The grocery business is not an easy one. With Wal-Mart Stores, Inc (NYSE:WMT) quickly becoming the largest seller of groceries in the United States, many traditional grocery chains have had trouble competing, let alone growing. But The Kroger Co. (NYSE:KR), the largest grocery store chain in the country, isn’t just sitting on its hands as Wal-Mart steals the show. The company recently acquired Harris Teeter Supermarkets Inc (NYSE:HTSI), an upscale chain located mainly in the southeast, for $2.5 billion in cash. This gives Kroger exposure to the area as well as about $4.5 billion in additional revenue.
An expensive deal
But The Kroger Co. (NYSE:KR) is likely buying the company not for its profits but to expand its footprint to better compete against the likes of Wal-Mart Stores, Inc. (NYSE:WMT). Kroger has little presence in some areas of the country, and Harris Teeter Supermarkets Inc (NYSE:HTSI) fills one of those gaps in coverage.
Since Harris Teeter is more upscale than most supermarkets, this deal gives The Kroger Co. (NYSE:KR) a fighter in the battle against Whole Foods Market, Inc. (NASDAQ:WFM). Whole Foods carries much higher margins than traditional grocery stores, and the popularity of organic and artisan food is only growing with time. Kroger posted an operating margin of 2.86% in 2012 compared to 6.36% at Whole Foods. Harris Teeter Supermarkets Inc (NYSE:HTSI) has low margins but that could be due to its small size, and integration should help the company become more cost efficient.
The Kroger Co. (NYSE:KR) will use debt to finance the deal, and according to an SEC filing as of May 25 the company has $247 million in cash and $7.53 billion in debt. This deal will push the debt up to about $10 billion. Kroger already pays about $460 million in interest payments annually, and this deal will increase that number significantly.
Is Kroger a buy?
Grocery chains have low margins and slow growth, making investing in them usually unappealing. The Kroger Co. (NYSE:KR) has seen its share price surge since the middle of 2012, up 80% from its 52-week low.
KR data by YCharts
It seems that this kind of move from a traditional grocer would signal that the stock is likely overvalued. The Kroger Co. (NYSE:KR) had owner earnings in 2012 of about $1.58 billion, or $3.03 per share. The Harris Teeter Supermarkets Inc (NYSE:HTSI) deal will add maybe $100 million to this total, bringing the per share number up to $3.23. The debt will total $10 billion after the deal, which comes out to about $19 per share. Adding this debt to the market price the EV/OE, or enterprise value divided by owner earnings, is 17.6.
That’s a high price to pay for a traditional grocer. This isn’t Whole Foods we’re talking about, which grew revenue by nearly 16% in 2012 and has more than doubled its margins. This isn’t Wal-Mart Stores, Inc. (NYSE:WMT), which uses groceries to bring people into the store and sell them higher-margin products. This a traditional grocery chain.
For comparison, Wat-Mart has an enterprise value of about 20 times owner earnings. The Kroger Co. (NYSE:KR)’s multiple should be nowhere close to that of Wal-Mart Stores, Inc. (NYSE:WMT), but it’s not far off at its current price. It seems that investors are getting excited about grocery stores, sending Kroger’s shares flying, while forgetting that it’s a grocery store.
The bottom line
Back when The Kroger Co. (NYSE:KR) was trading in the low-20’s the stock was inexpensive. But now, after an 80% rise, it just doesn’t make sense to buy Kroger, Harris Teeter Supermarkets Inc (NYSE:HTSI) deal or not. Goldman Sachs recently downgraded the stock for being too expensive, and I tend to agree. Kroger is a fine company, and the Harris Teeter deal, while expensive, is likely a good move, but paying such a high price for a traditional grocer is a bad idea.
The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they’ll handsomely reward those investors who understand the landscape.
The article This Grocer Is Expanding its Reach originally appeared on Fool.com.
Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Whole Foods Market (NASDAQ:WFM). The Motley Fool owns shares of Whole Foods Market. The article This Grocer Is Expanding its Reach originally appeared on Fool.com.
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