What's up With Supermarkets?

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

Supervalu (NYSE: SVU), Safeway (NYSE: SWY), and Kroger (NYSE: KR) have been up double and even triple digits in the last year. Supermarkets still have some of the thinnest margins of any industry so one has to wonder: is the party over?

Go East, young man!

The excitement over Kroger may be justified as it agreed to acquire Harris Teeter supermarkets, a chain of middle to high end supermarkets located in the mid-Atlantic and southeast, for $2.5 billion. Harris Teeter competes against privately held Wegman's, a chain that gets the highest ratings from shoppers year after year. Harris Teeter and Wegman's are both building new stores near me competing head-to-head. Harris Teeter stores are also a rival of Whole Foods Market for the higher end grocery dollar.

Kroger had little exposure to the affluent Eastern seaboard until now with the addition of 212 Harris Teeter stores but did they pay too much for a saturated market?  According to Fellow Fool Timothy Green's analysis Kroger is paying a 28 earnings multiple for Harris Teeter.  Fine, if that would really place them in a competitive advantage in this region, but Safeway and Giant Food and other grocer brands owned by Royal Ahold are dominating grocers in the mid-Atlantic region, not to mention Whole Foods doing well in this area. And, there's a plethora of smaller chains, including Weis Markets, bottom dollar, Food Lion, etc., if all the loyalty tags on my keychain are any indication (ten at last count).

Kroger, the nation's biggest grocer, is trading at 52-week highs after the announcement with an 82.46% surge in share price this last year. This party is definitely winding down as the easy money has been made. Now that Kroger has added even more debt to the balance sheet, pushing $10 billion, it's looking less attractive. The yield isn't that hot at this level, only 1.6% and trailing P/E is 13.43.

<img alt="" src="http://media.ycharts.com/charts/023d8880b631eb5cbe8118f2eda417b5.png" />

KR Profit Margin Quarterly data by YCharts

Is this party winding down, too?

Supervalu had been a disaster the last few years with the share price dropping to $2.00 giving reason to think the ticker was an acronym for Supermarket Victims Unit. It was easy to justify not wanting to join this party. However, it has run a whopping 234% in the last 52 weeks. Part of this run is attributable to big short squeezes with a current decreasing short interest at 25.70%. The forward P/E for 2015 is 13.89 so it seems the market has already priced in future growth.

Supervalu already has a presence in the mid-Atlantic with 55 Shoppers Food & Pharmacy stores and 46 Farm Fresh stores in Virginia for a total of 191 under its Retail Food segment. The company operates 350 and licenses an additional 950 Save-A-Lot stores. The company has a third leg of business with its wholesale distribution segment.

The company seems to be on track to execute its turnaround: eliminating the dividend, selling off its banners Albertsons, Acme, Jewel-Osco, Shaw’s and Star Market in March to Cerberus Capital, refinancing $400 million worth of loans and extending them to 2021, and finally, shaking up the Board of Directors with new appointments and a new CEO, Sam Duncan

The company reported Q1 2014 results of an improvement to gross profit margin of 13.8% to net sales  from 13.5% for the the year-ago quarter due to cost-cutting initiatives and reducing the declines in sales at all three segments. Adjusted EPS came in at $0.14 better than the expected $0.04 but revenues at $5.16 billion didn't quite meet the expected $5.17 billion.

Still, reducing sales declines is not as cheering as accelerating revenue growth. Now leaner and meaner, Supervalu still has to compete against Wal-Mart and Whole Foods as well as  other supermarkets. To that end CEO Duncan announced corporate owned stores would feature fresh saw-cut meat, training to improve fresh produce display and longevity, and  expansion and coordination of private label brands in which it lags both Kroger and Safeway as a percentage of sales (29% Kroger, 25% Safeway, and 22% Supervalu).

Is the party just starting at Safeway?

Safeway, which owns banners Safeway, Von's, and Dominick's, reported on July 18 numbers that met expectations of $0.51 on EPS and disappointed on revenue of $8.6 billion versus $10.45 billion expected.

Still, shares rose as operating profit margin improved to 1.59%, a two basis point gain.(What did I tell you about tiny margins?) Like Supervalu it has been jettisoning parts of the operation including all its Canadian stores and spinning off Blackhawk Network Holdings, its gift card division which IPOd in April. Proceeds from these two actions are to be used to pay down $2 billion in debt and buy back shares. Safeway still owns a 73% stake in Blackhawk worth $900 million.

Safeway stock has also surged by 72% but as a value name still offers a 3.00% yield at a trailing P/E of 11.78 with a price/book of 1.97. Despite that yield there still exists a high short interest of 22.40%, but decreasing.

Safeway has some initiatives in place that are helping margins improve: their Just for U loyalty rewards program with 5.8 million households signed up, expansion of private label, a soon to be rolled out Wellness program, and again, a new CEO in Robert Edwards.

On his first earning call as CEO, Edwards said one thing in particular which helped shares soar: "Our U.S. market share, as measured by Nielsen, grew for the fifth consecutive quarter. We gained 20 basis points in the supermarket channel and 2 basis points in the all outlet channel."

CFO Peter Bocian offered more encouraging words that free cash flow improved by $338 million due to lower capital expenditures. Historically, CEO Edwards pointed out the company uses 75% of FCF for shareholder return and buybacks and 25% to pay down debt.

 A good time was had by all

A very good time was had if you were in Supervalu from its lows, but not bad at either Kroger or Safeway. I think Kroger paid too much for Harris Teeter's presence in saturated markets. Supervalu should be considered a small-cap speculation. Shareholder-friendly Safeway can still be bought on pullbacks by value income investors but don't expect huge share price appreciation.

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AnnaLisa Kraft has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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