Kroger Buying Whole Foods Would Be 'Uncharacteristic' Says Citi

There have been unconfirmed media reports regarding Kroger Co KR offering to acquire Whole Foods Market, Inc. WFM for $40 per share. “While WFM could complement the KR portfolio, we believe there are challenges that reduce the likelihood and could be uncharacteristic for KR,” Citi’s Alvin C Concepcion said in a report.

Analyst Concepcion maintained a Buy rating on Kroger, with a price target of $39.

Not A Zero-Sum Game

Whole Foods Market is making “billions” in price investment. The company indicated that the investment would be rational, and flexible enough to be reduced in case the need arose. Concepcion mentioned, however, that there are concern over an industry price war.

“We didn’t hear anything new from the WMT analyst day that would change our bullish view on the stock. The read-throughs to KR are not a clear negative to us, because it’s not always a zero-sum game between them,” the analyst commented. He highlighted the following:

1. The industry is fragmented and both the companies have gained share over the last decade. Margins are “weakly correlated” even during periods of price investment. Concepcion pointed out that traffic at Kroger had risen strongly even with Whole Foods Market’s price investments in 2016.
2. “There’s more to driving sales improvement than price, which WMT already had an advantage in,” the Citi report noted.
3. Promotions, albeit elevated, have been within historical norms.

WFM Takeout

The analyst enumerated the following reasons for believing the takeout of Whole Foods Market was uncharacteristic for Kroger:

1. The takeout would be expensive, while Kroger has typically been disciplined with M&A
2. “KR would have to lever up to 3.5x net debt/EBITDA vs. the 2-2.2x target by our est. That said, with $500mm in synergies, the deal could look more attractive at 8x post-synergies (assuming 100bps lower FY17E EBITDA margin vs. FC for price investment). This scenario could result in ~30c EPS accretion for KR, but that level of synergies could be tough to achieve (would be ~40% of WFM’s FY17E EBITDA),” Concepcion wrote.

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