Kroger Is a Tasty Value for Smart Investors

 | Jul 18, 2017 | 1:30 PM EDT
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Healthy, but unexciting, stocks usually work out well if you buy them right. Shares of Kroger (KR) , America's largest pure-play grocery company, got stomped recently. The sell-off came on the heels of pared back earnings estimates plus Amazon's (AMZN) announced purchase of Whole Foods Markets (WFM) .

At 2015's peak, the stock was expensive near $43. At about $23, along with a 2.17% yield, KR is worth considering.

Things are not as bad as the almost 47% pullback would lead you to believe. Analysts think Kroger will post 2017 EPS of about $2, followed by $2.10 next year. At Monday morning's quote of $23.08 the shares fetched about 11.5x this year's, and 11.0x 2018 earnings, versus their long-term average multiple of 13.6x.

The 12.5-cent quarterly dividend is well-covered. The current yield weighs in more than 30% above the stock's typical level.

Kroger's last five 'best entry points' (green-starred below) launched from P/Es not much lower than today's. $23 - $24 doesn't appear expensive. KR carved out highs ranging from $32.50 to $42.80 during each of the calendar years since 2014, including 2017 YTD.

What is Kroger really worth? A return to a more normalized valuation suggests $27 - $30 is a reasonable 12 to 18-month target price range. Even the lower end of those goals would provide decent total return (around 20%) by the end of 2018.

Independent analysis from Morningstar seconds that notion. They rate Kroger a 4-star (out of 5) BUY while calling present day fair value as $28.50.

Option savvy traders can use buy/write combinations to establish positions with reduced risk yet solid upside. I'd recommend buying KR shares while simultaneously selling out-of-the-money $25 strike price covered calls plus $22.50 strike price naked puts.

Here are the actual details for those trades using the Jan. 18, 2019 expiration date.

Maximum profit would be reached on any move to $25 or greater on the options' expiration date. The worst-case scenario will play out if KR declines, and holds, below $22.50 at that time.

Here are three possible outcomes for those trades, depending on where KR closes on Jan. 18, 2019. The figures do not assume any dividend increase.

Even the worst-case scenario appears far from scary. It would involve doubling the initial share commitment, but the average net price would be lower than KR's absolute nadir since the first half of 2014.

Kroger could drop by up to $3.39 per share, or 14.6%, from the trade inception price without causing a start-to-finish loss on this buy/write combination.

If Kroger goes absolutely nowhere over the next eighteen months... traders who set up the buy/write combo would still do pretty well.

Getting a 35% gain on outright purchase, without the option action, would require KR to move to almost $31 per share.

If Kroger rebounds, as expected, to at least $25... the best-case result will occur. Investors who set up the buy/write combo and simply leave it alone could see 46% cash-on-cash returns.

Simply owning KR at $23.08 would need a move to near $33 to accomplish that same percentage gain.

Less patient traders can do the math on the Jan. 2018 series, expiring in about six months, using the quotes provided earlier. The annualized returns on those look good also.

Kroger now sits in low-risk territory. Buy the stock. Then also consider selling options to augment total return.

(This commentary originally appeared on Real Money Pro. Click here to learn about this dynamic market information service for active traders.)

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