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Will This Grocer’s Upscale Investment Pay Off?

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Kroger (NYSE: KR), the largest grocery chain in the United States, just got even bigger. The Cincinnati, Ohio-based company recently acquired its smaller rival, Harris Teeter (NYSE: HTSI) for $2.4 billion in cash, adding 212 more stores and bringing its total store count up to 2,631.

Although Kroger has soundly dominated its second and third place grocery rivals, Safeway (NYSE: SWY) and SuperValu (NYSE: SVU), over the past several years, it has come under pressure from superstore Wal-Mart (NYSE: WMT), which has been rolling out standalone grocery stores. Will this big acquisition tip the scales back in Kroger’s favor? Let’s take a look at the facts and figures behind the deal.

A rapidly growing grocer

Harris Teeter stores are primarily spread across the Mid-Atlantic region. It has a strong presence in more affluent communities, such as Fairfax, Virginia and Charlotte, North Carolina. The acquisition will expand Kroger’s reach out of its stronghold in the Midwest to reach areas that the company described as “high-growth markets, vacation destinations and university communities.”

Harris Teeter is a growing business, and has reported rising sales for ten consecutive years. In its most recent quarter, Harris Teeter reported 4.3% year-on-year revenue growth and an 8.6% increase in earnings. The company reported annual revenue of $4.5 billion last year. By comparison, Kroger’s revenue and earnings rose 3.4% and 9.6%, respectively.

Attracted by those solid numbers, Kroger was willing to pay a premium of 33% to acquire Harris Teeter for $49.38 per share, and assume $100 million in debt - bringing the total value of the deal to $2.5 billion - the fourth largest acquisition of a North American food retailer over the past decade.

Reaching for a richer shopper

For grocers like Kroger, preserving margins can be a tough balancing act due to unstable food prices. Let’s take a look at the operating and profit margins of these grocers to see where Kroger and Harris Teeter rank.

<table> <tbody> <tr> <td> </td> <td> <p><span><span><span><strong>Operating Margin (mrq)</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Profit Margin (mrq)</strong></span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Kroger</strong></span></span></span></p> </td> <td> <p><span><span><span>2.91%</span></span></span></p> </td> <td> <p><span><span><span>1.58%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Safeway</strong></span></span></span></p> </td> <td> <p><span><span><span>2.48%</span></span></span></p> </td> <td> <p><span><span><span>1.45%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>SuperValu</strong></span></span></span></p> </td> <td> <p><span><span><span>0.88%</span></span></span></p> </td> <td> <p><span><span><span>-8.57%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Harris Teeter</strong></span></span></span></p> </td> <td> <p><span><span><span>3.67%</span></span></span></p> </td> <td> <p><span><span><span>2.04%</span></span></span></p> </td> </tr> </tbody> </table>

Source: Yahoo Finance, 7/10/2013

Harris Teeter has stronger operating and profit margins than all three of the leading grocers in America. The reason is simple - just like Whole Foods Market, Harris Teeter opens its stores in more affluent neighborhoods where the average customer can spend more. To these customers, Harris Teeter offers specialty cheeses, freshly baked bread at its La Brea Bakery, aged beef, wine and other gourmet items.

Letting Wal-Mart deal with the dollar stores

Kroger’s shift towards more upscale markets is also aimed at distancing itself from Wal-Mart, which has been rolling out Wal-Mart Neighborhood Markets over the past few years. Wal-Mart Neighborhood Markets are much smaller than its namesake stores, focusing only on grocery items in stores between 30,000 to 50,000 square feet. Wal-Mart currently operates over 200 Neighborhood Market stores across the country, and plans to add 95 to 155 locations by January 2014.

Although it appears that Wal-Mart is going after Kroger with this strategy, I believe that its Neighborhood Markets are geared towards fending off dollar stores, such as Dollar General and Dollar Tree, which have been evolving from thrift stores into full discount grocers. Dollar stores have also been expanding into lower-income neighborhoods, where average shoppers pick their stores purely based on price and proximity, due to fuel costs. Last quarter, dollar stores posted strong gains across the board as the new format of “beefed up” dollar stores chipped away at Wal-Mart’s market share.

Therefore, Kroger realizes that the lower end of the market is already crowded enough, and adding more affluent shoppers is an attractive, margin-preserving alternative to fighting with Wal-Mart and the dollar stores for the dominance of lower-income neighborhoods.

A mutually beneficial deal

Harris Teeter has also come under pressure from Wal-Mart’s standalone grocery stores, as well as a fast growing regional competitor, Publix, which currently has 1,073 locations. Joining Kroger will improve the ability of both companies to remain competitive. Kroger shareholders agreed, sending the shares up nearly 3% on July 9 after the deal was announced. A closer look at the top and bottom line growth of Kroger, Harris Teeter, and its industry peers also backs this optimism.

<img alt="" src="http://media.ycharts.com/charts/30684b457004c09703ad02f181a0b902.png" />

<img alt="" src="http://media.ycharts.com/charts/d0f17d158fc188eb1d1897a9cf7e699c.png" />

Although Harris Teeter’s bottom line has slightly decreased over the past five years, it has held relatively steady as its revenue has consistently risen. Safeway has a more serious problem - it is facing tepid revenue growth, which could eventually drag down its bottom line if margins fall apart.

Lastly, Supervalu, which has been slimming down by selling off its Albertson’s, Acme, Shaw’s and Star Market chains, is having some serious trouble growing either earnings or revenue. Supervalu is currently unprofitable, reporting a loss of $0.14 in the most recent quarter, down from a profit of $0.38 per share in the prior year quarter. Revenue plunged 52.7% to $3.89 billion. In other words, the third-largest food retailer in the United States is still in serious trouble.

The Foolish Bottom Line

In closing, let’s compare Kroger’s value and growth fundamentals to Safeway and Supervalu to gauge if it is a worthy investment at current prices.

<table> <tbody> <tr> <td> </td> <td> <p><span><span><span><strong>5-year PEG</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Trailing P/E</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Price to Sales (ttm)</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Price to Book </strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Return on Equity</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Debt to Equity</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Dividend Yield</strong></span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Kroger</strong></span></span></span></p> </td> <td> <p><span><span><span>1.49</span></span></span></p> </td> <td> <p><span><span><span>12.80</span></span></span></p> </td> <td> <p><span><span><span>0.19</span></span></span></p> </td> <td> <p><span><span><span>4.05</span></span></span></p> </td> <td> <p><span><span><span>35.81%</span></span></span></p> </td> <td> <p><span><span><span>172.89</span></span></span></p> </td> <td> <p><span><span><span>1.60%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Safeway</strong></span></span></span></p> </td> <td> <p><span><span><span>1.54</span></span></span></p> </td> <td> <p><span><span><span>9.36</span></span></span></p> </td> <td> <p><span><span><span>0.13</span></span></span></p> </td> <td> <p><span><span><span>1.94</span></span></span></p> </td> <td> <p><span><span><span>20.96%</span></span></span></p> </td> <td> <p><span><span><span>206.04</span></span></span></p> </td> <td> <p><span><span><span>2.10%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Supervalu</strong></span></span></span></p> </td> <td> <p><span><span><span>-2.17</span></span></span></p> </td> <td> <p><span><span><span>N/A</span></span></span></p> </td> <td> <p><span><span><span>0.10</span></span></span></p> </td> <td> <p><span><span><span>N/A</span></span></span></p> </td> <td> <p><span><span><span>N/A</span></span></span></p> </td> <td> <p><span><span><span>N/A (total debt $2.89 billion)</span></span></span></p> </td> <td> <p><span><span><span>No div.</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span>Advantage</span></span></span></p> </td> <td> <p><span><span><span>Kroger</span></span></span></p> </td> <td> <p><span><span><span>Safeway</span></span></span></p> </td> <td> <p><span><span><span>Supervalu</span></span></span></p> </td> <td> <p><span><span><span>Safeway</span></span></span></p> </td> <td> <p><span><span><span>Kroger</span></span></span></p> </td> <td> <p><span><span><span>Kroger</span></span></span></p> </td> <td> <p><span><span><span><span>Safeway</span></span></span></span></p> </td> </tr> </tbody> </table>

Source: Yahoo Finance, 7/10/2013

Although Kroger and Safeway seem fairly matched, investors should remember that Kroger has been much better at growing its top and bottom lines than Safeway. With the addition of Harris Teeter, Kroger should be able to further widen the gap between itself and Safeway, as well as distance itself from Wal-Mart. Therefore, at current prices, Kroger looks like a solid, stable investment with robust financial metrics and solid plans for long-term growth.

Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of Supervalu. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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