Final Project

Part 1: Industry Analysis and Business Strategy Analysis

Industry analysis
1. The Kroger Company and its competitors operate in the retail industry (grocery stores).
The retail industry is comprised of firms who sell goods and services to individuals and
other businesses as end-users.

2. Apply the Porters Five Forces tool to the industry:

A. The degree of rivalry among firms in the retail industry is very high. Kroger
Companys top competitors are Safeway (SWY), Supervalu (SVU), Whole Foods
(WFMI), Wal-Mart (WMT) and Winn Dixie (WINN). Wal-Mart is the leading
seller of groceries in the country (First Research). The industry is concentrated
among few firms with the largest companies owning 70 percent of the grocery
industry market. The retail industry is growing at a steady pace partly due to the
improving economy. The sector is expected to add 1.6 million new jobs, reaching
16.7 million by 2014. Real output for retail trade is expected to grow at a rate of 4.6
percent annually, rising from $1.1 trillion in 2004 to 1.8 trillion in 2014. Also,
another growing trend is that retail stores are beginning to compete more heavily in
fuel sales by offering on-site fuel centers. Large retail stores have a competitive edge
in this industry due to their efficient distribution and purchasing power (economies of
scale). This is the reason why a firm needs to be large to successfully compete in the
retail industry. However, small firms can be competitive too if they differentiate
themselves by selling special products and providing quality superior foods.

B. The threat of new entrants in the retail industry is fairly low. New entrants in the
industry face a lot challenges such as high economies of scale, first mover advantage,
legal barriers, safety regulation by the U.S. and State governments and costly start- up
costs. The purchase of distribution centers is also a significant expense associated
with establishing business operations. New entrants have a difficult time competing
with big players such as Kroger and Wal-Mart because of these reasons. New entrants
may have to force their prices down which puts pressure on profits in the long run. In
addition, new firms 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.

C. The threat of substitutes in the retail store market is low. Though there are substitute
means of getting food, such as fast food, restaurants, and convenience stores, the
actual products sold within grocery stores usually are the same at all locations with
few variations. In addition, the threat of substitutes depends on the price and relative
performance of competing products. In the retail industry, there is not a large market
 for substitute products. We can cite manufacturers and wholesalers as industries
which produce substitute products but there are no exact substitutes. The threat of
substitutes may come from the competitive advantage by wholesalers like Sams club
and Costco. But it is not always easy for customers to switch to wholesalers because
retailers are usually more prevalent and are available in smaller markets where
wholesalers may not find it beneficial to be located. Retailers often have prices
comparable to wholesalers in many respects as well.

D. The bargaining power of suppliers in the retail industry is between low and moderate.
Both the supplier and retailer need one another to be profitable in this industry. Price
sensitivity and relative bargaining power are the two factors which determined the
bargaining power of suppliers. The power of the suppliers depends on how big the
retail store is and how popular the brand is selling. Large retailers have more power
over their suppliers because of the suppliers need to be associated with the large
grocery store and its dependence on the stores business to stay competitive.
Therefore, suppliers in the retail industry often have low bargaining power due to the
large size of their customers.

E. The bargaining power of buyers is also determined by two factors which are price
sensitivity and relative bargaining power. In the retail industry, even though most of
products prices in stores are already fixed by the companys management, customers
still have the power to switch to other competitors such as Wal-Mart or Marsh which
offer the same product at the same or cheaper price in many instances. It is relatively
easy for a buyer to switch to another store and not to a substitute. This leaves the
buyer with high price sensitivity. Because of the high number of retail stores in the
industry along with low switching costs, customers have quite high relative
bargaining power.

F. All of the 5 forces listed above deeply affect the current and future industry
profitability of the retail sector. Concerning the rivalry among firms, the competition
is very high, which can lead to a bad effect on current and future profitability of the
firm. The threat of new entrants, the threat of substitutes and the bargaining power of
suppliers are all low to moderate, which could potentially lead to greater current and
future industry profitability. Finally, the bargaining power of buyers is relatively high
in the retail industry, which could lead to a negative effect on industry profitability.

3. The retail industry is heavily affected by a number of macroeconomic factors. The state
of the economy due to the financial meltdown of 2008 had a tremendous effect on the
retail sector. Many retailers stores were forced to lay off employees and cut expenses in
other ways. The unemployment rate increase led to the reduced purchasing power of
customers. The retail industry is also sensitive to inflation. The recent increase to gas
prices and supply of gasoline has lead to an increase in operating expenses. Other
macroeconomic factors that could potentially affect the retail industry include legislation
such as labors laws and labor unions in the states in which stores operate. For example,
many retail store workers are affiliated with labors unions. This means retail store
 managers have to negotiate with these unions about salaries and benefits. Also, the
consumer spending patterns including discretionary spending affects sales, growth and
profitability. The nature and extent to which the competitors implement various pricing
and promotional activities can adversely affect profitability.

Company strategy analysis

1. The three most critical risk and success factors for Kroger include:
Product and service: Identified by product variety, product quality and strong customer
service
Price: Identified by low cost distribution, large inventory(economies of scale)
Growth: Identified by revenues from sales and the number of stores

A. A list of strategies that Kroger management is implementing:

Establishing the business level strategies to minimize the cost of doing
business (minimizing research costs)
Relying heavily on economies of scale
Implementing efficient production to generate revenues
Obtaining lower input costs
Investing in brand image
Investing about $200 million a year in expanding its store presence
Implementing superior product quality, product variety and customer service
Communicating with employees to decrease the effects of labor unions in its
business operations

B. The three that most important factors are:

Relying heavily on economies of scale
Implementing efficient production to generate revenues
Implementing superior product quality, product variety and customer service

We chose these three factors because they deeply represent the key risk and success factors.

2. Companies like Kroger generally achieve competitive advantages through differentiation

and low cost leadership. 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. Low cost
leadership usually appears when a firm supplies the same product or service at a lower
price. Kroger is applying those two strategies efficiently; thus it has achieved a
competitive advantage. Also, the brand image of the company provides a strong
competitive advantage to the company over other firms. The branding strategies adopted
 by the company are giving it leverage. Kroger utilizes a three pronged branding approach
which includes Private Selection, banner brands and Kroger value. Also, as being among
the first movers in the retail industry, this gives Kroger a strong competitive advantage.
In addition, proficient manufacturing capabilities and diversified retail product inventory
give Kroger a strong competitive advantage. All these strengths cited above have
positioned Kroger in the value chain in a way that is consistent with its strategy. The
brand name and sturdy market position are one of the assets that the company has to
achieve the strategy

3. Large retail stores such as Kroger have sustainable competitive advantages. Other stores
cannot easily replicate those advantages. The reasons can be quality strengths like a
companys brand equity, sturdy market position, proficient manufacturing capabilities
and diversified retail product inventory.

Part 2: Accounting Analysis

1. The balance sheet account and income statement that capture the critical risk and
success factors are:
Growth can be best identified with the income statement account Net Revenues
and the balance sheet account Property Plant and Equipment.
Products and service can be best identified with the income statement account
Cost of goods sold and balance sheet account Inventory
Price can be best indentified with income statement account Merchandise Cost
and balance sheet account

2. The accounting methods used to account for each of the accounts that comes from our
analysis of accounting and strategies are:

For recognition of revenues, Kroger has a particular business model. Revenues

from the sale of products are recognized at the point of sale. Discounts provided to
customers by the Company at the time of sale, including those provided in connection
with loyalty cards, are recognized as a reduction in sales as the products are
sold. Discounts provided by vendors, usually in the form of paper coupons, are not
recognized as a reduction in sales provided the coupons are redeemable at any retailer
that accepts coupons. This shows that they use the net accounting method. This
method provides flexibility in recording accounts receivables and sales. Companies
who use this method of accounting reduce discounts from revenues so their net
revenues are lower as compared to companies using the gross method. Kroger records
 a receivable from the vendor for the difference in sales price and cash
received. Pharmacy sales are recorded when provided to the customer.Net revenues
grew by 9% for the year ended 2011 and 7% for year ended 2012. Revenues are
earned and cash is generated as consumer products are sold to customers in the stores.
Kroger earns income predominately by selling products at price levels that produce
revenues in excess of the costs it incurs to make these products available to our
customers

Property, plant and equipment are recorded at cost. Depreciation expense,

which includes the amortization of assets recorded under capital leases, is computed
principally using the straight-line method over the estimated useful lives of individual
assets. Buildings and land improvements are depreciated based on lives varying from
10 to 40 years. All new purchases of store equipment are assigned lives varying from
three to nine years. Leasehold improvements are amortized over the shorter of the
lease term to which they relate, which varies from four to 25 years, or the useful life
of the asset. Manufacturing plant and distribution center equipment is depreciated
over lives varying from three to 15 years. Information technology assets are
generally depreciated over five years. Depreciation and amortization expense was
$1,652 in 2012, $1,638 in 2011 and $1,600 in 2010. The total cost of the Companys
owned assets and capitalized leases, at February 2, 2013 was $29.4 billion while the
accumulated depreciation was $14.5 billion. The company owns store equipment,
fixtures and leasehold improvements, as well as processing and manufacturing
equipment. Leasehold improvements, which are recorded on the balance sheet, are
22% of total property plant and equipment. Kroger has operating leases of $628
million, compared to property, plant and equipment of $14,875 million. The company
is not holding substantially high operating leases, which shows the accuracy of their
PPE and depreciation account (in regard of their straight line method). Kroger has a
substantially lower percentage of operating leases on PP&E compared to most
grocery stores.

Concerning merchandise costs, Kroger emphasizes on affordable price and cost

leadership. The company performs make or buy decisions to reduce the input cost but at
the same time they give importance to brand. Also, the strategy of the company focuses
on improving our customers shopping experiences through improved service, product
selection and price which affects the profitability of the company positively. So the
output of this strategy is high profit margins and free cash flows and an economic value
addition. The Merchandise costs line item of the Consolidated Statements of
Operations includes product costs, net of discounts and allowances; advertising costs
inbound freight charges; warehousing costs, including receiving and inspection costs;
transportation costs; and manufacturing production and operational costs. Warehousing,
transportation and manufacturing management salaries are also included in the
Merchandise costs line item. Merchandise cost as a percentage of net revenues is quite
steady for last 4 years. It just grew from 77% in 2009 to 79% in 2012.

The cost of goods sold is reported at higher amounts because of the inclusion of all
the above mentioned accounts associated with merchandise cost. This approach helps the
company to determine its merchandise costs accurately and price its products on that
basis.
Vendor allowances are recognized as a reduction in merchandise costs. Vendor
allowances are applied to the related product cost by item and, therefore, reduce the
carrying value of inventory by item.

Concerning Inventory, in the retail industry, managers use FIFO (first in first out)
and LIFO (first in last out) inventory accounting to illustrate operations involving
inventory. Kroger does not fully disclose the method used to calculate their inventory
because 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 Krogers inventory management
breakthroughs.We are not able to see the breakdown of inventory into categories or
percentages. However, we do know the average inventory for each year. Krogers
inventory turnover rate is consistent and shows steady growth. In Krogers 10-K, they fail
to thoroughly explain their activities and the consequences behind their inventory
operations.

3. Kroger utilizes a number of estimates and accounting methods that could have an
effect on income and future valuation. One of Krogers policies is to depreciate PP&E
on a straight-line basis. This is an acceptable method, but a large range of estimates
are employed when determining the useful lives of buildings and equipment. For
example, Kroger depreciates buildings and land improvements on a ten to forty year
basis. There is no in depth discussion in Krogers 10-K as to how they determine a
useful life in that range. Another estimate utilized by Kroger involves the impairment
of goodwill. The fair value of goodwill is determined using projected discounted
future cash flows, which is compared against the carrying value of the specific
division being analyzed to determine if goodwill should be impaired. Projected
discounted future cash flows are based off of a number of management assumptions,
including their assessments of the current operating environment and future
expectations. Clearly, there is substantial judgment needed in determining these
factors. Another area that involves estimates which could influence income and
 valuation is the calculation of pension expense. Pensions are a significant expense on
many large companies financial statements, and Kroger is no exception. Actuarial
estimates and assumptions play a significant role in determining what Krogers
pension expense for the year will be. This, in turn, could have a substantial effect on
earnings for the year. It is clear that care must be taken when evaluating earnings and
other financial data, because numerous and substantial estimates are often employed
to calculate expenses for the year. Although these estimates may have a material
effect on our ability to analyze future profitability and risk for Kroger, they are
standard practice. Estimation is a necessary part of accounting and the valuation of a
firm.

4. Krogers 10-K includes a fairly comprehensive disclosures section that covers topics
such as labor relations, indebtedness, pension obligations, PP&E issues, goodwill,
and the impairment of long-lived assets. Our group had questions regarding how
certain property (buildings and land improvements) are assigned useful lives.
Krogers 10-K goes into some detail as to the average useful lives of various fixed
assets, but there is no real discussion as to how those values are chosen. With this
being the case, we believe that Kroger has done a satisfactory job in disclosing
important information regarding their key accounting methods and estimates. Kroger
covers the valuation of its inventories in detail, discusses the methods for the
impairment of long-lived assets, and devotes multiple paragraphs to their pension
obligation. Kroger even acknowledges that the use of estimates in preparing GAAP
financial statements is pervasive and necessary. Although Kroger makes extensive
use of accounting estimates, their financial statements provide enough information,
including disclosures, to fairly assess their profitability and risk.

Part III: Analysis of profitability and risk:

When value a company, it is important to collect firm specific information and
information about competitors and the industry in which they are operating. The first area
of evaluation is to conduct analysis using liquidity, profitability, and capital structure
ratios.

1. An Analysis of profitability

Profitability ratios are extremely important for analysts, investors and other
stakeholders who are interested in measuring a companys operating efficiency and
overall performance. In this report, we have included a number of profitability ratios for
Kroger which will be discussed. In an analysis of ratios for a particular company, it is
important to understand the underlying reasons as to why the ratios change from year to
year, whether the reasons are related to economics, accounting, or both.

One particularly important ratio for Kroger and other companies in the grocery
store industry is gross profit margin. This ratio measures cost of goods sold
(merchandise) as a percentage of revenues. This ratio quantifies how well a company
controls its inventory costs and how much of that cost is passed on to customers. Over the
past three fiscal years, Krogers gross margin has slightly declined from 23.3% in 2010 to
20.9% in 2012. There are a number of underlying reasons for Krogers decline in gross
margin. These include increased fuel sales, a commitment to offer lower prices to
customers, and increased inventory shrinkage and warehouse costs. Krogers
commitment to offer lower prices stems from the current state of the economy and their
desire to attract customers in spite of this fact. Fuel sales often carry very low margins,
which is why increased fuel sales led to a drop in Krogers gross margin. Krogers
merchandise costs increased due to third party warehouse management increasing fees,
which had a negative effect on Krogers cost of goods sold. All of these factors led to a
decline in Krogers gross margin.

Gross Margin
24.00%
22.00%
20.00%
18.00%
2010 2011 2012

Operating margin is another important measure for companies in the grocery

industry. This ratio measures earnings before interest and taxes as a percentage of sales.
Operating margin measures Krogers day to day operating efficiency and gives an
indication of how well they manage such costs as COGS, SG&A, and rent expense.
Krogers operating margin increased from 1.4% in 2010 to 2.7% in 2011 and then back to
1.4% in 2012. A goodwill impairment charge in 2010 was a main reason for Krogers
low 1.4% operating margin. Krogers operating margin briefly increased in 2011, but
once again dropped to 1.4% in 2012. This drop can be attributed to a substantial increase
in Krogers merchandise and administrative costs. The increased merchandise costs can
be linked to volatility in commodity prices which Kroger was not able to completely
hedge themselves against. Increased executive compensation in 2012 also played a role in
Krogers decreased operating margin.
 Operating Margin
4.00%

2.00% Operating
Margin
0.00%
2010 2011 2012

One final ratio that is an important measure of profitability for Kroger is return
on assets. Return on assets measures the efficiency with which a company uses its assets
to generate earnings. Krogers 2011 ROA was 6.1%, a substantial increase from 3.3% in
the prior year. ROA for Kroger decreased to 4.2% in 2012. There are a number of reasons
for Krogers fluctuations in ROA for the fiscal years 2010 through 2012. In 2011, Kroger
was better able to convert invested funds (debt and equity) into net income. This was
achieved by controlling expenses such as general and administrative costs and
merchandise costs. Krogers income generating assets remained fairly constant from
2010-2012, so the spike in ROA in 2011 can be attributed to the successful control of
expenses resulting in higher earnings and ultimately higher ROA.

Return on Assets
10.00%

5.00% Return on
Assets
0.00%
2010 2011 2012

2. An analysis of risk

Risk ratios, which include measures of leverage and liquidity, are useful for assessing a
companys capital structure, exposure to certain business risks, and their ability to remain
solvent, among other things. This section will discuss some key risk ratios as they pertain to
Kroger.

One very common and often used ratio, the current ratio, is used to measure Krogers
liquidity risk. It is computed by dividing current assets by current liabilities and gives an
indication of Krogers ability to pay back short-term liabilities. Krogers current ratio has seen a
steady decline from 0.94 in 2010 to 0.72 in 2012. A current ratio under 1 is often considered
unhealthy, but it is actually quite common in the grocery store industry (Krogers main
competitor, Safeway, also has a current ratio under 1). There are a number of reasons for
Krogers low current ratio. Grocery stores often carry low levels of current assets due to quicker
inventory turnover and do not need to have large amounts of cash on hand. As a result, current
liabilities are often more than current assets. Grocery stores such as Kroger do not have the same
impetus as businesses in other industries to maintain a healthy current ratio because creditors
could easily use retail sales as collateral for loans. With this being said, Krogers rather sharp
current ratio decline is still of some concern. Kroger may be having difficulty collecting
receivables and their operating efficiency might be lagging. Although it is common for a retailer
such as Kroger to have a low current ratio, it should be carefully watched to make sure that they
will be able to meet obligations as they come due in the future.

Another common ratio used to measure business risk is the leverage ratio of debt to
equity. This is computed by dividing total liabilities by shareholders equity. Krogers debt to
equity ratio decreased from 1.73 in 2011 to 1.43 in 2012. The debt to equity ratio gives an
indication as to how a company utilizes debt to increase growth and earnings. Kroger has a
relatively low debt to equity in relation to other grocery store chains (Industry average of 2.4 in
2012). This is not necessarily a good thing. One of Krogers goals has been to keep interest
expense low and constant, which they have done in recent years. With that being said, Kroger is
in a position to take on more debt and leverage their operations to increase returns. Kroger
should do this as long as the increased interest expense does not cancel the increased earnings
from more leverage. Of course, taking on too much debt is not a good thing, and could put
Kroger into a position of having liquidity concerns. Currently though, it seems as if Kroger
should increase borrowings to facilitate a growth in operations that they may not have been able
to do without assuming additional debt.

Interest coverage is another ratio which helps to explain a companys business risk. This
ratio is computed by dividing operating profit by interest expense. Kroger had an interest
coverage ratio of 5.98 for 2012, which was higher than the industry average of 5.58 for the fiscal
year. This shows that Krogers operations are more than ample to cover their interest obligations.
This is another indication that Kroger could take on additional debt to spur increased growth.

Current Ratio
1
0.8
0.6
Current
0.4
Ratio
0.2
0
2010 2011 2012
Part 4: Prospective Analysis and Valuation
I. Pro forma financial statements:

A. For the next ten years (hard copy see Excel Sheet)
B. description of method to forecast sales:

Krogers sales growth is a function of identical store sales growth and new stores. In 2013
Kroger expects identical store sales growth to increase in accordance with its customer 1st
strategy. This sales growth is also expected to come from additions to square footage, as well as
from increased productivity produced in existing locations.

In 2013 Kroger believes that it can reduce operating costs in such areas as administration,
productivity improvements, shrink, warehousing and transportation. It intends to invest most of
these savings in its core business to drive profitable sales growth and offer improved value and
shopping experiences for its customers.

C. Key assumptions for important line items in the income statement and balance sheet are
provided below each line item. ( see excel sheet)

II. Valuation:
A. Valuation using the dividend model (see excel sheet)
B. Valuation using discounted free cash flow (see excel sheet)
C. Valuation using the residual income model ( see excel sheet)

D. Key assumptions in each model

Discount rate: Three components
Risk free rate- Taken from finance.yahoo.com- which is 2.2%
Beta describes the riskiness of the company, taken from Value Line
which is equal to 0.65
Market risk premium is taken from S&P which is equal to 4%.

III. Comparison of actual stock price to estimated stock prices (and analysis of
potential causes of difference), and your investment decision.

The estimated value per share for the company is $98.80 as per residual income model on
January 28 2013. The actual market price is $ 27.80 on that day.

The potential causes of difference are

1. Growth in revenues combined with market growth.

2. Stability in merchandise costs.
 Part 5: Valuation: Market-based Approaches
a. Please, look at our excel sheet (Kroger enginner)

b. Profitability*growth*risk = market price per share

Our valuation comes up to be 98 dollars per share, while the market was trading at 23

dollars per share. Therefore let us look at the variations that let the share price be underestimated.

Let us put all the components of share valuation, and see the effect of each factor.

The engineer factors of share price are sum of abnormal earning per share, continuing

value of abnormal earning per share and book value of equity. Those factors are coming from the

growth, profitability and risk. The continuing growth for Kroger is 2%, but when we reduce the

amount to 0%, the price per share is still very than the stock market price. Also, the risk factor

doesnt have huge impact of market price; it goes down to 46 dollars per share when the cost of

equity is 8%. Besides, the abnormal earning doesnt affect the market price either; it let the price

to go down to 87 dollars only. So we resume that the investors are assuming higher risks and not

expecting too much profitability from Kroger.

In our point of view, I assume that investors are underestimating the stock price, so I

would suggest buying few shares and holding on them for long time.
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