Kroger - Highly Strategic Vitacost Deal Confirms Capable Management

Jul. 2.14 | About: Kroger Co. (KR)


Kroger acquires in a highly strategic deal.

The deal will add to Kroger's omni-channel expertise as the grocery industry prepares to go online.

Shares continue to offer long term appeal thanks to a modest valuation and excellent management.

Investors in Kroger (NYSE:KR) hardly reacted to a small but very strategic deal to acquire Vitacost. The deal appears to be done to gain experience in building its omni-channel operations.

I like the strategic rationale of this deal, the long term growth and excellent management. While long term appeal remains very good, most of the immediate appeal has diminished in the medium term after strong momentum so far this year.

Highlights Of The Deal

Kroger announced that it has reached a definitive agreement to acquire (NASDAQ:VITC) for $8.00 per share, valuing the business at $280 million. is an online retailer of healthy living products which it sells through its website, while products are delivered through its own fulfillment centre.

The deal has already been approved by the board of directors of both companies. Investors who hold a combined 26.2% stake in Vitacost have already agreed to tender their holdings, with the tender offer being subject to a majority of the shares. If all goes well, the deal should already close in the third quarter of this year.

Strategic Rationale

With the deal Kroger will own a large and pure e-commerce company in the market for nutrition and healthy living. The platform which includes the related technology and fulfillment centers already serves the entire US and international countries. Vitacost offers about 45,000 products like vitamins, mineral, herbs, supplements, among others to is 2.3 million active customers.

Vitacost ships to all 50 states which includes 16 states currently not being covered by Kroger, boosting the company's reach both domestically as well as internationally.

CEO Rodney McMullen stresses that the deal is in alignment with Kroger's current strategy. Just like Harris Teeter's online order and store pick-up service, this deal makes it easier for consumers to shop for groceries on the internet. The focus of Vitacost on healthy products complements the fast-growing market for natural food. Kroger also stresses that the deal could boost sales of its own Simple Truth organic product line.

Perhaps more importantly Kroger will gain much more digital capabilities and employ an experienced team, which can be important for the company's omni-channel in the core grocery business. Kroger's customers already plan their shopping online and have downloaded over a billion coupons since 2009. With the acquisition of Harris Teeter earlier this year, Kroger is already learning from online ordering and store-pick up services.

All of these initiatives appear to be learning and preparation steps of full-online servicing at some day in the future.

Financial Implications

The purchase price of $8.00 per share implies that Kroger is willing to pay a 51% premium over the closing price of on the 19th of February. This was the day before a major shareholder of the firm asked the company to consider and evaluate strategic alternatives.

The deal will be paid in cash after issuing new debt and will not have great implications for Kroger's targeted 2.00-2.20 net debt to EBITDA ratio. Nor will the deal have implications for its current credit rating and the guidance of earnings between $3.19 to $3.27 per share this year.

Vitacost posted revenues of $382.7 million for the year of 2013 which was up by 15.7% compared to the year before. The reported $280 million deal tag, will come down to effectively $251 million given the net cash holdings of $29 million. This values the company at 0.65 times annual sales.

Despite solid revenue growth in recent years, Vitacost posted losses in recent years, totaling $13.7 million last year.

Long Term Strategic Implications, Limited Financial Consequences

The reasons for the deal is largely based upon learning and adding capabilities for Kroger's long term omni-channel strategy, a reason why the company was interested in Harris Teeter as well.

Just two weeks ago, Kroger released its first quarter results with both revenue growth and earnings growth coming in above consensus estimates. Given the $108-$109 billion in projected revenues, the deal will hardly put a dent in the operations, adding roughly 0.3-0.4% in annual sales. Given the losses the deal will have a very small dilutive effect, but this is negligible as well.

Around $49 per share, Kroger's equity is valued around $25 billion which values the company at just 0.25 times sales and 16-17 times GAAP earnings. What is important to notice is the roughly $11 billion net debt position of the firm which will increase slightly on the back of the deal.

Final Takeaway

The deal is very nice and investors should focus on the strategic implications over the financial consequences of the deal which are slightly dilutive, but largely negligible.

Investors hardly react to the deal, but I applaud management for making a smart acquisition. With this deal and the Harris-Teeter deal Kroger is learning quickly and is bolstering its omni-channel capabilities, potentially creating a leading online position among the traditional grocery retailers.

This is needed in a quickly changing industry, with some anticipating (NASDAQ:AMZN) to invade the traditional grocery market with its Fresh offering already delivering traditional groceries in a few selected markets. Kroger's largest traditional competitor Wal-Mart (NYSE:WMT) is making plans for its omni-channel ambitions as well, appointing a new manager for its online activities.

Two weeks ago when the company posted its first quarter results I checked Kroger's prospects. I concluded that the operational performance was very strong, accompanied by strong comparable sales growth, the smart acquisition of Harris Teeter and high payouts to investors. The commitment to 8-11% long term earnings growth furthermore provides great visibility.

Yet after shares have already risen 25% year to date, the most immediate appeal has diminished in my opinion. Yet shares continue to be a great long term investment in my eyes, especially when purchased on corrections. This latest smart deal with a strong strategic rationale once more underlines the quality of the company's management.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.