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.
- 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