Albertsons Shares: Merger Scrutiny Heats Up With FTC Lawsuit Nearing (NYSE:ACI)

Albertsons Companies, Inc. (NYSE:ACI) recently reported the company’s fiscal first-quarter results from the end of February to mid-June, showing steady revenue performance but continued profitability hiccups. The company’s planned merger with Kroger (KR) has also seen notable updates lately as the FTC’s plan to block the deal continues and as political scrutiny tightens.

In my previous article on stocks, “Albertsons: Grocery chains shouldn’t be trading at these multiples,” we initiated the stock at a Strong Buy rating because the success of the merger represented a win/win situation with Albertsons’ incredibly low valuation. After the article was published on 7^th since June, Albertsons has now returned 3%, compared to the S&P 500’s 4% return.

Kroger’s Planned Merger Gets Updates

A lot has happened recently the planned merger between Kroger and Albertsons. companies listed the 579 planned store divestments in early July. After that, at the end of July, a judge temporarily stopped deal, also canceling a hearing previously set for August – the merger is experiencing small headwinds in court, prolonging the deal battle.

Rallying to merger scrutiny, presidential candidate Kamala Harris recently announced that she will increase scrutiny of transactions between major food companies related to the current merger between Albertsons and Kroger. The comment comes amid the FTC’s investigation into potential food price gouging. The FTC investigation appears to be a low threat to Albertsons, in my view, amid the company’s declining profitability in the first quarter and Albertsons’ bottom line return on total equity close to its five-year average, which looks set to drop even lower in subsequent quarters if continued profitability. On the other hand, increasing political control does not bode well for the merger’s likelihood of success.

Because the FTC lawsuit against the merger will soon begin on the 26th^th since August, Kroger recently raised the company’s commitment to cut grocery prices to $1 billion from $500 million previously, adding to the deal’s positive effects on consumers. Previously increased divestments by stores and now larger consumer price cuts should make the merger more likely to go through – the combined company should be slightly less likely to be too competitively dominant, causing prices to rise in the future. However, the increased price cuts seem to be a difficult effort to carry out the merger.

Hedgeye analyst Daniel Biolsi is now increasingly bullish on the deal ending with further planned divestments. Still, political and regulatory scrutiny appears to be gathering on the merger. I would not price the deal as a base case scenario because of increasing scrutiny, even though increased food price cuts and divestments should mitigate competitive threats.

The highly uncertain merger should have more notable news in the future as the FTC lawsuit is set to begin soon.

Q1 report: Profitability down, but nothing too dramatic

Albertsons’ first-quarter report showed near-expected financials. Revenues totaled $24.3 billion, up 0.9 percent from last year on the back of sluggish food inflation. Like-for-like sales rose 1.4%, driven by good pharmacy sales growth, but offset by lower food inflation, at just 1.1% in June, and lower fuel sales. Reported revenue beat Wall Street estimates by $120.9 million, a noteworthy beat in the usually incredibly stable sector.

While revenue beat estimates, Albertsons still reported EPS of $0.02 below Wall Street estimates of $0.66, down from $0.84 in the year-ago quarter, excluding the first-quarter tax benefit previous. Below the EPS miss rate, Albertsons’ SG&A expenses expanded a comparable 79 basis points as a percentage of revenue amid continued labor inflation, digital investments, increased security costs and merger-related costs – some of the increase is due to temporary measures. on the planned merger with Kroger and digital investments.

On the other hand, labor inflation above food inflation and increased security measures amid heightened concerns about shoplifting appear to be more persistent problems for profitability. Village Super Market (VLGEA) also increased security measures, expanding security costs by 8 basis points in fiscal Q3, as we previously wrote. Comparable gross margin also declined 22 basis points year-over-year, even as floor-level gross margin expanded slightly due to LIFO accounting and the impact of fuel, which led to a fairly year-over-year profitability. The notable decline in profitability was already largely expected, but with persistent increases in operating expenses, I would like to see a stabilization in the future even at a slightly lower level.

Digital sales continued to grow at 23% in Q1, not a very good factor in my view – growth is ultimately cannibalizing Albertsons’ brick-and-mortar sales, and digital sales are characterized by lower margins, the effect of growth on total . profitability also weakens. Albertsons recently expanded its partnership with Instacart into nationwide pickup services, potentially extending digital sales growth beyond self-cannibalizing digital penetration.

Despite weaker profitability causing a slight EPS miss, I don’t think the quarter was too dramatic. Albertsons still had healthy earnings, with revenue holding up well amid slowing food inflation and lower fuel sales. The persistence of cost inflation presents a downside to cost estimates, however.

Updated rating

I’ve updated my discounted cash flow (DCF) model – amid slowing food inflation, I’m updating my perpetual growth estimate to just 1.5%, down from 2.0% previously.

Food has historically had slow inflation – data from 2004 to 2019 from the US BLS shows a CAGR in the household food category of 1.8%, compared to overall annual inflation of 2.2% in the period before the rapid inflation of food of the Covid pandemic, which in my opinion also justifies a slightly lower growth estimate than we previously modelled.

Otherwise, we kept the pattern similar, raising the FY24 growth estimate only slightly, but pushing the year’s EBIT down very slightly due to lower profitability in the first quarter. Cash flows in financial year 2024 still appear to be slightly better than previously estimated.

Estimates put Albertsons’ fair value at $33.28, 63% above the share price at the time of writing – the stock continues to be attractively valued in the low-risk sector. The fair value estimate was down from $38.44 previously, primarily due to lower revenue growth estimates, but also due to slightly lower margin estimates going forward.

Albertsons shares trade at a forward EV/EBITDA of 6.3, still below Kroger’s 7.0 and especially Walmart’s 14.7.

CAPM

A weighted average cost of capital of 5.59% is used in the DCF model, slightly lower than the 5.90% previously used 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, making the company’s interest rate 6.73% on its current amount of interest-bearing debt. We now estimate a lower long-term debt-to-equity ratio of less than 40%, down from about 50% previously estimated.

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. We kept 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’ revenue held up well in Q1, but earnings declined due to operating expense inflation, certain investments and a slightly lower comparable gross margin. The planned merger with Kroger has also seen notable news as scrutiny and operational compromises of the companies heat up with the FTC trial starting soon. Although the stock is still undervalued, my revised DCF model now predicts considerably less growth on the back of lower margins and lower expected inflation. As such, I’m downgrading Albertsons to Buy ahead of the merger.