Target (TGT) and Kroger (KR) ? While this morning's Fast Company report of merger talks between the two companies seems to have already been debunked by CNBC, it is a worthwhile exercise to analyze the fit between these two companies. Why? Well, obviously the retail landscape is changing massively and at a very rapid pace, so it can be possible for the disrupted to become the disruptors. So, partnerships are a logical response to the omnipresence of Amazon (AMZN) , especially now that Whole Foods Market is part of Jeff Bezos' empire.
The genesis for the rumors of a merger between Target and Kroger seems to be talks the two companies have had regarding how to best utilize Shipt, the same-day delivery company Target acquired for $550 million in December. To say Target and Kroger are lagging Amazon in instant delivery of groceries (or anything, really) would be to overstate the obvious.
Kroger's a supermarket, no more no less, and will become even more so when KR's sale of its convenience store business to EG Group closes in April. When I was in college in the South we used to lovingly refer our local Kroger as "Roger" because that store's management could never keep the "K" lit in the store's neon sign. Recent visits to Kroger locations have convinced me the company's on-the-ground management is no more advanced than they were in the '90s, but, man, do those stores get a lot of foot traffic.
In contrast, I have always been a huge fan of the "Tar-zhay" shabby chic merchandising that made Target great. Shopping at Target is fun, but the products I buy there tend to be in the packaged goods and apparel category. As I was reading about Target's efforts to improve its fresh food offer, I had to sheepishly admit to myself that I didn't even know Target had a grocery section. That's not where I hang out, and living in New York City, the space in Target's prime retail locations can be a little cramped.
Personal experiences aside, I am a financial analyst, so my first instinct this morning was to look at the balance sheets of Target and Kroger and see if they would fit. Actually, they would.
Kroger has the typical supermarket company balance sheet, which is one of the reasons many fund managers hate the stock. The company carries very little cash (only about $0.33/share as of last quarter) a tremendous amount of inventory, and a nasty slug of $15.1 billion in current and long-term debt. Kroger management has pledged to use some of the $2.15 billion in proceeds from the convenience store sale to reduce that debt. Also, unlike other supermarket chains, Kroger does not have a large net pension/OPEB liability, with only $792 million in net liability thanks to management's proactive efforts to pre-fund those costs.
At the end of the day, though, the key figure on Kroger's balance sheet is property, plant and equipment of $21.1 billion. This slightly exceeds KR's current equity market cap of $21.0 billion. So, Kroger's stock is worth less than the accounting (i.e. net of depreciation) value of its stores. That's the inherent bargain here, and, again, those stores shouldn't be worth a multiple to book value because they look pretty (they don't) but because they are in attractive locations and have the type of large footprint that can accommodate boatloads of walk-in customers.
So, Kroger could be attractive to Target, which in contrast to Kroger trades at a 50% premium to the unlevered book value of its stores. I am not sure TGT shareholders would like that maneuver, though, and, again, supermarkets are one of the least-loved stock subsectors in retail. So, Target would have to keep the premium down versus KR's current value of $24/share (KR shares have risen today on the rumors) and present a coherent plan for combining Kroger's offerings into a "Target-wide" same-day delivery scheme.
TGT shares have had a great run since last fall, and it's probably not worth the negative comments from the analyst community that would surely follow a purchase of a leveraged supermarket chain. There is certainly scope for those two companies to work together, but an outright merger would likely destroy shareholder value, not create it.