Why Safeway Buyout Makes Kroger Worth Twice as Much

This is not to say Kroger shares are going to $90 or $100, but the math says it could.

Cerberus and Safeway announced their $9.2 billion deal late Thursday. Cerberus would pay $32.50 a share in cash and add in $3.65 in other distributions. Plus, Safeway would continue distributing shares of Blackhawk Network Holdings, the gift-card provider subsidiary, to its shareholders. The three together would give shareholders $40.

Let’s assume $40 is the ultimate value of the Safeway deal. That means Safeway would be selling for 32-times the consensus 2014 earnings estimate of $1.25 a share.

If you apply that price-to-earnings (P/E) ratio to Kroger, the value of its stock explodes. Kroger was selling at $44.09 early Friday. Its forward P/E ratio was 12.44 times. If you bump that P/E ratio to 32 and apply it to 2014’s expected earnings of $3.14 a share, you get $100.48.

Safeway’s current forward P/E ratio was about 29. Plug that into Kroger, and the result is $87.50. That’s just the math, and of course the situation is more complicated than that since Safeway added so much cash in 2013.

Still, these numbers for Kroger are not entirely crazy. Whole Foods Market Inc. (NASDAQ: WFM) was selling Friday at 28 times forward earnings. Granted, Whole Foods is smaller than Kroger, and investors see it as a company with more growth potential — we have even said over and over that Whole Foods should be evaluated as a higher-dollar retail destination with above-industry margins rather than just as a grocery chain with a lower margin business.

Kroger is a big company, but it is decently run. It is expected to generate $105 billion in sales in fiscal 2015, up from $98.4 billion in the 2013-2014 fiscal year. It has powerful market positions in major markets around the country, including the West, Midwest and Southeast.

But one must account for the competition from the likes of Wal-Mart Stores Inc. (NYSE: WMT) and Target Corp. (NYSE: TGT), which have expanded into groceries over the past decade or so to capture more of their customers’ dollars. They have not derailed the grocery store segment, but they are definitely one of the factors that had been an issue for the likes of Safeway.

So, the end result is that $90 is far from an absolute upside price for Kroger’s share price. But the Safeway deal suggests Kroger shares could move higher.