Albertsons: Merger w/Kroger, Divestiture News

Apologies, this post is mostly for my benefit (I try to post on all new positions), there likey aren't any new thoughts below on combination of the country's two largest traditional grocery chains, Albertsons (ACI) and Kroger (KR), but I just wanted to acknowledge that I bought into the merger arb earlier this week.  Partially after hearing Andrew Walker and Daniel Biolsi discuss it in a recent Yet Another Value Podcast episode.

Nearly a year ago, the two announced that Kroger (~2700 stores) was buying Albertsons (~2300 stores) for $34.10/share in cash (the merger consideration has been adjusted down to $27.25 for a $6.85 special cash dividend ACI paid in early 2023), shares closed on Friday for $23.63, offering 15% upside to the adjusted closing price for a deal that is expected to close in early 2024.  Potentially a juicy IRR.

On its face, the merger appeares to have a significant anti-trust hurdles, but when you examine the industry, traditional grocers like KR and ACI are facing competitive pressure from big box stores like Walmart, Target and Costco, plus competition on the high end from specialty grocers like Sprouts and Whole Foods.  They've been share losers to both sides.  Although others don't always see it that way, regulators took a narrow view of the office supply industry and rejected the attempted Staples and Office Depot 2014 tie up, despite many alternative channels (notably Amazon) to buy office supplies.  Both companies have struggled since, hopefully regulators take a more holistic view here and realize that traditional grocery chains need a strong competitor to the big box concepts (Walmart, Target) that use grocery as an enticement to get shoppers into their stores to buy higher margin non-grocery goods.

From a Chicagoan's point of view (they have overlap significantly here), I was a bit surprised by the relative lack of overlap in the two chain's store map nationally.  Kroger has significant concentration in the midwest and southeast where Albertsons is generally absent, and Albertsons is more focused on the west coast and northeast where Kroger has less of a presence (other than Denver, Seattle, Southern CA):

To address the areas where they do have overlap, when the deal was initially struck, the two set the stage for a divestiture SpinCo that would house between 100 to 375 grocery stores.  In addition to the adjustment for the special dividend (since paid), the cash consideration was to be dropped by 3x the four-wall (store level, pre corporate overhead) EBITDA of the stores assigned to the SpinCo.  Traditional merger arbitrage investors don't like uncertainty in the total consideration, the ACI SpinCo (in the initial docs, it appeared that SpinCo would be ACI stores only) would have likely traded poorly or at had some uncertainty as to its public market valuation.  This uncertainty (in my view) has partially led to the wide merger arbitrage spread, along with concerns around regulatory approval.

Today's news that Kroger and Albertsons had reached a deal to sell 413 stores for $1.9B to C&S Wholesale Grocers ("C &S") should help in a couple ways:

• Divesting the overlap stores in an arm's length transaction should help calm fears that a SpinCo would be filled with the worst stores and be destined to fail.  A spin would not have been arms length and could have been the ultimate garbage barge, but now the divested stores will be plugged into an established operator who has done their due diligence and should be ready to compete against the combined KR/ACI following the closing of the deal.  That couldn't be said for a spin structure.
• If required by regulators, KR/ACI has also setup an option for C&S to buy an additional 237 stores if needed.  In the initial merger proxy, the two parties speculated that up to 600 stores would need to be divested in total, this option would firm that up and fully eliminate the need for a spinoff of uncertain value.
• The original spin appeared to only for ACI shareholders, this divestiture package includes both ACI and KR stores, again highlighting that a third party fully evaluated the competitive position in each market, versus a dump into a SpinCo that might have failed.
• Similar to above, but grocery stores are heavily unionized, by selling in an arm's length transaction versus a spin, this structure likely helps dispel fears that a SpinCo would fail or that stores would be closed.  C&W has committed to keeping stores open as-is which should help political perceptions around this combination.

That's pretty much my thesis, the divestiture firms up the merger consideration (shouldn't need the SpinCo any longer) and should appease regulators that a strong third party (versus a helpless SpinCo) has done their due diligence and purchased the divested stores in an arm's length transaction, thus ensuring proper competition.  Assuming this deal closes in mid-February, even after this week's run up, it is offering a 15% absolute return and a ~38% IRR.

If the merger is blocked or otherwise doesn't occur, Albertsons is valued at 8x earnings (roughly inline with peers) and is a semi-controlled company by Cerberus and other PE investors with capital allocation expertise.  The downside doesn't appear too significant.

Disclosure: I own shares of ACI

Can Mariano's Freshen up Roundy's?

The supermarket business is historically a highly competitive industry with razor thin margins.  In the past decade the competition has only increased with big box retailers and dollar stores squeezing the conventional supermarkets' bottom end customer base and the specialty and organic food retailers squeezing the top end customer base.

Roundy's is a Milwaukee based supermarket operator that was taken private in 2002 by Willis Stein, a private equity shop.  It returned to the public markets in February 2012 with a $112 million IPO, Willis Stein still controls 32.5% of shares, 41.3% of the voting rights, and 3 of the 7 board seats.  It operates mostly conventional supermarkets under three banners: Pick 'n Save (93 stores, mostly in Milwaukee), Rainbow (32 stores in Minneapolis/St Paul), and Copps (25 stores, mostly in Madison and Green Bay).  

Roundy's is the market share leader in Milwaukee and Madison, 40% share overall in Wisconsin, and the third ranked grocer in Minneapolis/St Paul.  Roundy's has gained share in the past decade despite the increase in competition from Wal-Mart and other big box retailers, with mostly smaller independent operators losing share, but despite this, sales have remained flat over the past 5 years and same stores sales growth is non-existent.  Roundy's growth strategy is centered around increasing higher margin business through promoting its own-brand Roundy's and Roundy's Select products and increasing the amount of perishable food it sells.  Their lack of top-line revenue growth is slightly masked by the gain in own brand sales as they are lower cost goods, but generally have higher profit margins.

Mariano's Fresh Market

Roundy's main outlet for their strategy is to expand their new Mariano's Fresh Market (9 current locations) concept in the Chicago market by opening 4-5 new stores annually over the next 5 years.  Named after their CEO, Robert Mariano (former executive of Dominick's in Chicago), the Mariano's concept features a smaller footprint store, focused on premium perishable/prepared foods and organic/natural offerings.  Roundy's is targeting the Chicago market due to the perceived missteps of conventional chains, the above average income levels, and the higher density population.  Being from Chicago, I've yet to actually visit one of their locations (moving with two blocks of one next month), I've heard nothing but great reviews, but does it make for an actionable investment idea?
 
Balance Sheet
I'm mostly a balance sheet guy, and Roundy's has a fairly simple, but also fairly weak balance sheet.  It's pretty obvious that the company is a former LBO buyout, Willis Stein streamlined the company by selling off the wholesale operations, piled on debt, and paid itself a healthy dividend in the process.  A quick glance at the balance sheet and you see $697 million in long term debt and capital leases against an equity market cap of $296 million, or a 2.35x debt-to-equity ratio.  However, I believe this understates the true leverage of the company for several reasons:

Operating Leases
Many struggling retailers, Sears or JC Penney, have a built in cushion to their valuation due to their vast real estate holdings, Roundy's doesn't have this floor.  Roundy's leases all but 2 of their stores and 1 of their operations centers, these leases are structured as long term net leases where the company pays for the real estate taxes, insurance, and maintenance of the properties.  By leasing, rather than owning, the company has effectively increased their leverage without accounting for it on the balance sheet.  Taking their $1.96 billion in future lease obligations and discounting it back at their cost of financing (5.75%) adds an additional $1.74 billion of long term assets and long term liabilities, bringing the adjusted debt-to-equity ratio to 8.23x. 

The company produced $199 million of adjusted EBITDA in 2012, add back the rent expense of $113 million (since if they owned their real estate it would be interest expense), giving an adjusted-adjusted EBITDA of $312 million, valuing Roundy's at a lofty 8.76 EV/EBITDA multiple when you capitalize the operating leases (most supermarkets trade in the 5-6x range).

Pension Fund Liability

Roundy's also has significant pension liability as 53% of their workforce is unionized.  As of year end, their pension plans were underfunded by $36 million (accumulated benefit obligation or "ABO" of $199.7 million versus assets of $163.7 million).  Their contributions are likely going to increase as the expected return on the portfolio (used to arrive at ABO) is 8.5%, yet they have a 35% allocation to bonds.  Vanguard's Total Bond Market Index Fund has an SEC yield of 1.67%, assuming Roundy's earns that amount on their bond portfolio (and bond prices don't fall), the equity component of the pension plan would need to return an average of 12.2%, a pretty lofty goal for a diversified plan.

Additionally, Roundy's participates in three multi-employer pension plans that are underfunded.  Multi-employer pension plans are particularly troublesome because as contributing employers become distressed and shed their liabilities, their liability shifts to those employers remaining in the plan, its almost a reverse pyramid.

Goodwill
Not surprisingly, given the lack of real estate or other assets, Roundy's balance sheet assets are made up of mostly goodwill.  In the fourth quarter of last year they took a $120 million write-down associated with the fall in the market value of their equity.  Usually a non-cash charge doesn't bother me much (see my investment in Ultra Petroleum) but there are no real assets here other than the operating business, in a distressed situation there's little for non-senior lenders to recover.

Dividend
A highly leveraged, yet consistent earner could still be a valuable investment if management was disciplined about paying down debt, as any improvement in results would accrue disproportionately to the equity.  When Roundy's returned to the public markets in the first quarter of last year, its intention was to pay a quarterly dividend of $0.23, most likely to attract dividend focused investors for the IPO.  But in order to reduce debt, the company wisely cut the dividend to $0.12 per quarter in the fourth quarter.  Even at the lower dividend amount, Roundy's sports a dividend yield north of 7%, probably quite enticing for a lot of people.  However, if Roundy's held onto that cash and used it to pay off debt even faster, it would probably be more advantageous to shareholders (and would be tax deferred to the investor). 

Conclusion
All the above pretty much kept me from digging too much further, the company doesn't report revenues by banner segment, so I couldn't find much in terms of projected incremental EBITDA per Mariano's store, but that could be the key number for a more growth oriented investor.  I like companies in disliked industries that have a hidden gem asset, if Mariano's was valued at Whole Foods like multiples, what would those 25-30 to Mariano's stores be worth?  Quite a speculative investment given the challenges, and I'll pass for now, but when I move in a couple weeks, I'll be sure to check out their new store.

Disclosure: No position in RNDY