Deflation Explains Why Kroger might be interested in Rite Aid

There is a simple reason why Kroger (NYSE: KR) might be interested in buying all; or some, of the 650 Rite Aid (NYSE: RAD) drugstores that Walgreen (NASDAQ: WBA) is trying to get rid of. Food simply is not that profitable for the nation’s largest grocer anymore because of deflation.

Deflation occurs when prices fall dramatically in a short period. The available statistics indicate that food is in deflation. Grocery prices dropped for nine months straight between December 2015 and August of 2016. To make matters worse deflation accelerated over the summer food prices fell by 1.5% in June; 1.6% in July and 1.8% in August, according to Bloomberg.

The price of food; Kroger’s principal product, fell by 4.9% in just three months. Nor is just food deflation that Kroger has to worry about some analysts think that gasoline prices might fall by 30¢ a gallon by Halloween, Market Watch reported. Kroger operates 1,397 supermarket fuel centers and 785 convenience stores.

How Deflation Hurts Kroger

Deflation hurts Kroger because its expenses are still the same but it is taking in less money from its operations. Even though food and gasoline prices are lower, the salaries for Kroger employees, the utility bills, taxes, finance payments on stores, etc. are still the same day. To make matters worse; expenses might go up because customers will buy more of the cheaper food increasing operating costs, even as Kroger makes less money.

 

 

 

The danger here is that Kroger’s operating margins are very thin. The company reported a free cash flow of just $24 million; on revenues of $112.41 billion on July 31, 2016. That made for a profit margin of just 1.44%. To make matters worse Kroger has very little float it; had just $319 million in the bank on July 31, 2016, even though it reported generating $5.11 billion in cash from operations.

Kroger’s business model is to offset lower food prices by also selling higher value items such as jewelry, furniture, electronics, clothing, gift cards, prescription drugs and fuel. Now the company faces a double whammy prices for two of its primary products are collapsing.

Are Prescription Drugs Deflation Proof?

The expansion of the prescription drug business is one method of offsetting food and gas deflation. Financial numbers indicate that the prescription drug business has become extremely profitable in recent years.

America’s largest drugstore operator CVS Health (NYSE: CVS) saw its revenues grow by $6.56 billion during second quarter 2016. CVS started the second quarter with $160.17 billion in revenues in March 2016 and finished it with $166.73 billion in revenues in June.

CVS obviously has other sources of revenue including prescription drug plans but this has to be pretty tempting to Kroger. Particularly since Kroger’s revenues grew by $1.03 billion during the second quarter; rising from $111.38 billion in April to $112.41 billion in July.

The source of CVS’s additional revenue is pretty obvious; prescription drug costs increased by 20% between 2013 and 2015, CBS News reported. One reason for the skyrocketing prices is that the nation’s two largest health insurers; Medicare and Medicaid, are not allowed to negotiate drug prices under federal law.

There were around 53.8 million Americans on Medicare and 40.5 million people receiving the Medicare Part D prescription drug benefit in 2014. Medicaid and the Children’s Health Insurance Program (CHIP) covered another 70 million Americans. So not only are prescription prices skyrocketing, Uncle Sam is picking up most of the bill.

Walgreen’s Woes are Kroger’s Opportunity

This means pharmacies might be a deflation-proof business that Kroger is already familiar with. The grocery giant already operates 2,231 pharmacies in its stores so it is familiar with the business.

Now Kroger might have an opportunity to pick up several hundred drugstores at a dirt cheap price. Walgreen needs to sell or close 650 Rite Aid locations in order to the get the Federal Trade Commission (FTC) to approve its takeover of the nation’s third largest drugstore operator.

Walgreen is having a hard time finding a buyer for those locations, because private equity firms are not interested in them, The New York Post reported. Nor is CVS Health; which would presumably only be interested in Rite Aid locations in cities where it has no standalone stores – such as Denver.

The FTC wants Walgreen to sell the stores to one buyer probably to preserve competition in the drugstore business. That presents an interesting opportunity for Kroger.

Kroger has a long history of pouncing on ailing competitors; it bought out the ailing supermarket operator Roundy’s last year. There’s also a good chance it will pounce upon the very sick supermarket operator and grocery distributor Supervalu (NYSE: SVU) making Rite Aid a natural target.

How Kroger Could Use the Rite Aid Locations

There are several ways that Kroger could integrate the Rite Aid stores into its existing operations. The most logical is to simply combine them with its existing pharmacy and health and beauty operations.

Another would be to convert the Rite Aids into small grocery stores similar to a Walmart Neighborhood Market or an Aldi. This can be done by adding refrigerator cases, a produce department, a deli, and perhaps a meat counter or a selection of precooked food. Kroger already owns 38 manufacturing plants to supply the food for such operations.

A more interesting possibility would be to prepare meals, entrees and deli foods at existing Kroger supermarkets; and have them shipped to the drugstores. Kroger might also use the Rite Aids as pickup locations for groceries ordered through its websites. It is rolling out a shop online/pickup instore program called List nationwide. The groceries might be dropped off at the Rite Aid by a Kroger van and picked up by the customer.

There are some other Kroger businesses that can be integrated with Rite Aids; including the Fred Meyer Jewelry stores, fuel, and the Pan Asian and other cafes popping up in some Kroger supermarkets. Starbucks would be another logical addition to Rite Aid. A natural addition to Rite Aid Kroger can offer is the Little Clinics which provide medical services in some of its stores.

The Rite Aid locations might also drive more business to Kroger’s existing locations through the grocer’s impressive reward cards program. The current program lets customers accumulate points that provide a discount on fuel for each dollar they spend on groceries. Extending it to neighborhood drugstores might drive more business to Kroger’s filling stations.

There is no guarantee Kroger will go after Rite Aid’s locations, after all it passed on buying the chain last year. Yet it may do so, if just to keep Target (NYSE: TGT), Walmart (NYSE: WMT), Safeway, Aldi or one of the dollar store operators from getting them. All grocers need to do something to offset deflation and expanding the pharmacy business seems like a logical means of achieving that goal.