This Grocer Presents a Super Value Opportunity

By Tom Gibbs - May 21, 2012 | Tickers: COST, SWY, SVU, KR, WMT | 0 Comments

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The grocery industry is abuzz thus far in 2012 as discretionary consumer spending has continued to increase and many shoppers begin to emerge from the “emergency saving” habits that have developed over the past several-year recessionary period.  Many of the sector’s primary players -- including Kroger (NYSE: KR), Safeway (NYSE: SWY), Wal-Mart (NYSE: WMT), and Costco (NASDAQ: COST) -- have enjoyed increasing top lines from mid-recession trough levels as a result of consumers spending more per shopping visit on more discretionary and higher-margin items like pre-made foods and wines/spirits.

The same cannot be said about Supervalu (NYSE: SVU), which has experienced a near 20% revenue decline and has lost 90% of its stock value over the past five years.  On the surface, the grocer appears to be an entity that most would not touch with other investors' money – short interest represents more than 40% of the float, the corporation has an extremely unattractive debt and pension obligation balance, and performance metrics (on square footage basis) continue to falter while competitors continue to enjoy year-over-year improvements. 

Despite the poor performance over the past several years and the huge strides Supervalu must take to restore confidence in its brand, the gross beating that the stock has taken since recent 2007 highs has created a unique value-focused opportunity for patient, long-term oriented investors.  The recent upgrade from Longbow Research from neutral to buy – with a price target of $8 (64% appreciation from today’s price) – suggests that others believe that the wheels are already in motion for a turnaround. 

Why is Supervalu a buy at current market valuations?

A Plan is Outlined

An investment in Supervalu is not based on hopes that the grocer can boost its top line and operating margins to average peer levels.  Due to the pessimism surrounding the stock and the weak outlook expectations (as the short interest implies), Supervalu simply needs to show some improvement to begin driving stock price appreciation. 

The corporation has, most importantly, identified one of the primary turnaround points for operations and has outlined a reasonable plan to begin experiencing improvement.  In order to re-build consumer loyalty and drive store traffic toward historic levels (comparable store sales have declined for the past 15 consecutive quarters), Supervalu is using these approaches:

• Private Label Focus: Private label brands represented 19.3% of the grocer’s sales in the most recent quarter, which was up 145 basis points from the same quarter in the prior year.  Through continued penetration of private label sales via heightened customer awareness and the addition of new product lines, Supervalu expects an additional 100 basis point improvement per year over the next three years.  Such an improvement in private brand sales will inherently reinforce customer buying habits and simultaneously drive gross margins.
• Every Day Low Prices: Supervalu continues to transition to a Wal-Mart-like every day low price merchandizing strategy, with the goal of building customer loyalty in mind.  Similar to Wal-Mart, the plan should reinforce the notion that Supervalu provides savings across its entire product line, as opposed to the pick-and-choose promotions traditionally used by the competition.  The plan should bode well with the grocer’s core value-focused, and generally less-affluent consumer group.  Recent price reductions of up to 20% on over 200 items have been implemented without a significant hit to gross margins.
• Hyperlocal Strategy: Supervalu has placed a larger emphasis on “fresh” food products and has rolled out locally grown produce displays to build closer ties with its local constituents. 

Cash Flow Positive

Supervalu is still free cash flow generative despite the dramatic fall in revenues over the past several years.  More importantly, the corporation is inexpensive on a free cash flow basis even when considering it's building debt and pension obligation balances. 

The following takes into account the cash/debt positions and the square footage performance metrics of each individual grocer.  The free cash flow “yield” that an investor would receive from an investment in Supervalu is made even more attractive when considering that such performance was generated from trough revenue levels.  Supervalu – which is already inexpensive – is in the best position when compared to other players in the field in terms of showing large performance improvements over the mid-term.

Note: “Yield” is defined as the purchase price of the TTM Cash Flow (EV/FCF) divided by the purchase price of the square footage (EV/Square Foot), i.e. what an investor receives for what they pay. 

More Catalysts in Future

Supervalu can be commended for the responsible use of its free cash over the past five years, as a significant portion has been used to repay long-term debt and distribute dividends to shareholders.  Nearly $5 billion has been used over the past five years to pay off debt, and although more debt has been raised over the same time period, the total burden has been cut by 30% since 2007.  Debt repayment continues to be of top priority, and because Supervalu is cash flow positive even when generating tough level revenues, there should be no concerns whether or not the corporation an continue to pay down debt over the near future.  A further beautification of the corporation’s balance sheet represents a rather attainable catalyst toward improved market optimism surrounding the stock. 

In order to maintain customer loyalty over the long run, however, Supervalu does need to place a higher emphasis on the reinvestment back into its vast store base.  On a sales and square footage basis, Supervalu has historically spent considerably less than its peers in capital expenditures, and it is now questionable whether or not free cash would be better spent in repaying shareholders with dividends or infusing the cash back into operations to maintain the attractiveness of its outlets.

• Capex/Sales Discrepancy (% difference between the average of Kroger, Costco, and Safeway versus Supervalu)
• 2011: 9.4%
• 2010: 16.8%
• 2009: 26.4%
• 2008: 7.7%
• 2007: 13.3%

Supervalu management may tend to agree with the latter argument, as the dividend payout has been cut in half over the past several years, and the capex/sales discrepancy with other grocery competitors appears to be diminishing.  A continued focus on existing stores will drive return visits and build loyalty among its core consumer base (loyalty is not built from a one-time remodeling of a given outlet). 

Supervalu is by no means in the best position in the grocery industry on any given metric – sales growth, earnings growth, balance sheet position, or free cash flow generation.  It is for this exact reason, however, that the corporation is selling for such attractively distressed levels.  Because it is doubtful that market sentiments of Supervalu will continue to weaken even further – the stock price has dropped 90% from historic 5-year highs, most of the competition has already experienced their post-recession returns to normalcy, there are several catalysts for continued operational improvement – even incremental, baby-step performance gains will tend to “wow” the market and drive disproportional price appreciation for Supervalu investors. 

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