Chains More Open to Merger Opportunities

CINCINNATI Two of the industry's largest chains said last week they might be more open to pursuing acquisitions of varying sizes. Speaking with analysts during Kroger's year-end financial conference call, Rodney McMullen, vice chairman, said price has been an issue as Kroger has evaluated possible acquisitions. It hasn't been a lack of looking but a lack of being able to get a price we think works

CINCINNATI — Two of the industry's largest chains said last week they might be more open to pursuing acquisitions of varying sizes.

Speaking with analysts during Kroger's year-end financial conference call, Rodney McMullen, vice chairman, said price has been an issue as Kroger has evaluated possible acquisitions. “It hasn't been a lack of looking but a lack of being able to get a price we think works for us and the seller,” he explained. “We continue to see a lot of things out there, but so far there has been a difference on what price we would pay.”

Speaking with investors the next day at the Bank of America's 2007 Consumer Conference in New York, Mike Schlotman, Kroger's senior vice president and chief financial officer, said Kroger is in the market for acquisitions, possibly even a major acquisition — but only if it can get the price it wants.

In a presentation at the same conference, Robert L. Edwards, executive vice president and CFO for Safeway, reiterated his company's previously reported interest in seeking potential acquisitions. “The industry consolidation that's occurring may provide acquisition opportunities that make sense for Safeway, and there are a number of market adjacencies that may make sense to move into,” he said.

Schlotman said Kroger could be interested in making “another Fred Meyer-type acquisition. We wouldn't be opposed to an acquisition of size, though we aren't prowling for one.”

Rather, Kroger has been focusing on fill-in acquisitions since the Fred Meyer transaction closed in 1999, purchasing between 250 and 300 stores in small increments during that time. Some of those additions came after Kroger missed out on an acquisition because of the price, Schlotman pointed out.

“We try to be very prudent with our shareholders' money on what we are willing to pay for assets in our existing markets, and oftentimes we don't win the first time around,” he said, citing an instance in 2005 — apparently referring to the sale of a group of Winn-Dixie stores in Kentucky that went to Buehler Foods, Jasper, Ind.

Although Kroger lost that bid, “we are in the process [now] of acquiring some of the stores we really wanted because the company that bought them overpaid. That happens a lot, and we are very diligent about our return criteria and what we are willing to pay for an asset.”

Kroger also released financial results last week for the fourth quarter and 53-week year that ended Feb. 3. For the 13-week quarter, net income rose 36.4% to $384.8 million, while sales rose 14.5% to $16.9 billion and identical-store sales, excluding fuel centers, rose 5.3%. Adjusting for the extra week, sales rose 5.7%.

For the 53-week year, net income jumped 16.4% to $1.1 billion, while sales rose 9.2% to $66.1 billion and IDs rose 5.6%, excluding fuel centers. Adjusting for the extra week, the company said sales increased 7% for the full fiscal year.

SUSTAINABLE MOMENTUM

Analysts contacted by SN last week said they believe the momentum Kroger has established is sustainable.

“Kroger's continued out-performance on sales, and now on earnings, supports the thesis that the U.S. is the place to be for investors interested in supermarkets,” Perry Caicco, an analyst with CIBC World Markets, Toronto, said, citing “Kroger's value-driven operating performance; Supervalu's strong upside from the Albertsons integration; Safeway's strong lifestyle remodels and surprise Blackhawk [gift-card] business; and A&P's tremendous purchase of Pathmark.”

The U.S. supermarket industry “has not been this well positioned for over a decade,” Caicco said.

“But Kroger is the lead dog, with a great track record, a mature approach to business and a sustainable strategy based on a foundation of low prices and regular improvement in the customer proposition,” he said, adding that Kroger has the potential to create “an even more compelling business” with its commitment to improve its perishables offerings and to segment its store base.

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., also said he sees Kroger's success as a long-term proposition. “Its sales productivity-driven earnings growth strategy is sustainable in the hyper-competitive U.S. retail food arena,” he said.

“While we remain wary as to the true defensive investment merits of many supermarket chains, Kroger is better positioned to generate decent earnings growth in the face of an economic downturn than at any time in [years],” he said.

According to Meredith Adler, an analyst with Lehman Brothers, New York, Kroger is driving sales growth and has been able to achieve earnings growth because “[it] has already brought its gross margin down. In addition, it has significant purchasing scale, [which] puts the company in a very strong competitive position, since few companies have the scale or expertise to achieve similar results.”

Dillon said Kroger was able to reduce selling gross margins for supermarkets by 21 basis points during the fourth quarter and 34 basis points during the year, reflecting the company's focus on delivering value to consumers.

“When we look at variances from one quarter to another, we typically put brackets around things that are unfavorable, and in the past we have considered declines in gross margins as unfavorable, with brackets around it,” Dillon pointed out. “But I would say we shouldn't put brackets around it, because it's a favorable move. We actually see it as a strength, an advantage and a plus, because to the extent we can reduce the expenses that are otherwise in the gross, it allows us in our selling gross margin to be even more meaningful to our customers.”

Kroger defines selling gross margin as gross margin before incurring expenses directly related to distributing and merchandising products on the store shelves.

Asked by an analyst if there is any “magic number” the chain is aiming for in terms of gross profit dollars, Don McGeorge, president and chief operating officer, said there is not.

“What we are looking for is a balance as we try to evaluate where we are on pricing in each category and where we want to be, and we are certainly more comfortable with where we are [today] than we were a year or so ago [at the time] we shifted to investing as we were able to save money, so we're generally pleased with where we are.”

John Heinbockel, an analyst with Goldman Sachs, New York, said the decline in selling gross margins reflects Kroger's ongoing investment in lower prices, “as it should, [coming] from a position of strength.”

In terms of market-share gains, Dillon said Kroger's share rose 65 basis points overall in 2006 in the 44 major markets where it operates around the country.

In 34 of those markets where supercenters had at least the No. 3 market share, Kroger's position improved by 70 basis points, he said, and in markets where Wal-Mart supercenters had at least a No. 3 share, Kroger's position climbed 75 basis points.

“Those gains were even more impressive after the strong gains we had in 2005, where our overall market share in the 44 major markets rose more than 35 basis points,” Dillon said

Asked to enumerate what's been driving Kroger's progress the last few years, Dillon said, “First, I would rate what we have done on price as essential. In addition, I would rate the shopping experience — with quicker checkouts, friendlier people and the degree to which our associates want to satisfy the particular needs of individual customers — as quite important.

“I also think the use of data through our loyalty cards — and what we offer [as a result] in our ads and our marketing practices — has been important.”

KROGER 4Q RESULTS
Qtr Ended 2/3/07 1/29/06
Sales $16.9 billion $14.7 billion
Change +14.5%
Comp-store +5.3%*
Net Income $384.8 million $282.1 million
Change +36.4%
Income/Share 54 cents 39 cents
53 Weeks 2007 2006
Sales $66.1 billion $60.6 billion
Change +9.2%
Comp-store +5.6%*
Net Income $1.1 billion $958 million
Change +16.4%
Income/Share $1.54 $1.32
*ID sales, excluding fuel centers
The 2007 quarter and year include an extra week.