Why It Makes Sense For Kroger And Albertson’s To Merge

Disclosure: I am an investor in Albertson’s.

By noon today, Albertson’s stock was up over 10% on reports that it will merge with its bigger rival KrogerKR
. The two companies are the #1 and #2 grocery-only businesses in the country and a possible combination would be a huge change in the industry. (WalmartWMT
sells more grocery than either but because it carries general merchandise is not considered a grocery company.)

Why Would This Happen?

Until several years ago, almost every household in America shopped for groceries the same way your mom did. But now the grocery industry is in an upheaval, as big as anything that has ever happened in any retail sector.

Now that groceries can be shopped for without ever going to a store, a low-margin business like grocery is challenged. Consumers historically picked their own products and brought it home themselves, saving the retailers billions in logistics. With customers shopping online and requiring delivery, the additional picking and delivery costs change the economics fundamentally.

Stores are becoming less necessary and logistics-to-home are critical. With the industry anchored in stores everywhere, the industry’s fixed cost structure is challenged.

In the future, the industry needs fewer stores for fewer customers coming in. Importantly, it also needs two types of distribution-to-home locations. One for regularly re-ordered products where you can order well ahead of time, usually the things you find in the core aisles of the store like paper towels, breakfast food, condiments, and one for fast delivery of fresh food or items needed immediately (like when you have a half-made dish on your counter that’s missing an ingredient).

For all of that change to happen, the industry has to be open to change. Stores need to be consolidated and while part or all of some stores will be suitable for conversion into distribution centers for home delivery, many will have to be shuttered. That will require enormous scale and capital to accomplish. Competing stores right next to each other will have to consolidate.

All those changes are why Kroger and Albertson’s should merge. They can close stores that compete directly, they will have greater resources to create the distribution they need and they will have increased buying power to remain efficient.

I wrote about all these ideas two years ago and explained why the two should merge; the idea was ridiculed. Legacy companies often don’t see how things are changing until it’s too late. Fifty years ago, Sears was the world’s largest retailer and was in the perfect position to become what AmazonAMZN
is today. Sears squandered that opportunity by choosing to remain what it was at the time. But unlike Sears, Kroger and Albertson’s get that something has to change for them to adapt and grow. If they do this deal or another involving similar changes, kudos to their management for being willing to change the fundamentals in their businesses to accommodate the changing market.

You might say that the deal won’t pass anti-trust muster. You might be right but this deal has a lot of arguments in its favor. Walmart is aggressively building its direct-to-consumer grocery business, using its massive scale in grocery and other businesses to gain advantage. Amazon acquired Whole Foods and is investing enormously in grocery. Success in grocery is mission-critical for all these companies. It would be folly to say that Kroger and Albertson’s will dominate the market if they merge, Walmart and Amazon will use everything they can to dominate the grocery business.

It’s impossible to say whether this combination will happen. Albertson’s announced in February that it is considering strategic alternatives, often a euphemism for a sale of the company. And it’s only a rumor at this stage. But the deal has a lot of arguments in its favor and whether it happens or not, it’s conceivable because it’s driven by the enormous changes taking place in the grocery business.

Whether this deal happens or not, a reconfiguration of the industry won’t be surprising as grocers realign themselves to survive the coming changes in the grocery industry and the competition Walmart and Amazon.