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This Grocer Is Expanding its Reach

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The grocery business is not an easy one. With Wal-Mart (NYSE: WMT) quickly becoming the largest seller of groceries in the United States, many traditional grocery chains have had trouble competing, let alone growing. But Kroger (NYSE: KR), the largest grocery store chain in the country, isn't just sitting on its hands as Wal-Mart steals the show. The company recently acquired Harris Teeter Supermarkets (NYSE: HTSI), an upscale chain located mainly in the southeast, for $2.5 billion in cash. This gives Kroger exposure to the area as well as about $4.5 billion in additional revenue.

An expensive deal

Harris Teeter is a small chain, with just 212 stores and $4.5 billion in revenue. The company has been growing, with revenue increasing at an annualized rate of 5.8% over the past decade. Net income has hovered around $90 million for the past six years, meaning that Kroger is paying about 28 times earnings for the company. Given the low-margin and slow-growth nature of the grocery business this seems like an extremely expensive acquisition.

But Kroger is likely buying the company not for its profits but to expand its footprint to better compete against the likes of Wal-Mart. Kroger has little presence in some areas of the country, and Harris Teeter fills one of those gaps in coverage.

Since Harris Teeter is more upscale than most supermarkets, this deal gives Kroger a fighter in the battle against Whole Foods (NASDAQ: WFM). Whole Foods carries much higher margins than traditional grocery stores, and the popularity of organic and artisan food is only growing with time. Kroger posted an operating margin of 2.86% in 2012 compared to 6.36% at Whole Foods. Harris Teeter has low margins but that could be due to its small size, and integration should help the company become more cost efficient.

Kroger will use debt to finance the deal, and according to an SEC filing as of May 25 the company has $247 million in cash and $7.53 billion in debt. This deal will push the debt up to about $10 billion. Kroger already pays about $460 million in interest payments annually, and this deal will increase that number significantly.

Is Kroger a buy?

Grocery chains have low margins and slow growth, making investing in them usually unappealing. Kroger has seen its share price surge since the middle of 2012, up 80% from its 52-week low.

<img alt="" src="http://media.ycharts.com/charts/12302522ede85be54115dcf015e813fc.png" />

KR data by YCharts

It seems that this kind of move from a traditional grocer would signal that the stock is likely overvalued. Kroger had owner earnings in 2012 of about $1.58 billion, or $3.03 per share. The Harris Teeter deal will add maybe $100 million to this total, bringing the per share number up to $3.23. The debt will total $10 billion after the deal, which comes out to about $19 per share. Adding this debt to the market price the EV/OE, or enterprise value divided by owner earnings, is 17.6.

That's a high price to pay for a traditional grocer. This isn't Whole Foods we're talking about, which grew revenue by nearly 16% in 2012 and has more than doubled its margins. This isn't Wal-Mart, which uses groceries to bring people into the store and sell them higher-margin products. This a traditional grocery chain.

For comparison, Wat-Mart has an enterprise value of about 20 times owner earnings. Kroger's multiple should be nowhere close to that of Wal-Mart, but it's not far off at its current price. It seems that investors are getting excited about grocery stores, sending Kroger's shares flying, while forgetting that it's a grocery store.

The bottom line

Back when Kroger was trading in the low-20's the stock was inexpensive. But now, after an 80% rise, it just doesn't make sense to buy Kroger, Harris Teeter deal or not. Goldman Sachs recently downgraded the stock for being too expensive, and I tend to agree. Kroger is a fine company, and the Harris Teeter deal, while expensive, is likely a good move, but paying such a high price for a traditional grocer is a bad idea.

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Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Whole Foods Market. The Motley Fool owns shares of Whole Foods Market. 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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