The Kroger Story: E-merging Emotions

Less than two years after merging with Fred Meyer Inc, The Kroger Company is achieving synergy savings at a much faster pace than was initially expected. But if the company is optimistic, analysts are even more so: they expect savings to reach US$415 million. So just how has this company managed to turn itself around so quickly and so successfully?
Elsevier Food International, Vol. 4, Number 1, February 2001
Pascal Kuipers

First shock, then irritation, but ultimately delight- these were the emotions that Kroger is said to have experienced after acquiring Fred Meyer back in 1999. Kroger believed it did a good job in procuring its limited general merchandise assortment, but a closer look into Fred Meyer's buying terms proved somewhat shocking. And Kroger was particularly irritated to discover that manufacturers had been holding out on them on price, claiming that they wanted to protect channel differentials. However, integrating Fred Meyer's purchasing terms into its own proved a catalyst for the final emotion: delight. This is because over 50 per cent of the US$ 345 million in synergies that Kroger anticipates from the acquisition can be attributed to procurement. And once the retailer combines volumes and renegotiates prices and bonuses, it can turn its attention to logistics efficiency, new general merchandise and expansion of its private label brands.

A perfect fit
The merger with Fred Meyer couldn't have come at a better time. After all, the 118-year-old Kroger company had only narrowly escaped not one but two take-over bids 11 years earlier. To ward off its attackers, Kroger borrowed US$ 4.1 billion to pay a special dividend to shareholders and to buy back shares. To lower the debt load, it sold equity, food stores and liquor stores. By 1990 Kroger was already back on the acquisition trail, taking over 29 Great Scott! supermarkets in Michigan. In the same year, Joseph A Pichler became chairman and CEO. Under his helm Kroger has become the largest supermarket chain in the US. Geographically, Kroger and Meyer are a perfect fit, with the only overlap occuring in Texas and Arizona. Even before the merger, Kroger could claim the country's top retail spot, with annual sales of US$ 28 billion - 1,398 food stores, 802 convenience stores and 34 manufacturing facilities in the eastern half of the country. Fred Meyer only made it bigger - US$ 15 billion bigger - with some 800 food and general merchandise stores extending across 12 western states, from Arizona to Alaska. Today, Kroger operates approximately 2,338 grocery stores in 31 states under more than a dozen banners, including Kroger, Fred Meyer, Ralphs, Smith's, King Soopers, Dillon, Fry's, City Market, Food 4 Less, and Quality Food Centres. It also operates 789 convenience stores, 397 jewellery stores, and 42 food processing plants. Grocery stores are Kroger's core business, accounting for 93 per cent of this US$45.35 billion retailer.

Optimism
Since 1997, Kroger has been in the process of reorganising its operations from a decentralised to a centrally co-ordinated business model, providing Kroger with both short and long-term opportunities to lower costs and increase earnings. On the cost side, increased purchasing power and logistics synergies will have a positive effect on the US retailer's bottom line since, as stated, approximately 50 per cent of the merger-related synergies can be attributed to improved purchasing. According to Merrill Lynch, four years ago Kroger was already buying " ... like a loosely-knit collection of 16 one-and-a-half-billion-dollar companies." This centralisation process, combined with the integration of Fred Meyer's purchasing leverage, will really benefit Kroger in the longer term. "It takes a while to flex those US$ 46 billion muscles," as Merrill Lynch put it in March last year.
When announcing the merger with Fred Meyer back in October 1998, Kroger expected annual cost savings of approximately US$ 225 million within three years, including around US$ 75 million in the first year alone through combined procurement of goods and services, reduced corporate overheads, in-market synergies and consolidation of support services. Almost two years later, in September 2000, Kroger estimated total synergy savings from the merger with Fred Meyer at US$ 257 million by the end of the second quarter of its fiscal year 2000. "We continue to achieve synergy savings more quickly than we projected at the time of our merger with Fred Meyer," said Pichler optimistically, stating that Kroger " ... now expects to exceed the combined synergy savings goal of US$ 260 million in fiscal 2000 and to achieve the total synergy savings goal of US$ 380 million in fiscal 2001, a year earlier than expected."
The Merrill Lynch analysts are even more optimistic. They expect total synergies to reach US$ 415 million, as most of the system integration cost savings are due to come through in Kroger's FY 2002 (ending January 2003) and given the fact that potential synergies have not been fully utilised yet. In the autumn of 2000, Kroger did not show a full integration of information systems between the different divisions. "It does not need full systems integration between Kroger, Fred Meyer, Ralphs, and Quality Foods to attain the full benefits from the merger," the analysts reported in September last year.

Frustration
Kroger is keen to communicate that expected merger synergies have been realised or even exceeded. The retailer's management was frustrated by the decline in stock value between March 1999 - when Kroger's share value peaked at US$ 34.38 and 28 January 2000, the day Kroger's shares bottomed out at US$ 16.56, just 48 per cent of its value 10 months earlier. Kroger was also frustrated that it took the Federal Trade Commission so long to approve the merger. While investors were deterred by the seven-month long FTC review, Kroger/Meyer writes it off as a loss of precious integration time.
Kroger does say, however, that in general, tough pressure on stock value is a problem affecting the entire US supermarket industry. "The index of peer group supermarket stocks experienced a similar decline as investors shifted away from old economy industries toward cyclical and technology stocks," Pichler said in the company's 1999 annual report. "The widespread decline in supermarket stocks also reflected investors' concerns about the rapid consolidation of the food retailing industry.
Within the past two years, four of the major supermarket firms have completed substantial mergers and have forecast significant cost savings from those transactions. Investors have reacted cautiously, reflecting their concern that merger synergies might not be realised." Kroger is now proving that those cautious investors who turned their backs on the retailer's shares were wrong. With the fervour for new economy companies cooling, the investment climate is on the up.

Enthusiasm
"Management is enthused about the company's prospects for continued growth," reads Kroger's 1999 annual report. The retailer's enthusiasm was justified last September when it reported positive Q2 results for FY 2000. "We are pleased with our strong earnings performance in the second quarter," Pichler announced. "These results were driven by the solid performance of our divisions and the success of corporate-wide category management strategies, increased private label penetration and synergies."
In the first two quarters of 2000, Kroger more than compensated for a disappointing performance in the second half of 1999. According to Merrill Lynch, the Fred Meyer businesses - Fred Meyer, Smith's, Quality Foods and Ralphs - underperformed in the second half of 1999 and had problems integrating with Kroger's banners and logistics facilities. These integration glitches, combined with a surplus in inventory and working capital in Q3 of 1999, gave the impression of a business out of control. If that was ever true the problem has been quickly righted."
Kroger's gross margin performance is benefiting from the company's centrally co-ordinated business model: its manufacturing divisions, procurement and administrative tasks are controlled from its Cincinnati headquarters. Each division also receives incentives to control direct costs and working capital, while at the same time driving sales. Important drivers of sales growth are general merchandise and private label items in the grocery categories, the former brought to Kroger from Fred Meyer as a constant part of the assortment and as a seasonal/promotional general merchandise offer that attracts shoppers and stimulates sales. This can be done more easily now that Kroger's business model is centralised. Fred Meyer's buying clout secures low price procurement of non food items, which should increase Kroger's current non food sales penetration from 14 per cent to 18 per cent in the next three years. Other non-food growth drivers are in-store pharmacies and petrol sales.
Sales of private labels - preferably produced in the 42 company production plants - also offer growth opportunities. Last October, Kroger announced the official launch of Private Selection, a private brand covering nearly 300 private label items in grocery, produce, meat, deli, bakery and seafood items. According to Merrill Lynch, by September 1999 the Fred Meyer businesses' private labels accounted for 18-20 per cent of sales.

Delight
Kroger expects further efficiency and savings via the Internet. In March 1999 the company became an equity partner in the global B2B online exchange for the retail industry, GlobalNetXchange (GNX) which includes retailers such as Metro AG (Germany). Sainsbury (UK), and Carrefour (France) among others, and has a total purchasing volume exceeding US$ 200 billion. "We are delighted to join this impressive roster of international retailers. We believe that GlobalNetXchange offers tremendous opportunities to improve the total supply chain," said Rodney McMullen, Kroger's executive vice president of strategy, planning, and finance. "We expect GlobalNetXchange to reduce Kroger's purchasing and procurement costs and to help automate our supply chain."
Last October Kroger expressed its intention to begin using GNX's E-commerce platform by early 2001 for the purchase of perishable items such as produce, meat, seafood, and flowers.
It will do this in co-operation with Tradingproduce.com, the B2B site specialising in Internet-based automated workflow systems for the agricultural industry. Tradingproduce.com is GNX's partner to create an E-commerce environment for purchasing perishable goods. According to Kroger, by using the information system platform provided by GNX and TradingProduce.com, it will eventually be able to monitor the progress and expected delivery time of a perishable shipment en route to anyone of the company's warehouse facilities. The system will also enable Kroger to identify - in real time - potential discrepancies between purchase orders and invoices the minute delivery trucks roll in. Kroger expects to be able to eliminate 90 per cent of the discrepancies between invoices and receipts that it experiences today.
Merrill Lynch analysts believe that Kroger will utilise the majority of the synergies realised from the Fred Meyer merger to stimulate sales. "Kroger knows it needs to join Safeway as a leader in industry sales growth," they say. "This is really quite bad news for Albertson's, who could use a more benign pricing environment to get back on terms of price image with the consumer. If companies like Albertson's are struggling to stay with the leading pack, what must this pace be like for smaller, weaker competitors?"