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Written by Sam Kovacs
Kroger (KR) recently experienced a notable rise before cooling off. In August of last year, I discussed the potential impact of its planned merger with Albertsons, highlighting that historically, the FTC has permitted most supermarket transactions to proceed with divestitures. This merger, valued at billions, has been in the spotlight due to concerns over creating a large monopoly in the grocery industry. Despite the uncertainty, Kroger and Albertsons have proposed a comprehensive divestiture package, including an additional 166 stores to address regulatory concerns.
The current regulatory landscape in the U.S. has become increasingly challenging for major mergers. The Biden administration, with Lina Khan as FTC Chair and Jonathan Kanter as the head of the DOJ's Antitrust Division, has adopted a tougher stance on corporate consolidation. This is evident from recent actions against notable tech and pharmaceutical mergers.
Kroger's merger with Albertsons is no exception, facing scrutiny under this new antitrust environment. The outcome remains uncertain, which has significant implications for Kroger's growth and dividend prospects.
Why the Merger Matters
If the merger goes through, Kroger stands to gain significantly, adding 30% to its free cash flow (FCF) over the first four years. This could translate into an annual growth rate of 11-15%, aligning with Kroger's historical growth. For dividend investors, this is crucial. Kroger's current growth projections without the merger are modest, with management expecting earnings growth of 3-5%, supported by 2-4% top-line growth and 1-2% margin improvement.
Currently, Kroger pays out 30% of its free cash flow as dividends, which is standard in the grocery sector. While share buybacks contribute to dividend growth, significant growth is contingent on the successful completion of the merger. Without it, Kroger's ability to sustain the double-digit growth needed to satisfy dividend-focused investors is questionable.
Dividend Growth and Investor Returns
Last year, Kroger increased its dividend by 11.5%. With the next dividend increase expected soon, there's anticipation for another double-digit hike. However, with management pausing its share repurchase program to focus on deleveraging ahead of the merger, the increase may not meet expectations.
Without the Albertsons deal, Kroger's growth prospects over the next two decades appear limited. This raises the question of whether Kroger remains a viable investment for dividend growth investors if the merger fails.
Updated Investment Targets
Given the current situation, I am updating my price targets for Kroger. The buy target is now set below $45, down from the prior target set three years ago. This adjustment considers the company's yield, which generally ranges between 2% to 2.5%, offering an attractive entry point. The sell target remains above $60, pending further details on the next dividend increase.
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