Could Kroger Stock Be a Potential Tripler?

kroger stock - Could Kroger Stock Be a Potential Tripler?

Last week’s merger announcement between Cerberus-controlled Albertsons and Safeway (SWY) creates the third-largest grocery retailer by revenues behind only Walmart (WMT) and Kroger (KR). The deal, which values Safeway shares at $40, suggests Cerberus could find as much as $750 million annually combining the two companies.

Kroger-stock-KRThat’s good news for its private equity investors. But Kroger stock holders are the ones who really benefit.

This deal instantly makes Kroger stock a whole lot more valuable. Here’s why:

#1: Grocery Prices

Analysts believe the deal reduces Kroger’s price advantage because Cerberus is going to focus on lowering prices at Safeway by passing cost savings on to consumers.

While some see a more competitive grocery landscape as bad news for Kroger stock, I see it as a positive. With the exception of Walmart, KR is the biggest player in the grocery store business. If you include only pure-play grocers, Kroger’s definitely the biggest.

Kroger earnings are due out Thursday. The company is expected to report $98.4 billion in annual revenues with net profits of $1.4 billion. Meanwhile, a merged Safeway/Albertsons will generate between $55 billion and $60 billion in annual revenue, which still is almost 40% less. KR brings greater pricing power to the table due to its sheer size. While a merged entity will be able to pass on cost savings to consumers in the form of lower prices, Kroger’s ability to secure better prices from its suppliers allows it to generate better profits while maintaining competitive prices.

Safeway/Albertsons might gain some market share through lower prices, but it will come at the expense of profits. Kroger has no such concern. In the long run, chasing market share through lower prices only helps Kroger stock.

#2: Intrinsic Value

Let’s sit down for a little math.

Cerberus is paying 5.8 times EBITDA for Safeway. Less than a year earlier, KR paid 7.2 times EBITDA for Harris Teeter, a much smaller regional grocery chain. Although Kroger paid more for Harris Teeter it gave the Cincinnati-based company exposure to higher-end customers in parts of the country where it didn’t have many stores. Doing business at both the high and low ends of the customer spectrum allows Kroger to maintain market share while remaining more profitable than its peers.

Importantly, Cerberus is paying 5.8 times EBITDA for a chain whose 2013 pretax profit margin was just 0.93%. If the cost savings gained are passed on to consumers in the form of lower prices, it’s unlikely that margins will change much. KR, on the other hand, had pre-tax margins that were higher than Safeway’s prior to the Harris Teeter acquisition; they are now more than double Safeway’s.

Kroger stock currently has an enterprise value that’s 7.5 times EBITDA. Its trailing 12-month EBITDA is $4.43 billion. If Kroger’s earnings grow by 8% annually over the next five years, its EBITDA will be $6.5 billion by the end of 2018. Assuming Kroger continues to trade at its current multiple of 7.5 times EBITDA, we’re talking about an enterprise value of $49 billion, or $96 per share, more than double the current price of Kroger stock, and that’s without any expansion of its multiple.

If KR makes other higher-end acquisitions or simply grows Harris Tweeter, its margins will grow from where they sit today — and if those margins are closer to Whole Foods and much higher than Safeway, it’s possible that the EV/EBITDA multiple expands to 10 or more.

If so, the value of Kroger stock five years out is more like $128 — an almost 200% gain over today’s share price.

#3: Market Share

According to the Wall Street Journal, a combined Safeway/Albertsons would have a 5.4% share of the US grocery market. That’s impressive until you consider that KR sits second at 9.6% while Walmart lords over them all with 29.8% market share. Even a Kroger/Safeway/Albertsons merger would give the combined entity 15% market share, or just half what Walmart currently enjoys.

Unfortunately, a combined entity means lower profit margins — something I’m sure owners of Kroger stock would be opposed to. However, if KR was able to finagle the same kind of annual savings as the current merger purports to be able to do, then passes those savings to the bottom line, I think a merged trio becomes a much more likely scenario over the next five years.

With a strong Kroger stock to use as currency, the company could become even more persuasive when it comes to supplier price negotiations, which is good for KR (although bad for food and beverage manufacturers and producers).

Bottom Line: Buy Kroger Stock

The Safeway/Albertsons deal demonstrates that industry consolidation is still alive and well. As Walmart’s growth slows, it will become easier for companies like Kroger to make even more money while margins drift higher.

Kroger stock underperformed over the last five years when compared to the S&P 500, but it finished up 54% in 2013 and is ahead 11% year-to-date, so it looks to be carrying on where it left off.

While the 200% gains by the EV/EBITDA math seem unlikely, I’d look for more strong appreciation out of KR in the months and years to come.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

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