Fitch Rates Kroger's Proposed 10- and 30-Year Notes 'BBB'

Fitch Ratings has assigned a rating of 'BBB' to The Kroger Co.'s (Kroger) proposed issue of 10- and 30-year senior unsecured notes. The Rating Outlook is Stable. As of May 25, 2013, Kroger had $7.9 billion of debt outstanding, including capital leases. A full list of rating actions is shown below. KEY RATING DRIVERS Kroger's ratings are supported by its industry-leading sales growth and market share gains balanced against ongoing share repurchase activity and intense price competition that will continue to pressure gross margins. The ratings also take into account Kroger's announcement that it has entered into a definitive merger agreement with Harris Teeter Supermarkets, Inc. (HTSI), a regional supermarket chain located in the southeast U.S. Kroger has agreed to acquire HTSI for $2.5 billion (7.3x EBITDA), and plans to finance the acquisition with debt. Fitch views the addition of HTSI as neutral-to-moderately positive from a business perspective, and believes that the risks associated with integrating HTSI into Kroger's network are manageable. In addition, financial leverage, after initially increasing to a pro forma 3.3x on an adjusted debt/EBITDAR basis, is expected to recover to near 3.0x within 18-24 months after the close of the acquisition. In light of the challenges facing the supermarket industry, including competitive pressures from discount formats and the margin compression that has occurred since 2009, adjusted leverage of around 3x would be at the high end of the rating level, and does not provide much cushion for additional leveraging actions or operating shortfalls. Steady Operating Results Kroger generates industry-leading non-fuel identical store (ID) sales as a result of strong pricing perception by customers, effective marketing through use of loyalty card data, and improvements to the shopping experience. ID sales growth of 3.3% in the first quarter of 2013 (1Q'13) follows increases of 3.5% in 2012 and 4.9% in 2011, leading to market share gains in most of its major markets. The company has achieved these results despite the weak consumer environment and intense competition from discount and specialty formats. Kroger has gradually managed down its gross margin ratio, and has offset this pressure with cost containment efforts and the leveraging of fixed costs. The EBIT margin on a FIFO basis excluding fuel and the effect of the extra week (in 2012) was up slightly in each of 2011 and 2012, and is expected to be flat to slightly improved going forward. Free cash flow (FCF) after dividends is expected to track around $300 million annually going forward, below the $500 million achieved in 2011-2012, due to an increase in capex, driven by management's desire to accelerate its store growth pace. RATING SENSITIVITIES A positive rating action would be considered if adjusted leverage improved to the mid-2x range, together with steady mid-single-digit ID sales growth and gradual margin improvement. A negative rating action would be considered if adjusted leverage does not improve to a level near 3x within 18 to 24 months after the close of the transaction, due to pressure on margins and/or a more aggressive approach to share repurchases or acquisitions. Fitch has affirmed Kroger's ratings as follows: --Long-term IDR at 'BBB'; --Senior unsecured notes at 'BBB'; --Bank credit facility at 'BBB'; --Short-term IDR at 'F2'; --Commercial paper at 'F2'. The Rating Outlook is Stable.