Kroger $1 Billion Buyback Right Size for Debt: Corporate Finance

Kroger Co. (KR), which saw the cost of insuring its bonds reach a nine-year high and its stock fall to a 16-month low this week, is laying the groundwork for a rebound.

Credit-default swaps linked to the largest U.S. supermarket chain fell to 117.9 basis points at 11:39 a.m. in New York from 138.7 on June 13 after Kroger raised its profit forecast and reported better results than analysts had expected. Its stock climbed 6.6 percent to $22.69 after the company announced a buyback of as much as $1 billion.

The retailer is supporting its credit with sales that have expanded every year since at least 1987 and rising income that includes a $2.40 per share profit forecast for the current fiscal year, an increase of two cents from an earlier estimate. The Cincinnati-based company has gained market share even as other grocers lost sales to discounters Wal-Mart Stores Inc. and Target Corp. while operating in “a brutal business with razor thin margins,” according to money manager Bonnie Baha.

“Kroger’s management has historically exhibited a balanced financial policy which treats both stockholders and bondholders fairly,” said Baha, head of global developed credit at Los Angeles-based DoubleLine Capital LP, which oversees $35 billion. The share repurchase program “doesn’t unduly alarm us from a bondholder perspective,” she said.

The company is rated Baa2 at Moody’s Investors Service, the second-lowest investment grade, and an equivalent BBB at Standard & Poor’s and Fitch Ratings.

Spreads Widen

“We will manage our leverage ratio to a level that will continue to support our BBB credit rating,” Mike Schlotman, Kroger’s chief financial officer, said in an e-mailed statement.

The extra yield investors demand to hold Kroger’s bonds instead of government debt has climbed 62 basis points to 200 basis points, or 2 percentage points, from the beginning of April, Bank of America Merrill Lynch index data show. That compares with a spread widening of 44 basis points to 210 basis points for the entire U.S. Corporates Food & Drug Retail index.

Investors were becoming concerned that the grocer wouldn’t be able to maintain its market share in the face of growing competition, Mickey Chadha, Moody’s lead Kroger analyst, said in a telephone interview.

‘Increased Competition’

“Being that the grocery space is under increased competition from the Wal-Marts, Targets and Costcos of the world and from the extreme value discounters like the dollar stores there was some concern over pricing pressure and how that would play out this quarter,” he said. “It was definitely reassuring that Kroger continues to perform well and outperform is peers in quite a challenging business environment.”

Kroger’s board approved the $1 billion share buyback program to replace an authorization exhausted June 12, after returning more than $1.6 billion to shareholders through buybacks and dividends in the past four quarters, the company said this week.

The retailer loaded up on debt in 1988 to protect itself against a wave of takeover in the supermarket industry. Its borrowings rose to $5.08 billion at the end of the calendar year from $1.33 billion a year earlier, sending its credit rating to B1 from A3 at Moody’s and B+ from A at S&P. It returned to investment-grade at both companies in 1997.

Kroger now has $8.11 billion of total debt, according to data compiled by Bloomberg.

Kroger Swaps

Credit swaps on Kroger, which pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt, had surged 70.6 basis points since the beginning of April, Bloomberg prices show. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

“It’s been a steady move,” Diana Allmendinger, research director at Fitch Solutions, said in a telephone interview. The contract’s rise “may be a correction,” because it held at low levels for an extended period and is now “right in line” with levels consistent with its credit rating.

“It’s not like it’s underperforming in terms of where its rating is, it’s just that it’s widened out so much from where it was,” she said.

Trades by JPMorgan Chase & Co. (JPM)’s London-based chief investment office responsible for a $2 billion trading loss may have raised the cost of hedging Kroger’s debt.

Kroger is part of the 10-year Markit CDX North America Investment Grade Index Series 9, the so-called IG9 index created in 2007 and one of the positions contributing to the JPMorgan Chase loss. It has surged relative to the current most-active index, creating a technical effect that pushed credit-default swaps on the vintage index’s constituents wider, according to Hale Holden, a Barclays Plc strategist.

‘Very Diversified’

The company has a “very diversified store base geographically and it also has diversified store formats which cover a wide consumer demographic,” said Chadha of New York- based Moody’s.

“Its margins are not increasing much but in this business and competitive environment, if you can hold your margins fairly stable or manage to limit their decline, you’re doing a good job,” he said.

Kroger’s gross margin fell to 20.9 percent last year from 22.2 percent the year before and 23.2 percent in the 12 months ended Jan. 30, 2010. By Jan. 31, 2014, the ratio of gross profit to sales is forecast to decline to 20.3 percent, according to the average of six analysts in a survey by Bloomberg News.

Sales at Kroger rose 10 percent to $90.4 billion in its fiscal year through January and are expected to increase 6.9 percent to $96.6 billion in the current year, according to analysts’ estimates in a Bloomberg News survey.

Sales Increase

Revenue rose 6.3 percent last year to $43.6 billion at Safeway Inc. and dropped 3.8 percent to $36.1 billion at Supervalu Inc. Pleasanton, California-based Safeway is the second-biggest U.S. grocery chain, while Supervalu, based in Eden Prairie, Minnesota, is third.

Kroger, which operates locations under the Ralphs, Dillons and Food 4 Less brands, was founded in 1883 and incorporated in 1902. Of its 2,435 supermarkets, about 45 percent have gas stations. The company also has about 790 convenience store and 350 fine jewelry stores.

The company has tried to attract customers with its 11,000 private-label items, which are sold in three price tiers. It recently introduced new flavors of snack chips, including sea salt, cinnamon sugar and gluten-free rice and bean, under Private Selection, its gourmet line.

‘Price Competitive’

Kroger’s lower prices are “the most meaningful differentiator” from Supervalu and Safeway, according to Ajay Jain, a New York-based stock analyst at Cantor Fitzgerald LP who rates the shares “hold.”

“They’re just much more price competitive,” he said in a telephone interview. Because of the “meaningful overlap” with Wal-Mart, “they’ve been investing in lower prices for a few years now,” he said. Kroger also competes with the dollar-store chains, he said.

Kroger is benefiting from consumers eating more meals at home, “taking market share from restaurants,” Jain said.

“We’re competing against more than just traditional grocery retailers,” Chief Executive Officer David Dillon said on a conference call with analysts and investors on June 14. “As we have grown market share, our customers come from a much broader base than just supermarkets. It is also clear that we compete very well with a broader array of food retailers -- and this includes restaurants.”

As global economic growth slows, Kroger’s ability to continue to “fend off” losing market share would be the only concern for DoubleLine’s Baha.

“Of the peers left in the space, they’re certainly the strongest player,” she said in a telephone interview. “They’ve shown good financial management. Given their earning report, what’s a billion stock buyback? I think that can be easily handled, given the cash flow the company throws off and the fact that they really have done a good job managing their business.”

To contact the reporters on this story: Mary Childs in New York at mchilds5@bloomberg.net; Leslie Patton in Chicago at lpatton5@bloomberg.net

To contact the editors responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net Robin Ajello at rajello@bloomberg.net

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