Description

Summary:

ACI is an attractive merger-arb play with 35% upside to a completed transaction and potentially significant double-digit total return upside looking out to 2024 on a standalone basis should the deal not close. 

Background:

Albertson’s (ACI) is a leading US grocer with 2,271 retail stores, 1,722 in-store pharmacies, 22 DCs, and 20+ banners operating in 34 states. $78B in sales and $2.3B in operating income in FY 2022 (ended 02/25/23).

Pending Kroger Acquisition

On October 13, 2022, Kroger reached a deal to acquire ACI for $34.10/share in all cash, or $24.6B including debt. This represented a ~30% premium. The deal was anticipated to close in early 2024 and foresaw up to $4B in ACI special dividends which would reduce the price accordingly. ACI subsequently paid a $6.85/share special dividend. 

The deal would create a combined portfolio of 5k stores and a clear market leader excluding WMT. 

Antitrust Issues

Not surprisingly, the FTC made a second request for information in December 2022 and political and industry/labor pressure against the deal is high. The FTC chair has previously cited the lack of financial viability of prior divestitures related to the ACI/Safeway merger in 2015. In that deal, 168 stores were divested to 4 smaller buyers including 146 to Haggen, which filed for bankruptcy only months later and then sold back many stores to ACI. The Haggen deal was pretty clearly dubious and Kroger/ACI are surely aware that they cannot get away with that this time. 

It was obviously foreseen that the the deal would bring intense antitrust scrutiny. The merger agreement contemplated the divestment of ACI stores in overlapping regions, with an associated price adjustment. Specifically, it contemplates the possible divestiture of 100-375 ACI stores (SpinCo) to be spun-off immediately prior to the deal close in order to obtain regulatory approval. The agreement also contemplates the potential outright sale of some stores, with an agreed-upon upper limit of 650 stores to be divested including via sale. If the SpinCo is utilized, the transaction price will be discounted by 3x the 4-wall EBITDA of the stores. The outside date is January 13, 2024 with up to 270 days of extension if regulatory approvals have not been satisfied. The Parent termination fee is $600M (~$1/share).  

KR/ACI is exploring the sale of stores with “numerous” potential interested parties. According to Reuters earlier this year, the companies were planning to sell 250-300 stores. A sale to a well-established player could blunt anti-trust arguments that the spun-off stores will be competitively disadvantaged and at risk of closure as followed the ACI/Safeway divestitures in 2015. Ahold Delhaize (AD AS) is reportedly interested and brings a more robust balance sheet with EUR 30B market cap and just EUR 4B in net debt. Amazon has also been thrown out as a potential party although this feels unlikely.  

Given the Biden Administration’s antitrust record to date and their public commentary, reasonable divestiture remedies may not be enough to win FTC support. But it is clear that KR/ACI are committed to litigate if necessary. They also hope to define the market more broadly to include Amazon, Aldi, dollar stores, warehouse clubs, etc. It is beyond my capabilities to handicap their prospects in court, but overlap should be limited post-divestiture and the Administration is clearly unafraid of bringing dubious cases to trial. 

Just last week, Kroger CEO/Chair Rodney McMullen has reinforced his vow to litigate if necessary:

“Usually you wouldn’t commit in advance to litigate. In this case we both committed to litigate in advance,” Kroger Chief Executive Officer Rodney McMullen said in an interview Wednesday at Bloomberg headquarters in New York.

https://www.bloomberg.com/news/articles/2023-05-10/kroger-ceo-vows-legal-fight-for-albertsons-deal-if-necessary

Skewed Risk/Reward

Since the day before the deal announcement, ACI shares have drastically underperformed the market as well as peers. ACI shares are up just +6% (total return including dividends) versus +18% for the S&P. Even Kroger is +10% despite some initial skepticism over the deal. Ahold-Delhaize has increased +30%. 

ACI shares currently trade at a (26%) discount to the deal price.  So it appears we essentially have a free call option worth somewhere between $0-$7/share. Carrying costs are real in this interest rate environment,  but ACI shares do offer a $0.12/share quarterly dividend (2.4%) yield. If the deal breaks, we have a potential ~5% yield on a reverse termination fee, as well as a likely HSD FCF yield from ongoing operations, so ultimate carrying costs are arguably de minimis/negative. 

Standalone Value

The grocery business is not exactly the most attractive business, nor is the current operating environment the most favorable. ACI recently reported weak 4Q22 results with GM% deteriorating due to inflation, digital sales mix, and weaker pharmacy results due to dissipating COVID business. ACI guided for an incremental $200M (~5%) headwind in 2023 from lower COVID vaccination and at-home test kit revenue. Additional headwinds are clearly possible, although inflation is moderating.

However, ACI remains a scale player in a staples business and these headwinds appear to be fairly reflected in the current market price/expectations. Sell-side consensus estimates are already very pessimistic, assuming almost no sales growth and persistent margin deterioration in the coming years. 

ACI shares trade at depressed multiples on any measure– 7x P/E, 7x FCF, 4.65x EV/EBITDA on the modest 2023 estimates. 

Valuation multiples are similarly depressed relative to comps. KR is the nearest comp, trading at 6.2x EV/EBITDA, with a longer term average closer to 6.5x. Ahold (AD NA) also trades at 6.3x EV/EBITDA, below its 5Y average of 6.6x. ACI deserves a discount, but even at 5.0-5.5x EBITDA there would be ~15%-30% upside. Including FCF yield in the interim and a potential $600M fee if the deal breaks, low double-digit upside is possible looking out to 2024 even without assuming any multiple expansion.

Catalyst

The lack of clear near-term catalysts is likely what has created the opportunity here. Shares may be lifeless until the merger is resolved, one way or another, probably stretching into 2024. However, this overhang should lift in 2024 and an announcement to sell stores to a financially formidable competitor could come much sooner, and FTC approval under those conditions is still possible.