Kroger Leverages Its Strength To Get Even Stronger

By Stephen D. Simpson, CFA | July 09, 2013 AAA

National supermarket chain Kroger (NYSE:KR) appears to be running off the playbook that says strong companies should leverage that strength to put even more distance between them and their rivals. In buying Harris Teeter (Nasdaq:HTSI), Kroger is not only buying a growing, high-quality grocery chain in the Mid-Atlantic, but also positioning itself to take advantage of even more leverage in purchasing, distribution, and logistics. Provided Kroger doesn't interfere with what made Harris Teeter stand out from the crowd, this looks like a deal with good long-term return prospects.

Paying Up For A Good Property
Harris Teeter was widely known to be for sale, with multiple speculations in the financial press about which private equity groups had, or had not, placed bids for the growing mid-Atlantic chain of supermarkets. Accordingly, it's no great surprise that Kroger had to pay up to get a deal done.

Kroger will pay $49.38 per share in cash, and assume $100 million in Harris Teeter debt. Not only is that per-share price about one-third higher than where Harris Teeter was before word spread that the company was exploring a scale, but the EV/revenue and EV/EBTIDA multiples are well ahead of industry averages.

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Kroger is paying an EV/revenue multiple of 0.5x and an EV/EBITDA multiple of 7.7x. Safeway (NYSE:SWY) currently trades at multiples of 0.26x and 5.23x, SUPERVALU (NYSE: SVU) trades at 0.27x, and 8.86x, Kroger itself trades at 0.27x and 5.84x, Ahold (Nasdaq:AHONY) (which owns Giant stores in the U.S.) trades at 0.33x and 5.05x, and Delhaize (NYSE:DEG) (which owns Food Lion in the U.S.) trades at 0.30x and 4.73x.

Why Pay Up?
So why should Kroger pay almost 50% to 100% above the going rates for supermarkets? For starters, Harris Teeter is located squarely in some of the most appealing markets in the country, including states like North Carolina, Virginia, Florida, and Georgia. Second, the company's differentiated store format, emphasis on fresh/healthy foods, and high service levels has led to significantly above-average growth with revenue and operating income growing at long-term rates in the mid single-digits versus virtually no growth (or actual contraction) for many rivals.

Adding Harris Teeter also adds scale, though, and the possibility of leveraging costs even further. Food retailing is a cutthroat low-margin business (sometimes even with specialty retailers like Whole Foods (NYSE:WFM) and Natural Grocers (Nasdaq:NGVC) and Kroger can now drive harder bargains with suppliers, as well as better leverage existing infrastructure and logistics across both stores. What's more, Kroger has a pretty good record of hitting merger-related cost targets and management here is talking about realizing $40 million to $50 million in annual cost savings within five years.

Still Some Risks Left
Although the deal does not allow Harris Teeter to actively solicit competing bids, I suppose there's still a chance that a rival will outbid Kroger. I don't think this is particularly likely. Even with access to cheap debt, I don't see how a private equity bidder can achieve the same synergies and cost savings as a strategic buyer like Kroger and justify a higher bid. On the strategic side, I can't see who would outbid Kroger – companies that may want to lack the financial strength to do so and companies with the financial strength to do so (like perhaps Costco (Nasdaq:COST)) have no clear strategic purpose in doing so.

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The bigger risk, then, is in Kroger screwing this up. As a frequent Harris Teeter shopper, I was not happy to see this news roll across the ticker this morning, as I would hate to see Kroger simply fold Harris Teeter into its existing operations and reduce the service and quality levels to Kroger standards. At this point, though, Kroger management is talking about Harris Teeter continuing to operate as an independent subsidiary, with current management staying in place and no store closings.

I guess we'll have to wait and see what happens. If Kroger ultimately does change how Harris Teeter operates, I see the store additions, footprint expansions, and cost savings as leading the deal to being net neutral, allowing the company to get bigger, but not necessarily all that better. If Kroger sticks with this plan to allow Harris Teeter to operate its own way, though, I can see this deal adding value to Kroger long-term, as well as giving the company a valuable food retailing niche between the likes of regular supermarkets and Wal-mart (NYSE:WMT) and the more expensive specialty food retailers like Whole Foods.

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