Is What's Left Worth Owning?

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

If you are a short-term trader, the deal Supervalu (NYSE: SVU) struck to sell its Retail Food division to Cerberus private equity had to feel like a big win. However, longer-term investors have watched the stock fall from $7 a share to under $2, before recovering to around $4 today. The question facing investors is, after this sale is there anything worth owning?

Cerberus Can Have It
To say that Supervalu's Retail Food division has been underperforming would be an understatement. Cerberus is buying the Albertsons, Acme, Jewel-Osco, Shaw's, and Star Market chains for about $3.3 billion, by taking $3.2 billion in debt off of Supervalu's balance sheet, $100 million in cash, and investing 20% - 30% at $4 a share. I'm sure that Cerberus has done its due diligence, but from what I can see, this division is no great jewel. To be fair, Albertsons, Acme, Shaw's, and the like compete with much stronger companies with better brands. 

These grocery stores are facing the likes of Kroger (NYSE: KR) in the traditional grocery business, Wal-Mart (NYSE: WMT) and Target (NYSE: TGT) in diversified retail, and Costco (NASDAQ: COST) in discount groceries. The biggest difference between what Cerberus is getting and these competitors is, they each have a niche market, and Retail Foods from Supervalu does not.

Facing These Companies, The Chance Of Success Is Slim At Best
Kroger is one of the best remaining diversified players in the traditional grocery business. The company's diversified businesses include fuel centers, department stores, convenience stores, and jewelry stores. 

Wal-Mart and Target are both favorite one stop shops for millions, where they can buy groceries, clothing, home goods, and more in one place. Wal-Mart has put the most emphasis on expanding with Super Wal-Mart’s that offer a full grocery store experience. Target has also stepped into the grocery business with about 75% of its stores offering an expanded grocery selection.

If traditional grocers are having problems with companies like Wal-Mart and Target, than Costco has to be their worst nightmare. Costco is willing to operate on razor thin margins to gain business, and they are growing by leaps and bounds because of it.

So What's Left?
The Retail Food unit that generated almost $5 billion of sales last quarter from over 1,000 stores, will be relatively inconsequential at less than 200 stores after this deal is completed. The two remaining businesses are Save-A-Lot, which has 1,329 stores, and the company's Independent business, which distributes to 1,950 grocery stores. 

If Save-A-Lot is the future of Supervalu, the store's results don't bode well for the future. In the last few quarters, Save-A-Lot's same-store sales have declined 4.6%, 3.5%, and 4.1% consecutively. The Independent business hasn't exactly been setting the world on fire, with sales flat on a year-over-year basis recently. The remaining company will be comprised of roughly two-thirds Independent business, and one-third Save-A-Lot. With the majority of the company showing flat sales, and the rest showing same-store sales declines, Supervalu will still be a troubled company.

What About The Balance Sheet?
This is where the deal with Cerberus gets a bit murky. The equity firm is taking $3.2 billion in debt, but Supervalu has secured a $900 million credit facility, and a $1.5 billion term loan to support the deal. In the end, the company only reduces its debt by $800 million. After the deal, Supervalu will still carry over $5.3 billion in debt to just $7 million in equity. By comparison, Kroger has a debt-to-equity ratio of 1.8, Target comes in at 0.89, Wal-Mart at 0.57, and Costco at just 0.11. As you can see, even after this deal, Supervalu will have one of the weakest balance sheets in the industry. 

While it's true that the new debt cost appears cheaper, this isn't the windfall investors might first expect. The $1.5 billion term loan is priced at 5.75 percentage points more than LIBOR, and the line is priced at 2% more than LIBOR. Even if the deal saves 20% on Supervalu's interest costs, quarterly interest may still be over $100 million. Save-A-Lot and the Independent division generated about $87 million in earnings last quarter. What part of $87 million minus $100 million makes you want to buy the stock?

Won't The New Company Have Better Margins?
Save-A-Lot's operating margin was 3.8% last quarter, and the Independent division reported an operating margin of 2.5%. The combined operating margin should be about 2.9%. While this compares favorably to Kroger at 2.73% or Costco at 2.69%, the company isn't in the same league as Wal-Mart at 5.37% or Target at 6.88%. The other problem is, both of these divisions have seen severe margin erosion in the last year. With Wal-Mart and Target offering a broader lineup of goods, and Kroger and Costco competing on price, there isn't a lot of room left for Supervalu. 

What Should Investors Do?
Given the alternatives, I don't see a reason to stick around and see what happens. Whether you choose Kroger, Wal-Mart, or Target, all of these companies offer yields of over 2% with projected growth rates of at least 9.2%. Costco pays a 1% yield, but is expected to grow faster at over 12.6% in the next few years. By comparison, Supervalu is projected to show negative EPS growth. Given the company's heavy reliance on traditional and discount grocery operations, it's likely that stronger competitors like Wal-Mart and Target will continue to take market share. What these two giants don't take, Costco or Kroger will step in to retrieve. The traditional grocery store business is in trouble, and Supervalu is in worse shape than its competition. The deal with Cerberus helped the stock in the short-term, but longer term, there doesn't appear to be anything worth owning.


MHenage has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale and Supervalu. 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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