Albertsons Stock: Merger Review Tightens in Light of Upcoming FTC Trial (NYSE:ACI)

Albertsons Companies, Inc. (NYSE: ACI) recently published its results for the first quarter of the fiscal year from the end of February to mid-June. These show stable sales development, but continued losses in profitability. The planned merger of the company with Kroger (KR) has also seen notable updates recently, as the FTC's plans to block the transaction remain in place and political scrutiny tightens.

In my previous article about the stock “Albertsons: Grocery chains should not trade at these multiples“, I gave the stock a strong buy rating as the merger’s success represented a win-win situation with Albertsons’ incredibly low valuation. After the article was published on June 7,^th Now in June, Albertsons has returned 3%, while the S&P 500 has returned 4%.

Planned Kroger merger receives updates

A lot has happened recently on planned merger between Kroger and Albertsons. The companies listed the planned 579 store sales in early July. Then, at the end of July, a judge ruled temporarily stopped The deal was rejected, and a hearing scheduled for August was also canceled. The merger is facing some headwinds in court, prolonging the fight over the deal.

Presidential candidate Kamala Harris recently announced that she will be taking a closer look at merger deals between major grocery companies in connection with the current Albertsons-Kroger merger. This statement comes in the wake of the FTC's investigation into possible price gouging in the grocery industry. The FTC's investigation does not seem to pose a major threat to Albertsons in my opinion, as the company's profitability is declining in the first quarter and Albertsons' return on assets is close to the five-year average, which is expected to be even lower in the coming quarters if profitability continues to decline. On the other hand, the increasing political scrutiny does not make the merger's prospects for success look very good.

With the FTC’s trial against the merger set to begin on the 26th,^th In August, Kroger recently increased its commitment to cut grocery prices from $500 million to $1 billion, further amplifying the deal's positive impact on consumers. The previously increased store sales and now even greater price cuts for consumers should increase the likelihood that the merger will go through – the combined company should be somewhat less likely to be too competitively dominant and cause price gouging in the future. However, the even greater price cuts seem like a desperate attempt to force the merger through.

Hedgeye's analyst Daniel Biolsi is now increasingly optimistic that the deal will go through with the new divestments planned. However, it appears that the merger is still under regulatory and political scrutiny. Due to the increasing scrutiny, I would not consider the deal to go through as a base case scenario, even though the increased food price reductions and divestments should mitigate competitive threats.

There is likely to be more important news regarding the highly uncertain merger, as the FTC trial is set to begin soon.

Q1 report: Weakening profitability, but nothing too dramatic

Albertsons' Q1 report showed near-expected financial numbers. Revenues came in at $24.3 billion, up 0.9 percent year over year, amid slowing grocery inflation. Identical sales rose 1.4 percent, driven by good growth in pharmacy sales, but offset by lower grocery inflation of just 1.1 percent in June and lower fuel sales. Reported revenues beat Wall Street estimates by $120.9 million, a notable achievement in the normally incredibly stable sector.

Although revenue beat estimates, Albertsons still reported earnings per share that were $0.02 below Wall Street estimates at $0.66. This is down from $0.84 in the first quarter of last year, excluding the first quarter tax benefit. Among the missed earnings per share, Albertsons' selling, general and administrative expenses posted a comparable increase of 79 basis points as a percentage of sales as labor costs continue to rise, digital investments, increased security costs and merger-related costs — part of the increase is due to temporary measures related to the proposed merger with Kroger and digital investments.

On the other hand, labor cost inflation above grocery inflation and increased security measures amid increasing shoplifting concerns appear to be more persistent issues in terms of profitability. Village Super Market (VLGEA) has also increased security measures, increasing security costs by 8 basis points in the fiscal third quarter, as I wrote previously. Comparable gross margin also shrank 22 basis points year-over-year, although surface-level gross margin increased slightly due to LIFO accounting and fuel impacts, resulting in a fairly significant decline in profitability year-over-year. The significant decline in profitability was largely already expected, but given the continued increases in operating costs, I would like to see it stabilize in the future, even at a slightly lower level.

Digital sales continued to grow, posting 23% growth in the first quarter, which I don't think is a very good factor – growth ultimately cannibalizes Albertsons' brick-and-mortar sales, and since digital sales are characterized by lower margins, the impact of growth on overall profitability also weakens. Albertsons recently expanded its partnership with Instacart to include nationwide pickup services, potentially scaling digital sales growth beyond self-cannibalizing digital penetration.

Although weaker profitability led to a slight EPS loss, I don't think the quarter was all that dramatic. Albertsons still had healthy profits and sales held up well despite slowing grocery inflation and lower fuel sales. However, ongoing cost inflation still poses some downside risk to profitability estimates.

Updated rating

I updated my discounted cash flow [DCF] Model – given the easing of food inflation, I am updating my estimate of terminal growth downward to just 1.5%, down from the previous 2.0%.

There has historically been little inflation in the food sector – US Bureau of Laws (BLS) data from 2004 to 2019 shows a 1.8% compound annual growth rate (CAGR) in the home food category, compared to 2.2% annual overall inflation in the period before the rapid food inflation during the Covid pandemic. This also justifies, in my opinion, a slightly lower growth estimate than I previously modelled.

Otherwise, I kept the model similar and only slightly increased the growth estimate for FY 2024, but very slightly lowered the EBIT for the year due to lower profitability in the first quarter. Cash flows for FY 2024 still seem to be slightly better than previously estimated.

The estimates put Albertsons' fair value at $33.28, 63% above the stock price at the time of writing – the stock remains attractively valued in the low-risk sector. Fair value has declined from the previous reading of $38.44, primarily due to lower revenue growth estimates, but also due to slightly lower margin estimates going forward.

Albertsons stock trades at an EV/EBITDA of 6.3, still below Kroger's 7.0 and especially Walmart's 14.7.

CAPM

The DCF model uses a weighted average cost of capital of 5.59%, which is slightly lower than the previously used 5.90% due to a lower equity risk premium. The WACC used is derived from a capital asset pricing model:

Over the last twelve months, Albertsons had interest expense of $498.8 million, which at the current level of interest-bearing debt works out to an interest rate of 6.73%. I now expect the debt-to-equity ratio to drop to 40% over the long term, down from 50% previously.

To estimate the cost of equity, I use the 10-year bond yield of 3.91% as the risk-free rate. The equity risk premium of 4.11% is Professor Aswath Damodaran's estimate for the US updated in July. I left the beta estimate at 0.41. With a liquidity premium of 0.2%, the cost of equity is 5.81% and the WACC is 5.59%.

Take away

Albertsons' sales held up well in the first quarter, but earnings declined due to operating expense inflation, certain capital expenditures, and a slightly lower comparable gross margin. The proposed merger with Kroger has also made notable news as the companies' scrutiny and operational trade-offs become more acute with the FTC process about to begin. While the stock is still undervalued, my revised DCF model now estimates significantly less upside given lower margins and lower expected inflation. As such, I'm downgrading my rating on Albertsons to Buy before the merger controversy.