Deriving Super Value from Supervalu

Palwasha 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), the famous grocer that owns Albertsons and Save-A-Lot chains, amongst numerous others, is down almost 70% year-to-date and down over 18% within a month. SVU saw a boost amid speculations that Cerberus Capital Management was bringing an acquisition offer to the table.

Cerberus wanted to go for a leveraged buyout (LBO) by borrowing an estimated $5 billion for the deal. It turns out, they are now having troubles generating those funds (or maybe having second thoughts). After all, SVU has a very high debt load on its balance sheet, and assuming all of its debt plus an additional $5 billion is not going to be easy for Cerberus. Supervalu's debt to equity is crossing a whopping 98, while all of its competitors have it effectively controlled under 1.

As for the acquirers having second thoughts, that too is a possibility. Word on the street is that Cerberus' interest in Supervalu is because of its long-standing relationship with Albertsons that would make this a synergistic acquisition. Cerberus bought over 650 Albertsons stores back in 2006. Supervalu owns the rest of the Albertsons chain, with about 1,100 stores across the US. However, bear in mind that Cerberus has sold or closed down most of the Albertsons stores over these years, so it may not be that big of an interest as some might think.

Secondly, negative EPS growth for the last eight quarters and declining sales year after year make Supervalu's future look bleak compared to competitors Kroger (NYSE: KR), Safeway (NYSE: SWY) and Wal-Mart (NYSE: WMT), which all have much more attractive financials. This fact is obviously not hidden from Cerberus.

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SVU EPS Diluted Quarterly YoY Growth data by YCharts


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SVU Revenue Quarterly YoY Growth data by YCharts

I'm a long term investor, what should I do?

Analyzing product life cycles is one of my favorite business study drills. It tells you what stage an industry has reached so you can anticipate its future. The supermarket/grocery industry with countless new and old players, has clearly reached a point of saturation now where one player (Wal-Mart) holds a fourth of the total market share and another (Kroger) holds over 11%. At this stage of maturity smaller, less competitive businesses are almost always elbowed out by the surviving bigger  businesses. Intuitively, that's also how nature adjusts itself.

So, speaking for the long term, do I think we'd see a turnaround for Supervalu? No! Sooner or later, it'll be no more. Competing with the likes of Wal-Mart, Target, Kroger, Safeway, Whole Foods, Dollar Stores (and the list goes), isn't going to get any easier than it is now. The only way out? Go underground (read, private) with a concentrated focus to meet business targets and not Wall Street's targets, or get sold out to one of the bigger players. Should you wager on it for the long run? No. Not until its financials start showing some signs of improvement.

So what's next for Supervalu?

Best Case Scenario

Despite the uncertainty regarding Cerberus' acquisition offer, Supervalu says it is continuing to review other strategic alternatives, for which the company management has taken help from Goldman Sachs and Greenhill & Co. Other parties who've shown interest in the company include private-equity firms KKR & Co., TPG Capital, and billionaire Ronald Burkle. SVU's real estate, distribution channels, and its wide portfolio of retail chains are going to attract potential buyers, while its debt burden and declining sales and margins are going to remain hurdles.

Assuming the company gets bought out, SVU shareholders can safely expect to get a good premium over their investment, if they get in at the current price of $2.55. Cerberus' $5 billion funding for acquiring just 213.15 million outstanding stocks is more than enough to pay holders a 25%-35% premium.

Worst Case Scenario

Say the sale doesn't go through; Supervalu management will either have to restructure the company on its own or sell the company piecemeal. Selling the company's parts would result in associated heavy tax payments, which management would obviously want to avoid. Either way, rest assured that the market is not going to like the news and the stock is plummeting again under $2.

Betting on Both Scenarios!

The odds of either of the two scenarios playing out are almost 50-50. The deal hasn't been confirmed so far, hence the equal chances of an upside and a downside. So what do we do? Buy? Sell short? Do nothing? If you're a risk-averse long term investor, let this opportunity pass. However, if you are a short term risk-lover, I suggest you buy a protective put. It will virtually limit the downside.

In a protective put, you buy the stock and at the same time also buy a put option on it. If the stock goes up, you win. If the stock goes down and is in-the-money, you sell it off at strike and save yourself from the slump. I suggest buying out-of-the-money January puts at a strike of $2.50.

SVU has a consensus mean EPS estimate for FY13 of $0.48. A forward P/E of 5.31 gives it a fair price of $2.55--yesterday's closing price. Play safe, Fools!

PalwashaS has no positions in the stocks mentioned above. The Motley Fool owns shares of Supervalu. Motley Fool newsletter services recommend 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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