Does a Target-Kroger Merger Make Any Sense?

Every grocery retailer needs a dance partner these days, it seems. After Walmart (NYSE: WMT) acquired Jet.com and Amazon (NASDAQ: AMZN) bought Whole Foods Market, rumors are now aflutter that Kroger (NYSE: KR) and Target (NYSE: TGT), two of the country's biggest retailers and grocery sellers, could also merge.

Last Friday, Fast Company reported that the two retail giants were discussing a merger, according to "several people familiar with the matter."

However, soon after, CNBC and Reuters reported that there was "no truth" to the possibility of a merger, though the two companies did discuss a partnership around Shipt, the delivery service that Target acquired late last year.

Despite the attempt to put the kibosh on rumors, talk in the financial media about a tie-up between the two companies has continued. Does a merger between Target and Kroger make sense? There would certainly be challenges in combining the two companies, but there are a few reasons why a merger could be in their best interest.

1. Kroger is already shopping for a partner

Kroger, the nation's largest traditional supermarket chain, has already been looking for a partner, likely a response to moves by rivals Walmart and Amazon. Kroger made an offer to acquire Boxed, the buy-in-bulk e-commerce company, for $400 million earlier in the year, but was rejected. Reports in January also indicated that Kroger had explored a relationship with Chinese e-commerce giant Alibaba as the two companies held early talks about business development, but no meaningful relationship appears to have followed.

Unlike Walmart, Amazon, and Costco Wholesale, which have all reached all-time highs lately, Kroger stock is down nearly 50% from its peak at the end of 2015. Due to rising competition, the company has been forced to repeatedly cut its profit forecast, and comparable-sales growth has slowed in recent years. In fiscal 2015, which ended in early 2016, Kroger posted 5% comparable sales growth. By fiscal 2017, which just ended, that had slowed to 0.7%, however that figure improved over the course of the year. Given those challenges and the increasing importance of the online channel, it makes sense for Kroger to seek a partner like Boxed, Alibaba, or Target, and the company has a long history of acquisitions.

2. Shipt could work well for Kroger

Target's acquisition of Shipt last year signaled that the company was getting serious about e-commerce and speedy delivery. With the help of Shipt, a rival to Instacart, Target has begun offering same-day delivery from select locations for an annual fee of $99 on orders of $35 or more. Fast delivery is most important in grocery, the biggest segment in retail. Though the vast majority of grocery shopping still takes place in stores, that may soon change as Amazon has promised to make two-hour delivery available from all Whole Foods locations by the end of the year, and Walmart is launching delivery from more than 800 stores to serve 40% of all Americans.

Kroger needs to catch up -- and Shipt presents an excellent opportunity to do so. Kroger already offers same-day delivery through Instacart and Shipt in some markets, but a closer partnership with Target and its new delivery service would allow it to rapidly expand its delivery capabilities, helping it to defend itself against Walmart and Amazon.

3. Target needs help in grocery

Target, whose brand has long been associated with "cheap chic" items in categories like home and fashion, has struggled to develop a meaningful presence in grocery. Rivals like Walmart and Costco, which also sell a wide variety of general merchandise, have made grocery their biggest category and used it as a way to drive frequent purchases. However, Target has had less success. Groceries are a $15 billion-a-year business for the big-box chain, but that's only about 20% of Target's total revenue, and groceries carry lower margins than other retail segments like apparel and home goods.

Grocery has always been something of an also-ran category for Target, but since competition has increased, the company needs to elevate its strategy. A merger or a partnership with Kroger would help the company lower prices and could improve its merchandising, supply chain, and tech, among other areas.

Despite these potential synergies, a full-fledged merger between Target and Kroger still seems unlikely. Both chains have over 2,000 of their own stores, and distinct cultures and businesses. If they were to combine, Target would likely retain its own brand since stores bear little resemblance to Kroger's banners. Both companies have also seen momentum building in comparable-sales growth in recent quarters, making a merger less desirable or and unnecessary.

Considering Kroger's talks with other companies, a strategic partnership with Shipt would be a smart move for the grocer, but a complete merger between Target and Kroger would bring too many of the usual risks that come with such combinations.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Jeremy Bowman owns shares of Kroger. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends Costco Wholesale. The Motley Fool has a disclosure policy.