Neighborhood grocery kingpin Kroger (NYSE:KR) has done a good job of building the preeminent middle-market grocery chain, sandwiched between Whole Foods and Wal-Mart Stores (NYSE:WMT), the kings of the high-end and low-end segments, respectively. However, the company had a chance to massively increase its scale with a purchase of regional grocer Safeway (NYSE:SWY), which would have upped its overall store base to roughly 4,000 locations and put it more on par with Wal-Mart's domestic store base. Kroger is rumored to have been the mysterious "Company A" that was interested in acquiring Safeway, as detailed in Safeway's annual meeting and merger proxy.
Instead, a private equity consortium led by Cerberus acquired Safeway. The consortium intends to combine the company with its existing grocery banners, thereby creating a major player with approximately 2,400 stores across 34 states. So did Kroger pass on an opportunity to increase shareholder value?
What was the value?
Despite a reduction of its overall store network over the past few years, Safeway is still a major force in the grocery business. It operates more than 1,300 stores around the country, with a major presence on the West Coast of the U.S. The company has dramatically improved its financial profile lately, mostly through the sale of its Canadian operations in 2013 for $5.8 billion Canadian dollars. The cash inflow has allowed Safeway to reduce its debt load and has provided funds for the company to invest in growth initiatives, like its Just For U digital-marketing initiative.
Unfortunately, Safeway's business changes haven't yet had the desired effect, namely making the company a more profitable enterprise. Indeed, Safeway's adjusted operating income actually fell 1.9% in its latest fiscal year, mainly hurt by the higher costs of its various marketing initiatives. That said, the company is still a consistently profitable franchise that generates a sizable amount of operating cash flow, which more than funds its capital expenditures.
Kroger undoubtedly could have improved the operating profitability of Safeway's franchise, partially by leveraging its own larger network of manufacturing plants and distribution centers as well as its own initiatives in the digital marketing arena. Digital marketing is clearly a focus area for Kroger, as highlighted by its recent acquisition of You Technology Brand Services, a major digital marketing services provider. In addition, Kroger could likely have increased the top-line growth at Safeway's store network, given the momentum that it has exhibited in its own store network; it posted a 3.3% comparable-store sales gain in its latest fiscal year, nearly double that of Safeway.
A battle brewing in groceries
More important, an acquisition of Safeway would have given Kroger a much larger footprint, especially in highly populated West Coast markets, as the company continues to engage in a battle for customer market share against Wal-Mart and Whole Foods. Wal-Mart, in particular, is becoming a larger threat for Kroger because of its major push to expand its smaller-format Neighborhood Markets brand, a shot across the bow for Kroger.
While Wal-Mart's results in its latest fiscal year were below average, as evidenced by its first negative comparable-store sales performance since fiscal 2011, it continues to generate a prodigious amount of cash flow as a result of its position as the low-cost seller in most of its markets. Consequently, Wal-Mart has a healthy cash war chest with which to invest in its growth initiatives, like its Made in America sourcing campaign, to further differentiate itself from its competitors.
The bottom line
Kroger has built a winning franchise of neighborhood grocery stores, with more than 2,600 at last count, as it succeeds in a space that has proven difficult to maneuver, as evidenced by shrinking store footprints at competitors like Safeway and SUPERVALU. However, the company likely missed out on a game-changing acquisition with Safeway, which would have given Kroger one of the largest store bases in the grocery business and undoubtedly improved its operating efficiency. Instead, Cerberus and company captured the prize and will have an overall network that rivals Kroger in absolute size, estimated at 2,400 stores. While Kroger's management saw more risks than rewards with Safeway, only time will tell if it was the right move.
John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool’s board of directors. Robert Hanley owns shares of Safeway and Whole Foods Market. The Motley Fool recommends and owns shares of Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.