Kroger’s Potential Acquisition of Albertsons Will Trigger 101% Put Right in Albertsons’ Notes Only If Accompanied by Ratings Decline; Kroger Revolving Facility Likely Cannot Remain Outstanding Following Purchase

Relevant Items:
Covenant Tear Sheet, Debt Document Summaries
Albertsons’ Debt Documents
Albertsons Q1’22 10-Q

This morning, various news outlets reported that grocery giant Kroger may acquire Albertsons in an “all-cash acquisition” that may be announced Friday morning, Oct. 14. The various news outlets did not report an acquisition amount as of today. Albertsons’ stock rose 11% and its bonds ticked up several points today.

Reorg Covenants, which previously discussed Albertsons’ flexibility to enter into various potential strategic alternatives, here updates that analysis and concludes that:
 

• The acquisition of Albertsons by Kroger is likely a “change of control” under Albertsons’ senior notes, but it will not trigger a 101% put right for noteholders unless the ratings on the notes are withdrawn or downgraded by both Moody’s and S&P Global Ratings;
   
• A “change of control” is an event of default under Albertsons’ ABL facility, so the ABL will need to be amended, terminated or replaced;
   
• Assuming that Kroger intends to use debt to finance all or a portion of the acquisition cost, it will likely need to amend, terminate or replace its unsecured revolving facility due to the restrictive nature of a subsidiary debt covenant contained therein; and
   
• Kroger’s senior notes and Albertsons’ senior notes likely do not present any issues for the acquisition in terms of financing, although certain legacy notes of Albertsons may restrict the possible collateral package if such financing is secured.
   

Earlier this year in February, Albertsons announced that its board was considering strategic alternatives to enhance growth and maximize shareholder value. The board’s strategic alternatives review included “an assessment of various balance sheet optimization and capital return strategies, potential strategic or financial transactions and development of other strategic initiatives to complement Albertsons’ existing businesses, as well as responding to inquiries,” according to the release.

In connection with its board-led review of potential strategic alternatives to enhance the company’s growth and maximize stockholder value, the company reported it has engaged a third party to review the value of its real estate portfolio. Based on the completed real estate appraisal, the total value of company-owned and ground-leased properties has increased approximately $2.5 billion to $13.7 billion, up from $11.2 billion in 2019.

This article will recap our previous covenants analysis regarding a change of control, analyze the companies’ financing flexibility under their debt documents and discuss Albertsons’ and Kroger’s recent financial results.

Albertsons’ capital structure as of the fiscal year 2022 first quarter ended June 18 is shown below:
 
Albertsons’ 5.875% unsecured notes due 2028 traded up 4 points today to 95.50. The 4.625% unsecured notes due 2027 traded up 3 points today to 93.25.
   
As shown in the cap table above, Albertsons’ senior notes can be divided into three categories: the Albertsons Senior Notes (“ACI Notes”), which are co-issued by Albertsons Cos. Inc., Safeway Inc., New Albertsons LP and Albertsons LLC and guaranteed by the company’s domestic subsidiaries; and the Safeway Notes and New Albertsons Notes, which are “legacy notes” that the company assumed in connection with various acquisitions.

Only the ACI Notes, and not any of the legacy notes, contain change-of-control provisions. As Reorg Covenants previously discussed, the ACI Notes require a 101% change-of-control offer upon the occurrence of both a change of control and a ratings event.

A change of control will occur if any person or group, other than certain permitted holders consisting of Albertsons’ sponsors and their affiliates, acquires more than 50% of the voting power of Albertsons or if Albertsons and its subsidiaries sell all or substantially all of their assets, taken as a whole, to anyone other than a permitted holder.

Although the precise structure of the Kroger acquisition is unknown, it will almost certainly constitute a “change of control” under the ACI Notes’ indentures. Holders of the ACI Notes will only receive a 101% put right, however, if a “ratings event” also occurs.

A ratings event requires that the applicable note series’ rating is lowered or withdrawn by both Moody’s and S&P any time during the period starting with the announcement of the change-of-control transaction and ending 60 days after the consummation of the transaction, and that the ratings agency publicly announces or confirms that such a reduction was the result, in whole or in part, of the change of control.

Accordingly, even though Kroger’s purchase of Albertsons would likely result in a change of control under the ACI Notes, holders of the ACI Notes would not be able to put their notes to the company unless the change of control was accompanied by a ratings downgrade and accompanying public announcement by both Moody’s and S&P.
 
The ABL facility, like most credit agreements, treats a change of control as an event of default. The undrawn ABL can likely be amended or replaced fairly easily and would therefore likely not be considered an obstacle to the Kroger acquisition.
 
CNBC reported that the acquisition will be “all-cash.” As of Aug. 13, Kroger had an undrawn $2.75 billion unsecured revolving facility and about $1.1 billion of cash on its balance sheet, which means that it will almost certainly be incurring debt to finance the acquisition.
 
As mentioned above, Kroger has an unsecured revolving facility as well as about $10.2 billion of unsecured senior notes as of Aug. 13. The senior notes, which are subject to an investment-grade covenant package, likely do not present any issues for the potential acquisition but Kroger will likely need to amend or replace its revolving facility in connection with its purchase of Albertsons.
 
Kroger’s revolving facility contains a limited negative covenants package that includes covenants restricting liens and subsidiary debt but no covenant restricting debt incurrences by Kroger. There is, however, a 3x net leverage ratio maintenance covenant that is always tested, which can limit debt capacity at the parent. Kroger reported that its net debt to adjusted EBITDA ratio as of Aug. 13 was 1.63x with about $12.4 billion of outstanding net debt, which would leave the company with about $10.5 billion of additional debt capacity.

Although Kroger will likely need more than $10.5 billion of additional debt to fully finance the acquisition, Albertsons’ EBITDA may provide additional capacity depending on the amount Albertsons’ debt that remains outstanding after the acquisition. As of June 18, Albertsons’ adjusted EBITDA was about $4.5 billion and its net leverage ratio was 1.1x.

In any case, an amendment or replacement will likely be required due to the subsidiary debt negative covenant. This covenant restricts Kroger’s subsidiaries from incurring debt, with very limited exceptions. The only exception the Albertsons’ debt could use is a general exception for debt equal to 5% of consolidated tangible assets, which would permit about $2.24 billion of debt as of Aug. 13, far less than Albertsons’ current senior note debt.

The liens covenant in the revolver contains similar exceptions to the liens covenant in the senior notes, discussed below, and therefore would likely not create any issues, but given the subsidiary debt covenant and leverage ratio maintenance covenant, the revolver likely will not survive the acquisition in its current form.
 
Kroger’s disclosures do not break out the senior notes by series or amount, so it is not clear how many, or which, series of notes remain outstanding. For this analysis, we review the most recent issuance: 1.7% senior notes due 2031 issued pursuant to a Forty-Ninth Supplemental Indenture dated Jan. 12, 2021 (the “2031 Notes”).

The 2031 Notes contain a liens covenant and sale-leaseback covenant but no other restrictive covenants, so they do not restrict Kroger’s ability to incur unsecured debt.

The liens covenant restricts Kroger and its restricted subsidiaries from incurring debt secured by liens on “Operating Property,” defined as owned or leased real property and improvements, including stores, warehouses, service centers and distribution centers, or “Operating Assets,” defined as merchandise inventories, furniture, fixtures and equipment (including all transportation and warehousing equipment but excluding office equipment and data processing equipment).

There is a general exception equal to 10% of Kroger’s consolidated net tangible assets, which permitted almost $2.9 billion of liens as of Aug. 13.

There are also exceptions for liens on property of any corporation that becomes a restricted subsidiary or is merged with or into a restricted subsidiary, as long as such liens extend only to the property of the acquired company. This type of exception often requires that such liens not be incurred in contemplation of the acquisition, but the baskets in the 2031 Notes do not contain such a requirement. Any liens put on Albertsons’ assets prior to the acquisition, even if in connection with acquisition financing, would therefore be permitted by this exception.
 
As discussed above, the ABL will likely need to be replaced or amended in connection with the acquisition, so the only applicable restrictions will be in the senior notes (if they remain outstanding). Only the ACI Notes restrict Albertsons’ ability to incur debt, but all note series restrict its ability to incur secured debt.
 
The ACI Notes permit unsecured debt as long as the pro forma interest coverage ratio is at least 2x. Given the company’s net interest coverage ratio of 9.6x as of June 18, this basket likely provides significant unsecured debt capacity.

The ACI Notes permit secured debt as long as the company is in compliance with a secured net leverage ratio of 3.75x, which as of June 18 would have permitted an additional $19.5 billion of secured debt. A term loan basket provides an additional $8 billion of secured debt capacity and general baskets permit over $3 billion of additional secured debt capacity. With over $30 billion of capacity, the ACI Notes are also not a significant limiter on secured debt.
 
The Safeway and New Albertsons legacy notes restrict the company’s ability to incur secured debt, but the restrictions apply only to certain entities (the legacy issuer and its subsidiaries) and specific types of collateral.

The liens covenant in the New Albertsons notes restricts liens on New Albertsons’ and its subsidiaries’ “Principal Property,” which includes real property and equipment with a book value over 1% of net tangible assets. A general exception permits liens equal to 10% of the net tangible assets of New Albertsons and its subsidiaries.

Similarly, the Safeway notes restrict only liens on the assets of Safeway and its subsidiaries and contain an exception equal to 10% of the net tangible assets of Safeway and its subsidiaries. In addition, the Safeway notes contain a lien basket for the “Bank Credit Agreement,” defined as the Safeway credit agreement dated April 8, 1997, which likely permits the liens on the ABL facility as refinancing debt and would likely permit other secured debt that refinances the ABL.

Albertsons does not break out asset values at New Albertsons or Safeway in its financial disclosures so we cannot calculate these capacities. The legacy notes do not restrict Albertsons from granting liens on any other assets.

If the lien provisions in the legacy notes are problematic, the company could eliminate the lien requirements by redeeming the notes or repurchasing them on the open market. The Safeway notes can be redeemed at any time subject to a make whole premium that applies through maturity (calculated at T+10 to 45 bps, depending on the series).

Certain New Albertsons Notes, however, cannot be redeemed prior to maturity and can be taken out only through open-market purchases. Although Albertsons has consistently repurchased these legacy notes in the open market and made cash tender offers for them, the missing or dissenting noteholders may be in a strong holdout position. To the extent any New Albertsons Notes remain outstanding, the property restricted by their lien covenants may be unavailable to pledge in connection with the Kroger acquisition.
 
In July, Albertsons reported results for its first quarter ended June 18, disclosing net sales of $23.31 billion, up 9.6% from $21.27 billion in the prior-year period. The increase in revenue was driven by a 6.8% increase in identical sales and higher fuel sales, with retail price inflation contributing to the identical sales increase.

The company reported adjusted EBITDA of $1.42 billion, up 8.6% year over year from $1.308 billion in the first quarter of 2021.

Gross margin in the quarter was 28.1%, down from 29.1% in the prior-year period. The company said that the decrease was driven by fewer Covid-19 vaccines and higher product and supply-chain costs due to inflation in the first quarter compared with the prior-year period.

The company generated $991.9 million of cash from operating activities and spent $613.8 million on capital expenditures during the first quarter, implying free cash flow of $378.1 million. Albertsons reported that first-quarter capex of $613.8 million primarily included the building of its digital and technology platforms and investments in the modernization of its store fleet, including 27 remodels. In the first quarter of 2021, the company generated $1.059 billion of cash from operating activities and spent $513.4 million on capex, implying FCF of $545.6 million.

The company reported cash of $3.123 billion as of June 18, up sequentially from $2.902 billion as of Feb. 26. Total debt was $7.947 billion as of June 18, down from $7.965 billion as of Feb. 26. The company also reported a net debt ratio of 1.05x as of June 18, compared with a 1.15x net debt ratio as of Feb. 26.

Albertsons raised guidance for fiscal year 2022. The company said it expects the following:
 

• Identical store sales growth to be 3% to 4%, up from previous guidance of 2% to 3%;
   
• Adjusted EBITDA to range from $4.25 billion to $4.35 billion, up from $4.15 billion to $4.25 billion; and
   
• Capex to remain unchanged at a range of $2 billion to $2.1 billion.

Albertsons announced that it would release results for the second quarter ended Sept. 10 on Tuesday, Oct. 18.

On Sept. 9, Albertsons and Cerberus Capital Management, Klaff Realty, Lubert-Adler Partners and Jubilee Limited Partnership entered into an amendment to the previous extended lockup agreement providing for the extended lockup period to be further extended until the sooner of the release of the company’s earnings for the fiscal second quarter or Oct. 18.

Furthermore, on Sept. 9, the company and certain funds associated with HPS Investment Partners entered into a lockup agreement with terms and conditions substantially similar to the amended extended lockup agreement, referred to as the preferred stock lockup agreement. Pursuant to the preferred stock lockup agreement, HPS agreed to restrictions on its ability to sell or transfer shares of the company’s Series A preferred stock and Class A common stock that it owns until the sooner of the release of the company’s earnings for the fiscal second quarter or Oct. 18.

According to the filing, Cerberus Capital Management, Klaff Realty, Lubert-Adler Partners, Jubilee Limited Partnership and HPS collectively own, in the aggregate, approximately 360.1 million shares of Class A common stock on a fully converted basis as of Sept. 9.
 
In September, Kroger reported results for the fiscal second quarter ended Aug. 13, disclosing total sales of $34.638 billion, up 9.3% from $31.682 billion in the prior-year period. The company reported that the increase was primarily due to increases in supermarket fuel sales and total sales to retail customers without fuel.

Identical sales, excluding fuel, for the second quarter of 2022, as compared with the second quarter of 2021, increased primarily due to an increase in the number of households shopping and an increase in basket value due to retail inflation, partially offset by a reduction in the number of items in basket, according to the second-quarter 10-Q.

The company reported that second-quarter gross margin, as a percentage of sales, was 20.9%, compared with 21.4% in the prior-year period. The decrease in gross margin rate was primarily due to increased fuel sales, which have a lower gross margin rate and a higher last-in, first-out, or LIFO, charge, partially offset by Kroger’s ability to manage product cost inflation through sourcing practices and keeping prices competitive, according to the 10-Q filing.

Kroger’s reported LTM adjusted EBITDA was $7.634 billion, up from $6.881 billion the prior year.

Kroger generated $2.427 billion of cash from operations and spent $1.43 billion on capex, implying $997 million of FCF in the second quarter. In the prior-year period, the company generated $3.123 billion of cash from operations and spent $1.319 billion on capex, implying FCF of $1.804 billion.

As of Aug. 13, Kroger had $251 million of cash and $851 million of temporary cash investments, compared with $245 million of cash and $1.137 billion of temporary cash investments as of May 21.

Total debt as of Aug. 13 was $13.277 billion, down from $13.639 billion as of May 21. The company reported a net total debt to adjusted EBITDA ratio of 1.63x as of Aug. 13, down from 1.68x as of May 21 and down from 1.78x the prior year.

Kroger guided to the following for full-year 2022:
 

• 4% to 4.5% of identical sales growth (without fuel);
   
• $3.4 billion to $3.5 billion of capex; and
   
• $2.3 billion to $2.5 billion of FCF.

--Wing Li and Alisha Turak