The Next Grocer To Fall

By Chad Henage - July 13, 2012 | Tickers: SWY, SVU, KR, WMT | 0 Comments

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For all the talk of how Amazon.com is disrupting big-box retailers, Wal-Mart (NYSE: WMT) is equally disrupting the major business of most grocery store chains. Proof of this fact was made very clear when SUPERVALU (NYSE: SVU) reported earnings recently. To say that the company's earnings release was bad news, is a huge understatement. The question that most investors would probably ask is, who's the next grocer to fall prey to Wal-Mart's expanded grocery selection? If you're a Safeway (NYSE: SWY) investor, consider this your fair warning.

If you look at the numbers for SUPERVALU, seemingly everything is working against the company. Sales were down 4.5%, earnings-per-share was down over 45%, and same-store sales were down as well. The main thing that caught my eye, was the financials that SUPERVALU is dealing with currently. The company sits on about $151 million in cash, however they have over $6 billion in long-term debt. This huge debt load, combined with much lower free cash flow, caused the company to have to cut capital expenditures, and eliminate the dividend. If investors in Safeway believe their company is completely different, consider some of the recent numbers.

In Safeway's last earnings report, the company reported total sales were up just 2.4%, and same-store sales were essentially flat. While this is marginally better than SUPERVALU's results, they are not exactly awe-inspiring. In addition, Safeway had a higher interest expense in 2012 versus 2011, because of higher average borrowings. I would also call into question the company's expected free cash flow projection for the full year of between $850 million and $950 million. If you look at the company's quarterly results for March of this year, and March of last year, you see that not only was the company not free cash flow positive, but they actually were free cash flow negative by a significant amount. For example in 2012, the company's operating cash flow was a negative $541 million. Considering the company did not generate any positive operating cash, this calls into question why Safeway would increase capital expenditures by over 66%. In order to make these numbers work, the company had to increase their long-term debt. Safeway's balance sheet, as a result of some of these challenges, looks eerily similar to that of SUPERVALU. Just to make the point, take a look at the difference between the cash versus long-term debt of Safeway, SUPERVALU, Kroger (NYSE: KR), and Wal-Mart.

If you look at the relative amount of cash versus long-term debt, you can see that SUPERVALU and Safeway have nearly the same numbers in both categories. While Kroger and Wal-Mart both sport a lot of long-term debt, compared to their cash balances, there's one huge difference between these two companies and the first two. Both Kroger and Wal-Mart are significantly free cash flow positive. In the most recent quarter, Kroger generated over $700 million in free cash flow and paid out just $65 million in dividends. Wal-Mart by comparison, generated over $3 billion in free cash flow and paid out about $1.3 billion in dividends. As you can see, looking at these four companies, Wal-Mart and Kroger appeared to be competing effectively, whereas Safeway and SUPERVALU seem to be in trouble.

The primary reason traditional grocers are having trouble with Wal-Mart, is simply because Wal-Mart offers much more than just groceries. The average family has to go to the grocery store at least once per week. If they need additional household items as well, most people know that these items are usually cheaper at a Wal-Mart, than they would be at the local grocery store. Because of this, the average family is choosing to go to Wal-Mart to buy everything they need in one trip. Probably the biggest difference between Kroger and the other two mentioned grocery store chains, is Kroger is more diversified in its retail operations. The company not only operates SUPERVALU traditional supermarkets, but it also operates many convenience stores, department stores, and even fine jewelry stores. This diversification gives the company some insulation from Wal-Mart's push into traditional groceries.

At this point, it seems the writing is on the wall for Safeway investors. The company's traditional grocery business is being attacked by Wal-Mart, and the company's financials look very similar to SUPERVALU. Given that we know what has just happened was SUPERVALU, it doesn't make a lot of sense for investors to stick with Safeway, waiting for the other shoe to drop. Don't say I didn't warn you.

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