In a previous column, I discussed a categorization scheme to help identify different types of companies based on the work of Bennett Stewart in his book The Quest for Value. Although the X, Y, Z scheme is not as well-known as Peter Lynch's six company types (fast growers, stalwarts, slow growers, cyclicals, turnarounds, and asset plays), it can play a valuable role in understanding a company's investment story.
The X, Y, Z categorization method is particularly valuable because it is grounded in the assets that produce the company's profits. Projected future cash flows can often become unmoored, and using an alternative method to triangulate a company's value is just plain Foolish.
Here, we're talking about an X company, a business that must focus on its operating efficiencies to maintain its franchise and ultimately generate value for its shareholders.
The grocery business is a perfect example of a competitive industry where economic profits continue to be put under pressure. The presence of Wal-Mart (NYSE: WMT ) and Costco (NYSE: COST ) has disrupted the traditional grocery format with even greater scale. The emergence of Whole Foods (NYSE: WFMI ) , which carved out its own niche by focusing on organic and natural foods, has put additional pressure on the traditional grocery chains.
If Kroger (NYSE: KR ) is going to survive in this environment, it needs to maintain its operating margins, which have slipped recently because of disruptions in California. However, Kroger has maintained an average 9.2% return on invested capital over the past five years, and its cost of capital is 8.5%. So even though the trailing-12-month return is still less than 8%, the trend has been upwards.
To verify whether Kroger is being priced as an X company, we compare its invested capital with its current enterprise value. Measuring the capital Kroger employs must include the operating leases, which are not included on the balance sheet. Kroger operates with $22 billion in invested capital -- considering operating leases, outstanding stock option grants, and previously written-off goodwill. With Kroger's current approximate share price of $22.89, the enterprise value is $23 billion.
Because the company trades with less than a 5% premium to its invested capital, Kroger is priced like an X company. This Fool would recommend purchasing a company like Kroger only if it traded for less than its invested capital or if there was an expectation that its profitability was going to improve. At Kroger's current price, I wouldn't be as eager to make a purchase.
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