Will Kroger Seek Other Acquisitions?

Kroger might have failed to acquire assets of Safeway, but with a strong business, and other potential suitors, investors shouldn't be too discouraged.

Mar 10, 2014 at 5:42PM

Kroger (NYSE:KR) lost all of its post-earnings stock gains on Thursday following news that Cerberus has offered $40 a share to acquire Safeway (NYSE:SWY). This news put a dent in Kroger's plan to acquire assets of Safeway, which clearly shows Kroger's willingness and desire to grow via acquisitions. Therefore, while discouraging, Kroger doesn't really need Safeway, and furthermore, the acquisition landscape is ripe with companies that will create great synergies, such as Sprouts Farmers Market (NASDAQ:SFM) and Rite Aid (NYSE:RAD).

Kroger fails to acquire Safeway assets: Does it matter?
Kroger is the largest supermarket company in the U.S., with annual revenue of nearly $100 billion. Safeway is a peer, with annual sales of $36 billion, and with the company being for sale, Kroger wanted to acquire certain assets.

Most likely, Kroger wasn't as interested in Safeway's physical stores, but rather its massive online network, including online ordering and at-home delivery. This is a business expected to grow in the next decade, and while Kroger has been the top-performing large grocery chain of the last two years, it's always good to seek new avenues of growth.

With that said, Kroger is clicking on all cylinders without Safeway, and its Thursday post-earnings loss following the Cerberus news will likely present a golden opportunity. For example, Kroger did see a 4% revenue decline in the fourth quarter, but on an identical supermarket sales basis, revenue increased 4.3%, thus showing strength at existing stores. This level of growth has been the story of Kroger for the last several years.

Kroger has plenty of options
Realistically, Kroger would've had a hard time acquiring large pieces of Safeway. In the last three years, antitrust regulators have become very strict about allowing large acquisitions by market leaders in core segments. The most notable example comes from AT&T's attempted, and blocked, acquisition of T-Mobile, which then resulted in a $7 billion breakup fee to T-Mobile.

Perhaps Cerberus and Safeway agreeing to a $40-per-share acquisition is good news for Kroger. Because although Safeway's online segment would have been a great edge for Kroger, the company still has many other acquisition possibilities in play, many of which could be equally lucrative for the company. Sprouts Farmers Market and Rite Aid, in particular, show two very different possible paths, neither of which would likely cause Kroger any trouble with regulators.

In regards to Sprouts, it is a specialty retailer of natural and organic foods focused on health and wellness. This is a space not dominated by Kroger, but one that is growing fast, which is evident by Sprout's near 20% growth rate. With that said, Sprouts operates significantly smaller stores than Kroger, but as seen with Wal-Mart, many large retailers are attempting a mini-store approach. Acquiring Sprouts would give Kroger a large, growing presence in the all-natural organic space and a mini-store presence.

While acquiring Sprouts is a possibility, Rite Aid might be a top fit for a company like Kroger. Rite Aid is the third-largest pharmacy in the U.S. -- Kroger is fifth -- and a merger between the two would still result in fewer total stores than Walgreen or CVS, meaning Kroger would likely face little regulatory resistance.

However, the most logical reason for such an acquisition is that aside from organic food, drug sales are what's responsible for a boost in margin for Kroger. Specifically, Kroger's gross margin increased 11 basis points in its last quarter, an impressive feat for a company with operating margins of only 2.86%.

Rite Aid has staged one of the biggest turnarounds of the last two years in the market, as its operating margins have rose from negative 1.5% in 2012 to positive 3.7% in the last 12 months. Also, thanks to the patent cliff, margins for pharmacies are expected to soar higher in the next five years. A Rite Aid acquisition could drive Kroger's total margins higher, add $25 billion in total sales, and like Sprouts, give Kroger a mini-store concept.

Final thoughts
Kroger is a great company and is trading at less than 13 times next year's earnings. Kroger could likely produce long-term gains without acquiring any additional assets. However, interest rates are still low. Kroger has retained earnings of more than $10.5 billion and has total assets in excess of $25 billion. It has the leverage on its balance sheet to raise debt and use accumulated earnings to make a big acquisition.

While Safeway might be lost, investors should be happy with what's left on the table, including companies like Sprouts and Rite Aid, both of which would add new elements to Kroger's core business.

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