Finally a Value Play in Retail

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

Just because company “A” acquires company “B” doesn’t imply that company “A” will have a bright future. Additionally if “B” is performing miserably, “A” should look to sell in order to unlock the remaining enterprise value. This frees up capital for “A” and eventually reduces the drag on its earnings. Such is the case with Supervalu (NYSE: SVU), and here are a few reasons why it makes a great investment option.

A Blessing in Disguise

Supervalu recently announced that it would be selling five of its retail chains to Cerberus for $3.3 billion. As per the deal, Supervalu will sell 877 stores for $100 million in cash payment, and the remaining $3.2 billion would be assumed as Cerberus’ debt. Moreover, Cerberus would be required to bid for up to 30% stake in Supervalu, at $4 a share and the deal is expected to close in March. Supervalu had purchased Alberton's for around $12 billion back in 2006, and over the last 7 years it seems to have destroyed more than 70% of its valuation. However this deal will not merely salvage its remaining value, but would also free up cash flows that its 877 stores are currently guzzling up.

According to Ycharts, its total liabilities stand at a towering $11.85 billion, and post deal it should shrink to $8.65 billion. This has two benefits. Its interest expenses will shrink massively and the company would have to mainly worry about its long term debt (around $6 billion). Furthermore, with a 30% debt reduction, lenders would be willing to restructure their loans, which not only reduces annual interest burden but also delays the repayment period (ofcourse these are the possibilities and not facts).

Corroborating a Value Play

The company shares its market space with Kroger (NYSE: KR), Whole Foods Market (NASDAQ: WFM), Costco Wholesale (NASDAQ: COST) and Safeway (NYSE: SWY).

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>Forward P/E</p> </td> <td> <p>Net Profit Margin</p> </td> <td> <p>Gross Margin</p> </td> <td> <p>Stock Perf. ½ yr</p> </td> </tr> <tr> <td> <p>Supervalu</p> </td> <td> <p>9.87x</p> </td> <td> <p>-1.37%</p> </td> <td> <p>21.86%</p> </td> <td> <p>67.4%</p> </td> </tr> <tr> <td> <p>Kroger</p> </td> <td> <p>10.91x</p> </td> <td> <p>0.78%</p> </td> <td> <p>20.52%</p> </td> <td> <p>31.6%</p> </td> </tr> <tr> <td> <p>Whole Foods</p> </td> <td> <p>25.1x</p> </td> <td> <p>4.06%</p> </td> <td> <p>35.56%</p> </td> <td> <p>-7.4%</p> </td> </tr> <tr> <td> <p>Costco</p> </td> <td> <p>20.15x</p> </td> <td> <p>1.8%</p> </td> <td> <p>12.45%</p> </td> <td> <p>13.34%</p> </td> </tr> <tr> <td> <p>Safeway Inc.</p> </td> <td> <p>10.86x</p> </td> <td> <p>1.2%</p> </td> <td> <p>26.58%</p> </td> <td> <p>44.34%</p> </td> </tr> </tbody> </table>

At the first glance, it’s not hard to conclude that Supervalu is the laggard amongst the mentioned peers. Kroger and Safeway still appear to be undervalued, with high gross margins. Their shares have also performed exceedingly well over the last 6 months, and they appear to be solid growth picks. However Whole Foods and Costco appear to be fairly valued and initiating longs at the CMP would entail comparatively greater risk.

But on taking a critical look, Supervalu appears to be a value play here. Its net margin may be the worst amongst the suggested group, but its gross margin is higher than the industry average. The company is able to generate healthy gross earnings, but is not able to filter them out as net earnings due to higher operating costs and high interest expenses ($126 million). This calls for business restructuring and that’s what Supervalu is doing here.

Once the sale is through, the management estimates its annual revenues to shrink from the current $36.1 billion to around $17 billion. Its grocery distribution chain would account to nearly half of its revenues while its “Save-A-Lot” and grocery chains will account almost equally for the remaining share. But the thing to note here is that its consolidated margins (1.8%) will improve almost instantly.

Its operating earnings before charges for “Save-A-Lot” stood at 3.9%, as compared to 6.1% last year. Its management explained that due to increases marketing and advertising activity, its margins remained under pressure. As a result of its marketing campaign, the management expects higher retail and wholesale volume in Q4. Likewise, due to increased investments in margin growth, its independent business recorded operating margin of 2.5% which shrank from 3.3%.

Wrap Up

I think that judging the company merely on poor margins would not be fair, as it is spending money to not only boost its revenue but also its margins. Its shares have already risen by nearly 70% over the last 6 months, yet its shares appear to be undervalued. As far as the towering debt is concerned, the deal will greatly affect its interest outflows. I think that Supervalu will continue to rally, as the sale of its stores would greatly boost its margins and reduce the financial drag on the company. I think Supervalu is worth a buy rating.

PiyushArora has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale and Whole Foods Market. The Motley Fool owns shares of Costco Wholesale, Supervalu, and Whole Foods Market. 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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