Harris Teeter Supermarkets, Inc (UNKNOWN:UNKNOWN) stockholders recently (and overwhelmingly) approved a $2.4 billion acquisition by Kroger Company (NYSE:KR), which also includes the assumption of all of Harris Teeter's $100 million in debt. There are a few hurdles remaining, but management expects the deal to close sometime in fourth quarter 2013.
I'd like to look at how Harris Teeter and Kroger's business models will benefit from this transaction, and the effect of Wal-Mart (NYSE:WMT) on the grocery market in general. This transaction will make Kroger an excellent investment over the long term.
A strong business model, and what the acquisition means for Kroger
Kroger's second quarter 2013 marked the 39th consecutive quarter of positive same-store comps. Management is hoping to make this the ninth consecutive year of reduced costs. Sales increased at a healthy 4.6%. Earnings per share grew a solid 17.6% to $0.60, from $0.51 in the second quarter of 2012. Successful contract negotiations with several store unions reduce near-term uncertainty. All of these strengthen the company as a potential investment.
Kroger's leadership made a great decision to purchase Harris Teeter.The acquisition of the upscale grocery chain of 212 stores will increase Kroger's exposure to Southeastern US markets. Harris Teeter has done a good job of differentiating itself from traditional grocery stores by occupying a niche at the higher end of the market, near Whole Foods Market and privately-owned Trader Joe's.
Harris Teeter's store placement in areas with high median incomes, such as in Northern Virginia and the North Carolina research triangle, gives Kroger an excellent opportunity to access these households. Kroger management will retain the Harris Teeter brand, which is powerful for loyal Harris Teeter customers (and there are a lot of them, at least here in Virginia).
Harris Teeter's financial position
Harris Teeter saw steadily-declining net income and EPS from 2010-2012, with an uptick more recently due in part to management's divestiture of the unprofitable American & Efird Mills business (see the company 10-K, page 12, here for more detail). After a disappointing beginning to the year, Harris Teeter recovered and delivered an impressive third quarter. EPS grew almost 97% to $0.63 from $0.32 in the third quarter of 2012, with same-store comps growing a modest 1.29%.
Wal-Mart as a threat to Harris Teeter and other regional grocers
Harris Teeter faces a challenging environment in its home theater of North Carolina (where two-thirds of stores are located), with Wal-Mart and privately owned Publix muscling in to seize market share. Earlier this year, Wal-Mart became the No. 1 grocer in Charlotte, a major Harris Teeter market in North Carolina. Wal-Mart has the resources to keep prices low and make a powerful value proposition to consumers. Given the low switching costs among grocery stores, this is a huge threat to Harris Teeter.
Wal-Mart currently has around 290 Neighborhood Market stores in the US; management reportedly intends to expand that to 500 units in the next 18 months. These small-footprint (averaging around 38,000 square feet) stores are intended to directly compete with grocers, pharmacies, and dollar stores. This is a smart capital allocation decision. The traditional big-box format doesn't fit all markets, and smaller stores should be cheaper to build. Grocers, particularly small regional grocers like Harris Teeter, should beware.
After being seemingly stuck in neutral for FY 2011 and 2012 with flat earnings and revenues, Wal-Mart is aggressively seeking market share, and it shows. EPS, for example, climbed 11% to $5.02 in FY 2013 from $4.52 in FY 2012 (EPS was up 5.1% to $1.24 for the second quarter of FY 2014, the most recent quarter for which information is available).
I have a variety of concerns about Wal-Mart as an investment, particularly weak comps (Wal-Mart posed a negative 0.3% comp in its most recent quarter, driven by a 0.5% decrease in traffic). Bad press from the continued battles between union organizers at Walmart and management continues to tarnish the company's image.
Dollar stores pose perhaps the greatest challenge to Wal-Mart as they continue to leach away the demographic that Wal-Mart has traditionally captured: middle-income families on a budget. That said, Wal-Mart remains formidable, and I believe that the firm will make serious inroads in markets traditionally dominated by regional grocers. However, it's not a good investment right now due to the amount of uncertainty these other circumstances generate.
How Kroger can help Harris Teeter fend off Wal-Mart
Here is where Kroger can make a big difference. As the largest grocery chain in the US, it can bring scale advantages and additional capital resources to protect and increase Harris Teeter's market share in the Southeastern US. Given Kroger's track record of business management, which includes 10 consecutive years of positive comps and eight consecutive years of lowering costs, Harris Teeter will have additional resources and management talent to compete and retain (and grow) market share.
In fact, in the press release announcing the merger, Kroger's management noted that they anticipate achieving $40-$50 million in cost savings in the first three years of the merger, primarily due to scale advantages and synergies. Harris Teeter and Kroger will be a potent combination.
If the transaction does not go through for any reason, I worry that Harris Teeter's position will continue to decline relative to Wal-Mart in North Carolina and elsewhere. The firm needs a powerful backer, like Kroger, to preserve and expand market share in the face of such a big competitor.
Kroger is making an excellent investment by purchasing Harris Teeter, an arrangement that will benefit both brands. Wal-Mart's Neighborhood Market concept is potentially powerful, particularly in terms of competing with regional grocers, but there are too many negatives to justify an investment in Wal-Mart at this time. Stick with the safe bet: Kroger.
Michael Douglass owns shares of Whole Foods Market. The Motley Fool recommends Whole Foods Market. The Motley Fool 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.