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11/01/2014

Kroger and Harris Teeter: An Odd Couple

Kroger's acquisition of Harris Teeter, closed in January, was in many respects uncharacteristic of the grocery giant.

It was Kroger's first major acquisition since its purchase of Fred Meyer, the Oregon-based chain, 15 years ago. The target is an upscale grocer centered in the Carolinas, a region where Kroger has mostly been absent. Many of Harris Teeter's 212 locations are in university towns and resort areas, where the clientele's needs and wants are different from those of middle-class shoppers doing their weekly marketing.

The stores are very different, too, with more of an emphasis on produce and fresh foods, premium prepared meals and customer service. Harris Teeter also has a better online presence than the rest of Kroger, with a developed and functioning click-and-collect service. And the workforce, unlike most of Kroger's other banners, is not unionized.

Kroger's reaction? Vive la différence.

"We do a nice job on the high-end customer but there are some things Harris Teeter does better," David Dillon, Kroger's then-CEO, told the Wall Street Journal after the deal was announced. "We expect we can learn a thing or two from them."

One thing they learned is to leave the new guys alone. For all its success with the stores under its own banner, Kroger has always followed a policy of leaving acquired banners in place, with their own names and, usually, their existing management structures. One of the first things Dillon said publicly after the purchase is that it would be completely transparent to HT shoppers, in looks, service and everything else.

So what is Kroger after with the HT acquisition?

For one thing, it's a potentially smart defensive play. As successful as it's been recently, with 43 consecutive quarters of same-store sales growth, Kroger has seen its market share erode for years, ever since Walmart started selling groceries. By going after more affluent HT shoppers, Kroger is entering a demographic where Walmart is unlikely to compete.

WHOLE PROBLEMS

And the major competitor in that demographic is having its problems. Whole Foods Market has been struggling with declining same-store sales for years, and its stock has lost about 40 percent of its value in the last year. Whole Foods is now engaging in wide-scale cost-cutting in a desperate attempt to shed its "Whole Paycheck" reputation. Other banners in the upscale niche, like Sprouts or Lucky's, are still making their reputations and don't have nearly enough nationwide penetration to constitute serious competition.

However, the competitive situation in the upscale niche is hardly stagnant. Grocers of all kinds are going after that market, at least in chunks, with expanded offerings of organic and high-end products. Even Walmart is making more of an effort to bring in organic produce at affordable prices.

As for Kroger, about two years ago they reorganized their organic private-label products into a line called Simple Truth Organic. (Another line, called just Simple Truth, is for products that are not organic but are nonetheless free of 101 different kinds of artificial ingredients and preservatives.) The reorganization and subsequent expansion was a smash hit, with the lines exceeding company sales goals by 33 percent in their first full year. They broke $1 billion in sales last year and were named by company president Mark Ellis as a factor in Kroger's overall success.

The Harris Teeter deal will help Kroger develop its organic offerings, at least indirectly. One of the things Kroger wants to learn from Harris Teeter is how to make its supply chain for produce, both organic and conventional, more efficient, Dillon told the New York Times: "It won't be as much, I think, in the actual products as in the methods by which we get the products to the market."

The HT deal also was attractive because of location. The purchase allowed Kroger to enter the Southeast, a region where it had had next to no presence. This not only spread their nationwide reach but, perhaps more importantly, required no divestment of property to satisfy antitrust regulators. The Carolinas are also a region relatively underserved in grocery outlets, although the competition is heating up there with the arrival of Publix.

Benefits from the deal have the potential to run in both directions. Kroger has one of the best-developed loyalty programs in grocery today, with some 90 percent of its shoppers estimated to participate, and it partners with dunnhumbyUSA in a joint venture to develop and extract the most information from its loyalty program. Harris Teeter's own loyalty database could potentially benefit from access to Kroger's expertise.

There's also the matter of Harris Teeter's debt, which Kroger assumed as part of the deal. The $100 million debt is part of the $2.44 billion purchase price and will be folded into Kroger's existing debt, which now stands at about $9.6 billion.

Wall Street seemed to approve of the deal, as it has approved of nearly everything Kroger has done lately. The shares of both companies rose immediately after the merger. Kroger is one of Wall Street's darlings generally, with a stock price that has more than doubled in two years.

The Harris Teeter acquisition may not look like much in the context of Kroger's total balance sheet. Harris Teeter generated $4.5 billion in revenue in 2012, less than half a percent of Kroger's revenue. But the deal was the third-largest acquisition of the decade in grocery up to that point, although eclipsed by the Safeway-Albertsons merger (see page 28). More will probably come, as grocers strive to defend themselves against Walmart and other discounters.