Odds Against Big Kroger Acquisitions: Analysts

If it ain’t broke, don’t fix it.

That’s the assessment of industry analysts concerning Kroger Co.’s strategy of growing organically rather than through major acquisitions in new markets.

“Kroger’s strategy is to increase returns on current assets, and that’s working,” Andrew Wolf, managing director for BB&T Capital Markets, Richmond, Va., told SN.

“Kroger is growing volume by getting more sales per square foot, which is a time-tested, winning strategy in retail, and that’s enabling the company to outperform all the other major multi-regionals, including Safeway, Supervalu, Ahold and Delhaize.

“Kroger is also focused on driving sales productivity in the markets in which it already operates, and that’s generating strong returns on investment. It’s also allocating capital very well, so that even in these difficult times, it’s generating increased earnings and cash flow.”

One of Kroger’s main concerns in any acquisition would be the cost of the price investment it would have to make in the acquired company, Wolf noted, citing as an example Ukrop’s, the Richmond-based chain that was for sale in 2009. Kroger was regarded as a potential buyer before the chain was sold to Ahold.

“Ukrop’s was a great asset, but it’s shelf prices and gross margins were the highest in the market,” Wolf said. “For Kroger to acquire it and install its own pricing program wouldn’t have made financial sense because of the investment it would have had to make.”

Ahold invested millions to lower the shelf prices at those stores by 7% or 8%, he explained.

“Most companies Kroger could possibly acquire are probably not 7% above the market, but they would probably be priced above Kroger. When Kroger looks at a potential acquisition, it has to take into account the cost of bringing prices down to fit its model in order to drive sales and market share, and that usually negates the value of any acquisition,” Wolf explained.

HIGHLY SELECTIVE

David B. Dillon, chairman and chief executive officer of Kroger, reemphasized the chain’s position on acquisitions during its fourth-quarter conference call earlier this month.

Asked whether Kroger was considering getting more aggressive on acquisitions, Dillon replied, “If I had the script from the last time we answered that question, I would just replay the tape for you because it’s the same answer — we’re always interested, always looking, highly selective.

“And we don’t need them to make our numbers.”

J. Michael Schlotman, senior vice president and chief financial officer, added, “We’re not opposed to [acquisitions], but we’re not going to change the metrics we look at and stretch to do something because of the current environment. If it meets our metrics, we would certainly look at. If it doesn’t, we won’t.”

One industry analyst, who asked not to be quoted by name, said Kroger would probably be willing to make a sizeable acquisition if the right opportunity and circumstances presented themselves.

“The company has said it is always looking but hasn’t seen anything attractive,” the analyst pointed out. “Kroger is very picky — it’s made it clear it doesn’t want to take on anyone else’s problems or have to turn around anyone else’s assets in a new market.

“But if it were looking in a new market, it would want a company with a good market share. So if Jewel were available at the right price, Kroger would probably be interested.

“Jewel is a great business but not right now, and that would affect the potential selling price. But that won’t stop Kroger from being seriously interested.”

Wolf also said that, “at a different valuation, it might make sense for Kroger to go after Jewel. For right now, even if Jewel were available, its current pricing levels do not make sense for Kroger’s pricing strategy.”

According to the unnamed analyst, “If you were a betting person, you probably wouldn’t want to bet on Kroger making a major acquisition. Too many things have to fall into line for the company to decide acquisition is the way to grow. But with the right combination of events, it’s possible that it could happen.”

What Kroger is interested in are in-market acquisitions, such as its 2007 purchases from Supervalu of 18 units of Scott’s Food & Pharmacy, Fort Wayne, Ind., and 20 Farmer Jack units from A&P in Detroit.

Chuck Cerankosky, an analyst with Northcoast Research, Cleveland, said Kroger has restricted itself to such in-market deals in recent years — “buying select pieces of busted chains in markets in which it already operates.

“It’s hard to say that constitutes a growth strategy because it’s really more opportunistic and allows Kroger to buy as little as a single store,” Cerankosky said. “In terms of acquiring a larger entity that would add meaningfully to sales, that’s a low probability for Kroger. Maybe that would change if the economy gets a little better, which might help Kroger see how potential synergies might benefit the entire corporation.”

What could change Kroger’s strategy, Wolf suggested, might be lower selling prices, which would enable Kroger to balance the price it pays with the cost of making the necessary adjustments in shelf pricing.

“If the price were right, Kroger would more likely be interested in acquiring a business that was 3% or 4% higher on shelf prices, where it could bring the selling price down and justify the cost of price investments more easily,” he explained.

According to Neil Currie, an industry specialist, Kroger believes there are a lot of in-market opportunities for smaller, add-on acquisitions.

Further, as a multi-format operator, Kroger has the option to make acquisitions outside of mainstream supermarkets, Currie added. “For example, it could look at small-store formats. And I thought it might have taken a look at BJ’s Wholesale Clubs before those stores went private.”

NEW GEOGRAPHIES

If given its choice, Kroger would probably like to expand into the Northeast, Currie added, “where Wal-Mart has less of a stranglehold in food retail and where Kroger could become the price leader with good-quality stores.”

According to Wolf, if Kroger were to seek to expand geographically through acquisition, it would probably be interested in the Northeast or Florida.

“The Northeast is attractive because of the huge populations in places like New York, Boston and Philadelphia,” he said. “What’s problematic for Florida is it’s a non-union state and Kroger, though it has some non-union operations, generally operates as a unionized chain.”

Cerankosky also cited the Northeast and Florida as the markets Kroger would most like to move into.

“It already has a large market share in most parts of the U.S., so it would run into antitrust issues in many regions. But in areas where it’s not represented, the Northeast and Florida would be particularly desirable.”

According to the unnamed analyst, Kroger would probably be most likely to make a major acquisition in a market where access to new sites is difficult.

“Kroger would have an interest anyplace where real estate is a challenge and where it makes sense for it to operate. That might mean it would consider doing an acquisition in the Washington, D.C., area — because it already operates in Richmond, Va. — before it would go into New England.

“It took a good hard look at both Acme and Shaw’s a few years ago, but neither was in good enough shape to meet Kroger’s criteria,” the analyst added.

Wolf told SN he doesn’t see Kroger changing its strategic approach to growth by acquisition “unless industry valuations come down over time. At certain valuations, it would make sense for Kroger to buy another chain, even if its prices were not close to Kroger’s levels.”