Updated by Bob Ciura on May 29th, 2019
2019 is shaping up to be a tumultuous year for the major grocery stocks. Industry trends are changing, as more consumers gravitate toward online shopping and grocery delivery.
Making matters even more complicated is that e-commerce giant Amazon.com Inc. (AMZN) is attempting to further disrupt the grocery industry through its acquisition of Whole Foods and its deployment of cashier-less technology.
Certain grocery stocks such as Costco Wholesale (COST), Walmart Inc. (WMT), and Target (TGT) have seen great success with their own e-commerce platforms, while others such as Kroger (KR) have fallen behind.
Many of these stocks remain attractive for dividend growth investors.
Wal-Mart and Target have dividend yields of 2.1% and 3.2%, respectively, and both stocks are members of the Dividend Aristocrats.
The Dividend Aristocrats are a group of 57 stocks in the S&P 500 Index, with 25+ years of consecutive dividend increases. You can see the entire list of 57 Dividend Aristocrats here.
The requirements to be a Dividend Aristocrat are:
Be in the S&P 500 Have 25+ consecutive years of dividend increases Meet certain minimum size & liquidity requirementsYou can download an Excel spreadsheet of all 57 (with metrics that matter) by clicking the link below:
Meanwhile, Costco and Kroger are members of the Dividend Achievers list, a group of stocks with 10+ years of consecutive dividend growth. You can see the entire list of all 264 Dividend Achievers by clicking here.
These retailers are all making progress to better compete with Amazon, and reinvent themselves through investments new technology to drive long-term growth.
In the meantime, investors can collect their dividends, and see those dividends grow over time. This article will discuss the key changes taking place in the grocery industry, then list the top grocery stocks ranked in order of expected returns.
Table of Contents
Walmart Inc. (WMT) Costco Wholesale (COST) Sprouts Farmers Market (SFM) Target (TGT) Kroger Co. (KR)Best Grocery Stock #5: Walmart (WMT)
Walmart is the largest retailer in the world, serving 270 million customers each week. Revenue will be well in excess of $500 billion this year and the stock trades with a market capitalization of $293 billion.
Walmart reported first-quarter earnings on 5/16/19 and results were mixed. Total revenue was up 1% to $124 billion on a reported basis, and on a constant currency basis, revenue would have been up 2.5%. Comparable sales were up 3.4% in the quarter, marking the best first-quarter comparable sales gain for a first quarter in nine years, and represents the fourth consecutive quarter above 3% growth.
Walmart’s strong sales growth is led by its e-commerce platforms. U.S. e-commerce revenue increased 37% due to company’s online grocery initiative, as well as the Home and Fashion categories at Walmart.com. Walmart’s online grocery initiative continues to be tremendously successful, and is driving the company’s revenue growth.
Source: Earnings Presentation
Sam’s Club saw its comparable sales rise 0.3% and eCommerce sales were up 28%. The International business continues to perform relatively poorly, seeing its sales decline 4.9%. Excluding currency translation, sales would have been up 1.2%. Adjusted earnings-per-share came in at $1.13 in Q1 as a result of the small revenue gain and declining margins.
Walmart’s competitive advantage is in its enormous size. As the largest retailer in the world, it can leverage its scale to pressure suppliers to lower costs. This gives it the status as the low-cost leader in discount retail, which will be especially important in grocery, as more than half of its revenue comes from groceries.
In addition, Walmart is highly resistant to recessions. The company managed to increase earnings steadily during and after the Great Recession. Hard economic conditions tend to send consumers on the margins to Walmart, which is also an advantage.
Walmart is a high-quality business, but the stock appears to be overvalued today. At a 2019 price-to-earnings ratio of 21.3x. Walmart’s valuation is currently at its highest level of the past decade. While its rising share price has meant strong gains for existing shareholders, it has made the stock much more expensive for new buyers. Investors continue to bet heavily on the future of the e-commerce business, but it has made the quite stock expensive. We are forecasting the price-to-earnings multiple to fall to 15x, near its 10-year average valuation, which would create a 6.8% annual headwind on a total return basis as a result of the revaluation of the stock.
Walmart is a dividend growth stock. It is a Dividend Aristocrat, and with a projected dividend payout ratio below 50% for 2019, should continue to increase its dividend each year. Walmart has a fairly low dividend yield of 2.1%, which is near a 10-year low, another consequence of its soaring share price.
That said, we view Walmart’s dividend as very safe. We discuss the safety of Walmart’s dividend in further detail in the following video:
Walmart’s dividend, along with 5.5% forecasted annual EPS growth, will help offset the impact of a declining stock valuation. However, total returns are still expected at less than 1% per year over the next five years. We currently rate Walmart a sell on the basis of overvaluation.
Best Grocery Stock #4: Costco Wholesale (COST)
Today, Costco is a diversified warehouse retailer that operates 770 warehouses that collectively generate in excess of $150 billion in annual sales. Costco’s leadership in this industry has rewarded shareholders handsomely over the years as it sports a $109 billion market capitalization.
Costco reported second-quarter earnings on 3/7/19 and results were very strong. Total sales increased 7.3% in the second quarter and have risen more than 8% for the first half of the year. Comparable sales were up 7.4% in the US, fell 0.3% in Canada, and were up 0.7% everywhere else. The consolidated comparable sales number of 5.4% was weaker than the first quarter number, but Costco continues to be tremendously productive.
Costco’s main driver of its profitability is its lucrative membership fees. Membership fee revenue rose 7.2%, or roughly the same rate as total revenue in the second quarter. Gross margins increased 30bps in the second quarter as well, rising to 11.3% of revenue, while SG&A costs were flat as a percentage of revenue, and thus had no impact on margins. In total, operating income was 3.4% of revenue in the second quarter against 3.1% in the year-ago period.
Earnings-per-share rose 26% in the second quarter year-over-year, increasing from $1.59 to $2.01. Given the strength in margins in the second quarter in particular, along with continued strong comparable sales growth, we’ve increased our estimate of earnings-per-share for this year from $7.50 to $7.75. Costco is making fairly quick progress when it comes to margin expansion, and we believe a higher earnings estimate is warranted after the second quarter report.
Costco is widely regarded as the premier growth stock in the brick-and-mortar retail industry, and is priced as such. Costco’s price-to-earnings multiple has been elevated for some time as investors have applied a premium to the stock due to the company’s excellent performance. However, that premium has made the stock expensive against its historical multiples.
Today, Costco shares trade for a price-to-earnings ratio of 31.8x, and as a result, we see a 5.5% headwind to annual total returns as the valuation moves down over time. Our fair value estimate for Costco is a price-to-earnings ratio of 24.0x, near its 10-year average valuation. Costco shares are as expensive right now as they have been in the past decade, and appear overvalued.
Costco has a 1.1% dividend yield, but makes up for this with high dividend growth.
Source: Earnings Presentation
The company raised its dividend by 14% in 2019, and has increased its dividend for over 10 years in a row. Costco also returns cash to shareholders through stock buybacks. The company approved a $4 billion share repurchase through 2023.
The combination of 9% annual EPS growth, the 1.1% dividend yield, partially offset by a 5.5% negative headwind from valuation changes, leads to expected returns of 4.6% per year through 2024. This gives Costco a hold recommendation from Sure Dividend.
Best Grocery Stock #3: Sprouts Farmers Market (SFM)
While big-box grocery stores struggle, niche players have found success, especially in areas that cater to a more health-conscious consumer. One example is Sprouts Farmers Market, a health-oriented grocery store that specializes in natural and organic foods. Sprouts had its initial public offering in 2013. Approximately 90% of the company’s more than 20,000 products are natural or organic.
It offers a wide range of products, including fresh produce, bulk foods, supplements, meat and seafood, deli, baked goods, dairy, and more. Sprouts operates more than 300 stores across the U.S., predominantly in the Southwest and Southeast.
Source: Investor Presentation
Sprouts credits its success to a multi-faceted management philosophy, which is to focus on healthy foods, while providing value to customers. These principles have resulted in excellent growth over the past several years. From fiscal 2014 through 2018, the company’s net sales increased at a 15% annual rate. Adjusted net income grew at an 8% annual rate from 2015 through 2018.
In early May (5/2/19) Sprouts Farmers Market reported fiscal 2019 first-quarter results. For the quarter, net sales of $1.4 billion increased 10% year-over-year. Comparable-store sales increased 1.4%. Adjusted earnings-per-share fell 8% for the quarter, as the company chose to absorb cost inflation rather than passing higher costs on to consumers.
Increasing sales at existing stores, along with new store openings, is expected to fuel the company’s future growth. Sprouts expects full fiscal-year comparable sales growth of 1.5% to 3%, and expects to build 28 new stores. Total sales are expected to grow 9% to 10.5% for the year.
Sprouts is in strong financial condition. It has a low target net-debt-to-EBITDA ratio of 1.2x to 1.5x, and the company generates excess cash flow which it uses to buy back stock. From September 2015 through April 2019, Sprouts repurchased 42 million shares of its own stock, equating to a 27% reduction in its shares outstanding. It has $55 million remaining on its share repurchase authorization, which will continue to boost EPS growth. It is reasonable to expect ~8% annual EPS growth in the years ahead.
Sprouts expects EPS in a range of $1.18 to $1.24 for 2019. At the midpoint, the company guides for EPS of $1.21 for the current fiscal year. As a result, the stock trades for a 2019 price-to-earnings ratio of 17.0x. Since its IPO, Sprouts shares have traded for an average price-to-earnings ratio of 24.8x. A reasonable fair value estimate for the stock is 18x, which is higher than its peer group but deserved given the company’s excellent financial metrics and growth.
If the stock valuation rises to meet the fair value estimate, the expanding multiple could boost annual returns by 1.2% per year through 2024. This would generate total annual returns of 9.2% per year over the next five years. Sprouts has an attractive expected rate of return, but the stock does not pay a dividend, making it an unappealing investment for income investors.
Best Grocery Stock #2: Target (TGT)
Target was founded in 1902, and has grown into a major player in the discount retail space. Unlike its close competitor Walmart, Target has no international operations. Its business consists of about 1,850 big box stores, which offer general merchandise and grocery. Target has a market capitalization of $42 billion and should produce about $78 billion in total revenue this year.
Target has moved in the right direction to fend off the increasing competition in retail. It has invested heavily in the remodeling of its stores and has expanded the same-day delivery option to about 65% of U.S. households. Target reported first-quarter earnings on 5/22/19 and the results were very strong, sending the stock up 8% on the day as investors cheered the report.
Total revenue increased 5% year-over-year, coming in at $17.6 billion in the first quarter. The gain consisted of comparable sales growth of 4.8% with the balance from stores that aren’t yet part of the comparable base. Digital sales also soared 42%, adding 2.1% to the comparable sales growth number, implying a +2.7% gain for the retail stores.
The top line gain produced in the first quarter was excellent and well ahead of expectations as it appears Target is picking up significant revenue momentum once again. Margins were strong as well as operating income rose 9% on a dollar basis to $1.135 billion in the first quarter, up from $1.041 billion in last year’s the first quarter.
Gross margins declined 20bps to 29.6% as higher digital fulfillment and supply chain costs weighed, but were partially offset by the benefit of the company’s merchandising strategies. SG&A costs were 20.8% in the first quarter, down 30bps and helping to offset the loss of gross margin, reflecting the savings in technology and lower market expenses.
Target’s growth investments are focused on its e-commerce business, store renovations, and increasing its buildout of small-format stores. These are stores designed to help penetrate densely-populated urban markets and large cities. Target had planned to have more than 100 small stores in operation this year.
Source: Earnings Presentation
Target continues to expect low to mid-single digit gains in comparable sales for this year and an earnings-per-share range of $5.75 to $6.05. As a result, we are reiterating our guidance of $5.90 for this year. Separately, Target returned $608 million to shareholders in the first quarter, including dividends of $330 million and share repurchases of $278 million in repurchases. The company has $1 billion left on its current buyback authorization.
Target shares are trading below our fair value estimate, meaning the valuation is still quite attractive in our view. Target is trading at a price-to-earnings ratio of 13.7x, which is lower than its 10-year average of 14.7x, and our fair value estimate of 15x. If the stock reverts to fair value over the next five years, it will enjoy a 1.8% annualized gain.
We see Target as undervalued and as possessing a reasonably strong growth outlook. In addition, the company’s dividend history is outstanding, as it is on the list of Dividend Aristocrats. We view the 3.2% dividend yield as attractive and safe for the foreseeable future.
The following video summarizes our view of Target’s dividend safety in greater detail.
We see total annual returns at 11% in the coming years, consisting of 6% earnings growth, the 3.2% dividend yield, and a 1.8% tailwind from a rising valuation. Target offers a good mix of growth, value, and yield that we find attractive, giving Target a buy recommendation at this time.
Best Grocery Stock #1: Kroger Co. (KR)
Kroger is the largest supermarket chain in the U.S., and it has a huge exposure to grocery. It has almost 2,800 stores in 35 states and serves more than 60 million households every year. It has a market cap of $19 billion. Kroger has been on a roller coaster ride since the summer of 2017, when Amazon acquired Whole Foods for $14 billion. The market panicked over the potential repercussions of the takeover on Kroger due to Kroger’s thin margins.
However, in nearly two years of operating Whole Foods under Amazon, the actual impact on Kroger has been much less than initially feared. Nevertheless, the competition in the retail sector has heated more than ever. Amazon recently expanded the grocery delivery service of Whole Foods to more key regions in the U.S.
In addition, according to a WSJ report, Amazon intends to open dozens of grocery stores across the U.S., with a lower price point and broader offerings than Whole Foods. The first store may open at the end of this year. Moreover, Walmart is expanding its online grocery delivery service to 100 metropolitan areas.
Source: Investor Conference
Kroger has successfully responded to the competition so far. Last year, it initiated a strategic plan called “Restock Kroger”, which aims to increase its operating income by $400 million until the end of 2020 by maximizing its efficiency and its cost savings.
In early March, Kroger reported (3/7/19) financial results for the fourth quarter of fiscal 2018. The company grew its adjusted sales by 1.6% but its gross margin shrank from 22.9% in prior year’s quarter to 22.0% due to changes in mix, price discounts and investment in supply chain. The operating margin was 1.4%, much less than the consensus of 2.4% and the prior year’s mark of 1.8%.
Adjusted earnings-per-share missed the consensus ($0.48 vs. $0.52). Management expects 2.0%-2.25% same-store sales growth this year and adjusted earnings-per-share of $2.15-$2.25. We expect that the retailer can grow its earnings-per-share by 5.0% per year over the next five years.
Due to the plunge of the stock after its earnings release, Kroger is trading at a price-to-earnings ratio of 10.6x, which is lower than its 10-year average of 13.4x. If the stock reverts to its average valuation level over the next five years, it will enjoy a 4.8% annualized gain thanks to the expansion of its earnings multiple over this period.
In addition, Kroger stock has a 2.4% dividend yield. Putting it all together, Kroger stock has expected annual returns of approximately 12.2% per year, giving it a buy recommendation and making it the top grocery stock today.
Final Thoughts
The grocery industry is changing like never before. Deflationary pressures are hurting companies across the industry, and Amazon represents a truly disruptive force. Now that Amazon has acquired Whole Foods, it is likely the company will accelerate its push into the grocery industry.
In addition, if Amazon is able to significantly lower Whole Foods’ notoriously high prices, it could represent a real threat to the entire grocery industry. Amazon is also on the precipice of opening cashier-less stores. Leveraging Whole Foods’ grocery presence and Amazon’s technological prowess could prove to be a formidable combination.
The top grocery stocks have decades of experience in the retail industry. They have proven the ability to navigate difficult waters before, and adapt to changing conditions when necessary. The grocery industry is evolving; the key players are differentiating themselves.
All of the above retailers will continue to compete amongst themselves. Investors looking to buy stocks in this industry should focus on the grocery stocks with durable competitive advantages, and the financial strength to continue investing in growth.
In the final analysis, one thing is true. People will always be buying groceries. Where and how consumers buy groceries may change, but different people will prefer different stores based on their own personal preferences. Of the above stocks, Walmart gets a sell recommendation while Costco is rated a hold, based primarily on valuation. Meanwhile, Sprouts could be an attractive growth stock, as it is the smallest company on this list and has a long runway of growth up ahead in its core niche. That said, it does not offer a dividend, meaning income investors should avoid the shares.
Lastly, Target and Kroger are more attractively valued stocks. They also have growth potential and dividends that result in attractive total returns at least in the high-single digit to low-double-digit range, giving Target and Kroger buy recommendations.