Bargain Hunting In The Grocery Sector

Bill is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The largest grocery company in the United Kingdom, Tesco (NASDAQ: TESO), is likely to divest its United States Fresh and Easy stores. This announcement was made because Fresh and Easy as a whole was unprofitable and in response to the departure of the segment’s business head.

This could be a boon for U.S. grocery stores. In the grocery industry, Tesco is a big and scary competitor. Its attempt to reduce its participation in the U.S. market is a victory for other grocery stores which were able to stand their ground.

This is a plus for grocery stocks. They may be able to recover market share and their ability to resist new entrants has been tested. However, investors must also make sure that potential buy candidates in the industry are trading at attractive valuations.

Tesco Looks to Leave

Tesco’s exit from the United States could take the form of closure, sale or a partnership. The company has already been approached for its business and has hired Greenhill, an investment bank. Fresh and Easy has stores in Nevada, Arizona and California. Potential partners have contacted the company for all as well as a part of Fresh and Easy. There are no expectations that major international retailers would be interested. It is expected that local retailers would take an interest in the company.

The strategy to exit has been met with approval from analysts. The reason is that Tesco has made an investment of $1.6 billion since 2007 but has not made a profit at all since formation. After the announcement, the shares of Tesco gained 4.8% in London trading, the highest gain since May 26th, 2009. This halted the decline in share price. The share price has seen a decline of about 17% this year. Tesco had also paid $64.67 million to Aeon in order to let go of its 50% stake in its Japanese business.

Tim Mason, the CEO of Fresh and Easy has also decided to leave. He had been with the company since its inception and was responsible for building the company. The grocery chain was built on the principles of healthy food, budgeted price as well as dominantly selling own brand items. An example of the own brand item is the Atlantic Salmon ready meal that was distributed in Riverside, California. The store is considered to be a discount store but its costs were high. Moreover, it was difficult to get people to change their shopping habits of buying from big supermarkets or supercenters. The breakeven of the company was even pushed back till the fiscal of 2013. Store openings were also to be slowed down in order to focus on the existing stores and improve their profitability.

The same store sales for the company rose by 1.8% in the third quarter but prior quarter growth was 6.9%. The growth in the United States has slowed down. It cannot keep subsidizing the business in the United States with the business from the United Kingdom. It has already exited Japan this year. An exit from the United States would mean a further retreat in the international markets. In terms of sales, one third of the company’s sales in the most recent financial year were from the international markets. South Korea was the largest contributor to this figure.

The sales in the United Kingdom at stores that have been open for at least a year have also fallen by 0.6% (excluding value added tax and gasoline) for a 13 week period that ended on November 24th. Same store revenue has gone up by 0.1% in the last quarter. This has reversed a decline that had continued for six quarters. The sales decline in the United Kingdom is another hurdle for the company. The company is investing $1.6 billion in order to upgrade its stores, hire more staff as well as introduce new products. The company has said that the fall in sales figures was mainly due to non-food items. This is only a partial reflection of the fall in demand by the consumers. The company outperformed the market in same store food sales.

Valuation Considerations

Consider the financial ratios of the firms which are operating in the U.S.:

Ticker

Company

P/E

P/S

P/B

D/E

EPS Growth Next 5 Years

SWY

Safeway

9.34

0.1

1.52

2.31

9.3%

KR

The Kroger

19.33

0.15

3.59

2.35

9.4%

CASY

Casey's General Stores

16.36

0.27

3.49

1.25

11.4%

WMK

Weis Markets

12.84

0.37

1.3

NA

NA

HTSI

Harris Teeter Supermarkets

18.18

0.4

1.76

0.2

12.0%

WFM

Whole Foods Market

35.13

1.4

4.32

0.01

16.8%

TFM

The Fresh Market

37.15

1.79

13.1

0.27

23.0%

Of these Fresh and Easy survivors, Safeway (NYSE: SWY) is easily the cheapest. It is also very highly leveraged with a debt-to-equity ratio of 2.31. The firm will be able to shore up some liquidity from the IPO of Blackhawk Network Holdings. Safeway’s geographic footprint in the Western U.S. makes it a beneficiary of reduced competition from a retreating Fresh and Easy.

Kroger (NYSE: KR) shares are reasonably priced at a low price-to-sales multiple. Its Ralph’s stores in California will benefit from Tesco’s divestment decision. Investors should probably consider Safeway first since it is much cheaper than Kroger on the basis of price multiples.

Another cheap name on this list is Weis Markets (WMK). It is less levered than Safeway, but it is also trading at somewhat higher price multiples. It operates in the Pennsylvania area, so it will not experience any relief from the Fresh and Easy surrender. Similarly, Casey’s General Stores (CASY) operate in the Midwest and will not feel any relief from this news.

The remaining names on this list are too expensive to warrant further consideration.

Conclusion

Shares of Safeway are the best way to play Tesco’s decision to divest from its Fresh and Easy stores. Since the firm is highly leveraged, any position would be speculative and should be kept small.


BillEdson11 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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