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After years of stagnation, Kroger (NYSE:KR) broke upward to retouch its 2022 highs following its strong Q1 earnings report. Since then, the stock has not moved much, with some declines following its difficulties with gaining FTC approval to merge with Albertsons (ACI). To appease the FTC, the company is looking to sell 579 stores to C&S Wholesalers for $2.9B in cash, expanding the terms of its previous deal. It is unclear if this will be sufficient as the FTC has been unable to gain documents regarding the specifics of its plan.
News regarding the potential merger will likely whipsaw KR and ACI over the coming months. On the one hand, as I detailed regarding the Merger Arbitrage ETF (MNA), the Biden administration’s FTC has become far more aggressive in blocking deals amid a bipartisan increase in antitrust sentiment (among voters).
In January 2023, I wrote “Kroger: Creating The ‘Too Big To Fail’ Grocery Behemoth.” My outlook on KR was neutral at that time. I argued that the merger was likely beneficial for KR, as it could allow earnings growth amid an increasingly competitive environment. However, rising food cost prices place Kroger and Albertson’s at competitive risk to better value stores like Costco (COST). Much has changed over the past year and a half, and KR recently broke to the upside but is facing resistance. Thus, I believe it is an excellent time to cover it again and provide an updated outlook.
Market Analysis of the Merger Deal
To a great degree, I see Kroger-Albertson’s in the same light as Kraft Heinz (KHC), where combining conglomerates does not necessarily fix the critical issue. To me, the key issue is that Kroger is neither the cheapest (Walmart and Costco) nor has the highest quality perception (Trader Joe’s, Whole Foods, Sprouts).
We live in an economy where the middle class is shrinking. Many people are either interested in getting the best prices amid rising prices and falling household savings, or are increasingly health-conscious and are looking for stores with better organic and produce options. Most Kroger and Albertson’s brands are stuck in the middle, offering both but excelling in neither. The CEO of Kroger noted the bifurcation in its consumer base last year, and I believe this trend is accelerating toward lower costs and more consumer discretion.
Fundamentally, technology, particularly in supply chain management, has encouraged immense consolidation of the grocery industry over recent decades. Kroger and Albtersons own most grocery chains, with its competitors (Costco, Trader Joe’s, Whole Foods, etc.) more often operating under just one or two brands. Thus, by lumping so many grocery chains into one company, the supply chain can theoretically be made more efficient, resulting in lower costs and better prices for the customer. At least, that is what Kroger and Albertson’s have argued to the FTC.
On one hand, Kroger and Albertson’s together would not be larger than Walmart. However, regionally, the merger would give the company immense market concentration in over 100 cities, with some people needing to drive over 50 miles to reach a non-Kroger market. Therefore, the company is looking to sell stores more often in rural areas where this may be an issue. In my view, at some point, the FTC will allow the merger.
However, by then, Kroger may have had to sell so many stores that the merger may not be accretive, as it might lose the competitive edge it might bring. Of course, as the company has argued, the main benefit is supposed to be supply chain improvements. Even then, the firm has stated that the combined company will not result in the closing of distribution centers or manufacturing facilities.
Thus, to me, the FTC is tying the company’s hands enough that the merger may not provide material benefits to investors. The effective transaction price for ACI is $27.25. ACI is trading at $20.55, implying the market’s odds of the merger deal are somewhat low, as the upside for a successful deal is relatively high. Failure would result in a $600M charge for Kroger, which is just 1.5% of its $38.75B market capitalization, though it is still notable.
What is Kroger Worth Today?
KR shares were in a range since 2022 of between $40 and $50 per share. The stock recently jumped up to over $57 following its strong Q1 performance but has backed off from that level and failed to break above its 2022 peak of ~$60. Since 2022, its income outlook has steadily improved from an EPS expectation of <$3 per share to around $4.5, with its EPS likely to remain at that level for a prolonged period. This has coincided with an improvement in its profitability outlook. See below:
Put simply, stocks rise and fall depending not on their performance, but their performance compared to expectations. Kroger’s expectations are somewhat high today, with analysts expecting its margins to rise to the upper range of its recent levels by 2026.
We must remember that Kroger’s margins are thin, typical of grocers. Its EBITDA margin has been over 5% for two quarters amid a rise in gross margins and continued pressure to keep its operating costs down. See below:
In my view, the improvement to its margin has little to do with the company’s decisions and more to do with changes in commodity costs. The cost of food is heavily determined by the price of agricultural commodities and gasoline used for transportation and processing.
Kroger cannot pass higher commodity prices onto its customers, as higher prices appear to encourage more to opt for cheaper alternatives like Walmart and Costco. For many people (particularly rural), Kroger-owned grocery brands may be closer but costlier. So, as prices rise, it becomes more reasonable to make the drive to the nearest wholesale grocer. Indeed, this pattern is seen in the inverse correlation between commodity prices and gross margins:
After commodities crashed in 2015, there was an improvement in its gross margins. That accelerated in 2020 when commodities became extremely cheap, and then reversed in 2021-2022 when commodities became expensive. Since 2022, commodities have stabilized at lower levels, aided by the ongoing release of the US government’s strategic oil reserve to lower gasoline prices. While this effort has continued, I believe oil and agricultural prices are starting to rise, as it is clear that the SPR cannot offset the shortage forever. In my view, it is most likely that the economy is headed back into the supply side inflation we saw in 2022, re-creating the rising cost pressure issues Kroger was facing then.
Now, if we compare Kroger’s price to its two-year ahead EPS outlook, its forward “P/E” ratio was very low at ~10X from 2023 to early this year. However, it rose to 12X, which aligns with its 2020-2021 range, following its Q1 earnings beat. See below:
Investors may still consider a 12X forward “P/E” low. However, I think the risk facing Kroger’s business model, namely its potential long-term margin pressures, is high enough that a low valuation is justified. The company does not have immense financial debt but carries significant lease liabilities. Personally, given its balance sheet, I would not argue that Kroger is overvalued or undervalued today. Still, its risk is skewed to the downside, particularly in light of rising commodity prices.
The Bottom Line
Overall, I am slightly bearish on KR today. Its valuation is not excessively high nor has significant near-term negative catalysts to its EPS. However, I believe the Albertsons deal is essentially a lose-lose scenario. If it fails, the company will take a breakup fee hit. If it succeeds, making so many agreements will cause it to lose the economic scale benefits that should come from mergers. Fundamentally, mergers are beneficial when they allow companies to close redundant operations and improve efficiency. However, Kroger appears only able to get the merger agreed upon by promising to do nothing to improve its market power.
The issue here is that Walmart, Costco, and others do not have the same constraints. They are already more extensive and, as input costs rise, appear to be gaining a significant edge by having larger stores with better economic scale. Fundamentally, the supermarket/wholesale business model is far better than the traditional model. Much of Kroger and Albertsons growth over recent decades depended on gaining market share by outcompeting “Mom and Pop” stores and consolidating. Now that most grocery brands are consolidated and very few “Mom and Pop” grocers remain, they can only benefit by merging and, ideally, cutting redundancies. However, if they cannot merge and cut redundancies, I think their profit margins will inevitably sink as input costs continue to rise as customers opt for Walmart and others.
Importantly, although I am mildly bearish on KR, I think it would be fairly valued at a 10X forward “P/E” based on its 2026 expected EPS, as I believe its EPS expectations are too high. That gives it a fair value target of $45, which is where it traded in 2023. So, it is not so overvalued that I think it is worth betting against. Further, my bearish outlook depends mainly on my view that food and gasoline input costs will rise over the coming months. If the opposite occurs, KR may increase as its margins improve.
