Albertsons Companies, Inc. (NYSE:ACI) and The Kroger Co. (KR) are expected to merge and create the largest grocery store operator, and one of the largest retail chains in the country. Kroger is the acquirer, buying Albertsons in a complex transaction that values Albertsons equity at ~$34.10 per share.
This article analyzes the merger from the perspective of ACI shareholders to determine whether ACI stock presents an opportunity today. This article dives into the transaction details, as well as the risks in the transaction.
Ultimately, we conclude that ACI offers a compelling ~32% upside potential assuming the merger goes through. We believe the merger has a reasonable chance of being approved given the retail industry isn't highly concentrated. When viewed relative to the overall retail market, the merger looks reasonable and, therefore, has stronger legs to stand against antitrust scrutiny.
Albertsons Cos. and Kroger operate nearly 5,000 stores in 48 states combined, but the merged company will look different for two important reasons:
After all that is done, Kroger gets to buy Albertsons for $34.10 minus the value of the special dividend and the value of the spun-off entity. Let's dive into some of those components, and what that means for ACI stock price.
The special dividend is a critical component of the merger agreement because reduces the total purchase price that Kroger will pay. After the dividend was declared, shares of ACI adjusted lower to reflect the payout, as shown in the chart below.
However, the special dividend is not guaranteed to be paid out because it is being challenged by multiple states attorney generals. The argument against paying the dividend is that Albertsons will distribute cash that should otherwise be reinvested in the business.
As of this writing, the special dividend cannot be paid out due to a restraining order issued by King County superior court. The Washington State attorney general called the decision a "huge victory!" A hearing is scheduled on Nov. 16 and 17, 2022 to determine the fate of the special dividend. Albertsons intends to fight for the right to pay a dividend to its shareholders.
As of the most recent 10-Q filing, Albertsons held ~$3.4 billion in cash, and was planning to borrow a portion of the capital to fund the special dividend. As mentioned before, the dividend is just a way for existing shareholders to get capital out of Albertsons.
An interesting angle for traders is that ACI stock has already adjusted in price, effectively implying that the dividend will be paid out. If the dividend is not allowed to go through, it represents value that is not captured in the ACI stock price today. If you buy ACI stock as of this writing, you are not entitled to receive the dividend. But if the dividend isn't paid out, you will end up owning a share of the capital that will stay in the company.
This means that any incremental news that confirms the dividend won't be paid out should result in the stock moving higher, potentially rising by ~$6.85 to the $27-$28 range if the dividend gets called off. On the other hand, any news that allows ACI to pay the dividend shouldn't result in large stock moves, as the market is already implying the dividend should be allowed to go through.
While the dividend is a big question mark at this point, the more important question mark is whether the merger will go through and how the combined company looks like.
The full combination of Kroger and Albertsons will lead to a strong nationwide presence in all states. Albertsons has a stronger presence on the West Coast and Northeast, which should improve Kroger's positioning in those markets once the merger is complete.
To reduce the size of the combined company, ACI will carve out 100 to 375 stores to form a separate public company. This company will be spun-off from Albertsons. It could provide a great opportunity for investors, but there are not enough details yet to analyze the opportunity. What we know is that the spun-off company will not go to Kroger, hence the discount from the purchase price.
Despite the spinoff, the merger will face strong regulatory scrutiny because of the size and scale of the combined company. The merger should result in at least ~4,600 stores operated by Kroger. The argument against the merger is that the combined entity will have too much market power and negatively impact consumers.
One of the measures used in calculating market concentration is the HHI (Herfindahl-Hirschman Index), which is used by the Department of Justice and considers the relative size distribution of companies in a market. While it isn't certain what inputs regulators will use when calculating HHI, one of the ways to look at it is from a revenue share standpoint.
According to the NRF (National Retail Federation) top 100 list of retailers, Kroger sits at #5 (with ~5.1% share of sales) and Albertsons at #10 (with ~2.7% share). The fully combined company would generate ~8% of sales among top 100 retailers. Walmart (WMT) and Amazon (AMZN) lead the list at 17% and 8% share, respectively. The top 100 retailers in the list generated $2.6 trillion in total sales, which accounts for ~50% of the total retail sales (ex motor vehicles, parts and gas stations) as reported by Census Bureau.
Using only the top 100 share in the HHI calculation, the retail industry HHI is ~545 before the combination of Kroger and Albertsons. HHI goes to 573 following the merger. A highly concentrated market is generally defined as having HHI above 2,500, which is not the case in our calculations.
Furthermore, the change in HHI is also important, and our calculations point to a 28-point increase in HHI. That's small. An increase of more than 100 points in moderately or highly concentrated markets are more likely to be blocked by regulators due to competitive concerns. In the Kroger and Albertsons merger, the HHI points to a market that is fragmented and this merger would not change that. When looking at it this way, the merger should be allowed to go through by regulators.
However, this is a simple analysis and does not imply the political risk is completely gone. The political risk in this merger remains high as the FTC hasn't yet fully reviewed the merger. Several members of Congress have urged the FTC to oppose the deal in an open letter, summarized as follows:
After the stock price adjusted for the special dividend, ACI traded in a tight band between $20.3 and $21.2. As mentioned earlier, the price of ACI today already discounts the $6.85 special dividend but does not fully reflect the value that Kroger ascribes to it. As the merger proposal stands today, the value of ACI equity is as follows.
As it stands today, if the merger closes as proposed, shareholders of ACI are expected to receive $27.75 per share in the form of:
The market is offering an interesting opportunity to be rewarded if the merger is allowed to go through as initially contemplated. This opportunity exists because of the high political risk that this merger carries. As mentioned earlier, several members of congress have raised concerns about the impact of the merger on consumers and employees.
The major risk in the investment in Albertsons is that the merger does not go through, at which point the merger is terminated and Albertsons will continue to be a standalone public company. The merger could be terminated for several reasons, and the role of regulators will play a key role in determining whether the merger goes through. This level of political risk is difficult to predict.
While the methodology for calculating the HHI index is straightforward, the relevant inputs that go into the calculation are not known. Regulators could argue that a different methodology to define market share is needed. Arguably, a narrower view of retail concentration that only considers grocers could negatively impact the HHI and cause the merger to be different than proposed.
Under the scenario that the merger does not go through, Albertsons may find itself in a more challenged position given the large dividend payout to its shareholders but would still have an okay balance sheet to operate in the grocery industry. Albertsons was doing well before the merger agreement took place, so the downside seems reasonably protected assuming Albertsons can continue to do well on its own.
While playing the "merger arbitrage" game can be dangerous, it seems like Albertsons offers interesting risk-reward characteristics at this point. In a best-case scenario, Albertsons will be acquired by Kroger, realizing ~$27.75 per share in value for ACI shareholders. Under a worst-case scenario, Albertsons will not be acquired and will continue to operate as a standalone company.
However, the worst-case scenario has an interesting upside opportunity due to the special dividend being challenged. If the special dividend is not allowed to go through, there is upside in the stock as ACI has already discounted the dividend. The decision on the stock dividend should come first, and the merger review is expected to take place over the next 12-18 months.
News that the merger is likely to be approved should send ACI shares higher, ultimately capping the gains at the offer price. As of this writing, there's ~32% upside potential if the merger goes through as planned.
This article was written by
Disclosure: I/we have a beneficial long position in the shares of ACI either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.