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The Kroger Co. (KR): This Is No Ordinary Supermarket

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The Kroger Co. (NYSE:KR)Earlier this week Fool blogger Timothy Green wrote a great piece detailing The Kroger Co. (NYSE:KR)‘s expansion plans. But I can’t help but feel he missed a key point when discussing the stock’s valuation. Here’s a snippet from the post:

Grocery chains have low margins and slow growth, making investing in them usually unappealing. The Kroger Co. (NYSE:KR) has seen its share price surge since the middle of 2012, up 80% from its 52-week low. […] It seems that investors are getting excited about grocery stores, sending Kroger’s shares flying, while forgetting that it’s a grocery store.”

But The Kroger Co. (NYSE:KR) is no ordinary grocery store. It’s the best company in the industry and the stock’s valuation does make sense with greater context.

Kroger is the best house in a bad neighborhood

But before we get started, let me completely acknowledge that supermarkets are a pretty crappy business (is that the technical term?). As Timothy mentioned the industry is plagued by tight margins and slow growth. At this point, almost all of the grocery stores America will ever need have already been built.

Worse, the industry is under attack from all sides. At the top-end, high-end organic chains like Whole Foods Market, Inc. (NASDAQ:WFM) are stealing market share. At the low-end, Wal-Mart Stores, Inc. (NYSE:WMT) and dollar stores are compressing margins. You’ll need some rose tinted goggles to make this sector look attractive.

Yet despite the troubling economics, The Kroger Co. (NYSE:KR) has weathered the barrage surprisingly well due to an exceptional management team and excellent execution.

First, the company identified emerging threats before its rivals like Safeway Inc. (NYSE:SWY) and SUPERVALU INC. (NYSE:SVU). Management sacrificed margins for market share over a decade ago allowing the company to become the country’s largest grocer. Today, Kroger is the only company with the size and scale needed to compete against a juggernaut like Wal-Mart.

Worried that prices might fall further? You shouldn’t be. During the company’s last investor day conference management hinted that they were comfortable with their current pricing strategy. That could mean my favorite two words in the English language: margin expansion!

Second, The Kroger Co. (NYSE:KR) was one of the first supermarkets to see the boom in private label brands. At this moment, consumers across all demographics are looking for ways to save on basic necessities and we’re seeing an explosion in private branded products. No longer will shoppers pay a premium for Kellogg Frosted Flakes. The store brand will due just fine.

Kroger is a leader in the private label trend with store brands which account for 27% of the company’s sales. Cutting out the middleman means higher margins for the retailer. In contrast, Kroger’s rivals have been slower to exploit this trend. Private label products account for only 25% and 20% of Safeway Inc. (NYSE:SWY)’s and SUPERVALU INC. (NYSE:SVU)’s revenues respectively.

Altogether, both scale and private brands make The Kroger Co. (NYSE:KR) the most profitable of its peers. Please note, all of the below figures are for full year 2012.

Company Gross Margin Operating Margin Net Margin

Kroger

20.56%

2.86%

1.54%

Safeway

26.51%

2.50%

1.35%

SUPERVALU

13.41%

-0.92%

-8.57%

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