
Winn-Dixie
Industry Average
40.00
20.00
0.00
2002
2003
2004
2005
2006
Year
A/R Turnover
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
$76.45
$80.55
$44.70
$106.19
$76.97
2003
$72.69
$92.78
$40.13
$105.37
$77.74
2004
2005
$68.16 $88.27
$105.67 $109.57
$45.12 $41.70
$97.50 $33.96
$79.11 $68.38
2006
$84.97
$87.13
$45.23
$47.25
$66.15
The diagram above is an illustration of Accounts Receivable Turnover
ratios for Kroger and its competitors. Accounts Receivables Turnover is a
measure of net sales compared to accounts receivables. The accounts receivable
turnover is a good indication of the average time needed to convert receivables
into cash. To calculate accounts receivable turnover, take company’s net sales
and divide them by accounts receivable in the same year.
Over the five year span, from 2002 through 2006, Kroger has reported an
average accounts receivables turnover of 78.1. Over the same period, the
88
industry has reported an average ratio of 73.67 (the industry average excluding
Winn-Dixie is 72.2). The Company’s receivables turnover ratio is very consistent
through the years; it modestly jumps above and below the 80:1 ratio line.
Kroger has achieved an 11% growth rate in their accounts receivable turnover
during the five year period. It stays near the industry’s average and has recently
been able to exceed their competitors average receivables turnover ratio. Winn
Dixie’s ratio is very volatile; they report an industry high in 2002 then, in 2004,
they experience a rapid drop to an industry low. “A low or declining accounts
receivable turnover ratio indicates a collection problem, part of which may be
due to bad debts (www.money-zine.com). Through the years, Safeway has
operated with the most efficient ratio; however Kroger has caught up to their
mark in 2006. Kroger’s ratio is well above the industry’s average, which is a very
positive sign of operating efficiency. The Company’s high turnover is not the
result of a tight credit policy. The high turnover is a result of a fast time period
for collecting receivables and the high percentage of customers having general
cash on hand. In the grocery industry, receivables turnover ratios are generally
high, due to the fact that most of the stores high sales volume is generated from
customers who pay with actual cash or through local checking accounts.
Nevertheless, Kroger still manages to out perform their industry, proving to
investors that they are an efficient company.
89
Days Supply of Receivables
Days Supply of Receivables
12.00
10.00
8.00
Kroger
Safeway
6.00
SuperValu
Winn-Dixie
Industry Average
4.00
2.00
0.00
2002
2003
2004
2005
2006
Year
Days Receivable
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
4.77
4.53
8.17
3.44
5.23
2003
4.57
3.93
9.09
3.46
5.27
2004
4.28
3.45
8.09
3.74
4.89
2005
4.10
3.33
8.75
10.75
6.73
2006
4.27
4.19
8.07
7.72
6.06
The chart above is a collection of Days Supply of Receivables for Kroger,
its competitors, and the industry as a whole. Days’ supply of receivables is
calculated by taking the number of days in the year (365) and dividing by the
accounts receivable turnover. This ratio measures how long it takes the firm to
collect cash from previous sales.
Over the five year period from 2002 through 2006, Kroger has achieved a
day’s supply of receivables of 4.4 days. Over the same period, the industry
reported an average of 5.6 days. For this efficiency ratio, the lower number of
days the better. This ratio calculates how many days it takes for a company to
collect on its accounts receivables; fewer number of days means the company is
collecting more quickly on its accounts (www.investopedia.com). The analysis
for these ratios is described in the accounts receivable section (above).
90
Winn-Dixie’s ratio fluctuates tremendously and Safeway represents the
industry’s leader. Kroger’s days sales outstanding ratio is well below the industry
average. This is important because it gives Kroger the ability to quickly collect
cash and use that cash to reinvest, in order to make more sales. Days’ supply of
receivables is used in the calculation for “cash-merry-go-round,” or cash to cash
cycle. This shows that Kroger’s cash to cash cycle is efficient and that
investments are repaid in a short period (Dr. Moore). The grocery store industry
typically has a lower day’s sales outstanding ratio compared to other industries.
The reason for this is because grocery stores do not finance or issue credit to
their customers. Grocery stores do offer store credit cards, however; they do
not handle the collection of issued debt. Kroger hires and pays a third party
collection agency to secure accounts receivable. This allows Kroger to recognize
a larger percentage of credit sales immediately.
Inventory Turnover
The chart below shows each firm’s cost of goods sold and inventory.
Average annual inventory is calculated by adding the beginning and ending
inventory values and dividing by two. Inventory turnover ratios allow analysis to
view how many times a firm replenishes their inventory in a given year. We
were able to calculate Kroger’s and its competitor’s inventory turnover ratio
below:
91
Inventory Turnover
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
9.06
8.81
17.50
8.39
10.94
2003
8.82
9.47
15.79
8.31
10.60
2004
8.91
9.20
16.11
8.31
10.63
2005
9.33
9.87
16.16
6.48
10.46
2006
9.91
10.82
17.79
11.15
12.42
The chart above illustrates the current inventory turnover ratios
throughout the retail grocery industry. The inventory turnover ratio is calculated
by taking the cost of goods sold and dividing by the inventory section in the
balance sheet. Average annual inventory is calculated by adding the beginning
and ending inventory values and dividing by two.
Over the five year period from 2002 through 2006, Kroger has achieved
an average inventory turnover ratio 9.2. Over the same period, the industry has
92
reported an average ratio of 11.01 (the average industry ratio excluding
Supervalu is equal to 9.1). The inventory turnover ratio for Kroger and its
competitors is fairly high. On average, the ratio increases after each year of
operation. As you can see, Kroger’s inventory turnover rate is the most
consistent and shows steady growth. Kroger has achieved a 9.4% growth rate in
their inventory turnover during the five year period. The inventory turnover ratio
shows how many times a firm’s inventory is sold and replaced over the year. In
the grocery industry, a high inventory ratio is a positive sign
(www.investopedia.com). High ratios show that a firm’s cash to cash cycle is
efficient and that investments for inventory are repaid in a short period (Dr.
Moore).
Kroger’s ratio is slightly below the industry benchmark, but this
occurrence can be explained and should not be a negative sign for investors.
Supervalu is home to the industry’s most efficient inventory turnover ratio.
Consequently, their ratios are high because their COGS (cost of goods sold) and
inventory amounts have sharply declined just prior to the recent five year period.
The drop in these accounting items has a direct negative effect on Supervalu’s
sales revenue. Kroger’s COGS is double that of its competitors. Kroger stores
must keep a higher inventory level than its competitors. This ensures that
Kroger stores will not miss any sales opportunities due to lack of inventory.
Kroger’s high inventory level allows the company to achieve more sales revenue;
which explains why their inventory turnover ratio is below the industry par. In
the grocery industry, high levels of inventory lead to more lost, stolen, and
damaged goods. The high inventory of perishable goods also exposes Kroger to
more loss from spoilage (Dr. Moore). This helps explain why Kroger’s inventory
turnover ratio is smaller than its competitors.
93
Days’ Supply of inventory
Days Inventory
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
40.30
41.41
20.85
43.53
36.52
2003
41.37
38.55
23.12
43.93
36.74
2004
40.96
39.65
22.66
43.90
36.79
2005
39.14
36.98
22.58
56.30
38.75
2006
36.85
33.72
20.51
32.74
30.96
Above is a graphic representation of Kroger and its competitors Days
Supply of inventory. The illustration also includes an industry average for the
retail grocery industry. Days’ supply of inventory is calculated by taking the
number of days in a year (365) and dividing by the inventory turnover ratio.
Over the five year period from 2002 through 2006, Kroger has achieved a
days’ supply of inventory of 39.7 days. During the same period, the average
reported by the industry is 35.9 days (the industry average excluding Supervalu
is 40.6). Days’ supply of inventory corresponds directly with inventory turnover,
94
however; a smaller number is better. Basically, the number of days illustrates
how long a firm’s inventory remains on hand until they are able to replace and
replenish their inventories. A company would prefer a short time period for the
process of selling current inventories and starting the inventory supply and
distribution operation again (www.allbusiness.com). Kroger’s five year days
average is slightly more than the industries average (it is just below the industry
average excluding Supervalu). The same factors that explain why Kroger’s
inventory turnover is slightly lower than the industry benchmark can be used to
explain the Company’s marginally higher days supply of inventory. Days’ supply
to inventory the second part used to calculate the cash to cash cycle.
Cash to Cash Cycle:
Cash to Cash Cycle
80.00
70.00
60.00
Kroger
Days
50.00
Safeway
40.00
SuperValu
Winn-Dixie
30.00
Industry Average
20.00
10.00
0.00
2002
2003
2004
2005
2006
Year
Cash to Cash Cycle
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
45.08
45.94
29.02
46.96
41.75
2003
45.95
42.48
32.21
47.39
42.01
95
2004
45.24
43.11
30.75
47.65
41.68
2005
43.24
40.31
31.33
67.05
45.48
2006
41.11
37.91
28.58
40.47
37.02
The diagram above illustrates the cash to cash cycles for Kroger, its
competitors, and the industry average. The cash to cash cycle is calculated by
adding the number of day’s supply of inventory and the day’s supply of
receivables. Kroger’s average cash to cash cycle is 44.1 days (39.7 + 4.4 =
44.1). In the grocery industry, the number of days incorporated in a company’s
cash to cash cycle is relatively lower than most other industries. The average
cash to cash cycle of Kroger’s competitors is 41.5 days. As can be seen in the
chart, Kroger’s cash to cash cycle is more efficient then the industry benchmark.
Working Capital Turnover
Working Capital Turnover
2000.00
1500.00
1000.00
Kroger
Safeway
500.00
SuperValu
0.00
Winn-Dixie
Industry Average
-500.00
-1000.00
-1500.00
2002
2003
2004
2005
2006
Year
W/C Turnover
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
-1232.38
-104.06
-214.53
23.34
-381.91
2003
1630.03
819.19
156.98
26.76
658.24
96
2004
2005
794.85 -243.18
-184.27 -68.36
122.39
39.49
25.81
8.65
189.69 -65.85
2006
-80.04
-38.80
30.03
17.07
-17.93
Above is a graphic presentation of Working Capital Turnover ratios for
Kroger, its competitors, and the industry average. The working capital turnover
ratio compares sales revenue to working capital. “This is a measurement of
management’s ability to use working capital to generate revenue
(www.chartfilter.com).” A company’s working capital is calculated by taking
current assets and subtracting current liabilities.
Over the five year period from 2002 through 2006, Kroger has managed
an average working capital turnover of 173.9. Over the same period, the
industry has produced an average turnover of 76.4. On average, The Company
is well above the industry’s benchmark. A company uses working capital to
finance day to day operations and purchase inventory. Operations and inventory
are the two main factors that influence sales revenue for a firm. “In a general
sense, the higher the working capital turnover, the better because it means
that the company is generating a lot of sales compared to the money it uses to
fund the sales (www.investopedia.com).” The Company’s successful working
capital turnover is a positive sign for investors. Kroger’s turnover has realized a
ratio as low as -1200 and to a high of 1600. These swings are a result of sudden
increases in sales revenue while the firm maintained a similar working capital
figure.
Overall, the firms in the industry report a volatile working capital turnover
ratio. A sharp turnover decrease does not mean that a firm’s sales revenue has
declined. Firms in the grocery industry are constantly shifting inventories,
leasing obligations, and other various short term accounting items; they also
have the ability to generate a large volume of sales in a short period of time.
Current assets and current liabilities are constantly changing. In this industry,
these decreases are caused by companies increasing current assets more than
current liabilities. Recently, firms in the industry are reporting a turnover ratio
that is approaching the industry equilibrium; the large separation between firms
is shrinking.
97
Liquidity Conclusion
Overall Kroger demonstrates its ability to be a fairly liquid company. Their
current ratio is .97:1; which means that they just about maintain enough current
assets to meet their short-term obligations. Kroger is the largest firm in their
respective industry; therefore, they struggle to maintain high liquidity ratios.
The Company’s quick asset ratio, receivables turnover, inventory turnover, and
working capital turnover exceed or are approaching the grocery store industry’s
benchmark. This is an indication to analyst and investors that Kroger has a
sufficient amount of current assets that can be converted to cash in order to pay
their short-term obligations.
Profitability Analysis
The purpose of the profitability analysis is to evaluate a firm’s
performance using profitability ratios. This analysis allows analyst to determine
how effectively a company handles its costs in their attempt to generate profits.
The profitability analysis uses six key ratios to evaluate not only a firm’s
performance but the industry’s performance as well. These ratios include: Gross
Profit Margin, Operating Income to Net Sales, Net Profit Margin, Asset turnover,
Return on Assets (ROA), and Return on Equity (ROE). These are key ratios used
by analyst and investors to measure the profitability and growth of a company.
The subsections below provide a detailed analysis and show the profitability
ratios for Kroger, its competitors, and the industry averages.
98
Gross Profit Margin:
Gross Profit Margin
35.00%
30.00%
Percentage %
25.00%
Kroger
Safeway
20.00%
Supervalue
15.00%
Winn-Dixie
Industry Average
10.00%
5.00%
0.00%
2002
2003
2004
2005
2006
Year
Gross Profit Margin
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
26.95%
31.10%
13.51%
27.71%
24.11%
2003
26.31%
29.63%
13.53%
28.51%
23.89%
2004
25.33%
29.58%
14.04%
26.46%
23.36%
2005
24.75%
28.93%
14.64%
26.11%
23.23%
2006
24.20%
28.82%
14.53%
25.95%
23.10%
The chart above illustrates Gross Profit Margins for Kroger, its
competitors, and the industry over the last five years. Gross Profit Margin is a
key profitability ratio that is used to evaluate a company’s efficiency when selling
its inventory. The ratio is computed by taking revenues less cost of goods sold
to give us gross profit. Gross profit is then divided by revenues for the current
year to derive Gross Profit Margin. Analysts prefer to see high ratios for Gross
Profit Margin because this demonstrates that a company is experiencing fewer
expenses in their selling activities compared to their sales.
Although Kroger has seen an average increase in sales of 5.73% per year,
they have experienced increases in their costs of goods sold as well. Currently,
Kroger’s cost of goods sold represents 75.80% of their sales and this number has
continued to increase over the past five years. As you can see in the chart
99
above, this increase in cost of goods sold compared to their sales has led to a
decline in the companies Gross Profit Margin which stands currently stands at
24.20% at the end of 2006.
The retail grocery industry as whole experienced declines in Gross Profit
Margin and has an average Gross Profit Margin of 23.10% in 2006. Kroger’s
declining Gross Profit Margin has reduced almost to that of the industry average
which has averaged 23.54% over the past five years. The average is somewhat
distorted by the fact that Supervalu has experienced very low profit margins over
the five year history. This industry experiences low Gross Profit Margins due to
the fact that retail markup on goods is relatively low compared to other
industries. Low markups on goods require companies in the retail grocery
industry to move a large amount of products in order to be profitable. This
means that inventory management and cost of goods sold are key decision
factors that managers of grocery companies must deal with.
Operating Income Margin:
Operating Income Margin
6.00%
Percentage %
4.00%
Kroger
2.00%
Safeway
Supervalue
0.00%
Winn-Dixie
-2.00%
Industry Average
-4.00%
-6.00%
2002
2003
2004
2005
Year
100
2006
OI Ratio
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
4.97%
2.73%
2.47%
2.97%
2.72%
2003
2.55%
1.61%
2.97%
2.53%
2.37%
2004
1.49%
3.27%
2.98%
-0.69%
1.85%
2005
3.36%
3.16%
3.66%
-4.40%
0.81%
2006
3.38%
3.98%
2.19%
-2.08%
1.36%
The chart above illustrates Operating Income Ratios for Kroger, its
competitors, and the industry as a whole the last five years. This ratio allows
analysis and investors to determine how efficiently a company handles their cost
associated with their daily operations. Operating Expenses are also known as
selling, general, and administrative expenses (SG&A Expenses). These SG&A
expenses include cost such as: operating expenses, transportation cost, salaries,
rent expense, advertising, and depreciation. The Operating Expense ratio is
derived by taking a company’s operating income and dividing it by the company’s
sales during the current year.
The chart above indicates that Kroger has experienced an Operating
Income Ratio that has been volatile over the past five years. With the exception
of 2004, Kroger has maintained an Operating Profit Ratio that is above its
competitors and the industry average. Kroger experienced an exceptional
operating profit in 2002 that was followed by two declining years of operating
profit. The decline in the companies operating profit for the years 2003 and
2004 is the result of decreasing Gross Profit Margins and a steady increase in
SG&A expenses. Although Operating income saw a sharp decrease in these two
years, the Company has increased its operating efficiency and improved its
Operating Income Ratio from 1.49% in 2004 to 3.38% in 2006.
As you can see in the chart above, Kroger’s competitors and the retail
grocery industry have experienced fairly low Operating Income Ratios over the
five year history. The last five years, Operating Income Ratios in this industry
have averaged 1.82% and in 2006 Operating Income Ratios averaged 1.36%.
The industry experiences these low Operating Income Ratios as a result of being
in a low margin market. The industry’s low Gross Profit Margins leave little room
101
for major SG&A expenses incurred by grocery companies. Kroger, for the most
part, has been able to maintain an Operating Income Ratio that exceeds the
industry average.
Net Profit Margin:
Net Profit Margin
3.00%
2.00%
Percentage %
1.00%
Kroger
0.00%
Safeway
-1.00%
Supervalue
-2.00%
Winn-Dixie
-3.00%
Industry Average
-4.00%
-5.00%
-6.00%
2002
2003
2004
2005
2006
AVG
Year
Net Profit Margin
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
2.33%
-2.38%
0.98%
0.70%
-0.23%
2003
0.59%
-0.48%
1.34%
1.97%
0.94%
2004
-0.18%
1.56%
1.39%
-0.94%
0.67%
2005
1.58%
1.46%
1.97%
-5.48%
-0.68%
2006
1.69%
2.17%
1.04%
1.38%
1.53%
The chart above is a collection of Kroger’s, its competitors, and the
industry averages for Net Profit Margins for the past five years. Net Profit Margin
is a key performance evaluator in terms of a company’s profitability. Net Profit
Margin is derived by taking a company’s net income and dividing it by the current
year’s sales. This ratio allows analyst and investors to determine the percentage
of net income that is generated from the company’s revenues in a given year.
102
This is important to investors because net income is the source of funds that
dividends are distributed from.
As can be seen in the chart, Kroger has experienced a large amount of
fluctuation in their Net Profit Margin. Currently, Kroger has a Net Profit Margin
of 1.69% and has an average ratio of 1.20% during the previous five years. It
should be noted that Kroger’s Net Profit Margin follows the same trend as their
Operating Income Ratio. For example, in the years Kroger experienced
decreases in their operating profit they also saw decreases in their net income.
Once operating income began to increase in 2005 and 2006, net income also
increased. This implies that Kroger’s main expenses are within its SG&A
expenses and that its profitability is a direct result of its gross profit and how
efficiently they handle their operating expenses in their day to day activities.
The industry as a whole has also experienced fluctuating Net Profit
Margins. Over the past five years, Kroger’s competitors and the industry have
seen an average Net Profit Margin of 0.44% and in 2006 Net Profit Margin
averaged 1.53% for the industry. The fluctuations throughout the industry in
Net Profit Margins could be the result of increased competition. With super
centers such as Wal-Mart and Target gaining rapid market share in the grocery
industry, traditional grocers have had to change their business style in order to
compete. Many companies such as Kroger experienced declines in their net
profits after 2002 because of these newly formed discount grocers.
103
Asset Turnover:
Asset Turnover
5.00
4.50
4.00
Turnover
3.50
Kroger
3.00
Safeway
2.50
Supervalue
2.00
Winn-Dixie
Industry Average
1.50
1.00
0.50
0.00
2002
2003
2004
2005
2006
AVG
Year
Asset Turnover
2002
2003
2004
2005
2006
Kroger
2.57
2.67
2.75
2.96
3.12
Safeway
2.17
2.36
2.33
2.44
2.47
Supervalu
3.59
3.25
3.28
3.11
3.29
Winn-Dixie
4.23
4.36
4.06
3.52
4.51
Industry Average
3.33
3.32
3.22
3.03
3.42
The chart above shows the Asset Turnover Ratios for Kroger, its
competitors, and the industry average the last five years. The asset turnover
ratio is used by analyst and investors to evaluate how efficiently a firm uses its
assets to generate revenues. Asset Turnover is calculated by taking the
revenues in a given year and dividing it by total assets in the same year. In
most cases, higher asset turnover ratios are better. High asset turnover
indicates that the firm is efficiently utilizing its assets to generate sales revenue.
Low margin industry’s usually experience high asset turnover and high margin
industry’s see low asset turnover (www.about.com). This is due to the fact that
104
low margin industry’s need to sell a large amount of products in order to be
successful and high margin industry’s do not.
As you can see in the chart above, Kroger has continued to increase its
Asset Turnover the past five years. This indicates to investors that Kroger is
generating more revenue from its assets every year. Kroger’s continued increase
in revenues has been driven by a boost in their total assets. At the end of 2006,
Kroger had an Asset Turnover Ratio of 3.12 and an average of 2.81 in the last
five years.
The retail grocery industry is a low margin industry that experiences high
Asset Turnover ratios compared to other industries. As previously mentioned,
low margin industries usually experience high Asset Turnover Ratios due to their
need to sell a large quantity of goods in order to be profitable. In 2006, the
retail grocery industry had an average Asset Turnover Ratio of 3.42 and in the
last five years the ratio has been approximately 3.26. As of now, Kroger has an
Asset Turnover Ratio that slightly below the industry average. Kroger’s increased
efficiency in their asset management has led to an increase in their Asset
Turnover and should continue to increase in the coming years.
Return on Assets:
ROA
10.00%
5.00%
Percentage %
0.00%
Kroger
Safeway
-5.00%
Supervalue
-10.00%
Winn-Dixie
Industry Average
-15.00%
-20.00%
-25.00%
2002
2003
2004
2005
Year
105
2006
ROA
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
5.99%
-5.16%
3.53%
2.98%
0.45%
2003
1.56%
1.12%
4.36%
8.57%
4.68%
2004
-0.51%
3.64%
4.55%
-3.83%
1.45%
2005
4.68%
3.56%
6.15%
-19.31%
-3.20%
2006
5.26%
5.35%
3.41%
6.20%
4.99%
The line graph above is a collection of Return on Asset Ratio’s (ROA)
generated by Kroger and its competitors for the year’s 2002 through 2005. ROA
is a key performance measurement used by analyst to evaluate a firm’s
performance based on profit that is draw from a firm’s assets. ROA is a function
of net profit margin and asset turnover generated by a firm. ROA can be simply
calculated by taking net income in the current year and dividing it by total assets
in the previous year. This allows analyst to view how a company’s investments
in assets has affected net income. The higher the ROA ratio is the better
because this indicates to investors that a higher percentage of net income is
generated from the firm’s assets. This would lead investors and analyst to
believe that the firm’s managers are acting in the best interest of the company
by investing in assets that create value for shareholders.
In the chart above it shows that Kroger has seen ups and downs in their
Return on Assets. In 2006, Kroger had a Return on Asset Ratio of 5.26% and
averaged a ratio of 3.40% the last five years. ROA for Kroger experienced a
decline in the years 2003 and 2004. The decrease in ROA for these years is a
direct result of a decrease in the Company’s net profit margin. Since ROA is a
function of both net profit margin and return on assets, a decline in the
Company’s net profit margin resulted in a low ROA ratio during these years. So
although Kroger experienced and increase in its asset turnover for the years
2003 and 2004, its sharp decrease in net profit margin lead to a decrease in their
Return on Assets Ratio. After 2004, Kroger’s net profit margins and ROA showed
an improvement increasing from -0.51% in 2004 to 5.26% in 2006.
As can be seen in the chart, the retail grocery industry has experienced
volatile ROA ratios over the past five years. In 2006, the retail grocery industry
106
had an average ROA of 4.99% and over the past five years the industry has
averaged a ROA of 1.67%. The industry average was somewhat offset by WinnDixie’s poor ROA it experienced in 2005. For the majority of the last five years,
Kroger has managed to maintain a ROA ratio that has been higher than the
industry average. Their increased efficiency and improved net profit margins has
allowed them to increase their ROA for the past two years.
Return on Equity:
ROE
40.00%
30.00%
Percentage %
20.00%
Kroger
10.00%
Safeway
0.00%
Supervalue
Winn-Dixie
-10.00%
Industry Average
-20.00%
-30.00%
-40.00%
2002
2003
2004
2005
2006
Year
ROE
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
31.30%
-22.83%
10.72%
10.69%
-0.47%
2003
7.85%
-4.66%
12.79%
23.26%
10.46%
107
2004
-2.87%
13.01%
12.68%
-10.95%
4.91%
2005
21.82%
11.41%
15.37%
-6.90%
6.63%
2006
22.65%
15.36%
7.87%
-35.07%
-3.95%
The diagram above illustrates the Return on Equity Ratios (ROE) obtained
from Kroger, its competitors, and the industry the last five years. ROE is useful
for investors and analyst when evaluating a firm’s performance because it
enables them to see how much of net income is driven by the equity section on
the company’s balance sheet. ROE is a function of both ROA (previous
paragraph) and a company’s financial leverage. ROE can be determined by
taking a company’s net income in the current year and dividing it by total
shareholders equity in the previous year. High ROE ratios are preferred because
it tells investors that management is allocating shareholder investments
effectively. Also, high ROE ratios indicate to investors and analyst that the
company can raise funds internally (www.about.com).
In the diagram above it shows that Kroger’s ROE over the last five years
has been very volatile. In the same years that Kroger experienced declines in
their ROA, Kroger also showed a decrease in their ROE. Since ROA is a function
of ROE, this should not be surprising to investors. In the years 2005 and 2006
Kroger Co. showed an increase in ROE that matched their increase in ROA for
the same two years. This tells investors that the Company’s financial leverage
has been fairly stable while ROA has varied over the past five years. Kroger
currently has a ROE of 22.65% in 2006 and has an average ROE of 16.15% the
last five years.
The retail grocery industry has experienced the similar up and down
trends as Kroger. In our diagram it can be seen that Winn-Dixie’s ROE has
performed way below Kroger and the other competitors in this industry. Over
the last five years ROE has averaged 7.17% for the retail grocery industry.
Kroger’s ROE comfortably exceeds the industry average in 2006 and over the last
five years. Although it is important to note that the retail grocery sector is a very
competitive industry and with new supercenters such as, Wal-Mart and Super
Target gaining market share, Kroger’s ROE should return to standard industry
levels.
108
Profitability Conclusion:
After performing the financial ratio analysis using profitability ratios, it can
be concluded that Kroger is performing above the industry average in the retail
grocery industry. Profit margins suffered in 2003 and 2004 due to increased
competition and the economy being in a recession, but Kroger was able to
quickly recover. Kroger was able to improve their profitability in 2005 and 2006
and increased their profit margins above the current industry averages. Kroger
has also continued to increase their return on assets and their return on equity
which are also currently above the industry as a whole. This demonstrates
Kroger’s ability to bounce back from years with low earnings and continue to
increase their profitability each year.
Capital Structure Analysis
The purpose of the Capital Structure Analysis is to determine how a firm
raises funds for capital expenditures. Raising capital can be done either through
debt or equity and it is important for analyst and investors to determine
management’s capital structure strategy. There are three ratios analyst and
investors can use to measure a firms capital structure. These include the Debt
to Equity Ratio, the Times Interest Earned Ratio, and the Debt Service Margin
Ratio. These ratios measure a company’s ability to meet their debt obligations
and their use of equity in their capital structure decisions. These ratios are
discussed in detail below for the evaluation of Kroger and their competitors.
109
Debt to Equity
Debt to Equity Ratio
35.00
30.00
Debt/Equity
25.00
Kroger
20.00
Safeway
15.00
Supervalue
10.00
Winn-Dixie
5.00
Industry Average
0.00
-5.00
-10.00
2002
2003
2004
2005
2006
Year
Debt to Equity
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
4.22
3.42
2.04
2.59
2.68
2003
4.03
3.14
1.93
1.71
2.26
2004
4.66
2.57
1.78
1.85
2.07
2005
3.67
2.20
1.50
32.52
12.07
2006
3.31
1.87
1.31
-6.65
-1.16
The Chart above provides the Debt to Equity Ratios for Kroger, its
competitors, and the industry average over the past five years. The Debt to
Equity Ratio is an important tool used by investors to determine how much of a
firms capital is financed from either debt or equity. The debt to equity ratio is
derived by taking a company’s total debt and dividing it by the equity portion on
the balance sheet. Firms that receive good credit ratings can obtain capital
rather cheaply through debt financing because they can obtain low interest rates
on their debt. This could lead to high Debt to Equity Ratios for companies with
good credit ratings and low Debt to Equity Ratios for companies with poor credit
ratings. Although debt financing has its advantages, too much debt could
potentially scare away investors.
110
Kroger’s Debt to Equity Ratio is displayed in the above diagram and has
been fairly stable over the past five years. At the end of 2006, Kroger had a
Debt to Equity Ratio of 3.31 and averaged a ratio of approximately 4.00 the last
five years. This tells investors that on average, Kroger finances their capital with
4 times more debt than equity. Kroger has a credit rating of Baa2 by Moody’s
and a BBB- by the S&P. These ratings are stated as stable to positive and
Kroger has maintained the ability to obtain cheap debt financing because of this
credit rating.
The chart above demonstrates that the majority of the retail grocery
stores in this industry have followed the same Debt to Equity trend as Kroger.
The average Debt to Equity Ratio for this industry over the last five years is 3.59.
The only exception to this trend can be seen with grocery stores such as WinnDixie who are struggling with increased competition from traditional grocery
stores and new super centers like Wal-Mart. These grocery stores have
experienced major declines in their Debt to Equity Ratio due to their poor
performance and decreased credit ratings by Moody’s and Standard and Poor’s.
As can be seen in the chart, Kroger has maintained a Debt to Equity ratio that
has been around or above the industry standard.
Times Interest Earned
Times Interest Earned Ratio
10.00
5.00
OI/Interest
Kroger
0.00
Safeway
Supervalue
Winn-Dixie
-5.00
Industry Average
-10.00
-15.00
2002
2003
2004
2005
Year
111
2006
Times Interest Earned
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
4.24
0.61
2.99
5.94
3.18
2003
2.27
1.32
3.52
8.93
4.59
2004
1.51
2.93
4.10
-5.09
0.65
2005
3.99
3.11
6.23
-9.32
0.01
2006
4.58
4.13
4.10
-12.53
-1.43
The diagram above is a collection of Times Interest Earned Ratios for
Kroger, its competitors, and the entire industry over a five year span. Times
Interest Earned Ratios can be calculated by taking a firms operating income or
EBIT and dividing it by the company’s interest expense in the same year. This
ratio allows analyst and investors to compare a companies operating income with
interest expense and determine how much income before taxes a firm has
available to pay their interest expenses on their financial obligations.
Over the past five years Kroger has maintained fairly stable interest
compared to their operating income. This is due to the company relying mainly
on debt financing for their capital expenditures and having to pay interest on
these debt obligations. In 2006, the Company had a Times Interest Earned Ratio
of 4.58 and a five year average of 3.32. The decrease in Kroger’s 2003 and
2004 Times Interest Earned Ratio is a result of lower operating profits during
these years. This can be seen by Kroger’s debt to equity ratio remaining
constant over the last five years. Since this ratio has remained constant, analyst
and investors can conclude that the company is paying the same amount of
interest on their debt obligations, but the decrease in operating income has lead
to a decrease in the company’s Times Interest Earned Ratio.
The industry as a whole has seen an average Times Interest Earned Ratio
of 1.40 times the last five years. The average without the distorted numbers of
Winn-Dixie is 3.31 times. The majority of companies in the retail grocery
industry have seen stable levels of Times Interest Earned Ratios ranging from
1.00 to 6.00 times the last five years. This is a result of many grocers having
good credit ratings and being able to obtain cheap debt financing for their capital
112
expenditures. Kroger’s Times Interest Earned Ratio is right around the industry
standard in the retail grocery industry.
Debt Service Margin
Debt Service Margin
70.00
60.00
Margin
50.00
Kroger
Safeway
40.00
Supervalue
30.00
Winn-Dixie
Industry Average
20.00
10.00
0.00
2002
2003
2004
2005
2006
Year
Debt Service Margin
Kroger
Safeway
Supervalu
Winn-Dixie
Industry Average
2002
2.59
2.48
28.64
60.70
30.61
2003
3.96
2.15
7.17
62.03
23.78
2004
32.82
3.47
10.01
49.19
20.89
2005
8.93
2.50
8.69
39.54
16.91
2006
9.04
2.62
10.01
2.18
4.94
Above is a graphic representation of Kroger’s, its competitors, and the
industries Debt Service Margin Ratios (DSM) over the past five years. DSM
allows investors to gain insight on a company’s ability to repay their current
portion of long term debt or notes payable using their cash flows generated from
operating activities. The Debt Service Margin Ratio can be calculated by taking
cash flows from operating activities in the current year and dividing them by
notes payable on the balance sheet that are do in the upcoming year (previous
years notes payable). The higher the ratio the better in most cases because it
113
demonstrates a companies ability to repay its current portion of long-term debt.
A very high ratio in multiple years tells investors that the company does not
finance its capital expenditures using debt.
Kroger’s Debt Service Margin has increased and decreased tremendously
over the past five years. The Company’s DSM increased from 3.96 in 2003 to
32.82 in 2004. This was a result of Kroger paying off the remainder of its term
loan in 2003 and having no current maturities due in 2004. Debt Service Margin
decreased to normal levels in 2005 when the company obtained new debt
financing for their capital expenditures and expansion. Currently Kroger has a
DSM of 9.04 in 2006 and has seen an average ratio of 11.47 the past five years.
The high Debt Service Margin Ratio generated by Kroger shows investors/debt
lenders their ability to repay their short term obligations and reduces the chance
of default.
The retail grocery industry has experienced a variety of different Debt
Service Margin Ratios the past five years. This is a factor of both timing and the
ability of companies to obtain cheap debt financing for their capital expenditures.
Timing is an issue because management has the ability to make the decision on
when and how they want to take on debt and repay it. There are many different
forms of debt financing with different maturities and different repayment terms.
Also, many firms in the retail grocery industry such as Winn-Dixie have been
performing poorly due to the increased competition in the retail grocery industry.
The poor performance by these companies has led them to receive poor credit
ratings and makes it very costly for them to use debt to finance their capital
expenditures. The grocery industry had an average Debt Service Margin of 4.94
in 2006 and has a five year average ratio of 19.42. Kroger’s Debt Service margin
of 9.04 in 2006 is above the industry average in this year. This indicates to
investors that Kroger and the majority of its competitors can easily repay their
short term obligations using their cash flows from operations.
114
Credit Risk:
A firm’s credit risk can be determined by numerous factors and influences.
There are vast amounts of rating agencies and credit scoring methods that are
relevant in the industry. One of the most highly regarded credit rating tool is the
Altman Z-score. The Altman Z-score is a weighted ratio based formula that
includes numerous items from the balance sheet and income statement. The
scores are used to asses the credit risk of a firm. It also measures a company’s
bankruptcy potential and their ability to pay off debt. We will analyze calculate
and analyze Kroger’s score in the “Credit Analysis” section.
Capital Structure Conclusion:
The retail grocery industry finances the majority of their capital
expenditures through debt financing. Retail Grocers use of debt financing over
equity financing for their capital expenditures is the result of them being able to
obtain low interest rates on their borrowed funds. Kroger’s time’s interest
earned and debt service margin are both above current industry averages. This
implies that Kroger is able to generate more than adequate cash flows and
operating income to cover their short-term liability obligations. Kroger’s ability to
pay their short-term liabilities has allowed them to maintain a good credit rating.
This is why their debt to equity ratio has been above their competitors and the
industry for the majority of the past five years.
SGR and IGR Analysis
The sustainable growth rate analysis (SGR) and internal growth rate
analysis (IGR) are used by analyst to evaluate a company’s growth. Looking at a
company’s SGR and IGR allow investors to evaluate the potential profitability of a
company as they increase or decrease their growth. SGR and IGR also indicate
to investors a company’s ability to increase its growth without debt financing and
115
by utilizing its assets. In the subsections below, SGR and IGR are broken down
and explained in detail in regards to the retail grocery industry.
Sustainable Growth Rate:
Sustainable Growth Rate
40.00%
30.00%
Percentage %
20.00%
Kroger SGR
10.00%
Safeway
0.00%
Supervalu
Winn-Dixie
-10.00%
Average SGR
-20.00%
-30.00%
-40.00%
2002
2003
2004
2005
2006
Year
SGR Growth
Kroger SGR
Safeway
Supervalu
Winn-Dixie
Average SGR
2002
30.96%
-22.65%
10.53%
10.69%
-0.48%
2003
7.76%
-4.62%
12.56%
23.26%
10.40%
2004
-2.84%
12.91%
12.45%
-10.95%
4.80%
2005
21.58%
11.32%
15.09%
-6.90%
6.50%
2006
22.40%
15.24%
7.66%
-35.07%
-4.06%
The chart above is a diagram of sustainable growth rates for Kroger, its
competitors, and the industry as a whole. The sustainable growth rate is
calculated by taking a company’s ROE and multiplying it by one minus the
company’s dividend policy. The SGR is a measure of the firms growth that is a
result of the company’s ROE. Analyst can determine how much an individual
firm can grow without increasing their debt.
Kroger’s SGR is currently at 22.40% in 2006 and has an average SGR of
15.97% over the last five years. Kroger’s high ROE and the fact that they do not
116
pay regular dividends have allowed them to increase their SGR over the past two
years. The retail grocery industry as a whole has averaged an SGR of 3.43%
over the past five years. Many stores in this industry are experiencing decreases
in growth due increased competition. This has resulted in retail grocers losing
profits and experiencing low return on equity. Kroger has managed to increase
its SGR above the industry average and its competitors over the past two years.
Internal Growth Rate:
Internal Growth Rate
10.00%
5.00%
Percentage %
0.00%
Kroger IGR
Safeway
-5.00%
Supervalu
-10.00%
Winn-Dixie
Average SGR
-15.00%
-20.00%
-25.00%
2002
2003
2004
2005
2006
Year
IGR Growth
Kroger
Safeway
Supervalu
Winn-Dixie
Average
2002
5.92%
-5.12%
3.47%
2.98%
0.44%
2003
1.54%
1.11%
4.28%
8.57%
4.66%
2004
-0.50%
3.61%
4.47%
-3.83%
1.42%
2005
4.63%
3.53%
6.04%
-19.31%
-3.25%
2006
5.20%
5.31%
3.35%
6.20%
4.95%
The chart above is a collection of internal growth rates for Kroger, its
competitors, and industry averages over the past five years. The IGR can be
calculated by taking a company’s ROA and multiplying it by one minus the
117
company’s dividend payout policy. High IGR’s demonstrate a company’s ability
to finance their assets with their internal funds. IGR ratios also show a firms
ability to grow through internal financing.
Kroger currently has an IGR ratio of 5.20% for 2006 and has averaged an
IGR ratio of 3.36% over the past five years. This indicates that on average, the
Company is able to increase their growth by 3.36% a year through internal
financing of their assets. The retail grocery industry has fairly similar IGR’s as
Kroger. Retail grocers have averaged an IGR ratio of 1.64% over the past five
years and currently the industry averages an IGR of 4.95% in 2006. Kroger has
experienced fluctuations in their IGR’s that have been above and below the
industry average. After Kroger’s poor performance in the years 2003 and 2004,
the Company increased its IGR to the industry standard in 2006. The table
below shows the Sustainable and Internal Growth Rates for Kroger the last five
years.
The sustainable and internal growth rate analyses are used to evaluate a
company’s growth and profitability. The SGR and IGR ratios are vital elements
when attempting to forecast a company’s financial statements. An analyst
forecasting financial statements uses these growth ratios to estimate the future
growth of a firm. SGR and IGR ratios illustrate the increases and decreases
involving growth; they must be accurate and used appropriately in order to
properly forecast financial ratios.
Financial Statement Forecasting
Financial statement forecasting is a process in which future values of the
firm are estimated using ratio trends, industry averages, and a company’s
financial reports. The trend analysis can help analyst establish company and
industry standards that can be used for determining future values of the income
statement, balance sheet, and cash flow statements. When conducting the
financial statement forecasting analysis, it is important to start with the income
118
statement before forecasting the balance sheet and cash flow statements.
Analyst may also use industry averages they found in their benchmark analysis
to help them determine forecasted numbers. For our evaluation of Kroger we
began by forecasting the income statement and then moved to the balance
sheet and cash flow statements. In our forecast of Kroger’s income statement,
balance sheet, and cash flow statements we used company and industry trends,
as well as, Kroger’s monthly, quarterly, and annual reports.
Income Statement Analysis:
In our forecast of Kroger’s income statement, we began by creating a
common size report that gave a percentage for each line item in the Company’s
income statement when compared to net sales. Creating a common size report
revealed Company trends that will be used for our forecasting. We then took a
five year average of each item in the common size income statement to aid us in
our forecasting process. We also used industry averages found in our Financial
Ratio Analysis to guide our future forecasts.
The main driver for the income statement is the forecasting of future sales
and sales growth. In forecasting Kroger’s future sales growth, we used a growth
rate of 6.00%. Although this growth rate is below the previous two years
growth, we felt that a 6.00% growth rate was appropriate because it is closer to
industry averages and the retail grocery industry has become saturated. The
projected sales for 2007 in our forecast are $70.1 billion dollars which is a 6.0%
increase from the previous year’s sales of $66.1 billion. Kroger’s 2nd quarter
ending August 31, 2007, showed earnings of $36.9 billion and are on pace with
our 6.00% sales growth.
We implemented our cost of goods sold forecast by looking at Kroger’s
five year cost of goods sold history. After evaluating previous year trends and
looking at industry averages we decided that cost of goods sold represented
approximately 76% of sales during each year. Historically, the cost of goods has
shown and increase in the retail grocery industry. This is the reasoning behind
119
our increase of cost of goods sold from 75.80% in 2006 to 76% in our forecasted
income statement. Gross profit for Kroger was forecasted to be 24% of sales in
each of our forecasted years. Due to increases in the cost of goods, gross profit
has seen a downward trend in the retail grocery industry. This downward trend
in gross profit margin was utilized in our forecasted income statement by putting
it at 24% of sales which is below the previous year’s gross profit margin. Net
income was forecasted using the net profit margins in years 2005 and 2006 as a
guideline. Net income has fluctuated for Kroger over the past five years due to
increased competition in the retail industry. We forecasted net income by using
a net profit margin of 1.60%. The volatile nature of net income and recent
industry averages resulted in our forecasted net profit margin to be lower than
the previous two years. The remaining line items in our 10 year forecast for
Kroger’s income statement were also implemented by taking their percentage of
sales in previous years and forecasting them out.
One limitation associated with our ten year forecast of Kroger’s income
statement was their fluctuating net income totals over the past five years. For
our forecast we remained optimistic and believe Kroger has turned their
performance around after 2003 and 2004.
120
(reported in millions)
Income Stmt.
Sales
COGS
Gross Profit
S,G,&A Exp.
Operating Profit
Interest expense
EBT
Income TX exp.
Net earnings
2002
2003
2004
2005
2006
Used
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
51,760
37,810
13,950
11,381
2,569
619
1,950
748
1,202
53,791
39,637
14,154
12,784
1,370
604
766
454
312
56,434
42,140
14,294
13,447
847
557
290
390
-104
60,553
45,565
14,988
12,953
2,035
510
1,525
567
958
66,111
50,115
15,996
13,760
2,236
488
1,748
633
1,115
6.0%
76.0%
24.0%
20.8%
3.3%
0.65%
2.6%
1.0%
1.6%
70,078
53,259
16,819
14,541
2,278
456
1,822
701
1,121
74,282
56,455
17,828
15,414
2,414
483
1,931
743
1,189
78,739
59,842
18,897
16,338
2,559
512
2,047
787
1,260
83,464
63,432
20,031
17,319
2,713
543
2,170
835
1,335
88,471
67,238
21,233
18,358
2,875
575
2,300
885
1,416
93,780
71,273
22,507
19,459
3,048
610
2,438
938
1,500
99,407
75,549
23,858
20,627
3,231
646
2,585
994
1,591
105,371
80,082
25,289
21,864
3,425
685
2,740
1,054
1,686
111,693
84,887
26,806
23,176
3,630
726
2,904
1,117
1,787
118,395
89,980
28,415
24,567
3,848
770
3,078
1,184
1,894
121
Common Size
Sales
Growth
COGS
Gross Profit
S,G,&A Exp.
Rent
Depr & ammort
GW impairment
Impair charge
Restruct. charge
Merger cost
Operating Profit
Int. expense
EBT
Income TX Exp
Net earnings
2002
100%
3.32%
73.05%
26.95%
21.99%
1.28%
2.10%
0.00%
0.00%
0.03%
0.00%
4.96%
1.20%
3.77%
1.45%
2.32%
2003
100%
3.92%
73.69%
26.31%
23.77%
1.22%
2.25%
0.83%
0.22%
0.00%
0.00%
2.55%
1.12%
1.42%
0.84%
0.58%
2004
100%
4.91%
74.67%
25.33%
23.83%
1.20%
2.23%
1.59%
0.00%
0.00%
0.00%
1.50%
0.99%
0.51%
0.69%
-0.18%
2005
100%
7.30%
75.25%
24.75%
21.39%
1.09%
2.09%
0.00%
0.00%
0.00%
0.00%
3.36%
0.84%
2.52%
0.94%
1.58%
2006
100%
9.18%
75.80%
24.20%
20.81%
0.98%
1.92%
0.00%
0.00%
0.00%
0.00%
3.38%
0.74%
2.64%
0.96%
1.69%
Used
100%
6.00%
76%
24%
20.75%
1.00%
2.00%
0.00%
0.00%
0.00%
0.00%
3.25%
0.65%
2.60%
1.00%
1.60%
2007
100%
6%
76%
24%
20.8%
1.0%
2.0%
2008
100%
6%
76%
24%
20.8%
1.0%
2.0%
2009
100%
6%
76%
24%
20.8%
1.0%
2.0%
2010
100%
6%
76%
24%
20.8%
1.0%
2.0%
2011
100%
6%
76%
24%
20.8%
1.0%
2.0%
2012
100%
6%
76%
24%
20.8%
1.0%
2.0%
2013
100%
6%
76%
24%
20.8%
1.0%
2.0%
2014
100%
6%
76%
24%
20.8%
1.0%
2.0%
2015
100%
6%
76%
24%
20.8%
1.0%
2.0%
2016
100%
6%
76%
24%
20.8%
1.0%
2.0%
3.3%
0.7%
2.6%
1.0%
1.6%
3.3%
0.7%
2.6%
1.0%
1.6%
3.3%
0.7%
2.6%
1.0%
1.6%
3.3%
0.7%
2.6%
1.0%
1.6%
3.3%
0.7%
2.6%
1.0%
1.6%
3.3%
0.7%
2.6%
1.0%
1.6%
3.3%
0.7%
2.6%
1.0%
1.6%
3.3%
0.7%
2.6%
1.0%
1.6%
3.3%
0.7%
2.6%
1.0%
1.6%
3.3%
0.7%
2.6%
1.0%
1.6%
122
Balance Sheet Analysis:
After creating a common size report and evaluating industry trends, we
began our forecast of Kroger’s ten year balance sheet starting with the
estimation of total assets. To determine total assets for ten years on Kroger’s
balance sheet, we used an asset turnover ratio of 3.30 times. The reasoning
behind our selection of an asset turnover ratio of 3.30 is based Kroger’s continual
increase in asset turnover and industry averages.
After determining total assets we focused on the current asset portion of
the balance sheet. For this section we used liquidity ratios to find our forecasted
accounts receivable and our inventory. The forecasted accounts receivable were
based on an account receivable turnover ratio of 86.50 times. This turnover
ratio represents an average of Kroger’s 2005 and 2006 accounts receivable
turnover ratios. The inventory turnover ratio we implemented for our forecast of
Kroger’s inventory is 11.00 times. This ratio is comparable to other companies in
the industry and also demonstrates Kroger’s continual increase in their inventory
turnover ratios the last five years. The last current asset in Kroger’s balance
sheet we decided to forecast is their cash and short term investments. Over the
past two years, Kroger has had an average cash and short-term investments
account that represented 0.96% of their total assets. We took this average an
applied it to the cash account in our ten year forecast. After reviewing company
trends we noticed current assets had been steadily increasing the past five years.
Current assets were increased in our projections from 31.84% to 32.00% of total
assets.
In our estimation of Kroger’s future value in long term assets, we began
by looking at trends in their property, plant, and equipment on their common
size balance sheet. In our evaluation we noticed that property, plant, and
equipment has remained stable around 55% of total assets and for the previous
two years it had been 55.50%. We concluded that property, plant, and
equipment should represent 55.50% of total assets for our financial forecast.
We forecasted goodwill for ten years by taking an average of the previous two
123
years which gave us 10.50%. Non-current assets in our forecast were
determined by taking total assets minus current assets.
After we forecasted assets for Kroger’s balance sheet, we then proceeded
to the shareholders equity section. For our ten year forecast of shareholders
equity, we began by calculating the retained earnings for Kroger for ten years.
We calculated retained earnings for 2007 by taking Kroger’s ending balance in
retained earnings for 2006 and adding their net income generated in 2007.
Since Kroger started issuing dividends again in 2006, we had to adjust our
retained earnings balance by subtracting dividends paid during the year. On
Yahoo Finance, it showed that Kroger issued quarterly dividends of $0.065 in
2006, which resulted in a yearly dividend of $0.26 for every share. Yahoo
Finance also showed that Kroger had raised its quarterly dividends to $0.075 in
2007, which will result in $0.04 increase in their yearly dividends to $0.30 per
share. Since Kroger is generating a higher net income in every year of our
forecast, we decided to forecast our dividends by raising them $0.04 a year in
each of our forecasted years. In our calculations of dividends paid each year, we
simply took Kroger’s average number of shares they use for determining their
dividends in 2006 and multiplied it by our growing yearly dividend. The average
number of shares Kroger used for their calculations of dividends paid during
2006 was 715. We then used our forecasted retained earnings to estimate total
shareholders equity over a ten year span. We determined our forecasted
shareholders equity by combining total shareholders equity in the previous year
with our current year retained earnings and then subtracted the previous years
retained earnings.
The last section we forecasted for Kroger’s balance sheet was the liability
section. Since this is an equity valuation, we decided to distort our total liabilities
section so that our balance sheet would balance. Total liabilities were forecasted
as being equal to total assets less shareholders equity in a given year. After
determining total liabilities we performed a ten year forecast for Kroger’s current
liabilities. Current liabilities were forecasted out ten years by taking Kroger’s
124
average current ratio of 0.925% for the previous two years 2005 and 2006.
Kroger’s accounts payable were then forecasted out over ten years at 23.50% of
total liabilities. We chose 23.50% because Kroger’s accounts payable balance
increased every year over the last five years and in 2006 accounts payable
represented 23.35% of total liabilities.
In our ten year forecast for Kroger’s balance sheet we experienced
limitations regarding projections of their retained earnings section. Kroger
recently paid their first dividends in 2006 and until then had not paid dividends
since 1988. This made evaluating Kroger’s retained earnings difficult because we
do not know if they will continue to pay dividends or not
125
Balance Sheet
Cash
Deposits
Receivables
Inventory
LIFO credit
Employee ben.
Other assets
Total CA
PP&E, net
Goodwill
Other assets
Fix Assets
Total Assets
CPLTD
Acc. payable
Accrued Liab.
Def taxes
Other liab.
Current Liab
LT Debt
Def taxes
Other liab
Non-curr Liab
Total Liab
Com stock
Paid-in capital
Acc. loss
Dividends
Ret. Earnings
Treas Stock
Tot. Equity
Tot. L/E
2002
$171
$0
$677
$4,175
-$290
$300
$243
$5,566
$10,548
$3,575
$413
$14,536
$20,102
$352
$3,269
$571
$39
$1,377
$5,608
$8,222
$709
$1,713
$10,644
$16,252
$908
$2,317
-$206
N/A
$3,352
-$2,521
$3,850
$20,102
2003
$159
$0
$740
$4,169
-$324
$300
$251
$5,619
$11,178
$3,134
$253
$14,565
$20,184
$248
$3,058
$547
$138
$1,595
$5,586
$8,116
$990
$1,481
$10,587
$16,173
$913
$2,382
-$124
N/A
$3,667
-$2,827
$4,011
$20,184
2004
$144
$506
$828
$4,356
-$373
$300
$272
$6,406
$11,497
$2,191
$397
$14,085
$20,491
$71
$3,778
$659
$267
$1,541
$6,316
$7,900
$939
$1,796
$10,635
$16,951
$918
$2,432
-$202
N/A
$3,541
-$3,149
$3,540
$20,491
2005
$210
$488
$686
$4,486
-$400
$300
$296
$6,466
$11,365
$2,192
$459
$14,016
$20,482
$554
$3,546
$780
$217
$1,618
$6,715
$6,678
$843
$1,856
$9,377
$16,092
$927
$2,536
-$243
N/A
$4,573
-$3,403
$4,390
$20,482
2006
$189
$614
$778
$4,609
-$450
$300
$265
$6,755
$11,779
$2,192
$489
$14,460
$21,215
$906
$3,804
$796
$268
$1,807
$7,581
$6,154
$722
$1,835
$8,711
$16,292
$937
$2,755
-$259
$187
$5,501
-$4,011
$4,923
$21,215
2007
$204
2008
$216
2009
$229
2010
$243
2011
$257
2012
$273
2013
$289
2014
$307
2015
$325
2016
$344
$810
$4,842
$859
$5,132
$910
$5,440
$965
$5,767
$1,023
$6,113
$1,084
$6,479
$1,149
$6,868
$1,218
$7,280
$1,291
$7,717
$1,369
$8,180
$6,795
$11,786
$2,230
$7,203
$12,493
$2,364
$7,635
$13,243
$2,505
$8,093
$14,037
$2,656
$8,579
$14,879
$2,815
$9,094
$15,772
$2,984
$9,639
$16,718
$3,163
$10,218
$17,721
$3,353
$10,831
$18,785
$3,554
$11,481
$19,912
$3,767
$14,440
$21,236
$15,307
$22,510
$16,225
$23,860
$17,199
$25,292
$18,230
$26,810
$19,324
$28,418
$20,484
$30,123
$21,713
$31,931
$23,016
$33,846
$24,396
$35,877
$3,620
$3,698
$3,783
$3,876
$3,977
$4,087
$4,204
$4,330
$4,465
$4,608
$7,305
$7,743
$8,208
$8,700
$9,222
$9,776
$10,362
$10,984
$11,643
$12,342
$8,101
$15,406
$7,991
$15,735
$7,889
$16,097
$7,793
$16,494
$7,702
$16,924
$7,614
$17,390
$7,528
$17,891
$7,443
$18,427
$7,356
$18,999
$7,266
$19,607
$215
$6,408
$243
$7,353
$272
$8,341
$300
$9,376
$329
$10,463
$358
$11,606
$386
$12,810
$415
$14,082
$443
$15,425
$472
$16,848
$5,830
$21,236
$6,775
$22,510
$7,763
$23,860
$8,798
$25,292
$9,885
$26,810
$11,028
$28,418
$12,232
$30,123
$13,504
$31,931
$14,847
$33,846
$16,270
$35,877
126
Common Size
Cash
Deposits
Receivables
Inventory
Employee ben.
Other Assets
Current Assets
PP&E
Goodwill
Other assets
Non-Curr Assets
Total Assets
CPLTD
Accounts
payable
Accrued Liab
Def income
taxes
Other liabilities
Tot curr liab.
LTD
Deferred taxes
Other liabilities
Non-Curr Liab
Total Liab
Common stock
Paid-in capital
Acc. earnings
Treasury Stock
Total Equity
2002
0.85%
0.00%
3.37%
20.77%
1.49%
1.21%
27.69%
52.47%
17.78%
2.05%
72.31%
100%
2.17%
2003
0.79%
0.00%
3.67%
20.65%
1.49%
1.24%
27.84%
55.38%
15.53%
1.25%
72.16%
100%
1.53%
2004
0.70%
2.47%
4.04%
21.26%
1.46%
1.33%
31.26%
56.11%
10.69%
1.94%
68.74%
100%
0.42%
2005
1.03%
2.38%
3.35%
21.90%
1.46%
1.45%
31.57%
55.49%
10.70%
2.24%
68.43%
100%
3.44%
2006
0.89%
2.89%
3.67%
21.73%
1.41%
1.25%
31.84%
55.52%
10.33%
2.30%
68.16%
100%
5.56%
Used
0.96%
2007
0.96%
2008
0.96%
2009
0.96%
2010
0.96%
2011
0.96%
2012
0.96%
2013
0.96%
2014
0.96%
2015
0.96%
2016
0.96%
87
11
3.82%
22.80%
32.00%
3.82%
22.8%
3.82%
22.8%
3.82%
22.8%
3.82%
22.8%
3.82%
22.8%
3.82%
22.8%
3.82%
22.8%
3.82%
22.8%
3.82%
22.8%
32%
55.5%
10.5%
55.50%
10.50%
55.5%
10.5%
55.5%
10.5%
55.5%
10.5%
55.5%
10.5%
55.5%
10.5%
55.5%
10.5%
55.5%
10.5%
55.5%
10.5%
55.5%
10.5%
68%
3.30
68%
100%
68%
100%
68%
100%
68%
100%
68%
100%
68%
100%
68%
100%
68%
100%
68%
100%
68%
100%
20.11%
3.51%
18.91%
3.38%
22.29%
3.89%
22.04%
4.85%
23.35%
4.89%
23.5%
23.5%
23.5%
23.5%
23.5%
23.5%
23.5%
23.5%
23.5%
23.5%
23.5%
0.24%
8.47%
34.51%
50.59%
4.36%
10.54%
65.49%
100%
23.58%
60.18%
87.1%
-65.4%
100%
0.85%
9.86%
34.54%
50.18%
6.12%
9.16%
65.46%
100%
22.76%
59.39%
91.4%
-70.4%
100%
1.58%
9.09%
37.26%
46.60%
5.54%
10.60%
62.74%
100%
25.93%
68.70%
100.0%
-88.9%
100%
1.35%
10.05%
41.73%
41.50%
5.24%
11.53%
58.27%
100%
21.12%
57.77%
104.2%
-77.5%
100%
1.64%
11.09%
46.53%
37.77%
4.43%
11.26%
53.47%
100%
19.03%
55.96%
111.7%
-81.4%
100%
0.925
47.4%
49.2%
51.0%
52.8%
54.5%
56.2%
57.9%
59.6%
61.3%
62.9%
SE-TA
52.6%
100%
50.8%
100%
49.0%
100%
47.2%
100%
45.5%
100%
43.8%
100%
42.1%
100%
40.4%
100%
38.7%
100%
37.1%
100%
BB+NI-D
109.9%
108.5%
107.4%
106.6%
105.8%
105.2%
104.7%
104.3%
103.9%
103.6%
RE-DIV
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
127
Statement of Cash Flow Analysis:
To start our forecast of Kroger’s cash flow statement, we created a
common size report that compared each cash flow with the total cash from
operating activities in each of the previous five years. Next, we compared
company activities with cash flow from operations (CFFO) using the ratios:
CFFO/NI, CFFO/OI, CFFO/Net Sales, and CFFO/Gross Profit. After conducting
these ratios over Kroger’s previous five year history of cash flows, we noticed a
trend associated with their cash flow from operating activities and their net sales
(CFFO/Net Sales). During the previous two years, Kroger’s cash flows from
operating activities represented 3.60% of the Company’s total net sales. This
allowed us to forecast ten years worth of cash flow from operations activity by
comparing it to sales in the same year. We also forecasted out net earnings
(loss) for Kroger for the next ten years by setting it equal to net income that was
generated during the same year. Cash flows from financing activities were
forecasted by taking Kroger’s increase in their capital expenditures each year.
These capital expenditures include increases in cash and short term investments,
increases in inventory, and additions to property, plant, and equipment. An
increase in capital expenditures represents a decrease on the statement of cash
flows.
In our ten year forecast of the cash flow statement we were able to find a
strong linkage between the companies operating cash flows and net sales. This
is due to the retail grocery industries lack of credit sales/accounts receivable and
cash generated from sales being represented by cash flows from operating
activities accordingly. One limitation in our forecast of the future values in the
cash flow statement is the estimation of cash flow from investing activities
(CFFI). Although we were able to calculate CFFI by taking changes in property
plant and equipment, the first year of our forecasted CFFI is much lower than
the previous years. This reduction in CFFI is the result of our liabilities section
showing a decrease in the first year of our forecast.
128
Conclusion:
After conducting a ten year forecast of Kroger’s financial statements it can
be seen that the company is rapidly growing. Kroger’s performance in 2003 and
2004 set them back but the Company has rebounded and looks to be very
prosperous in the coming years. In the forecasted years, it shows Kroger
increasing their sales, net income, total assets, shareholders equity, and its cash
flows from operations each year. This demonstrates that we believe Kroger has
changed its business style in order to take on new competition from supercenters
and its ability to rebound from a recession following September 11th.
129
(reported in millions)
Cash Flow Statement
Net earnings (loss)
Depr & amortization
LIFO charge
Stock option expense
Expense- pension plans
GW impairment charge
Asset Impair Charge
Deferred Income Taxes
Other
deposits in-transit
Inventories
Receivables
Prepaid expenses
Accounts payable
Accrued expenses
Income taxes
Company pension plans
Other
CFFO Activities
CFFI Activities
Cash Flow Ratios
CFFO/Sales *Used
CFFO/OpInc
CFFO/NetInc
2002
$1,205
$1,087
-$50
$0
$0
$0
$0
$468
$38
$0
-$62
$2
-$34
$359
-$4
-$11
$0
$49
$3,183
-$1,907
2003
$315
$1,209
$34
$0
$0
$444
$120
$331
$22
$0
-$20
$3
$5
-$318
$224
-$62
-$100
$8
$2,215
-$2,026
2004
-$104
$1,256
$49
$13
$117
$861
$0
$230
$59
$73
-$236
$13
-$31
$167
-$23
-$86
-$35
$7
$2,330
-$1,608
2005
$958
$1,265
$27
$7
$138
$0
$0
-$63
$39
$18
-$157
-$19
$31
-$80
$155
$200
-$300
-$27
$2,192
-$1,279
2006
$1,115
$1,272
$50
$72
$161
$0
$0
-$60
$20
-$125
-$173
-$90
-$43
$256
$98
-$4
-$150
-$48
$2,351
-$1,587
2002
2003
2004
2005
2006
6.15%
4.12%
4.13%
3.62%
3.56%
123.9%
264.8%
161.7%
709.9%
275.1%
-2240.4%
107.7%
228.8%
105.1%
210.9%
2007
$1,121
2008
$1,189
2009
$1,260
2010
$1,335
2011
$1,416
2012
$1,500
2013
$1,591
2014
$1,686
2015
$1,787
2016
$1,894
$2,523
$20
$2,674
-$866
$2,835
-$918
$3,005
-$974
$3,185
-$1,032
$3,376
-$1,094
$3,579
-$1,159
$3,793
-$1,229
$4,021
-$1,303
$4,262
-$1,381
130
Cost of Capital Estimation
A company wanting to increase its capital can receive funds from outside
the firm in two ways: Equity Financing and Debt Financing. Raising funds for
capital expenditures can be very costly for firms and it is important that analyst
and investors evaluate the cost of obtaining money through debt and equity.
Cost of equity can be measured by inputting a company’s beta, market risk
premium, and a risk free rate in the CAPM Model. This requires analyst to
perform a series of regression analysis for the company being valued. An
alternative method to estimating the cost of equity is by using the Back Door
Method. This calculation requires analyst to implement the companies book
value of equity, the market value of equity, the companies ROE, and an
estimated growth rate. Cost of debt can be calculated by taking the weights of
debt and multiplying it by their respective rates. In our estimation of Kroger’s
cost of Capital we used each of these methods for our approximations.
Cost of Equity
In estimating Kroger’s cost of capital, we began by looking at their cost of
equity. To determine the cost of Kroger’s equity, we used the CAPM Model and
the Back Door Method for our calculations. Using the CAPM Model required us to
research information on the St. Louis Federal Reserve to find risk free rates on 3
month, 1 year, 2 year, 5 years, 7 years, and 10 year Treasury Bills. These
monthly and yearly percentages are considered to be risk free rates. This process
was used because there is a high correlation between Kroger’s monthly and
yearly returns and the returns produced from the S&P 500. After locating these
risk free rates, we then determined that Kroger’s market risk premium was
7.50%. The market risk premium was calculated by taking the average return
for the S&P 500 over treasury bonds a year of 6.80% and adding 0.70% because
Kroger’s market cap is above $16 billion. The function of the CAPM Model is the
131
beta and is calculated using a regression analysis. After we performed a
regression analysis over 72, 60, 48, 36, and 24 months for the stated rates
above, we were able to collect data that would help determine Kroger’s beta. By
putting this data into a regression analysis we can find the beta with the highest
explanatory rate, R^2. Looking at our regression analysis chart we noticed that
the highest R-Squared number was 2.33% and it was located in the 1 year rate,
24 month return column. Taking the beta in this column of -0.7023, a risk free
rate of 4.16%, and a market risk premium of 7.5% we calculated Kroger’s cost
of equity as follows:
CAPM Model:
Ke = RF + beta (Market Risk Premium)
Ke = 4.16% – 0.7023 (7.50%)=-1.11%
As previously mentioned, Kroger’s highest R-Squared value was only
2.33%. R-Squared values that are less than 10% indicate that the regression
analysis does not do a sufficient job of estimating values to be implemented into
our CAPM Model. This is why we chose to include an alternative method for the
calculation of Kroger’s cost of Equity. The alternative calculation we chose to
use is the Back Door Method. This estimation of the cost of equity is
implemented using the following formula:
Market Value of Equity = Book Value of Equity (1 + ROE – Ke)
Ke - growth
For the calculation of equity using this formula we used Kroger’s market
value of equity, which was the number of shares outstanding at Kroger’s fiscal
year end on February 3, 2007 (715), times their closing price on the same day of
25.90 (equals $18,518.50). Book value of equity was determined by taking
Kroger’s current shares outstanding of $681 million and multiplying it by the
current closing price of $27.33. We set ROE at Kroger’s current rate of 22.65%
132
and estimated growth to mirror our 6.00% sales growth implemented in our
forecasted balance sheet. This resulted in Kroger’s cost of equity to be
approximately 23.76%, which is fairly high given normal standards. Due to our
regression analysis providing R-Squared values below 10%, this method for
calculating the cost of equity may be preferred over the CAPM model.
133
Regression Analysis Chart
72 Months
60 Months
48 Months
36 Months
24 Months
3 Month Rate
RF
R2
Beta
Ke
4.00%
-0.011037
0.11746
4.88%
4.00%
-0.006039
0.26200
5.96%
4.00%
-0.000993
-0.41902
0.86%
4.00%
0.020950
-0.38969
1.08%
4.00%
-0.007845
-0.70509
-1.29%
1 Year Rate
RF
R2
Beta
Ke
4.16%
-0.010940
0.11902
5.05%
4.16%
-0.005831
0.26409
6.14%
4.16%
-0.001381
-0.41461
1.05%
4.16%
-0.007913
-0.38868
1.24%
4.16%
0.023316
-0.70239
-1.11%
2 Year Rate
RF
R2
Beta
Ke
3.97%
-0.010758
0.12198
4.88%
3.97%
-0.005608
0.26653
5.97%
3.97%
-0.001879
-0.40909
0.90%
3.97%
-0.007887
-0.38837
1.06%
3.97%
0.023016
-0.69966
-1.28%
5 Year Rate
RF
R2
Beta
Ke
4.20%
-0.010446
0.12713
5.15%
4.20%
-0.005142
0.27222
6.24%
4.20%
-0.002948
-0.39792
1.22%
4.20%
-0.007807
-0.38921
1.28%
4.20%
0.022689
-0.69797
-1.03%
7 Year Rate
RF
R2
Beta
Ke
4.33%
-0.010361
0.12852
5.29%
4.33%
-0.004968
0.27432
6.39%
4.33%
-0.003331
-0.39388
1.38%
4.33%
-0.007808
-0.38933
1.41%
4.33%
0.022542
-0.69736
-0.90%
10 Year Rate
RF
R2
Beta
Ke
4.53%
-0.010315
0.12930
5.50%
4.53%
-0.004837
0.27594
6.60%
4.53%
-0.003682
-0.39012
1.60%
4.53%
-0.007846
-0.38912
1.61%
4.53%
0.022297
-0.69637
-0.69%
134
Cost of Debt:
The cost of debt represents the interest rate for a firm’s current and long
term debt. Kroger’s cost of debt was calculated using various interests rates
found in Kroger’s 10-K and by researching interest rates on FRED at the St. Louis
Federal Reserve website.
We used the three month non-financial commercial paper rate (CPR) of
4.63% for current accounts payable, accrued liabilities, and other current
liabilities. We also used the 10-year treasury rate for deferred income taxes
found in the current liabilities section in Kroger’s balance sheet.
The interest rate for long term debt was 7.275%. To find the long term
debt interest rate of Kroger, we took an average rate of senior notes (7.075%)
and mortgages (7.475%) found in Kroger’s 10-K. The interest rate used for
other long-term liabilities was Kroger’s pension plan discount rate of 5.90%. The
pension plan represents a large portion of the Company’s other long-term
liabilities and that discount rate can be used to accurately measure similar
obligations.
To find total cost of debt, we took each liability item and set it as a
percentage of total liabilities to get a weighted average. We then multiplied the
weighted average by the interest rates we already determined to calculate their
percentage of the cost of debt. To find the total cost of debt, we simply took the
sum of all the cost of debt percentages. Kroger’s cost of debt before taxes was
5.77% and in the Company’s 10-K it stated a corporate tax rate of 35%. This
gave us an after tax cost of debt of 3.75% for Kroger.
Weighted Average Cost of Capital (WACC):
A firm’s WACC is calculated by weighting the costs of debt and equity
capital corresponding to their market values. Variables related to the WACC
include: the cost of debt capital (Rd), the cost of equity capital (Ke), the book
value of debt (Vd), the market value of equity (Ve), and the relevant tax rate (T).
The WACC is calculated by the formula:
135
WACC = ___ Vd ___ [Rd(1-T)]
Vd + Ve
+
_____ Ve ___ (Ke)
Ve + Vd
We used the book value of debt of $16,292 (total liabilities), a market
value of equity of 20,163 (the market value of shares multiplied by the number
of outstanding shares), and the appropriate tax rate of 35%. The value of debt
was taken from the most recent Kroger 10-K and the value of equity was
determined by analyzing current market conditions. Kroger WACC:
* Ke= -1.11% using the CAPM Model and r^2 < 10%
0.88% = 16,292 [.0577(.65)] + 20,163 (-.0111)
44,036
44,036
* Ke = 13.90% using the Back Door Method to estimate equity:
7.75% = 16,292 [.0577(.65)] + 20,163 (.1390)
44,036
44,036
Conclusion:
In determining the Weighted Average Cost of Capital for Kroger, we had
to determine Kroger’s cost of equity and cost of debt. We used several different
calculations in our estimation for the Company’s cost of equity and debt. These
include the CAPM Model, the Back Door Method, and weighted average debt.
We found that Kroger’s cost of Equity was -1.11% using the CAPM Model and
13.90% using the Back Door Method. The cost of debt was determined to be
5.77% before tax and 3.75% after tax. Using these costs of capital percentages,
we were able to generate Weighted Average Cost of Capital after tax values of
0.88% and 7.75% using each cost of equity values. The second WACCAT is
based on our cost of equity estimation using an alternative method.
136
Equity Valuations
In determining the equity valuation of a company, analyst and investors
can use many different methods to estimate the true value of a firm. A
company’s equity value can be estimated using either the Method of
Comparables Ratios or by using Intrinsic Valuation Models. The method of
comparables uses ratios and allows analyst to compare a firm’s equity value to
other companies in the firms industry. The Method of Comparables analysis is a
quick way to gain insight into the equity value of a firm. Another method used
to determine the value of a firm’s equity is by using the Intrinsic Valuation
Models. The Intrinsic Valuation Models consists of several different valuation
methods and each requires different financial data to determine a company’s
share price. This method is different from the Method of Comparables
evaluation because it is more in depth and does not compare a company’s value
to that of its competitors. These two methods for valuing a firm are important to
investors and analyst because it allows them to determine whether a firm’s stock
price is overvalued or undervalued. These two methods for valuation are
discussed in further detail below.
Method of Comparables
Kroger's Method of Comparable Ratios
Ratios
Share Price
Trailing Price to Earnings
$27.79
Forward Price to Earnings
$27.21
Price to Book
$17.07
Dividend Yield
$21.25
Price Earnings Growth
$18.86
Price to EBITDA
$45.17
Enterprise Value to EBITDA
$28.36
Price to Free Cash Flow
-$41.14
*Prices were determined using Kroger’s 10-K and Yahoo Finance
137
The chart above illustrates Kroger’s Method of Comparable Ratios that
were generated using the Company’s annual 10-K. The Method of Comparables
analysis is done by calculating ratios using numbers that are provided by each
company’s annual reports and on Yahoo Finance. These ratios include: Forward
Price to Earnings, Trailing Price to Earnings, Price to Book Values, Dividend
Yields, Price Earnings Growth, Price to EBITDA, Enterprise Value to EBITDA, and
Price to Free Cash Flow. As you can see in the chart above, the Method of
Comparable Ratios in our analysis of Kroger has generated somewhat fluctuating
share prices. The Method of Comparable Ratios for Kroger and its competitors
are discussed in detail in the following subsections.
Trailing Price to Earnings
Trailing Price to Earnings
KR
SWY
SVU
WINN
WMT
PPS
$28.20
$32.86
$37.56
$20.10
$44.03
EPS
$1.70
$1.96
$2.22
$5.23
$2.94
P/E
$16.54
$16.77
$16.89
$3.84
$14.99
Industry Avg.
$16.30
KR Share Price
$27.79
The chart above shows the Trailing Price to Earnings Ratios for Kroger, its
competitors, and the industry average. The numbers in the chart were gathered
from each company’s annual reports and from Yahoo Finance. To calculate
Kroger’s share price using the Trailing Price to Earnings Ratio, each of Kroger’s
competitor’s Price per Share (PPS) was divided by their Earnings per Share (EPS)
and then added up and divided by 4 to generate an industry average of $16.30.
Winn-Dixie was not used in our calculations due to their very low P/E ratio using
this method. The industry average was then multiplied by Kroger’s EPS to derive
a share price of $27.79. Since Kroger’s observed share price on November 1,
2007 was $28.20, this ratio indicates that Kroger’s current price is fairly valued.
138
Forward Price to Earnings
Forward Price to Earnings
PPS
$28.20
$32.86
$37.56
$20.10
$44.03
KR
SWY
SVU
WINN
WMT
EPS
$1.93
$2.17
$2.84
$0.54
$3.31
P/E
$14.58
$15.13
$13.24
$37.21
$13.32
Industry Avg.
$14.07
KR Share Price
$27.21
The chart above shows the Forward Price to Earnings Ratios for Kroger,
its competitors, and the industry average. To calculate Forward Price to
Earnings, we used Kroger’s competitors PPS and divided it by their estimated
future EPS to determine each companies Price to Earnings Ratio (P/E). An
industry average P/E ratio was then determined to be $14.07. In determining
the industry average we decided not to use Winn-Dixie in our calculations
because of their very high P/E ratio. To calculate Kroger’s share price using the
Forward Price to Earnings Ratio, we multiplied our expected EPS for Kroger by
the industry average to derive a share price of $27.21. As stated previously,
Kroger’s observed share price is $28.20 and the Forward Price to Earnings Ratio
in this case shows Kroger’s share price as fairly valued.
Price to Book
Price to Book Ratios
KR
SWY
SVU
WINN
WMT
PPS
$28.20
$32.86
$37.56
$20.10
$44.03
BPS
$7.27
$14.35
$24.23
$17.79
$15.24
P/B
$3.88
$2.29
$1.55
$1.13
$2.89
Industry Avg.
$2.35
KR Share Price
$17.07
The diagram above is a list of Price to Book Ratio’s for Kroger, its
competitors, and the industry average. This method of comparables ratio was
calculated by taking each company’s current PPS and dividing it by their book
price per share (BPS) that was provided in each company’s most recent annual
139
report. An industry average of price to book ratios (P/B) was taken by adding up
Kroger’s competitors P/B ratios and then dividing by four to derive an average of
$2.35. The industry average was then multiplied by Kroger’s P/B ratio to
determine a share price of $17.07 using the Price to Book method of
comparables technique.
Dividend Yield
Dividend Yield
KR
SWY
SVU
WINN
WMT
PPS
$28.20
$32.86
$37.56
$20.10
$44.03
DPS
$0.30
$0.25
$0.67
N/A
$0.83
D/P
0.011
0.008
0.018
N/A
0.019
Industry Avg.
0.0137
KR Share Price
21.84
The table above shows the Dividend Yields for Kroger, its competitors,
and an industry average. The Dividend Yield is determined by taking a
company’s dividends per share (DPS) and dividing by the company’s PPS to
produce a dividend to price ratio (D/P). In our calculation of Kroger’s share price
using the Dividend Yield Method of Comparables ratio, we first took an industry
average of D/P ratios by adding each companies results and dividing by four.
This gave us an industry average of 0.0137, which was then used to calculate
Kroger’s share price by dividing Kroger’s DPS by this industry average. Using this
valuation technique, Kroger’s share price totaled $21.84, which indicates to
investors that Kroger’s current PPS is overvalued.
Price Earnings Growth
Price to Earnings Growth
KR
SWY
SVU
WINN
WMT
PPS
$28.20
$32.86
$37.56
$20.10
$44.03
EPS
$1.70
$1.96
$2.22
$5.23
$2.94
P/E
$16.54
$16.77
$16.89
$3.84
$14.99
PEG
1.52
1.58
1.66
5.23
1.22
Industry Avg.
1.495
140
KR Share Price
$18.86
The excel chart above is a collection of Price Earnings Growth numbers for
Kroger and its competitors. The Price Earnings Growth (PEG) calculation can be
done by taking a companies P/E ratio and dividing it by a company’s expected
PEG. To calculate Kroger’s share price using this method we divided Kroger’s
P/E ratio of 16.54 by the industry average (1.495) and then multiplied Kroger’s
EPS by this number. It is important to note that for our calculations of Kroger’s
share price using this method, we decided to not include Winn-Dixie due to the
fact that their numbers make it an outlier company. As can be seen in the chart,
this generated a share price of $18.86 and demonstrates that Kroger’s current
share price is overvalued.
Price to EBITDA
Price to EBITDA
KR
SWY
SVU
WINN
WMT
PPS
$28.20
$32.86
$37.56
$20.10
$44.03
EBITDA
$3.74
$2.80
$2.80
$0.77
$27.65
P/EBITDA
7.5401
11.7357
13.4143
26.1039
1.5924
Industry Avg.
8.5706
KR Share Price
$32.05
The chart above is a diagram of Price to EBITDA ratios for Kroger and
other competitors in the industry. The Price to EBITDA ratio can be used to
estimate a company’s share price. In the diagram above each company’s
EBITDA numbers are stated in billions in order to simplify our calculations. In
our calculation of Kroger’s share price using this method, we determined an
industry average of Price to EBITDA ratios (excluding Winn-Dixie) to be 12.08.
This industry average was then multiplied by Kroger’s EBITDA of $3.74 billion to
generate a share price of $32.05. Our generated share price using this method
indicates that Kroger’s observed share price is fairly stated because it is within
$4.00.
141
Enterprise Value to EBITDA
Enterprise Value to EBITDA
KR
SWY
SVU
WINN
WMT
PPS
$28.20
$32.86
$37.56
$20.10
$44.03
EBITDA
$3.74
$2.80
$2.80
$0.77
$27.65
EV/EBITDA
$6.84
$7.33
$6.25
$9.36
$8.13
Industry Avg.
$7.58
KR Share Price
$28.36
The diagram above is a collection of Price to EBITDA Ratios for Kroger, its
competitors, and the industry average. To calculate Kroger’s share price using
the Enterprise Value to EBITDA method, it was important for us to find each
company’s enterprise value to EBITDA numbers on Yahoo Finance. Once each of
Kroger’s competitors EV/EBITDA numbers were determined we were then able to
generate an industry average of 7.58. The industry average of EV/EBITDA was
then multiplied by Kroger’s EBITDA to determine a share price of $28.36. This
method indicates that Kroger’s share price is fairly valued.
Price to Free Cash Flow
Price to Free Cash Flow
KR
SWY
SVU
WINN
WMT
PPS
$28.20
$32.86
$37.56
$20.10
$44.03
FCF
$533.75
-$92.36
$471.38
-$113.91
$3,070.00
P/FCF
0.05
-0.36
0.08
-0.18
0.01
Industry Avg.
-0.08
KR Share Price
-$41.14
The chart above demonstrates the Price to Free Cash Flow Ratios
provided by Kroger and its competitors. As can be seen in the above chart, this
method of valuation generated a negative share price for Kroger due to many
companies in the industry having negative free cash flows. Free cash flows are
determined by taking a company’s cash from operating activities and
subtracting/adding increases or decreases in the company’s investing activities.
The negative free cash flows experienced by some of Kroger’s competitors
142
resulted in an industry average that was negative. This led to a negative share
price for Kroger in our calculations and is a poor method to use in determining
Kroger’s share price.
Conclusion
In our equity valuation of Kroger using the Method of Comparables
analysis are result varied across the board. The trailing price to earnings ratio,
the forward price to earnings ratio, and the enterprise value to EBITDA ratio all
showed that Kroger’s observed share price of $28.20, on November 1, 2007, as
being fairly valued. On the other hand, the price to book ratio, the dividend
yield, and the price earnings growth ratio all indicated that Kroger’s observed
share price was overvalued. The price to EBITDA ratio showed Kroger as being
undervalued and the price to free cash flow was unhelpful due to the negative
cash flows experienced in this industry. These valuations are used for simplicity
and a more thorough analysis should be conducted using the Intrinsic Valuation
Models.
143
Intrinsic Valuations
The intrinsic valuation models are used to determine the true equity value
of a firm. These valuation models are more precise than the Method of
Comparables technique, because they focus only on the company at hand while
using more financial data in the analysis. The five intrinsic valuation models we
performed in our analysis of Kroger Co. include: The Discount Dividends Model,
The Free Cash Flow Model, The Residual Income Model (RI), The Long Run
Residual Income Model, and the Abnormal Earnings Growth Model (AEG). Along
with these equity valuation models we have included a sensitivity analysis in
order to demonstrate the change in price when there is a variable change in our
calculations.
Discount Dividends Model
The Discount Dividends Model is a tool used by analyst to determine the
value of a firm by discounting a firm’s future dividends back to the current time
period. This is important to shareholders because the value of the firm is their
expected dividends discounted back to the present. Although the Discount
Dividend approach is more precise than using the Method of Comparables
technique it still has a few disadvantages. For example, the Discount Dividend
Model assumes that a company will have an indefinite life span (Palepu & Healy).
Of course this is inaccurate because all firms are subject to business and
systematic risk and could go bankrupt. Also, the Discount Dividends Model is a
more simplistic method of determining a firm’s equity value when compared to
the other Intrinsic Valuation Models. This can create inconsistencies when trying
to determine the equity value of a firm.
In our equity valuation of Kroger using the Discounted Dividends Model,
we took our forecasted future dividend per share and discounted them back
144
using their respective present value factors in order to get annual present value
dividends. Kroger pays dividends quarterly and showed a total dividend of $0.26
paid to its shareholders during 2006 and are expected to pay total dividends of
$0.30 per share by the end of 2007. For our analysis, we decided that we would
increase dividends by $0.04 cents a year, indicating an average growth rate of
dividends of 9%. To determine the present value of Kroger’s future dividends,
we determined a present value factor for each year. The expected annual
dividends were then multiplied by their respective present value factor. This was
done using the following formulas:
•
Present Value Factor= 1 / (1+ Ke) ^ number of periods out from cur yr
As previously mentioned, we determined Kroger’s cost of equity to be
13.90% using the Back Door Method. Once the present value of future
dividends was determined they were totaled to give us the total present value of
future annual dividends. The continuing value perpetuity, which is the
Company’s expected dividends after our forecasted ten years, was then
determined using the following perpetuity formula:
Continuing TV Perpetuity = $14.29 = $0.70 / (.1390 - .09)
Dividend Growth
1
15.38%
2
13.33%
3
11.76%
4
10.53%
5
9.52%
6
8.70%
7
8.00%
8
7.41%
9
6.90%
10
6.45%
Avg.
9.00%
We determined that the growth rate for future dividends was 9%, which is
an average of Kroger’s expected dividend growth. The continuing terminal value
of perpetuity was then multiplied by the year ten’s present value factor to give us
a present value of the terminal perpetuity of $3.89. Kroger’s January 2007 share
145
price can now calculated by adding the total present value of future dividends
and the present value of the terminal perpetuity. The November 1, 2007 is then
calculated by taking January 2007’s share price and multiplying by the cost of
equity raised to the remaining 9 months over 12. The equations below illustrate
this process.
•
1/31/07 Share Price = $6.18 = $2.89 + 3.89
•
11/01/07 Share Price = 6.82 = $6.82* (1 + .1390) ^ (9/12)
After our calculations, we determined Kroger had a share price of $6.18 at
the end of January 2007 and a share price of $6.82 on November 1, 2007. In
our calculation of Kroger’s 11/01/07 share price we used the Company’s cost of
equity of 13.90. Kroger’s observed share price on November 1, 2007 is $28.20,
and it can be concluded that after our calculations using the Discounted
Dividends Model, Kroger’s share price is overvalued.
Sensitivity Analysis
11.90%
12.90%
13.90%
8%
$9.08
$7.28
$6.09
9%
$11.27
$8.47
$6.82
Growth
10%
$15.76
$10.49
$7.92
11%
$30.23
$14.62
$9.77
11.80%
$250.15
$23.35
$12.53
14.90%
15.90%
16.90%
$5.24
$4.61
$4.12
$5.72
$4.94
$4.35
$6.39
$5.38
$4.66
$7.40
$6.00
$5.06
$8.68
$6.71
$5.50
Ke
Overvalued < $23.69
Fairly Valued w/n $4.50
Undervalued > 32.71
Actual Share Price 11/01/2007 = $28.20
The chart above is a sensitivity analysis for Kroger using the Discounted
Dividends Model. As can be seen in the chart, our sensitivity analysis shows that
most of the combinations between Ke and growth produce share price values
that show Kroger’s observed share price as being overvalued. The chart also
demonstrates that Kroger’s share prices can fluctuate substantially if changes are
146
made to the Company’s cost of equity and growth rates. The most significant
changes in share price occur when the cost of equity and growth rates move
towards each other. After conducting the sensitivity analysis for the Discount
Dividends Model, we found that a 11.90% cost of equity and a 11% growth rate
is the only instance where the mixture of the two variables resulted in a fairly
valued share price for Kroger. Kroger’s current equity cost of 13.90% is right
around the industry standard and it would be difficult for them to lower it to
11.90%. Increasing the dividend growth rate would also be difficult for Kroger
due to the fact that our forecast show a decrease in dividend growth each year.
Free Cash Flows Model
The Free Cash Flow Model is used to determine the value of equity by
calculating the present value of future free cash flows generated by a firm. Free
cash flows are the funds available to the firm to pay debt and equity holders and
can be calculated by using the following formula:
Free Cash Flow = CFFO Activities +/- CFFI Activities
When determining the equity value of Kroger using the Free Cash Flow
Model, we began by forecasting the Company’s free cash flows and discounting
them back to the present using a present value factor. This done using the
same formula in the Discount Dividends Model, but instead of using Kroger’s cost
of equity we used their WACCBT in our calculations of each year’s present value
factor. Each year’s free cash flow values were then multiplied by their respective
present value factors to give us the annual present value of free cash flows.
Adding the annual present value of free cash flows gave us a total present value
of free cash flows of $14,920 million. The continuous terminal value perpetuity
and its present value was then calculated using the following equations:
147
•
Continuous TV Perpetuity = FCFyr 11/ (WACCBT – FCF growth rate)
$132,920 = $3,323 / (.085 - .06)
•
PV of Terminal Perpetuity = Cont. TV Perpetuity x PV Factoryr 10
$58,788 = 132,920 x 0.4423
The total firm value of Kroger was determined to be $73,708 million by adding
the total present value of annual free cash flows and the present value of the
terminal perpetuity. Since we already know that Kroger’s book value of debt is
$16,292 million, we simply subtracted this value from our calculated firm value of
$73,708 million to get the Company’s market value of equity on 1/31/07 of
$57,416 million. The market value of equity was then divided by Kroger’s 715
million shares outstanding to get a 1/31/07 share price of $80.30. This value
was then converted into a 11/01/07 share price by multiplying it by one plus the
WACCBT raised to the remaining 9 months over 12. Below is an illustration of
our calculations.
1/31/07 PPS= VF – BVE or $73,708 - $16,292 = $57,416/715 = $80.30
11/01/07 PPS = 80.30*((1+.085) ^ (9/12)) = $85.37
The formula’s above indicate that Kroger has an estimated share price of
$80.30 on 1/31/07 and an implied share price of $85.37 at 11/01/07. Since
Kroger had an observed share price of $28.20 on 11/01/07, this indicates to
analyst and investors that Kroger’s share price is undervalued using the
Discounted Free Cash Flow Model.
148
Sensitivity Analysis
WACC
7.50%
8.50%
9.50%
10.50%
11.50%
12.50%
3.0%
51.95
37.69
27.82
20.57
15.02
10.63
4.0%
67.07
46.52
33.43
24.36
17.68
12.56
Growth
5.0%
94.27
60.40
41.54
29.52
21.17
15.02
6.0%
157.76
85.37
54.29
36.97
25.92
18.22
7.0%
475.18
143.64
77.23
48.69
32.78
22.60
Overvalued < $23.69
Fairly Valued w/n $4.50
Undervalued > 32.71
Actual Share Price 11/01/2007 = $28.20
The above chart is the sensitivity analysis for Kroger using the Free Cash
Flow valuation model. By fluctuating Kroger’s WACCBT values and their free cash
flow growth rates, we were able to view different share prices based on these
two variables. The share prices generated in our sensitivity analysis show a
substantial amount of volatility. For example, at Kroger’s current free cash flow
growth rate of 6%, the share price declines by $140 as the WACCBT is increased
from 7.50% to 12.50%. The chart also shows that as the WACCBT is decreased
(increased) and the growth rate is increased (decreased), the share price also
increases (decreases).
Residual Income Model
The Residual Income Model is another intrinsic valuation method that can
be used by analyst and investors. This model is known to be one of the most
accurate for the valuation of a firm’s equity because it is not significantly affected
by estimation errors surrounding cost of equity and growth rates. Calculating a
firm’s share price using the Residual Income Model involves the following
information: book value of equity, forecasted earnings, forecasted dividends,
cost of equity, and the growth rate of residual income (negative growth).
For our equity valuation of Kroger using the Residual Income Model, we
began by implementing the Company’s current and future book value of equity
values, forecasted earnings, and forecasted dividends. In order to derive a share
149
price for Kroger using this model, their residual income numbers needed to be
calculated and discounted back to the current time period. To calculate Kroger’s
residual income we first had to determine the normal or benchmark income in
each of the 10 years. The benchmark income was calculated by taking the
beginning book value of equity in a given year (previous year’s ending book
value) and multiplying it by the cost of equity (13.90%). After each year’s
normal income was found for Kroger, it was subtracted from the same year’s
earnings to derive a residual income value for each year. Below are the normal
and residual income formulas.
•
Normal Income = BVEprevious yr x Cost of Equity
•
Residual Income = Earningscurrent yr - Normal Income current yr
Residual Income Values
1
$437
2
$378
3
$318
4
$256
5
$192
6
$126
7
$58
8
-$14
9
-$90
10
-$169
Forecast
-$186
Change in Residual Income Values
2008
2009
2010
2011
2012
2013
2014
2015
2016
Forecast
-$58.76
-$60.10
-$61.76
-$63.76
-$66.11
-$68.85
-$71.98
-$75.55
-$79.56
-$16.95
The present value of each year’s residual income was then determined by
inputting Kroger’s cost of equity into the same present value factor equation that
was used in the previous models. Once the present value of each year’s annual
residual income was determined, they were added to give us a present value of
annual residual incomes of $1,145 million for Kroger. We then calculated the
continuous terminal value perpetuity and its present value. In our calculation of
Kroger’s continual terminal value, we assumed a conservative growth rate of
-10% for their residual income and a 13.90% cost of equity to determine the
present value of our continual terminal value. These calculations are provided
below.
150
•
Continuous TV Perpetuity = RIyr 11/ (Ke – RI growth rate)
$-780 = $-186 / (.1390 + -.10)
•
PV of Terminal Perpetuity = Cont. TV Perpetuity x PV Factoryr 10
$-212 = -780 x 0.2721
The total present value of annual residual income and the present value
were then added to Kroger’s 1/31/07 book value of equity and divided by the
Company’s number of shares outstanding to get a January 31, 2007 share price
of $8.19. This value was then converted into today’s dollars by multiplying it by
one plus Kroger’s cost of equity raised to the remaining 9 months over 12. This
generated a share price of $9.03 for Kroger on 11/01/07. The calculation of
these share prices are below.
•
1/31/07 PPS = ($4,923 + $1,145 + -$212.16) / 715 = $8.19
•
11/01/07 Share Price = 8.19*((1+Ke)
^ (9/12))
= $9.03
Our calculated implied share price using the Residual Income Model is well
below Kroger’s observed share price of $28.20 and indicates to investors that it is
overvalued. Below we evaluate our results even further by conducting a
sensitivity analysis for Kroger using the Residual Income Model.
Sensitivity Analysis
Ke
9.50%
10.50%
11.50%
12.50%
13.90%
14.50%
0
16.09
12.8
11.97
10.48
8.82
8.23
-10%
14.43
12.89
11.56
10.41
9.03
8.53
Growth
-20%
13.9
12.58
11.42
10.39
9.14
8.66
-30%
13.63
12.42
11.34
10.37
9.19
8.73
Actual Share Price 11/01/2007 = $28.20
151
-40%
13.48
12.32
11.29
10.36
9.22
8.78
Overvalued < $23.69
Fairly Valued w/n $4.50
Undervalued > 32.71
The diagram above shows a mixture of both cost of equity and residual
income growth rates to determine different share prices for Kroger. After
conducting the sensitivity analysis for the Residual Income Model, we noticed
there was very little volatility in share prices as the variables were changed.
This is why the Residual Income Model is considered as one of the most accurate
measures of a firm’s equity value. As you will notice in the chart above, the
share prices generated by different mixtures of the two variables indicate that
Kroger’s observed share price of $28.20, on November 1, 2007, is overvalued.
Long Run Return on Equity Residual Income Model
The Long Run Residual Income Model is used to calculate a firm’s equity
value by using information found in the Residual Income Model. This model is
used by analyst and investors in their determination of the present value of a
firm’s equity using long run equity growth rates, long run return on equity
estimates, forecasted book value of equity, and the firm’s cost of equity. These
numbers are places into a perpetuity formula to determine the present value of a
firm’s equity.
In our equity valuation of Kroger using the Long Run Return on Equity
Residual Income Model, the first step we took was to determine our forecasted
book value of equity. We forecasted our book value of equity to be $16,270
million using the following formula in our Residual Income Model:
Ending BV of Equity = Beginning BV of Equity + Earnings – Dividends Paid
After calculating our forecasted book value of equity, we then computed
Kroger’s long run return on equity and growth rate numbers. These calculations
were done using the following formulas:
152
ROE = Net Income in current year / Book Value of Equity in previous year
ROE Values
2007
22.7%
2008
20.3%
2009
18.5%
2010
17.2%
2011
16.1%
2012
15.1%
2013
14.4%
2014
13.7%
2015
13.2%
2016
12.7%
Growth = (Current year’s equity – previous year’s equity) / Previous year
Equity Growth Rates
1
18.4%
2
16.2%
3
14.5%
4
13.3%
5
12.3%
6
11.5%
7
10.9%
8
10.3%
9
9.9%
10
9.5%
Forecast
9.0%
The diagrams above show Kroger’s long run return on equity and growth
rates over a ten year period. In each consecutive period, both return on equity
and growth showed a slight decline. The decline is natural for companies like
Kroger who are experiencing above average return on equity and growth rates.
Over time growth and return on equity should return to normal industry
standards. So in our equity valuation, we concluded that Kroger’s long run
return on equity is 13% and their equity growth rate is 9%. We used the
information we gathered for Kroger in the following perpetuity formula to
determine the present value of the firm’s equity.
Value of Firm= BVE (1+ ((LR ROE – Ke / (Ke – LR Growth of Equity))
Using this formula we determined that the value of the firm was $13,282
million at the end of January 2007. Dividing the value of the firm by the 715
million shares outstanding gave us a share price for Kroger of $18.58 on January
31, 2007. Converting this price to a November 1, 2007 showed a share price for
Kroger of $20.48. This indicates that Kroger’s observed share price of $28.20 is
overvalued using the Long Run Return on Equity Residual Income Model. Below
is a sensitivity analysis for Kroger using this valuation model.
153
Sensitivity Analysis
g = .09
Ke
0.13
0.15
ROE
0.17
0.19
0.21
11.90%
31.39
47.08
62.77
78.47
94.16
12.90%
23.34
35.01
46.68
58.35
70.02
13.90%
14.90%
18.58
27.86
37.15
46.44
55.73
15.43
23.14
30.85
38.57
46.28
15.90%
13.19
19.79
26.38
32.98
39.57
16.90%
11.52
17.28
23.04
28.80
34.56
0.08
75.85
60.37
50.14
42.87
37.45
33.24
Growth
0.09
94.16
70.02
55.73
46.28
39.57
34.56
0.10
131.74
86.31
64.18
51.08
42.43
36.28
0.11
252.84
119.76
78.47
58.35
46.44
38.57
0.10
0.105
5.83
17.50
29.17
40.84
52.51
64.18
3.35
16.73
30.12
43.50
56.89
70.27
Ke
ROE = 0.13
11.90%
12.90%
13.90%
14.90%
15.90%
16.90%
ROE
Ke = .1390
0.11
0.13
0.15
0.17
0.19
0.21
0.07
65.01
54.00
46.17
40.33
35.79
32.18
0.07
0.08
Growth
0.09
13.19
19.79
26.38
32.98
39.57
46.17
11.57
19.28
27.01
34.71
42.43
50.14
9.29
18.58
27.86
37.15
46.44
55.73
Actual Share Price = $28.20
Overvalued < $23.69
Fairly Valued w/n $4.50
Undervalued > 32.71
The above charts are sensitivity analyses for the Long Run Return on
Equity Residual Income Model for Kroger. In this sensitivity analysis, we used
three different variables to evaluate the fluctuations in share prices. These
variables include Kroger’s long run return on equity, long run equity growth rate,
and cost of equity. It is interesting to note that Kroger’s share price is fairly
valued if the cost of equity is kept constant at 13.90% and Kroger’s ROE is
154
placed at 15%. As the growth rate increases, the share price also increases, but
as you can see it still shows Kroger’s share price as being fairly valued.
Abnormal Earnings Growth Model
The Abnormal Earnings Growth Model (AEG) is one of the most difficult
methods used to value in the valuation of a firm’s equity. This valuation model
consist of future utilized earnings and the above normal earnings experienced by
a firm. This model is calculated using a company’s forecasted earnings, their
drip income, their cumulative dividend earnings, and their normal or benchmark
earnings in each year. Abnormal Earnings Growth is the difference between a
firms cum-dividend earnings and their normal income and these values need to
be discounted back to the present for the share price calculation. This model is
known to be one of the most accurate valuation models because each year’s
abnormal earnings growth is directly related to the change in Company’s residual
income.
A major difference in this model is that future abnormal earnings are
forecasted out beginning in year two instead of year one like the previous
models.
In our equity valuation of Kroger using the Abnormal Earnings Growth
Model, we began by implementing our forecasted earnings for the Company.
The next step using this model is to calculate the cum-dividend earnings for each
of our forecasted years. In order to find each year’s cum-dividend earnings we
first needed to determine our drip income in each year; which is the previous
year’s dividend reinvested at 13.90%, Kroger’s cost of equity. Adding Kroger’s
drip income in each year to the earnings in the same year gave us our cumdividend earnings. The calculation of drip income and the cumulative dividend
earnings is below.
155
•
Drip Income = Dividendprevious yr x Ke
•
Cum-Dividend Earnings = Drip Income 1 + Earnings1
To find the Abnormal Earnings Growth for each of our forecasted years we
took the cum-dividend earnings and subtracted it from the Kroger’s normal
income in the same year. Normal or benchmark income is calculated by
multiplying the previous year’s earnings by one plus the Company’s cost of
equity. The respective formulas for normal income and abnormal growth
earnings can be seen below:
•
Normal /Benchmark Income = Earnings previous yr * (1 + Ke)
•
AEG = Normal/Benchmark Income – Cum-Dividend Earnings
Annual Abnormal Earnings
2008
2009
2010
2011
2012
2013
2014
2015
2016
Forecast
-58.49
-60.10
-61.76
-63.76
-66.11
-68.85
-71.98
-75.55
-79.56
-84.03
2013
-68.85
2014
-71.98
2015
-75.55
2016
-79.56
Forecast
-84.03
Residual Income Check Figure
2008
-58.49
2009
-60.10
2010
-61.76
2011
-63.76
2012
-66.11
Using Kroger’s cost of equity of 13.90%, we were able to generate present
value factors for each year using the same formula in the previous models. The
present value factor in each year was then multiplied by the same year’s AEG
and their values were combined to create a total present value of AEG equal to
-$323.89. For our calculations of the continuous terminal value we used an AEG
growth rate of -12% and a 13.90% cost of equity. The present value of the
continuous terminal value was calculated to be -$100.59. Our calculations of
Kroger’s continuous terminal perpetuity and its present value are provided below.
156
•
Continuous TV of Perpetuity = AEG yr 11 / (Ke – AEG growth)
-324.44 = -84.03 / (.1390 + -.12)
•
PV of TV Perpetuity = Continuous TV of Perpetuity x PV Factoryr 10
-100.56 = -324.44 x .3099
The present value of the terminal perpetuity was then added to the total
present value of annual AEG to generate a total present value of AEG equal to
-424.20. To calculate the share price of Kroger, we then added the total present
value of AEG to Kroger’s Core 2007 earnings of $1,121 to find the total average
earnings perpetuity of $696.80. This value was then divided by Kroger’s cost of
equity (13.90%) and their number of shares outstanding (715) to calculate a
share price of $7.01 at the end of January 2007.
•
Total Avg. Earnings Perp. = Tot. PV AEG + PV of TV + Earnings 2007
696.80 = -424.20 + -100.56 + 1,121
•
1/31/07 Share Price = (696.80 / .1390) / 715 = $7.01
The end of January 2007 share price was then plugged into the future
value formula to determine a share price of $7.73 on November 1, 2007. This
implied share price is substantially lower than our observed share price for
Kroger on November 1, 2007 and it can be determined that the stock price is
overvalued using the Abnormal Earnings Growth Model.
Sensitivity Analysis
Ke
9.50%
10.50%
11.50%
12.50%
13.90%
14.50%
0%
6.68
6.82
6.87
6.85
6.76
6.71
-12%
9.03
8.71
8.4
8.11
7.73
7.57
Actual PPS 11/01/2007 = $28.20
Growth
-24%
9.69
9.28
8.9
8.54
8.08
7.9
-36%
10.01
9.56
9.14
8.76
8.26
8.07
157
-48%
10.19
9.72
9.29
8.89
8.38
8.17
Overvalued < $23.69
Fairly Valued w/n $4.50
Undervalued > 32.71
The chart above is a sensitivity analysis for the Abnormal Earnings Growth
Model in our equity valuation of Kroger. Similar to the Residual Income Model,
the Abnormal Earnings Growth method shows very little fluctuation in share
prices as the variables are increased and decreased. The sensitivity analysis also
indicates that Kroger’s share price is overvalued regardless of the changes in cost
of equity and growth rates. The fact that share price is not highly dependent on
either of these two variables is the reason the Abnormal Earnings Growth Model
is one of the most accurate models for valuating a firm’s equity.
Conclusion
After conducting all five of the Intrinsic Valuation Model, it can be
determined that Kroger’s observed share price of $28.20, on November 1, 2007,
is overvalued. Each of the models, excluding the Free Cash Flow Model, showed
that Kroger’s actual equity value is well below that of its current share price. The
Residual Income Model and the Abnormal Earnings Growth Model are known to
be the two most accurate methods of determining a Company’s equity value.
Both of these models indicate to investors that the share price is overvalued and
should be sold or not purchased.
158
Credit Analysis
Altman Z-Score
The Altman Z-score is a weighted ratio based formula that includes
numerous items from the balance sheet and income statement. The scores are
used to asses the credit risk of a firm. It also measures a company’s bankruptcy
potential and their ability to pay off debt. To calculate a score: plug in historical
data into the formula to gauge how a firm is leveraged.
The Altman Z-Score is computed by using the following formula:
Z = 1.2 (X1) + 1.4 (X2) + 3.3 (X3) + 0.6 (X4) + 1.0 (X5)
Where
X1 = Net Working Capital / Total Assets
X2 = Retained Earnings / Total Assets
X3 = EBIT / Total Assets
X4 = Market Value of Equity / Book Value of Total Liabilities
X5 = Sales / Total Assets
Altman
2002
2003
2004
2005
2006
Z-Scores
3.2611
3.1792
3.1702
3.6168
3.8149
On average, a score of less than 1.8 indicates that the firm is at a higher
risk of defaulting; probability of financial embarrassment is very high
(www.creditguru.com). A Z-score of 1.8 through 2.7 shows that the firm is on
159
the edge of bankruptcy and survival; there is a good chance the firm will be
bankrupt in two years. A Z-score of 2.7 through 2.99 alerts the company for
caution; there is a smaller risk of imminent bankruptcy. They are close from
being either a high risk or low risk firm. A company with a Z-score of 3.0 and
above illustrates that the firm is safe; they are at a low risk for bankruptcy and
the financial figures used are healthy. The Altman Z-score is an accurate
measure of bankrupt and non bankrupt firms. “Of the former, 94% had Z scores
less than 2.7 before they went bankrupt. In contrast, 97% of the non-bankrupt
firms had Z scores above this level. It has a reported 72% accuracy in predicting
bankruptcies two years in advance (www.wikipedia.com).”
Credit risk and Z-score are important factors in the firm’s ability to raise
capital through debt. A company that has a low default risk has the ability to
raise capital through debt that will trade at par or a premium. A company that
receives a high credit risk rating will likely issue debt that trades at a discount.
We evaluated Kroger’s Z-score to determine their creditworthiness. Over
the five year period, Kroger has recorded an average score of 3.4; showing a
17% increase over the same period. This score is a very healthy sign regarding
Kroger’s creditworthiness. Kroger is well above the preferred 3.0 benchmark set
for low risk firms. Kroger’s strong credit rating is crucial and valuable when it
comes to raising capital through debt. The Company will be subject to a lower
risk premium than that of a high risk firm. Kroger’s major advantage is that
creditors weigh a company’s Z-score very high. The Company will benefit greatly
from their consistent and favorable score.
160
Analyst Recommendation
Our equity valuation of Kroger was conducted very thoroughly as we
evaluated all aspects of the Company. We began by conducting a business and
industry analysis for Kroger, its competitors, and the retail grocery industry as a
whole. After evaluating Kroger and the retail grocery industry we conducted an
accounting analysis, a current and future financial analysis, cost of capital
estimations, and an equity valuation for Kroger. For our business, financial and
equity valuation of Kroger, we used Kroger’s and its competitor’s financial data
presented in their annual reports as well as financial statistics from Yahoo
Finance. After thorough examination of Kroger and its competitors, it can be
concluded that Kroger’s share price is overvalued and should be sold.
The business and industry analysis allowed us to gain insight into how
Kroger is performing compared to the rest of the retail grocery industry.
The
retail grocery sector is a highly competitive and concentrated industry. Kroger’s
main competitors are Safeway, Supervalu, Winn-Dixie, and Wal-Mart. These are
relatively large companies that control the majority of the market share in the
retail grocery industry. It is difficult for new companies to enter this market due
to Kroger and the majority of its competitors experiencing increases in sales,
total assets, and growth over the past five years. Their size has allowed them to
make large investments and has made it almost impossible for new grocers to
compete with them on price.
After conducting the accounting analysis we discovered that Kroger had a
few areas in which their accounting policies were flexible. The most notable of
our findings was the Company’s use of operating leases for the majority of their
properties. We then viewed Kroger’s sales and expense manipulation ratios to
determine if the Company had overstated or understated their earnings. After
161
careful examination, we concluded that Kroger’s sales and expense diagnostic
ratios were on target over the last five years.
The next area of focus in our equity valuation of Kroger was to conduct a
current and forecasted financial analysis as well as capital estimations for the
Company. Using liquidity ratios, profitability ratios, and capital structure ratios in
our financial analysis of Kroger enabled us to view a five year history of Kroger’s
financial performance and compare it to other companies in the industry. The
majority of these ratios indicate that Kroger is performing above its competitors
and the industry as a whole. Forecasting Kroger’s financial statements out for
ten years required us to make a few assumptions regarding their financial data.
These assumptions are presented in our equity valuation for Kroger in the
forecasted financial statements section. Our forecast was fairly conservative as
we showed Kroger gradually increasing their earnings, assets, free cash flows,
and equity values each year. Our cost of equity estimations for Kroger was
determined to be irrelevant using the regression analysis. The back door method
was determined to be a better alternative for the companies cost of equity
valuation.
Kroger’s equity value was thoroughly examined by using the Method of
Comparables technique and the Intrinsic Valuation Models. The Intrinsic
Valuation Models were used in our final decision of Kroger’s share price because
of its in-depth approach and accuracy. These models, with the exception of the
Free Cash Flow Model, all indicate that Kroger’s observed share price of $28.20
on November 1, 2007 is overvalued. Due to the results found in the Intrinsic
Valuation Models, we are recommending that Kroger’s stock should be set to sell.
162
Appendix
Liquidity Ratios
Current Ratio
Kroger
Safeway
SuperValu
Winn-Dix
Industry
Quick Asset Ratio
2002
0.15
0.13
0.28
0.33
0.22
2003
0.16
0.16
0.33
0.26
0.23
2004
0.23
0.16
0.40
0.20
0.25
2005
0.21
0.17
0.57
0.72
0.42
2006
0.21
0.15
0.75
0.61
0.43
A/R Turnover
2003
1.01
1.01
1.08
1.45
1.14
2004
1.01
0.95
1.09
1.44
1.12
2005
0.96
0.87
1.30
3.03
1.54
2006
0.89
0.77
1.44
1.73
1.21
Days Receivable
2002
2003
2004
2005
2006
Kroger
76.45
72.69
68.16
88.27
84.97
Safeway
80.55
92.78
105.67
109.57
87.13
Supervalu
44.70
40.13
45.12
41.70
45.23
Winn-Dix
106.19
105.37
97.50
33.96
47.25
Industry
76.97
77.74
79.11
68.38
66.15
Inventory Turnover
Kroger
2002
0.99
0.91
0.94
1.48
1.08
Kroger
Safeway
SuperValu
Winn-Dix
Ind. Avg
Kroger
Safeway
SuperValu
Winn-Dix
Industry
2002
4.77
4.53
8.17
3.44
5.23
2003
4.57
3.93
9.09
3.46
5.27
2004
4.28
3.45
8.09
3.74
4.89
2005
4.10
3.33
8.75
10.75
6.73
2006
4.27
4.19
8.07
7.72
6.06
Days Inventory
2002
2003
2004
2005
2006
9.06
8.82
8.91
9.33
9.91
2002
2003
2004
2005
2006
Kroger
40.30
41.37
40.96
39.14
36.85
Safeway
8.81
9.47
9.20
9.87
10.82
Safeway
41.41
38.55
39.65
36.98
33.72
SuperValu
17.50
15.79
16.11
16.16
17.79
SuperValu
20.85
23.12
22.66
22.58
20.51
Winn-Dix
8.39
8.31
8.31
6.48
11.15
Winn-Dix
43.53
43.93
43.90
56.30
32.74
Industry
10.94
10.60
10.63
10.46
12.42
Industry
36.52
36.74
36.79
38.75
30.96
Cash to Cash Cycle
W/C Turnover
2002
2003
2004
2005
2006
2002
2003
2004
2005
2006
Kroger
45.08
45.95
45.24
43.24
41.11
Kroger
-1232.3
1630.03
-243.1
-80.04
37.91
Safeway
-104.06
819.19
794.85
184.27
Safeway
45.94
42.48
43.11
40.31
SuperValu
29.02
32.21
30.75
31.33
-68.36
-38.80
28.58
SuperValu
-214.53
156.98
122.39
39.49
30.03
Winn-Dix
46.96
47.39
47.65
67.05
40.47
Winn-Dix
23.34
26.76
25.81
8.65
17.07
Industry
41.75
42.01
41.68
45.48
37.02
Industry
-381.91
658.24
189.69
-65.85
-17.93
163
Inventory Turnover Ratio
2002
Kroger Co.
Ratio
8.71
COGS
$36,398
INV
$4,178
Safeway Inc.
Ratio
10.06
COGS
$23,696.70
INV
$2,354.70
SuperValu Inc.
Ratio
17.05
COGS
$17,704.20
INV
$1,038.05
Winn-Dixie
Ratio
7.46
COGS
$8,942.04
INV
$1,198.60
2003
2004
2005
2006
2007
8.46
$37,810
$4,465
8.82
$39,637
$4,493
8.91
$42,140
$4,729
9.32
$45,565
$4,886
9.9
$50,115
$5,059
8.8
$23,920.80
$2,717.80
9.47
$25,033
$2,642.20
9.2
$25,227.60
$2,740.70
9.87
$27,303.10
$2,766
10.82
$28,604
$2,642.50
15.78
$16,567.40
$1,049.28
16.11
$17,372.43
$1,078.34
16.16
$16,681.47
$1,032.03
17.79
$16,977
$954
10.64
$29,267
$2,749
8.38
$8,916.50
$1,063.28
8.3
$8,698.91
$1,046.91
8.31
$7,819.06
$940.52
10.73
$5,131.81
$477.88
8.23
$5,282.48
$641.45
*Numbers were provided by Kroger and its competitor’s 10-K
164
Profitability Ratios
Gross Profit Margin
2002
2003
2004
2005
2006
Kroger
26.95%
26.31%
25.33%
24.75%
24.20%
Safeway
31.10%
29.63%
29.58%
28.93%
28.82%
Supervalu
13.51%
13.53%
14.04%
14.64%
14.53%
Winn-Dixie
27.71%
28.51%
26.46%
26.11%
25.95%
Industry Average
24.11%
23.89%
23.36%
23.23%
23.10%
OI Ratio
2002
2003
2004
2005
2006
Kroger
4.97%
2.55%
1.49%
3.36%
3.38%
Safeway
2.73%
1.61%
3.27%
3.16%
3.98%
Supervalu
2.47%
2.97%
2.98%
3.66%
2.19%
Winn-Dixie
2.97%
2.53%
-0.69%
-4.40%
-2.08%
Industry Average
2.72%
2.37%
1.85%
0.81%
1.36%
Net Profit Margin
2002
2003
2004
2005
2006
Kroger
2.33%
0.59%
-0.18%
1.58%
1.69%
Safeway
-2.38%
-0.48%
1.56%
1.46%
2.17%
Supervalu
0.98%
1.34%
1.39%
1.97%
1.04%
Winn-Dixie
0.70%
1.97%
-0.94%
-5.48%
1.38%
Industry Average
-0.23%
0.94%
0.67%
-0.68%
1.53%
Asset Turnover
2002
2003
2004
2005
2006
Kroger
2.57
2.67
2.75
2.96
3.12
Safeway
2.17
2.36
2.33
2.44
2.47
Supervalu
3.59
3.25
3.28
3.11
3.29
Winn-Dixie
4.23
4.36
4.06
3.52
4.51
Industry Average
3.33
3.32
3.22
3.03
3.42
ROA
2002
2003
2004
2005
2006
Kroger
5.99%
1.56%
-0.51%
4.68%
5.26%
Safeway
-5.16%
1.12%
3.64%
3.56%
5.35%
Supervalu
3.53%
4.36%
4.55%
6.15%
3.41%
Winn-Dixie
2.98%
8.57%
-3.83%
-19.31%
6.20%
Industry Average
0.45%
4.68%
1.45%
-3.20%
4.99%
ROE
2002
2003
2004
2005
2006
Kroger
31.30%
7.85%
-2.87%
21.82%
22.65%
Safeway
-22.83%
-4.66%
13.01%
11.41%
15.36%
Supervalu
10.72%
12.79%
12.68%
15.37%
7.87%
Winn-Dixie
10.69%
23.26%
-10.95%
-6.90%
-35.07%
Industry Average
-0.47%
10.46%
4.91%
6.63%
-3.95%
165
Capital Structure Ratios
Debt to Equity
Kroger
2002
2003
2004
2005
2006
4.22
4.03
4.66
3.67
3.31
Safeway
3.42
3.14
2.57
2.20
1.87
Supervalu
2.04
1.93
1.78
1.50
1.31
Winn-Dixie
2.59
1.71
1.85
32.52
-6.65
Industry Average
2.68
2.26
2.07
12.07
-1.16
Times Interest Earned
2002
2003
2004
2005
2006
Kroger
4.24
2.27
1.51
3.99
4.58
Safeway
0.61
1.32
2.93
3.11
4.13
Supervalu
2.99
3.52
4.10
6.23
4.10
Winn-Dixie
5.94
8.93
-5.09
-9.32
-12.53
Industry Average
3.18
4.59
0.65
0.01
-1.43
2005
2006
Debt Service Margin
2002
2003
2004
Kroger
2.59
3.96
32.82
8.93
9.04
Safeway
2.48
2.15
3.47
2.50
2.62
Supervalu
28.64
7.17
10.01
8.69
10.01
Winn-Dixie
60.70
62.03
49.19
39.54
2.18
Industry Average
30.61
23.78
20.89
16.91
4.94
Growth Rate Ratios
IGR
2002
2003
2004
2005
2006
5.92%
1.54%
-0.50%
4.63%
5.20%
-5.12%
1.11%
3.61%
3.53%
5.31%
Supervalu
3.47%
4.28%
4.47%
6.04%
3.35%
Winn-Dixie
2.98%
8.57%
-3.83%
-19.31%
6.20%
Average SGR
0.44%
4.66%
1.42%
-3.25%
4.95%
SGR
2002
2003
2004
2005
2006
30.96%
7.76%
-2.84%
21.58%
22.40%
-22.65%
-4.62%
12.91%
11.32%
15.24%
Supervalu
10.53%
12.56%
12.45%
15.09%
7.66%
Winn-Dixie
10.69%
23.26%
-10.95%
-6.90%
-35.07%
Average SGR
-0.48%
10.40%
4.80%
6.50%
-4.06%
Kroger IGR
Safeway
Kroger SGR
Safeway
166
3 Month Regression
SUMMARY OUTPUT
72 Months
Regression Statistics
Multiple R
0.056592
R Square
0.003203
Adjusted R Square
-0.01104
Standard Error
0.07256
Observations
72
ANOVA
df
1
70
71
SS
0.001184
0.368546
0.36973
MS
0.001184
0.005265
F
0.224903
Significance F
0.636805
Coefficients
0.003523
0.117459
Standard Error
0.008598
0.247678
t Stat
0.409724
0.47424
P-value
0.68326
0.636805
Lower 95%
-0.01363
-0.37652
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
Upper 95%
0.020671
0.611438
Lower 95.0%
-0.01363
-0.37652
Upper 95.0%
0.020671
0.611438
Upper 95%
0.027341
0.914577
Lower 95.0%
-0.00787
-0.39058
Upper 95.0%
0.027341
0.914577
Upper 95%
0.031276
0.444801
Lower 95.0%
-0.00651
-1.28284
Upper 95.0%
0.031276
0.444801
60 Months
Regression Statistics
Multiple R
0.104942
R Square
0.011013
Adjusted R Square
-0.00604
Standard Error
0.065604
Observations
60
ANOVA
df
1
58
59
SS
0.00278
0.249629
0.252408
MS
0.00278
0.004304
F
0.645862
Significance F
0.424878
Coefficients
0.009737
0.261999
Standard Error
0.008794
0.326009
t Stat
1.107141
0.803655
P-value
0.272803
0.424878
Lower 95%
-0.00787
-0.39058
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
48 Months
Regression Statistics
Multiple R
0.142495
R Square
0.020305
Adjusted R Square
-0.00099
Standard Error
0.062902
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
46
47
SS
0.003772
0.182006
0.185778
MS
0.003772
0.003957
F
0.953377
Significance F
0.333968
Coefficients
0.012383
-0.41902
Standard Error
0.009386
0.429144
t Stat
1.319287
-0.97641
P-value
0.193603
0.333968
Lower 95%
-0.00651
-1.28284
167
3 Month Regression
SUMMARY OUTPUT
36 Months
Regression Statistics
Multiple R
0.144742
R Square
0.02095
Adjusted R Square
-0.00785
Standard Error
0.058486
Observations
36
ANOVA
df
1
34
35
SS
0.002489
0.116299
0.118788
MS
0.002489
0.003421
F
0.727555
Significance F
0.399646
Coefficients
0.018956
-0.38969
Standard Error
0.010078
0.456861
t Stat
1.880863
-0.85297
P-value
0.068578
0.399646
Lower 95%
-0.00153
-1.31814
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
Upper 95%
0.039437
0.538765
Lower 95.0%
-0.00153
-1.31814
Upper 95.0%
0.039437
0.538765
Upper 95%
0.045873
0.465977
Lower 95.0%
-0.00357
-1.87616
Upper 95.0%
0.045873
0.465977
24 Months
Regression Statistics
Multiple R
0.257256
R Square
0.06618
Adjusted R Square
0.023734
Standard Error
0.055416
Observations
24
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
22
23
SS
0.004788
0.067561
0.072349
MS
0.004788
0.003071
F
1.559155
Significance F
0.224914
Coefficients
0.021149
-0.70509
Standard Error
0.011922
0.564676
t Stat
1.774046
-1.24866
P-value
0.089898
0.224914
Lower 95%
-0.00357
-1.87616
168
1 Year Regression
SUMMARY OUTPUT
72 Months
Regression Statistics
Multiple R
0.057429
R Square
0.003298
Adjusted R Square
-0.01094
Standard Error
0.072556
Observations
72
ANOVA
df
1
70
71
SS
0.001219
0.36851
0.36973
MS
0.001219
0.005264
F
0.231634
Significance F
0.631816
Coefficients
0.003545
0.119019
Standard Error
0.008592
0.247294
t Stat
0.412543
0.481283
P-value
0.681202
0.631816
Lower 95%
-0.01359
-0.37419
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
Upper 95%
0.02068
0.612231
Lower 95.0%
-0.01359
-0.37419
Upper 95.0%
0.02068
0.612231
Upper 95%
0.027341
0.915818
Lower 95.0%
-0.00779
-0.38763
Upper 95.0%
0.027341
0.915818
Upper 95%
0.031111
0.448384
Lower 95.0%
-0.00658
-1.27761
Upper 95.0%
0.031111
0.448384
60 Months
Regression Statistics
Multiple R
0.10591
R Square
0.011217
Adjusted R Square
-0.00583
Standard Error
0.065598
Observations
60
ANOVA
df
1
58
59
SS
0.002831
0.249577
0.252408
MS
0.002831
0.004303
F
0.657959
Significance F
0.420598
Coefficients
0.009777
0.264095
Standard Error
0.008775
0.325582
t Stat
1.114171
0.811147
P-value
0.269802
0.420598
Lower 95%
-0.00779
-0.38763
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
48 Months
Regression Statistics
Multiple R
0.141158
R Square
0.019925
Adjusted R Square
-0.00138
Standard Error
0.062914
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
46
47
SS
0.003702
0.182077
0.185778
MS
0.003702
0.003958
F
0.935205
Significance F
0.338571
Coefficients
0.012264
-0.41461
Standard Error
0.009363
0.428733
t Stat
1.309895
-0.96706
P-value
0.196736
0.338571
Lower 95%
-0.00658
-1.27761
169
1 Year Regression
SUMMARY OUTPUT
36 Months
Regression Statistics
Multiple R
0.144514
R Square
0.020884
Adjusted R Square
-0.00791
Standard Error
0.058488
Observations
36
ANOVA
df
1
34
35
SS
0.002481
0.116307
0.118788
MS
0.002481
0.003421
F
0.72521
Significance F
0.400399
Coefficients
0.018884
-0.38868
Standard Error
0.010059
0.456417
t Stat
1.877435
-0.85159
P-value
0.06906
0.400399
Lower 95%
-0.00156
-1.31623
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
Upper 95%
0.039326
0.538869
Lower 95.0%
-0.00156
-1.31623
Upper 95.0%
0.039326
0.538869
Upper 95%
0.045773
0.467984
Lower 95.0%
-0.00362
-1.87276
Upper 95.0%
0.045773
0.467984
24 Months
Regression Statistics
Multiple R
0.256477
R Square
0.065781
Adjusted R Square
0.023316
Standard Error
0.055428
Observations
24
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
22
23
SS
0.004759
0.06759
0.072349
MS
0.004759
0.003072
F
1.549074
Significance F
0.226369
Coefficients
0.021075
-0.70239
Standard Error
0.011909
0.564342
t Stat
1.769695
-1.24462
P-value
0.090639
0.226369
Lower 95%
-0.00362
-1.87276
170
2 Year Regression
SUMMARY OUTPUT
72 Months
Regression Statistics
Multiple R
0.058977
R Square
0.003478
Adjusted R Square
-0.01076
Standard Error
0.07255
Observations
72
ANOVA
df
1
70
71
SS
0.001286
0.368444
0.36973
MS
0.001286
0.005263
F
0.244333
Significance F
0.622642
Coefficients
0.003563
0.121984
Standard Error
0.008585
0.246781
t Stat
0.414997
0.494301
P-value
0.679414
0.622642
Lower 95%
-0.01356
-0.37021
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
Upper 95%
0.020686
0.614174
Lower 95.0%
-0.01356
-0.37021
Upper 95.0%
0.020686
0.614174
Upper 95%
0.027337
0.917871
Lower 95.0%
-0.00773
-0.38481
Upper 95.0%
0.027337
0.917871
Upper 95%
0.031006
0.45325
Lower 95.0%
-0.00664
-1.27143
Upper 95.0%
0.031006
0.45325
60 Months
Regression Statistics
Multiple R
0.106939
R Square
0.011436
Adjusted R Square
-0.00561
Standard Error
0.06559
Observations
60
ANOVA
df
1
58
59
SS
0.002887
0.249522
0.252408
MS
0.002887
0.004302
F
0.670956
Significance F
0.416072
Coefficients
0.009803
0.266533
Standard Error
0.00876
0.32539
t Stat
1.119081
0.819119
P-value
0.267719
0.416072
Lower 95%
-0.00773
-0.38481
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
48 Months
Regression Statistics
Multiple R
0.139418
R Square
0.019438
Adjusted R Square
-0.00188
Standard Error
0.06293
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
46
47
SS
0.003611
0.182167
0.185778
MS
0.003611
0.00396
F
0.911849
Significance F
0.344616
Coefficients
0.012182
-0.40909
Standard Error
0.009351
0.428408
t Stat
1.302715
-0.95491
P-value
0.199156
0.344616
Lower 95%
-0.00664
-1.27143
171
2 Year Regression
SUMMARY OUTPUT
36 Months
Regression Statistics
Multiple R
0.144603
R Square
0.02091
Adjusted R Square
-0.00789
Standard Error
0.058487
Observations
36
ANOVA
df
1
34
35
SS
0.002484
0.116304
0.118788
MS
0.002484
0.003421
F
0.726124
Significance F
0.400105
Coefficients
0.018875
-0.38837
Standard Error
0.010055
0.45577
t Stat
1.877094
-0.85213
P-value
0.069108
0.400105
Lower 95%
-0.00156
-1.31461
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
Upper 95%
0.039309
0.537861
Lower 95.0%
-0.00156
-1.31461
Upper 95.0%
0.039309
0.537861
Upper 95%
0.045856
0.468902
Lower 95.0%
-0.00361
-1.86823
Upper 95.0%
0.045856
0.468902
24 Months
Regression Statistics
Multiple R
0.255917
R Square
0.065493
Adjusted R Square
0.023016
Standard Error
0.055436
Observations
24
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
22
23
SS
0.004738
0.06761
0.072349
MS
0.004738
0.003073
F
1.541832
Significance F
0.227421
Coefficients
0.021123
-0.69966
Standard Error
0.011926
0.56347
t Stat
1.771273
-1.24171
P-value
0.090369
0.227421
Lower 95%
-0.00361
-1.86823
172
5 Year Regression
SUMMARY OUTPUT
72 Months
Regression Statistics
Multiple R
0.061525
R Square
0.003785
Adjusted R Square
-0.01045
Standard Error
0.072539
Observations
72
ANOVA
df
1
70
71
SS
0.0014
0.36833
0.36973
MS
0.0014
0.005262
F
0.265984
Significance F
0.607664011
Coefficients
0.003617
0.127134
Standard Error
0.008573
0.24651
t Stat
0.421871
0.515736
P-value
0.674412
0.607664
Lower 95%
-0.013481412
-0.36451413
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
Upper 95%
0.020715
0.618782
Lower 95.0%
-0.01348
-0.36451
Upper 95.0%
0.02071471
0.61878191
Upper 95%
0.027346
0.924348
Lower 95.0%
-0.00757
-0.37991
Upper 95.0%
0.027346
0.924348
Upper 95%
0.03077
0.46487
Lower 95.0%
-0.00677
-1.26071
Upper 95.0%
0.03077
0.46487
60 Months
Regression Statistics
Multiple R
0.109062
R Square
0.011895
Adjusted R Square
-0.00514
Standard Error
0.065575
Observations
60
ANOVA
df
1
58
59
SS
0.003002
0.249406
0.252408
MS
0.003002
0.0043
F
0.698186
Significance F
0.406823
Coefficients
0.009889
0.272218
Standard Error
0.008721
0.325785
t Stat
1.13387
0.835575
P-value
0.261514
0.406823
Lower 95%
-0.00757
-0.37991
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
48 Months
Regression Statistics
Multiple R
0.135614
R Square
0.018391
Adjusted R Square
-0.00295
Standard Error
0.062963
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
46
47
SS
0.003417
0.182362
0.185778
MS
0.003417
0.003964
F
0.86184
Significance F
0.35807
Coefficients
0.011999
-0.39792
Standard Error
0.009325
0.428632
t Stat
1.286724
-0.92835
P-value
0.204628
0.35807
Lower 95%
-0.00677
-1.26071
173
5 Year Regression
SUMMARY OUTPUT
36 Months
Regression Statistics
Multiple R
0.14487
R Square
0.020987
Adjusted R Square
-0.00781
Standard Error
0.058485
Observations
36
ANOVA
df
1
34
35
SS
0.002493
0.116295
0.118788
MS
0.002493
0.00342
F
0.72887
Significance F
0.399225
Coefficients
0.018848
-0.38921
Standard Error
0.010046
0.455894
t Stat
1.876162
-0.85374
P-value
0.069239
0.399225
Lower 95%
-0.00157
-1.3157
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
Upper 95%
0.039265
0.537274
Lower 95.0%
-0.00157
-1.3157
Upper 95.0%
0.039265
0.537274
Upper 95%
0.045881
0.470755
Lower 95.0%
-0.00361
-1.86669
Upper 95.0%
0.045881
0.470755
24 Months
Regression Statistics
Multiple R
0.255304
R Square
0.06518
Adjusted R Square
0.022689
Standard Error
0.055446
Observations
24
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
22
23
SS
0.004716
0.067633
0.072349
MS
0.004716
0.003074
F
1.533951
Significance F
0.228574
Coefficients
0.021133
-0.69797
Standard Error
0.011933
0.563545
t Stat
1.771012
-1.23853
P-value
0.090414
0.228574
Lower 95%
-0.00361
-1.86669
174
7 Year Regression
SUMMARY OUTPUT
72 Months
Regression Statistics
Multiple R
0.062206
R Square
0.00387
Adjusted R Square
-0.01036
Standard Error
0.072536
Observations
72
ANOVA
df
1
70
71
SS
0.001431
0.368299
0.36973
MS
0.001431
0.005261
F
0.271921
Significance F
0.603692
Coefficients
0.003644
0.128516
Standard Error
0.008568
0.246455
t Stat
0.425301
0.52146
P-value
0.671922
0.603692
Lower 95%
-0.01344
-0.36302
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
Upper 95%
0.020733
0.620055
Lower 95.0%
-0.01344
-0.36302
Upper 95.0%
0.020733
0.620055
Upper 95%
0.027358
0.926748
Lower 95.0%
-0.00749
-0.37812
Upper 95.0%
0.027358
0.926748
Upper 95%
0.030666
0.469144
Lower 95.0%
-0.00683
-1.2569
Upper 95.0%
0.030666
0.469144
60 Months
Regression Statistics
Multiple R
0.109842
R Square
0.012065
Adjusted R Square
-0.00497
Standard Error
0.06557
Observations
60
ANOVA
df
1
58
59
SS
0.003045
0.249363
0.252408
MS
0.003045
0.004299
F
0.708331
Significance F
0.403455
Coefficients
0.009934
0.274316
Standard Error
0.008704
0.325936
t Stat
1.141306
0.841624
P-value
0.258433
0.403455
Lower 95%
-0.00749
-0.37812
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
48 Months
Regression Statistics
Multiple R
0.134225
R Square
0.018016
Adjusted R Square
-0.00333
Standard Error
0.062975
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
46
47
SS
0.003347
0.182431
0.185778
MS
0.003347
0.003966
F
0.843963
Significance F
0.363058
Coefficients
0.01192
-0.39388
Standard Error
0.009313
0.428747
t Stat
1.27998
-0.91867
P-value
0.20697
0.363058
Lower 95%
-0.00683
-1.2569
175
7 Year Regression
SUMMARY OUTPUT
36 Months
Regression Statistics
Multiple R
0.144866
R Square
0.020986
Adjusted R Square
-0.00781
Standard Error
0.058485
Observations
36
ANOVA
df
1
34
35
SS
0.002493
0.116295
0.118788
MS
0.002493
0.00342
F
0.728823
Significance F
0.39924
Coefficients
0.018823
-0.38933
Standard Error
0.010039
0.456049
t Stat
1.874987
-0.85371
P-value
0.069405
0.39924
Lower 95%
-0.00158
-1.31614
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
Upper 95%
0.039226
0.537469
Lower 95.0%
-0.00158
-1.31614
Upper 95.0%
0.039226
0.537469
Upper 95%
0.045857
0.471687
Lower 95.0%
-0.00363
-1.8664
Upper 95.0%
0.045857
0.471687
24 Months
Regression Statistics
Multiple R
0.25503
R Square
0.06504
Adjusted R Square
0.022542
Standard Error
0.05545
Observations
24
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
22
23
SS
0.004706
0.067643
0.072349
MS
0.004706
0.003075
F
1.53043
Significance F
0.229091
Coefficients
0.021115
-0.69736
Standard Error
0.01193
0.563701
t Stat
1.769846
-1.23711
P-value
0.090613
0.229091
Lower 95%
-0.00363
-1.8664
176
10 Year Regression
SUMMARY OUTPUT
72 Months
Regression Statistics
Multiple R
0.06257
R Square
0.003915
Adjusted R Square
-0.01031
Standard Error
0.072534
Observations
72
ANOVA
df
1
70
71
SS
0.001447
0.368282
0.36973
MS
0.001447
0.005261
F
0.275126
Significance F
0.601571
Coefficients
0.003669
0.129297
Standard Error
0.008565
0.246503
t Stat
0.428395
0.524525
P-value
0.669679
0.601571
Lower 95%
-0.01341
-0.36234
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
Upper 95%
0.020751
0.620931
Lower 95.0%
-0.01341
-0.36234
Upper 95.0%
0.020751
0.620931
Upper 95%
0.027373
0.928711
Lower 95.0%
-0.00741
-0.37684
Upper 95.0%
0.027373
0.928711
Upper 95%
0.03056
0.473088
Lower 95.0%
-0.00688
-1.25333
Upper 95.0%
0.03056
0.473088
60 Months
Regression Statistics
Multiple R
0.110425
R Square
0.012194
Adjusted R Square
-0.00484
Standard Error
0.065565
Observations
60
ANOVA
df
1
58
59
SS
0.003078
0.249331
0.252408
MS
0.003078
0.004299
F
0.715968
Significance F
0.400947
Coefficients
0.009981
0.275936
Standard Error
0.008689
0.326108
t Stat
1.148703
0.846149
P-value
0.255394
0.400947
Lower 95%
-0.00741
-0.37684
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
48 Months
Regression Statistics
Multiple R
0.13294
R Square
0.017673
Adjusted R Square
-0.00368
Standard Error
0.062986
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
46
47
SS
0.003283
0.182495
0.185778
MS
0.003283
0.003967
F
0.827582
Significance F
0.367715
Coefficients
0.011841
-0.39012
Standard Error
0.0093
0.42884
t Stat
1.273193
-0.90972
P-value
0.209346
0.367715
Lower 95%
-0.00688
-1.25333
177
10 Year Regression
SUMMARY OUTPUT
36 Months
Regression Statistics
Multiple R
0.144739
R Square
0.020949
Adjusted R Square
-0.00785
Standard Error
0.058486
Observations
36
ANOVA
df
1
34
35
SS
0.002489
0.1163
0.118788
MS
0.002489
0.003421
F
0.727515
Significance F
0.399659
Coefficients
0.018789
-0.38912
Standard Error
0.01003
0.456206
t Stat
1.873207
-0.85295
P-value
0.069658
0.399659
Lower 95%
-0.0016
-1.31624
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
Upper 95%
0.039173
0.538003
Lower 95.0%
-0.0016
-1.31624
Upper 95.0%
0.039173
0.538003
24 Months
Regression Statistics
Multiple R
0.254570276
R Square
0.064806025
Adjusted R Square
0.022297208
Standard Error
0.05545681
Observations
24
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
22
23
SS
0.004689
0.06766
0.072349
MS
0.004689
0.003075
F
1.524531
Significance F
0.229961
Coefficients
0.021077033
-0.696368389
Standard Error
0.011924
0.563989
t Stat
1.767556
-1.23472
P-value
0.091004
0.229961
Lower 95%
-0.00365
-1.86601
178
Upper 95%
0.045807
0.473274
Lower 95.0%
-0.00365
-1.86601
Upper 95.0%
0.045807
0.473274
Cost of Debt & WACC
Current Liabilities
CPLTD + Capital Leases
Accounts payable
Accrued salaries and wages
Deferred income taxes
Other current liabilities
Total Current Laibilities
Obligation
$906
$3,804
$796
$268
$1,807
$7,581
Weight
0.056
0.233
0.049
0.016
0.111
0.465
Rate
4.63%
4.63%
4.63%
4.53%
4.63%
23.05%
Cost of Debt
0.26%
1.08%
0.23%
0.07%
0.51%
2.15%
Long-Term Debt
LTD
Deferred income taxes
Other long-term liabilities
Total Long-term Liabilities
$6,154
$722
$1,835
$16,292
0.378
0.044
0.113
1.000
7.275%
4.530%
5.900%
17.705%
2.748%
0.201%
0.665%
3.613%
Tax Rate = 35%
Total Cost of Debt BeforeTaxes
Total Cost of Debt After Taxes
Back Door ke
P/B
PB-1
growth
P/B - 1*g
ROE
plug
Ke =
3.85
2.85
10%
0.285
0.25
0.535
0.1390
5.77%
3.75%
WACCBT = (Vd/VF) * Kd + (Ve/VF) * Ke or (16,292/44,036)*.0577 + (20,163/44,036)*.1390 =
WACCAT = (Vd/VF) *(Kd*1 - TX) + (Ve/VF) * Ke or (16,292/44,036)*(.0577*.65)+(20,163/44,036)*.139 =
8.50% WACCBT
7.75% WACCAT
Method of Comparables
PPS
KR
SWY
SVU
WINN
WMT
KR
SWY
SVU
WINN
WMT
Industry Avg
$28.20
$32.86
$37.56
$20.10
$44.03
EPS Forecast
EPS
$1.57
$2.17
$2.84
$0.54
$3.31
$1.70
$1.96
$2.22
$5.23
$2.94
P/E (Trailing)
P/E (Forward)
$16.54
$16.77
$16.89
$3.84
$14.99
$16.30
$14.58
$15.13
$13.24
$37.21
$13.32
$14.07
DPS
$0.30
$0.25
$0.67
N/A
$0.83
BPS
EV
$7.27
$14.35
$24.23
$17.79
$15.24
$6.84
$7.33
$6.25
$9.36
$8.13
FCF
$764
P/B
D/P
P.E.G.
EBITDA
P/EBITDA
P/FCF
EV/EBITDA
$3.88
$2.29
$1.55
$1.13
$2.89
$2.35
0.011
0.008
0.018
N/A
0.019
0.0137
1.52
1.58
1.66
5.23
1.22
1.495
$3.74
$2.80
$2.80
$0.77
$27.65
7.552
7.5401
11.7357
13.4143
26.1039
1.5924
8.5706
0.05
-0.36
0.08
-0.18
0.01
-0.08
$6.84
$7.33
$6.25
$9.36
$8.13
$7.58
Kroger Method of Comparables Ratios
Share Price
Ratios
Trailing Price to Earnings
$27.79
Forward Price to Earnings
$22.09
Price to Book
$17.07
Dividend Yield
$21.25
Price Earnings Growth
$18.86
Price to EBITDA
$45.17
Enterprise Value to EBITDA
$28.36
Price to Free Cash Flow
-$41.14
179
LR ROE RI Model
WACCAT = 7.75%
Book Value of Equity
Long Run Return on Equity
Long Run Growth Rate in Equity
Cost of Equity
$16,270
0.13
0.09
13.90%
Present Value of BE
Number of Shares
Kroger Share Price end of January 2007
Implied Share Price 11/01/2007
Observed Share Price
$13,282
715
$18.58
$20.48
$28.20
BVE
Growth in Equity
$5,830
Growth = .09
ROE = 0.13
Ke = .1390
$6,775
16.22%
$7,763
14.58%
Kd = 5.77%
$8,798
13.33%
$9,885
12.35%
$11,028
11.56%
Ke = 13.90%
$12,232
10.92%
$13,504
10.39%
$14,847
9.95%
$16,270
9.58%
Ke
11.90%
12.90%
13.90%
14.90%
15.90%
16.90%
0.13
31.39
23.34
18.58
15.43
13.19
11.52
Sensitivity Analysis
ROE
0.15
0.17
0.19
47.08
62.77
78.47
35.01
46.68
58.35
27.86
37.15
46.44
23.14
30.85
38.57
19.79
26.38
32.98
17.28
23.04
28.80
Ke
11.90%
12.90%
13.90%
14.90%
15.90%
16.90%
0.07
65.01
54.00
46.17
40.33
35.79
32.18
0.08
75.85
60.37
50.14
42.87
37.45
33.24
Growth
0.09
94.16
70.02
55.73
46.28
39.57
34.56
0.10
131.74
86.31
64.18
51.08
42.43
36.28
0.11
252.84
119.76
78.47
58.35
46.44
38.57
Overvalued < $23.69
Fairly Valued w/n $4.50
Undervalued > 32.71
ROE
0.11
0.13
0.15
0.17
0.19
0.21
0.07
13.19
19.79
26.38
32.98
39.57
46.17
0.08
11.57
19.28
27.01
34.71
42.43
50.14
Growth
0.09
9.29
18.58
27.86
37.15
46.44
55.73
0.10
5.83
17.50
29.17
40.84
52.51
64.18
0.105
3.35
16.73
30.12
43.50
56.89
70.27
Overvalued < $23.69
Fairly Valued w/n $4.50
Undervalued > 32.71
180
0.21
94.16
70.02
55.73
46.28
39.57
34.56
Overvalued < $23.69
Fairly Valued w/n $4.50
Undervalued > 32.71
Discounted Dividend Approach
WACCAT = 7.75%
0
2006
Earnings
DPS (Dividends Per Share)
1
4
5
6
7
8
9
10
11
2017
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
$1,189
$1,260
$1,335
$1,416
$1,500
$1,591
$1,686
$1,787
$1,894
0.30
0.34
0.38
0.42
0.46
0.50
0.54
0.58
0.62
0.66
0.70
13%
12%
11%
10%
9%
8%
7%
7%
6%
AVG= 9%
0.8780
0.7708
0.6768
0.5942
0.5217
0.4580
0.4021
0.3530
0.3099
0.2721
$0.26
$0.26
$0.26
$0.25
$0.24
$0.23
$0.22
$0.20
$0.19
$0.18
$4,293
PV Factor
PV Dividends Year by Year
Total PV of Annual Dividends
3
Ke = 13.90%
$1,121
Dividend Growth
Book Value Equity Per Share Jan. 2007
2
Kd = 5.77%
$2.29
Continuing Value Perpetuity
$14.29
PV of Terminal Value Perpetuity
$3.89
62.88%
Estimated Price Per Share end of January 2007
$6.18
100%
Implied Price Per Share 11/1/07
$6.82
Observed Share Price 11/01/2007
$28.20
Sensitivity Analysis
Growth
Initial Cost of Equity
13.90%
Ke
8%
9%
10%
11%
11.80%
Growth Rate
9.00%
11.90%
$9.08
$11.27
$15.76
$30.23
$250.15
12.90%
$7.28
$8.47
$10.49
$14.62
$23.35
13.90%
$6.09
$6.82
$7.92
$9.77
$12.53
Overvalued < $23.69
14.90%
$5.24
$5.72
$6.39
$7.40
$8.68
Fairly Valued w/n $4.50
15.90%
$4.61
$4.94
$5.38
$6.00
$6.71
Undervalued > 32.71
16.90%
$4.12
$4.35
$4.66
$5.06
$5.50
Back Door ke
P/B
3.85
PB-1
2.85
growth
10%
P/B - 1*g
0.285
ROE
0.25
plug
0.535
plug/3.85
0.139
181
Discounted Free Cash Flow Model
WACCAT = 7.75%
Kd = 5.77%
Ke = 13.90%
0
1
2
3
4
5
6
7
8
9
10
11
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
$1,121
$1,189
$1,260
$1,335
$1,416
$1,500
$1,591
$1,686
$1,787
$1,894
0.30
0.34
0.38
0.42
0.46
0.50
0.54
0.58
0.62
0.66
$2,523
$2,674
$2,835
$3,005
$3,185
$3,376
$3,579
$3,793
$4,021
$4,262
-$20
-$866
-$918
-$974
-$1,032
-$1,094
-$1,159
-$1,229
-$1,303
-$1,381
Annual Free Cash Flow
$2,503
$1,808
$1,916
$2,031
$2,153
$2,282
$2,419
$2,564
$2,718
$2,881
PV Factor
0.9217
0.8495
0.7829
0.7216
0.6650
0.6129
0.5649
0.5207
0.4799
0.4423
PV of Free Cash Flows
$2,307
$1,536
$1,500
$1,466
$1,432
$1,399
$1,367
$1,335
$1,304
$1,274
Earnings
DPS (Dividends Per Share)
Book Value Equity Jan 2007
$4,293
Cash Flows From Operations
Cash Investments
Total PV of Annual Free Cash Flows
$14,919.76
Continuing Value Perpetuity
PV of Terminal Value Perpetuity
$132,920.00
$58,788.58
Value of Firm
$73,708.34
Book Value of Debt
$16,292.00
Estimated Market Value of Equity
$57,416.34
Number of Shares
$3,323
715
Sensitivity Analysis
Growth
WACC
4%
5%
6%
7%
8%
Estimated Price Per Share end of Jan 2007
$80.30
8.50%
46.52
60.4
85.37
143.64
435.01
Implied Price Per Share 11/01/07
$85.37
9.50%
33.43
41.54
54.29
77.23
130.76
Overvalued < $23.69
$28.20
10.57%
23.82
28.84
36.04
47.29
67.29
Fairly Valued w/n $4.50
Perpetuity Growth Rate
6.00%
11.50%
17.68
21.17
25.92
32.78
43.56
Undervalued > 32.71
WACCBT
8.50%
12.50%
12.56
15.02
18.22
22.6
28.91
13.50%
8.51
10.29
12.55
15.5
19.53
Observed Share Price
182
6% growth
Residual Income Model
WACCAT = 7.75%
Kd = 5.77%
Ke = 13.90%
0
1
2
3
4
5
6
7
8
9
10
11
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
$16,270
Beginning Book Value of Equity
$4,923
$5,830
$6,775
$7,763
$8,798
$9,885
$11,028
$12,232
$13,504
$14,847
Net Income/Earnings
$1,121
$1,189
$1,260
$1,335
$1,416
$1,500
$1,591
$1,686
$1,787
$1,894
$215
$243
$272
$300
$329
$358
$386
$415
$443
$472
$5,830
$6,775
$7,763
$8,798
$9,885
$11,028
$12,232
$13,504
$14,847
$16,270
$2,523
$2,674
$2,835
$3,005
$3,185
$3,376
$3,579
$3,793
$4,021
$4,262
-$20
-$866
-$918
-$974
-$1,032
-$1,094
-$1,159
-$1,229
-$1,303
-$1,381
Dividends
Total Ending Book Equity
$4,923
Cash Flows From Operations
Cash Investments
Actual Earnings
$1,121
$1,189
$1,260
$1,335
$1,416
$1,500
$1,591
$1,686
$1,787
$1,894
$2,008
"Normal" or Benchmark Income
$684.30
$810.33
$941.75
$1,079.10
$1,222.98
$1,374.02
$1,532.90
$1,700.31
$1,877.01
$2,063.80
$2,261.51
Residual Income - Annual
$436.95
$378.18
$318.08
$256.32
$192.56
$126.45
$57.61
-$14.37
-$89.92
-$169.48
-$186.43
-$58.76
-$60.10
-$61.76
-$63.76
-$66.11
-$68.85
-$71.98
-$75.55
-$79.56
-$16.95
0.877963
0.770819
0.676751
0.594162
0.521653
0.457992
0.402100
0.353029
0.309946
0.272121
$383.62
$291.51
$215.26
$152.30
$100.45
$57.91
$23.16
-$5.07
-$27.87
-$46.12
Change in Residual income
Present Value Factor
Present Value of Residual Income
BV Equity Jan. 2007
$4,923.00
Total PV of RI (Jan. 2007)
$1,145.16
84.07%
Continuation (Terminal) Value
PV of Terminal Value (Jan 2007)
Number of Shares
-780.03
-212.26
-3.62%
Sensitivity Analysis
715
Growth
Ke
Estimated Share Price end of Jan. 2007
$8.19
-10%
-20%
-30%
-40%
Implied Share Price 11/01/07
$9.03
9.50%
16.09
14.43
13.9
13.63
13.48
Actual Price per share
$28.20
10.50%
12.8
12.89
12.58
12.42
12.32
Overvalued < $23.69
100%
0
Growth
-10.00%
11.50%
11.97
11.56
11.42
11.34
11.29
Fairly Valued w/n $4.50
Initial Cost of Equity
13.90%
12.50%
10.48
10.41
10.39
10.37
10.36
Undervalued > 32.71
13.90%
8.82
9.03
9.14
9.19
9.22
14.50%
8.23
8.53
8.66
8.73
8.78
183
Abnormal Earnings Growth Model
WACCAT = 7.75%
0
1
2006
2
3
Kd = 5.77%
4
5
6
Ke = 13.90%
7
8
9
10
11
2017
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Earnings
$1,121
$1,189
$1,260
$1,335
$1,416
$1,500
$1,591
$1,686
$1,787
$1,894
Dividends
$215
$243
$272
$300
$329
$358
$386
$415
$443
$472
Forecast Earnings
$1,189
$1,260
$1,335
$1,416
$1,500
$1,591
$1,686
$1,787
$1,894
Drip income (13.90%)
$29.82
$33.79
$37.77
$41.74
$45.72
$49.69
$53.67
$57.64
$61.62
Cumulative Dividend Earnings
$1,218
$1,294
$1,373
$1,457
$1,546
$1,640
$1,740
$1,845
$1,956
"Normal" Annual Income (Benchmark)
$1,277
$1,354
$1,435
$1,521
$1,612
$1,709
$1,812
$1,920
$2,035
Annual AEG
-$58.49
-$60.10
-$61.76
-$63.76
-$66.11
-$68.85
-$71.98
-$75.55
-$79.56
Book Value Equity end Jan 2007
$4,293
PV Factor
0.8780
0.7708
0.6768
0.5942
0.5217
0.4580
0.4021
0.3530
0.3099
PV of AEG
-$51.35
-$46.33
-$41.80
-$37.88
-$34.49
-$31.53
-$28.94
-$26.67
-$24.66
-58.76
-60.10
-61.76
-63.76
-66.11
-68.85
-71.98
-75.55
-79.56
Residual Income Check Figure
Core Earnings
Total PV of AEG
$1,121
-$323.65
Continuing (Terminal) Value
-324.44
PV of Terminal Value
-$100.56
Total PV of AEG
-$424.20
Total Average Earnings Perp (t+1)
$696.80
Capitalization Rate (perpetuity)
13.90%
Number of Shares
-$84.03
715
Sensitivity Analysis
Estimated Share Price end of Jan. 2007
$7.01
Implied Price 11/01/2007
$7.73
Ke
0%
-12%
-24%
-36%
-48%
$28.20
10.50%
6.82
8.71
9.28
9.56
9.72
13.90%
11.50%
6.87
8.4
8.9
9.14
9.29
Overvalued < $23.69
-12.00%
12.50%
6.85
8.11
8.54
8.76
8.89
Fairly Valued w/n $4.50
13.90%
6.76
7.73
8.08
8.26
8.38
Undervalued > 32.71
14.50%
6.71
7.57
7.9
8.07
8.17
Nov 1, 2007 Observed price
Initial Cost of Equity
Growth
Growth
184
Altman Z-Score
Z = 1.2 (X1) + 1.4 (X2) + 3.3 (X3) + 0.6 (X4) + 1.0 (X5)
Legend
X1 = Net Working Capital / Total
Assets
X2 = Retained Earnings / Total Assets
X3 = EBIT / Total Assets
X4 = Market Value of Equity / Book Value of Total Liabilities
X5 = Sales / Total Assets
2002
2003
2004
2005
2006
X1
X2
-0.00251
0.233449
0.001962
0.25435
0.005271
0.241931
-0.01459
0.312577
-0.04672
0.363017
X3
X4
X5
0.421734
0.033522
2.574868
0.223989
0.033871
2.665032
0.136406
0.032494
2.754087
0.327873
0.034564
2.956401
0.347811
0.034508
3.116239
Z score
3.261067
3.179204
3.170188
3.616826
3.814852
Average
Growth
185
3.408427
0.169817
Reference Page
1.) Kroger: www.kroger.com
2006 Annual Report
www.krogerCo.com
2.) Edgarscan: edgarscan.com
2006 Annual Reports
Historical Annual Reports
3.) First Research: www.firstresearch.com
4.) Yahoo Finance: http://www.finance.yahoo.com/
5.) Onesource: www.onesource.com
6.) St. Louis Federal Reserve Bank
7.) Business Analysis and Valuations: Using Financial Statements 4th Ed
Palepu and Healy
8.) http://www.moneycentral.msn.com
9.) www.wikipedia.com
10.) www.money-zine.com
11.) www.creditguru.com
12.) www.investorwords.com
13.) www.allbusiness.com
14.) www.chartfilter.com
15.) www.investopedia.com
16.) www.winndixie.com
17.) www.safeway.com
18.) www.walmart.com
19.) www.supervalu.com
20.) www.wholefoods.com
186