Could Kroger Buy Sprouts?

Kroger (NYSE: KR) has been in an acquisitive mood lately. It just gobbled up Milwaukee-area grocer Roundy’s (NYSE: RNDY), a chain that was not able to survive despite rising revenues and expansion.

Naturally, many people will be wondering what else Kroger might acquire? One interesting prospect is Sprouts Farmers’ Market (NASDAQ: SFM), the fast-growing discount organics chain. Sprouts is obviously a very different business from Roundy’s, which operates mostly traditional supermarkets that cater to middle-class customers—Kroger’s core business. Sprouts sells organics and other high-end products to the fast-growing upper middle class markets in expanding urban markets like Denver.

Yet financially, Sprouts does have a lot in common with Roundy’s, including:

• Fast growing revenues. Roundy’s revenues actually grew by $396 million between September 2014 and September 2015, rising from $3.632 billion to $4.028 billion. Sprouts’ revenue grew from $2.8141 billion to $3.397 billion between September 2014 and September 2015, an increase of around $589.2 million.

 

• A hard time generating income from that revenue. Sprouts reported a net income of $118.52 million on September 30, 2015, and a free cash flow of just $35.3 million. Roundy’s reported a negative income of -$6.0544 million and a negative free cash flow of -$6.012 million on September 30, 2015. Sprouts is obviously making money right now, but it is not making that much money.

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• Limited resources. Roundy’s had $33.65 million in the bank on September 30, 2015. It also reported making just $65.31 million in cash from operations on the same day, meaning it lacked the cash to survive any sort of crisis. One reason it sold itself to Kroger was to prevent the death spiral that occurs when a retailer lacks the cash to pay the bills. Sprouts reported having $132 million in the bank and making $209.01 million in cash from operations on September 30, 2015, meaning it is making money yet operating on a very narrow margin. Sprouts’ resources are larger than Roundy’s but not by much.

 

• Expanding operations, particularly in the organic sphere. One reason why Kroger bought Roundy’s is that it operates 34 upper end Mariano’s supermarkets in Chicago, a city where Kroger has a minimal presence with a handful of Food 4 Less discount stores. Kroger has been attempting to expand its footprint in the organic and upper end grocery markets, which are more lucrative than traditional supermarkets. Sprouts has been successful in that regard.

• Sprouts currently operates around 200 stores in 13 states; Roundy’s was operating 151 stores when Kroger grabbed it.

 

Why Kroger Probably Will Not Buy Sprouts

Sprouts definitely has some of the attributes that Kroger likes in an acquisition, but I do not think the grocery giant will buy it, for a number of reasons. These include:

• Sprouts’ cost. The organic grocer was trading at $25.49 a share on December 15, 2015. Roundy’s was trading at $3.59 a share on the same day. One reason why Kroger bought Roundy’s was that it was cheap. It paid just $800 million for Roundy’s operations. Roundy’s had a market capitalization of just $177.28 million on December 15, 2015; Sprouts’ market cap was $3.906 billion. Kroger added more revenue at a far lower price by buying Roundy’s rather than Sprouts.

• Sprouts’ business model is somewhat incompatible with Kroger. Sprouts stores do not have pharmacies, a core Kroger business, nor do they operate gas stations. There is also no loyalty card program at Sprouts; loyalty cards are at the center of Kroger’s business.

 

• Sprouts would not help Kroger spread to any new geographic areas like Roundy’s did. Buying Roundy’s helped Kroger expand its presence in one major urban area, Chicago, dramatically and enter another: Milwaukee. Roundy’s has around 39% of the grocery market in Milwaukee through its Pick N’ Save subsidiary. Kroger already has a strong presence in most of the states where Sprouts operates, including Arizona, Colorado, Nevada, Texas, Utah and California.

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• There are other cheaper grocers out there. A big one is Supervalu (NYSE: SVU), which reported $18.04 billion revenue on August 31, 2015, yet had a market cap of just $1.1795 billion and a share price of $6.75 on December 15, 2015. Buying Supervalu or its supermarket operations would get Kroger into two new metro areas: St. Louis and the Twin Cities. It would also help Kroger expand existing operations in Virginia; Maryland; Washington, DC; and Central Illinois. Another target could be Fresh Market (NASDAQ: TFM), which operates 170 stores in 27 states but reported a free cash flow of $1.82 million on October 31, 2015. Fresh had a market cap of just $1.38 billion and revenues of $1.818 billion. Buying Fresh would help Kroger enter some new markets, including the Northeast, Florida, Iowa and New York State. Fresh has some large operations in Florida, where Kroger’s presence is minimal.

 

My take is that Kroger will not buy Sprouts unless its price drops dramatically. There are simply too many other cheaper grocers that would be a better fit with Kroger’s business model out there.

Disclosure: the Blogger owns shares of Kroger and plans to keep them for a long, long time because it is a good company.