Fitch Rates Kroger's $1.75B Notes 'BBB'
The Rating Outlook is Stable. A full list of ratings follows at the end of this release.
KEY RATING DRIVERS
Industry-Leading ID Sales Slow: Kroger's ID sales have been positive for 13 consecutive years with Kroger gaining market share as positive pricing perception by customers, effective marketing through use of loyalty card data, and improvements to the shopping experience continue to result in increased customer visits. ID sales increased 5.0% in 2015, 5.2% in 2014, and 3.6% in 2013 but have slowed in 2016 due to deflation.
For the quarter ended Aug. 13, 2016 and the first half of 2016, ID sales increased 1.7% and 2.1%, respectively, with deflation the grocery category estimated as having a negative 1.5% impact in the latest quarter. Kroger expects ID sales to approximate 1.4% - 1.8% for 2016. Fitch anticipates that ID sales can return to the 3% range in 2017 as deflationary pressures ease. The USDA is forecasting food at home CPI of 1% - 2% in 2017, versus 0% to 1% in 2016, as wholesale prices for categories; such as eggs, dairy, protein stop declining.
Relatively Stable-to-Improving EBIT Margins: Kroger's gross margin including retail fuel continues to expand as declining fuel prices and the merger with Roundy's which had a higher gross margin offset price investments, lower top line growth due to deflation, and increased warehousing, advertising and shrink costs. Gross margin expanded 78 basis points (bps) to 22.6% during the first half of 2016, after increasing 100 bps to 22.2% in 2015 and 60 bps to 21.2% in 2014. Excluding fuel and the impact of Roundy's, FIFO gross margin declined a modest 6 basis points during the first half of 2016 due mainly to investments in price.
Kroger has demonstrated an ability to offset historical gross margin pressure with cost-containment and the leveraging of fixed costs. The company's EBIT margin remained relatively stable at 2.8% from 2010 to 2012 and then gradually increased to 3.4% in 2015. Fitch anticipates Kroger's EBIT margin will decline slightly to approximately 3.3% in 2016 due in part to additional labor hours and the acquisition of Roundy's, which had lower EBIT margin, despite projecting roughly 50 bps of gross margin expansion.
Increased Capex to Support Growth: Kroger has steadily increased capex to over 3% of sales to support high-return projects and faster store growth in its existing and high-potential markets for fill-in opportunities. Capex is projected to approximate $3.6 to $3.9 billion for 2016 versus $3.3 billion in 2015 and $2.8 billion in 2014. Kroger had planned capex of $4.1 billion to $4.4 billion. While capex remains higher than historical levels, the company reduced planned capex for 2016 to allow flexibility for additional share buybacks in the near-term.
Cash Flow Usage, Healthy FCF: Kroger has utilized its cash to invest in its business, repurchase shares, and to fund its dividend. Annual free cash flow (FCF) is forecast to be approximately nearly $600 million in 2016 versus $1.1 billion in 2015 due mainly to higher capex and modest dividend growth. Kroger reviews its dividend yearly but the payout to net income has been approximately 20% in recent years.
Steady Leverage: Adjusted debt/EBITDAR declined to 2.7x at the LTM period ended Aug. 13, 2016 from 3.2x at year-end 2013 (post the Harris Teeter Supermarkets, Inc. acquisition). Leverage is expected to stay within Kroger's targeted range of 2.0x - 2.2x net debt/EBITDA, which equates to adjusted debt/EBITDAR below 3.0x, over Fitch's forecast period. Debt reduction is not anticipated as management is expected to direct essentially all its FCF after dividends to share repurchases.
Scale, Diversity Are Benefits: Kroger benefits from its position as the largest supermarket retailer in the nation, its geographic diversity, and its multiple store formats which provide convenience to its customers. Kroger generates over $100 billion of revenue, and operated 2,778 supermarket and multidepartment stores, 784 convenience stores, and 323 jewelry stores across 49 major markets in 2015. The company generally holds the No. 1 or No. 2 position in those markets. Kroger has a significant fuel business, and manufactures about 40% of the private-label products sold in its stores. Corporate brands represent about 25% of total units sold, excluding fuel and pharmacy.
Fitch's key assumptions within the rating case for Kroger include:
--Mid single-digit revenue growth in 2015 and 2016, with ID sales of 1.8% in 2016 and 3.5% in 2017. The acquisition of Roundy's is expected to add about $4 billion of annual revenue, or a 4% contribution, in 2016.
--EBIT margin approximates 3.3% in 2016 and 3.4% in 2017. EBITDA margin remains above 5%.
--FCF (post dividends) of nearly $600 million in 2016 and roughly $400 million in 2017, reflecting increases in capex and modest dividend growth.
--Net debt/EBITDA remains within management's targeted 2.0x - 2.2x range, approximating adjusted debt/EBITDAR of 3.0x or lower throughout the forecast period with debt increasing and proceeds used for share repurchases or tuck-in acquisitions.
A positive rating action would be considered if adjusted leverage improved to the mid-2x range, together with steady mid-single-digit ID sales growth and gradual margin improvement. This is not anticipated at this time.
A negative action would be considered if adjusted leverage moved up to the low 3x range due to pressure on margins and/or a more aggressive approach to share repurchases or acquisitions.
Kroger had approximately $1.8 billion of liquidity at Aug. 13, 2016, of which $319 million was cash and the remainder was availability on the firm's $2.75 billion revolver which backs commercial paper borrowings. Ongoing liquidity is supported by the company's FCF, which Fitch projects will be approximately $600 million in 2016 and $400 million in 2017. Kroger's revolving credit facility expires in June 2019. The revolver subjects Kroger to a maximum net debt/EBITDA financial maintenance covenant of 3.5x. The company's 2.0x - 2.2x leverage target results in significant covenant cushion. Kroger had no outstanding borrowings on its revolver but had $1.3 billion of CP and $13 million of letters of credit under the credit facility at Aug. 13, 2016.
FULL LIST OF RATING ACTIONS
Fitch currently rates Kroger as follows:
--Long-Term IDR 'BBB';
--Senior unsecured notes 'BBB';
--Bank credit facility 'BBB';
--Short-Term IDR 'F2';
--Commercial Paper 'F2'.
The Rating Outlook is Stable.