Albertsons Companies And Kroger: It's Okay If The Merger Fails (NYSE:ACI) (2024)

In October of last year, news broke that Albertsons Companies (NYSE:ACI) and The Kroger Co. (NYSE:KR) had decided to merge in what was slated as a $24.6 billion transaction. All combined, the retail chain would generate revenue of roughly $210 billion per year, with net profits exceeding $3.3 billion while EBITDA would be in excess of $11.6 billion. A big driver behind this merger was the prospect of $1 billion of annual run rate synergies, even after factoring in certain divestitures that the management teams of both firms felt would be needed in order to get regulators to be okay with the transaction. Recently, however, shares of Albertsons have taken a tumble. In fact, the stock is currently down 42.4% from its 52-week high.

There is no doubt that broader economic concerns are playing some role in this. But the bigger issue is likely the fact that there are worries about whether or not the transaction will even come to fruition. My view on the matter, after evaluating the data carefully, is that investors might be overthinking this. If things work out and the transaction in question materializes, something we won't know about until sometime next year, upside for investors from this point could be significant. In the event that the deal falls apart, however, I do not believe that Albertsons would justify any material amount of downside. If anything, the stock should rise from here even without the merger being taken into consideration. Of course, there could be a middle-of-the-road path where the deal does get completed, but on terms that are less favorable than previously agreed. But outside of that occurring, I see the risk of pain for shareholders being quite limited at this moment.

Worries are mounting

When Albertsons and Kroger announced that they were merging into one company, the management teams at both firms were resigned to the fact that they would have to make some sort of concession in order for regulators to approve the deal in question. In addition to selling off assets to help cover a sizable dividend, the company also said that it was prepared to spin off between 100 and 375 quality stores into a separate publicly traded company. To appease regulators, the grocery chains began a sales process in February of this year to get rid of between 250 and 300 stores. But some recent sources have indicated that this number may need to be revised higher. RBC Capital Markets, for instance, stated that ultimate divestitures may need to be up around or even exceed 650 locations.

According to the original merger agreement, Kroger was planning to pay $34.10 per share to investors in Albertsons. That amount would ultimately be decreased by a special dividend paid out by Albertsons that ultimately ended up being worth $6.85 per share. In total, this dividend cost the company $3.92 billion. But there was some uncertainty as to whether or not it would be paid out at all. Initially planned to be paid out in early November of last year, the dividend was halted by a legal motion by the Attorney General of the State of Washington That followed a previous denial from the courts to enjoin Albertsons from paying the dividend. This temporary restraining order that had been in place has since been lifted. And as a result, Albertsons ended up paying the distribution on January 20th of this year.

The fact that this dividend was paid already, means that the effective price of the buyout for shareholders who buy in now is $27.25. Of course, that number could be revised lower based on the aforementioned spinoff. But at the end of the day, assets that would be spun off would still go to the shareholders in question. So it shouldn't make much of a difference between collecting the rest of this amount in cash or some of it in cash with the remainder in stock. Even so, the market seems incredibly pessimistic. At the moment, shares of Albertsons are trading for only $20.75. That implies upside of 31.3% if the deal gets completed as agreed upon.

Such a large disparity rarely exists in the market. And it does go to underscore just how uncertain investors are that the transaction will be completed. Frankly, however, if I were an investor, I would want the fairly quick upside. On the other hand, I don't believe that the company is likely to drop materially should the merger fall apart entirely. I say this because, fundamentally, the company is still very healthy. Consider financial performance achieved during the most recent quarter. Revenue of $18.15 billion for the third quarter of 2022 it came in 8.5% higher than it was the same time one year earlier. You can see, above, that both net profits and operating cash flow for the company worsened in the latest quarter for which data is available. But if we adjust for changes in working capital, the picture actually improved. Over the same window of time, EBITDA for the company also increased.

The financial performance in the third quarter was not a one-time event. We should also look at the entirety of the 2022 fiscal year through the date that we have data for. In this case, with the exception of operating cash flow, data is greater across the board. Unfortunately, management has not provided any detailed guidance for what the final quarter will look like. But if we assume that the final quarter looks very similar, year over year, to what the first nine months of the year looked alike, we would anticipate net income for all of 2022 as a whole of $1.67 billion, adjusted operating cash flow of $4.63 billion, and EBITDA of roughly $4.80 billion.

Using the estimates for 2022, as well as the results from 2021, you can see exactly how shares of priced. Meanwhile, in the table below, you can see how the business stacks up against four similar companies. In all three cases, Albertsons ended up being the cheapest of the group. Some investors who are critical of the company might point out that a failure of the deal to materialize would leave the company saddled with excess debt since it ended up paying out such a large amount of capital to shareholders in the form of a distribution. But even with that $3.92 billion cash outflow, and assuming that data for 2022 is accurate, Albertsons has a net leverage ratio of only 1.80. That's not great, but it's certainly not bad either.

Takeaway

At this moment in time, investors in Albertsons may very well be scratching their heads. It doesn't make sense to me for shares to be as cheap as they are at this moment. In one scenario, the deal ends up getting completed as agreed upon and the effect of upside for shareholders should be attractive. Even if the deal falls through, shares are cheap on both an absolute basis and relative to similar firms. Sure, the company does have a decent chunk of debt on its books. But it's not so large that it could not pay this off over time. The worst scenario would be a decision by Kroger to try and reduce the ultimate price being paid by them for Albertsons. We could speculate till the cows come home on that one. But more likely than not, any sort of renegotiation would still include some premium over the current share price. What this ultimately means, when taking all of the information together, is that this truly does look like a favorable risk-to-reward prospect. And because of that, I've decided to rate Albertsons a 'buy' to reflect my view that this favorable ratio should allow investors to outperform the broader market for now.

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