Is Kroger Likely to Disturb the Merger Between Albertson’s and Safeway?

Safeway’s board has accepted a bid from the US private equity vehicle Cerberus, which controls Albertson’s, valuing it at US$9.4 billion. This transaction, with a merger due to be completed by October 2014, could help Safeway firm up its nascent recovery. However, the transaction allows a so-called “go-shop” three-week period during which Safeway is allowed to choose a rival bid. As the offer from Cerberus does not give a large premium over Safeway’s share price and a low price-to-earnings ratio, this raises the prospect of it being subject to a rival bid, especially from Kroger.

Would the Cerberus Deal be Good for Safeway?

With stagnant sales and falling operating profits in 2013, Safeway has suffered from low capital expenditure and from divesting some of its operations for several years, most recently with the closure of the Dominick’s chain in Chicago and the sale of its Canadian operations.

Alongside other large US supermarket operators, Safeway is also losing ground to other small-store formats with an aggressive price positioning for grocery products, including discounters (Aldi), dollar store chains and parapharmacies/drugstores (CVS and Walgreens), as well as some big-box chains, notably Costco warehouse clubs. Against these rivals, the company struggles to compete on price, which contributes to its razor-thin profit margins.

Therefore, being part of a larger group would help recoup costs and create more economies of scale to improve operating margins, which lagged below 2% in 2013, while it would retain the flexibility of operating local chains that meet varied demands from customers in various areas. Cerberus has also stated its intention to boost investment in improving store layout so as to make Safeway more competitive. In addition, being no longer subject to investors’ scrutiny could also help Safeway focus on longer-term investment to improve its operations and reverse previous retrenchments.

However, due to the modest size of the Albertson’s chain compared to Safeway, a merger would not create a major size advantage for Safeway, and would be unlikely to alter its strategy fundamentally, with Cerberus insisting that it would avoid store closures. The main beneficiary of the deal could be Albertson’s, notably through its gaining access to Safeway’s strong private label reach and expertise, alongside an established internet retailing presence supporting its loyalty scheme.

Kroger May Prefer to Take a Back Seat

The clause giving Safeway a three-week period and leaving the door open for a higher bid may have been written with a view to facilitating a counter-offer from Kroger, although this would incur a US$150-250 million break-up penalty fee. Amidst the challenging conditions for US supermarket operators, Kroger could be tempted to make such an offer.

For Safeway, a Kroger bid could have a more far-reaching impact than the Cerberus one, with stronger scope for economies of scale, but with a risk that it may dilute the Safeway brand.

However, regulatory concerns may block a possible move by Kroger as the combined companies would create a retailing behemoth with almost 5,000 stores and sales exceeding US$110 billion, accounting for over 13% of grocery retailing in the US. Although a potential Kroger bid may be successful if it is based on the premise of selling a large chunk of the acquired stores, another obstacle remains convincing Safeway’s shareholders, whose preferred option is to sell the chain as a single entity. In addition, as Kroger bought the Harris Teeter supermarket chain under a US$2.5 billion deal finalised in January 2014, it may prefer to focus on integrating it rather than embarking on another large and potentially disruptive acquisition.

With Kroger and Safeway both having a strong presence in California, Texas and states in the Pacific Northwest, their geographical focus also overlaps too closely and, ultimately, Kroger would be unlikely to benefit in the long term from acquiring a less profitable supermarket player facing similar challenges to its own.

Hence, a post-acquisition negotiated deal between Cerberus and Kroger whereby Kroger would buy selected Safeway stores from Cerberus could be a more suitable outcome for all parties involved.