OREANDA-NEWS. Fitch Ratings has affirmed The Kroger Co.'s (Kroger) Long-term Issuer Default Rating (IDR) at 'BBB' and Short-term IDR and commercial paper ratings at 'F2'. The Rating Outlook is Stable.

KEY RATING DRIVERS

Industry-Leading ID Sales: Kroger generates industry-leading nonfuel identical store (ID) sales growth, which has led to market share gains in most of its major markets. Nonfuel ID sales have been positive for 46 consecutive quarters and have accelerated in recent periods due mainly to an increase in customer visits. ID sales increased 5.7% in the first quarter ended May 23, 2015, after rising 5.2% in 2014, 3.6% in 2013, and 3.5% in 2012. Growth has been due to pricing perception by customers, effective marketing through use of loyalty card data, and improvements to the shopping experience. Fitch expects Kroger will maintain low to mid-single-digit ID sales growth of 3% - 4% over the next 2 - 3 years.

Gradually Improving EBIT Margins: After trending lower for several years due to investments in price, Kroger's gross margin is currently benefitting from the decline in fuel prices and the positive mix effect of the $2.4 billion acquisition of Harris Teeter Supermarkets, Inc. (HTSI) in 2014. Kroger has successfully offset long-term gross margin pressure with cost-containment and the leveraging of fixed costs, enabling gradual EBIT margin expansion from 2.8% in 2012 to 3.0% in 2014 and 3.5% in the latest quarter. Fitch expects slight EBIT margin expansion in the 5 basis points (bps) to 10 bps range in 2015 and 2016.

Higher Capex to Support Growth: Kroger has stepped up its new store growth, both organically and through acquisitions, to support its long-term earnings per share growth target of 8%-11%. Capex is projected to approximate $3 billion to $3.3 billion in 2015, up from $2.8 billion in 2014, to support high return projects and faster store growth in its existing markets. Kroger's acquisition of HTSI expanded its presence in the Southeast and Mid-Atlantic markets while the company has identified several high potential markets for fill-in opportunities.

Cash Flow Usage, Healthy FCF: Kroger has utilized its cash to invest in its business, repurchase shares, which helps support its long-term annual EPS growth goal of 8% - 11%, and to fund its dividend. Fitch expects FCF after dividends to track around $500 million-$600 million annually over the next three years. This takes into account growth in capex in 2015, increasing by $200 million per year in subsequent years, and modest dividend growth. Kroger reviews its dividend yearly but the payout to net income has approximated 20% in recent years.

Steady Leverage: Adjusted debt/EBITDAR declined to 2.9x at the LTM period ended May 23, 2015 from 3.25x at year-end 2013 (post the HTSI acquisition). Leverage is within the company's targeted range of 2.0x - 2.2x net debt/EBITDA, which equates to adjusted debt/EBITDAR of around 3.0x. Debt reduction is not anticipated as management is expected to direct essentially all its FCF after dividends to share repurchases. Absent acquisitions, Kroger could also use debt to fund buybacks, given the firm's 2.0x - 2.2x net debt/EBITDA target.

Scale, Diversity Are Benefits: Kroger benefits from its position as the largest supermarket retailer in the nation, its geographic diversity, and its multiple store formats which provide convenience to its customers. Kroger generates over $100 billion of revenue, and operated 2,625 supermarket and multidepartment stores, 782 convenience stores, and 326 jewelry stores across 49 major markets in 2014. The company generally holds the No. 1 or No. 2 position in those markets. Kroger has a significant fuel business and manufactures about 40% of the private-label products sold in its stores. Corporate brands represent about 25% of total units sold, excluding fuel and pharmacy.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for Kroger include:

--Low single-digit revenue growth in 2015, due mainly to lower retail fuel prices, and then mid-single-digit growth thereafter driven primarily by supermarket ID sales.

--Nonfuel ID sales approximating 4% in 2015 and 3.5% annually thereafter.

--Moderate gross margin expansion in 2015, driven mainly by lower retail fuel dollars, as gross margin excluding the impact of fuel is projected to decline 10 - 20 bps annually due to continued investments in price.

--Fuel gross margin is assumed to stay around Kroger's normalized level of roughly 12 - 13 cents/gallon.

--EBIT margins gradually expand towards the mid 3% range over the next several years as cost reduction efforts help fund investments in price. EBITDA grows at a mid-single-digit rate with EBITDA margin remaining in the low 5% range.

--FCF (post dividends) averages roughly $500 million over the forecast period, reflecting increases in capex and modest dividend growth.

--Net debt/EBITDA remains within management's targeted 2.0x - 2.2x range, approximating 3.0x throughout the forecast period with debt increasing and proceeds used for share repurchases or tuck-in acquisitions.

RATING SENSITIVITIES

A positive rating action would be considered if adjusted leverage improved to the mid-2x range, together with steady mid-single-digit ID sales growth and gradual margin improvement. This is not currently anticipated given that management's 2.0x - 2.2x net debt/EBITDA target equates to total adjusted debt/EBITDAR of around 3.0x.

A negative action would be considered if adjusted leverage moved up to the low-3x range due to pressure on margins and/or a more aggressive approach to share repurchases or acquisitions. Persistent declines in supermarket ID sales and/or the consistent loss of market share could also contribute to a negative rating action.

LIQUIDITY

Kroger had $3.7 billion of liquidity at May 23, 2015, of which just under $1 billion was readily available cash and the remainder was availability on the firm's $2.75 billion revolver. Ongoing liquidity is supported by the company's FCF which Fitch projects will approximate $500 million - $600 million annually. Kroger's revolving credit facility expires in June 2019 and supports commercial paper (CP) borrowings and letters of credit (LCs). The revolver subjects Kroger to a maximum net debt/EBITDA financial maintenance covenant of 3.5x, with the company's 2.0x - 2.2x leverage target resulting in significant cushion. Kroger had no borrowings and $8 million of LCs under the credit facility as of May 23, 2015.

FULL LIST OF RATING ACTIONS

Fitch has affirmed Kroger's ratings as follows:

--Long-term IDR at 'BBB';
--Senior unsecured notes at 'BBB';
--Bank credit facility at 'BBB';
--Short-term IDR at 'F2';
--Commercial paper at 'F2'.

The Rating Outlook is Stable.