Shares of Kroger (KR) trade at fresh all time highs in Tuesday's trading session following the announcement of the acquisition of Harris Teeter Supermarkets. While the deal is a bit expensive, shareholders are enthusiastic as Kroger will generate annual revenues surpassing the $100 billion mark following completion of the deal.
The well-led company continues to offer appeal, despite the solid returns already so far this year. Investors continue to applaud Kroger's well balanced strategy between operational growth, share repurchases and a fair dividend yield.
Investors should not expect spectacular returns in the short-to-medium term. The increase in debt, limits the flexibility for more deals or shareholder gifts in the medium term.
Under terms of the deal, Kroger will pay $49.38 per share in cash for each share in Harris Teeter, a 33.7% premium compared to the share price on January 18, when media reports indicated that the supermarket chain was evaluating its strategic alternatives. The deal values Harris Teeter around $2.5 billion.
With the acquisition, Kroger buys a strong brand with 212 stores in the Southeastern and mid-Atlantic markets. According to the press release the stores are located in high-growth markets like North Carolina, Virginia, Maryland, and Florida, among others.
CEO and Chairman David B. Dillon commented on the rationale behind the deal, "We are excited to welcome Harris Teeter to the Kroger family. Harris Teeter is an exceptional company with a great brand, friendly and talented associates, and attractive store formats in vibrant markets run by a first-class management team."
Harris Teeter generated annual revenues of $4.54 billion for 2012, up 5.8% on the year before. Despite the increase in revenues, net earnings fell by 10% to $82.5 million as competition is intensifying.
The $2.5 billion price tag values Harris Teeter around 0.55 times last year's revenues and roughly 30 times annual earnings. The deal will be financed with debt. Shareholders should continue to expect to receive their quarterly dividend, while Kroger will continue to repurchase its own shares.
Solid operating cash flows should reduce the increased debt level of Kroger to 2.0-2.2 times net debt to EBITDA in the coming 18 to 24 months.
The deal has already been approved by the board of directors of both companies. The deal should increase earnings per diluted share by six to nine cents in the first year following completion, excluding one-time costs. Accretion should occur on the back of annual cost savings of $40-$50 million per annum in three to four year's time.
Kroger ended its first quarter with $247 million in cash and equivalents. The company operates with $7.95 billion in short- and long-term debt, for a net debt position of around $7.7 billion. Following completion of the deal, the net debt position will increase towards the $10 billion mark.
For the year of 2012, Kroger generated revenues of $96.8 billion, up 7.1% on the year before. Net income rose sharply to $1.50 billion.
Trading around $37 per share, the market values Kroger at $19.1 billion. This values the equity of the firm at 0.2 times annual revenues and 12-13 times annual earnings.
Kroger pays a quarterly dividend of $0.15 per share, for an annual dividend yield of 1.6%.
Some Historical Perspective
After being a dormant stock for years, Kroger's shareholders have seen spectacular returns so far in 2013. The stock slowly drifted down from $30 per share in 2008 towards $20-$25 in 2012. So far in 2013, shares have already risen by some 40%, currently exchanging hands at $37 per share.
Underlying the strong returns is a solid execution, margin growth and a disciplined strategy of returning capital to shareholders. Between 2009 and 2012, revenues have grown by a quarter to almost $97 billion. Net income rose from essentially nothing in 2009 towards $1.5 billion over the past year.
Shareholders in Kroger react very favorably to the deal with Harris Teeter. The market capitalization of Kroger rose by roughly $500 million after the $2.5 billion deal was announced.
The deal values Harris Teeter at roughly 0.55 times annual revenues and 30 times annual earnings. This compares to valuation multiples of 0.2 times revenues and 12-13 times earnings for Kroger itself. Even when factoring in annual synergies of 1% of total revenues, the deal values Harris Teeter at 20 times earnings.
Yet investors applaud the deal as Kroger seems a giant coming out of its winter sleep. Annual revenues will surpass the $100 billion mark following the deal, forming a sizable competitor to Wal-Mart (WMT), which is struggling a bit lately, possibly on the back of all the bad publicity regarding employees pay.
The consolidation in the supermarket industry seems to accelerate following this deal with Wal-Mart, Kroger, Costco Wholesale (COST) and Whole Foods Market (WFM) leading the pack. Struggling competitors like Supervalue (SVU) and Safeway (SWY) have already embarked on deals as they failed to effectively compete with these national giants.
Before the turn of the millennium, Kroger made its last large acquisition when it bought Fred Meyer. The new deal gives Kroger access to affluent markets and expands its footprint into another three states. Kroger will receive a fair $75 million break-up fee if Harris Teeter could attract another bidder, but is forced to pay a $200 million fee if it walks away from the deal itself.
Just a few weeks ago when Kroger reported its first-quarter results, I thought shares offered appeal trading around $33 per share. The sell-off following the earnings report made shares appealing at 12 times earnings as the company has found a nice balance between operational growth and shareholder gifts.
Shares have risen some 12% ever since, trading around $37 per share on the back of the acquisition, setting fresh all-time highs. I still like the prospects of Kroger at these levels although I would expect that shares would need some time to consolidate before attacking the $40 level.