Investors often have difficulty letting go of outperforming growth stocks, even if there are clear signs it’s time to cash out. Case in point: the seemingly unstoppable rise in shares of The Kroger Co. (NYSE: KR), the nation’s largest supermarket chain by revenue.

 

 

 

With such bullish-looking technicals, Kroger may seem like an investment you can buy and hold, especially after the company’s recent quarterly report. In early March, Kroger announced that Q4 earnings grew 23% (from the year ago quarter), well ahead of consensus forecasts.

 

The quarterly report caps off an impressive five-year surge, which saw revenues jump more than 40% to nearly $109 billion and net earnings soar more than 30-fold to $3.44 a share during the past five years.

 

#-ad_banner-#However, it would be unwise to assume Kroger will keep outperforming. With the company’s stock perched at record highs, now is a perfect time to determine if fundamentals can support current prices. And from where I’m sitting, this popular stock looks set to boil over.

 

Investor Overexuberance

In the fiscal year ended February 1, earnings rose about 19%. Yet Kroger’s stock gained nearly 90% during the same period. This worrisome disconnect suggests investors are chasing performance, pushing the stock up much faster than earnings warrant.

 

Since earnings are the main driver of stock prices in the long-term, at least for firms that are turning a profit, Kroger’s stock may suddenly look far overvalued if operating performance begins to fade.

 

Indeed, valuations look stretched already, as shares trade for more than 20 times last year’s earnings. That’s more than an 80% premium to the historical price-to-earnings, or P/E, ratio of around 12, according to Morningstar. Their analysts note that  Kroger would need to sustain mid-single-digit same-store sales growth and maintain operating margins into the mid-3% range over the next decade, to justify current valuations.

 

The trouble: management’s own long-term guidance only calls for 2.5%-to-3.5% same-store sales growth. And while operating margins are currently around 3.6%, the five-year average is just 2.7%.

 

High Leverage

During the past five fiscal years, Kroger spent $11 billion on new construction, store expansions and other capital investments. Lately, it has picked up its pace of acquisitions as well, closing a $2.5-billion buyout of upscale grocer Harris Teeter Supermarkets, Inc. in January and a $237 million takeover of online vitamins and supplements retailer Vitacost.com in August 2014, for instance.

 

Like most supermarket chains, though, Kroger has thin margins so there isn’t nearly enough cash available to cover acquisitions and capital investments. This means the company must fund growth in large part through debt.

 

The current debt load, nearly $10 billion, gives Kroger a 1.8 debt-to-equity ratio, compared with the industry average of just 1.1. Net profitability could be compromised if the burden increases — a good bet given Kroger’s historically high rate of capital spending and recent predilection for acquisitions. More leverage could also jeopardize Kroger’s investment-grade credit rating, leading to higher borrowing costs and placing further stress on the company’s balance sheet.

 

A Burdensome Pension Plan

Kroger’s pension liability of $900 million may not seem terribly important next to its debt, especially since benefits are paid out to retirees over many years. However, analysts point out that the plan is underfunded, meaning plan assets may soon be insufficient to cover benefit payments.

 

As the plan sponsor, Kroger is on the hook for any shortfall, which could be large enough to consume a good portion of cash flows, Morningstar analysts warn. Kroger would then have a lot less cash for expansion initiatives, dividend raises and debt repayment.

 

The jolt would be especially nasty if the financial markets go south, since investment returns are a critical influence on pension plan funding levels.

 

For years, the company has been assuming an 8.5% rate of return on pension assets, which proved realistic during the past decade but may be a tall order in coming years.

 

Slower Profit Growth

Kroger faces many formidable rivals. Among them: discounters like Wal-Mart Stores, Inc. (NYSE: WMT) and Target Corp. (NYSE: TGT), as well as other “full-service” grocers such as Whole Foods Market, Inc. (Nasdaq: WFM).

 

In such a crowded field, Kroger has resorted to price concessions more than once. Last May, the grocer cut prices on 2,000 products and fresh produce to retain market share. Whole Foods and other competitors have taken similar action recently, suggesting price battles are set to intensify and create a potential drag on profits industrywide.

 

Considering all the headwinds, Kroger is unlikely to come anywhere near the 18% pace of profit growth it achieved during the past five years. I’d even be skeptical of management’s long-term guidance for 8%-to-11% growth — particularly against the current backdrop of global economic weakness, which could seep into the still-vulnerable U.S. economy.

 

Risks To Consider: With fueling stations at about half its stores, Kroger generates substantial revenue through gasoline sales. Sharply lower gas prices present a significant near-term risk and could knock 1%-to-2% off bottom-line growth in 2015 if they persist.

 

Action To Take –> Kroger may look unbeatable, but it’s at high risk for a sizeable correction. Shareholders would be prudent to take profits, before the stock has a chance to reverse course. More adventuresome investors might consider shorting Kroger when technicals indicate an imminent breakout to the downside.

 

When a stock has had upward momentum like Kroger, it’s hard to call a top… unless you have the Maximum Profit system. Academic studies have shown that momentum is one of the only indicators that has consistently outperformed the market. In fact, two of my colleagues have been quietly testing the Maximum Profit system, which is making a small group of investors a lot of money. It flags exactly which stocks are about to jump double, even triple digits in the coming days, weeks and months. And when momentum begins to subside, it tells you when to sell. Recently, the system tagged a few more stocks that could do the same. To learn more, click here.​