Can This Grocer Live Up to Its Name?

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

SUPERVALU’s (NYSE: SVU) name might imply something extraordinary, but its results have been less than extraordinary lately, as it struggles with declining store profitability and too many brands. SUPERVALU's untimely purchase of Albertson’s grocery chains in 2006 almost proved to be the company’s undoing, as it had limited recourse to pay off its debt maturities.

Fortunately, private equity giant Cerberus and its partners came to the rescue earlier this year with a deal to buy most of the ill-fated deal’s grocery chains for $3.3 billion and assume related debt. In addition, Cerberus bought a stake of roughly 20% in SUPERVALU through a tender offer. So, should investors follow Cerberus’ lead?

What’s the value?
The deal with Cerberus simplified SUPERVALU’s operations and assumed away over $6 billion of its debt load. Post-transaction, the company’s main asset is its value-priced Save-A-Lot unit, which is complemented by five regional grocery chains, including Cub Foods and Farm Fresh that do business in the Minnesota and Virginia regions, respectively. It also owns a major food wholesaling unit that distributes products to a national network of roughly 1,300 independent grocers.

In its latest fiscal year, SUPERVALU reported weak financial results, with declining sales and an operating loss. Its top-line growth was negatively impacted by lower same-store sales across its business units and the divestiture of selected fuel centers in its retail segment. More importantly, SUPERVALU generated an operating loss due to weak product pricing caused by competition from the mass merchandisers’ grocery units. Its overall results were also weighed down by the costs of its restructuring and recapitalization activities.

Follow the leader
SUPERVALU may think that it can compete on price, but its neighborhood stores are no match for the huge product selections and cut-rate prices at the mass merchandisers. Its best bet is to follow the lead of Kroger (NYSE: KR), the neighborhood grocery giant with over 2,400 supermarkets around the country that operate under various brands, including Kroger, Fred Meyer, and Ralphs. Kroger has enjoyed 37 consecutive quarters of rising comparable store sales by providing a compact and friendly shopping environment for its customers, as well as by focusing on converting customers to its private label offerings, like its Private Selection premium brand.

In its latest fiscal year, Kroger reported solid financial results, with increases in revenue and adjusted operating income of 7.1% and 10.2%, respectively, versus the prior year. The company continued its string of rising comparable store sales, up 3.5% for the period, and benefited from an expansion of its fuel centers. While Kroger's gross margin was hurt by the growth in low-margin fuel sales, it offset the impact with slightly higher average prices across its grocery departments.

The organic phenomenon
SUPERVALU should also follow Kroger’s move to add more organic and natural food items, an area of increasing demand from customers, both old and young. Despite having eight times fewer stores than Kroger, organic segment leader Whole Foods Market (NASDAQ: WFM) has a comparable market valuation due to its higher profit margin and growth rate. In addition, the strong operating cash flow that flows from its premium product pricing allows it to fund capital expenditures without taking on debt, providing a competitive advantage against its traditional supermarket competitors.

In FY2013, Whole Foods has continued its solid pace of growth, with increases in revenue and adjusted operating income of 13.1% and 21%, respectively, compared to the prior-year period. Its top-line growth benefited from strong comparable stores sales, up 7.2%, as well as the addition of stores in nine new markets. Looking ahead, Whole Foods’ management forecasts a domestic market opportunity of approximately 1,000 stores, providing ample room to grow beyond its current base of 351 stores.

The bottom line
SUPERVALU has improved its balance sheet, thanks to a strategic investment from its well-heeled private equity partners. Now comes the hard part, delivering better financial results for shareholders. While its Save-A-Lot and distribution units reported segment profits in the latest fiscal year, the company's retail unit is still struggling to reach break-even. The best way forward is likely to follow Kroger, which has successfully operated in the space between the discount mass merchandisers and higher-priced food retailers, like Whole Foods. Until the proof shows up in its financials, though, investors should avoid this turnaround story and stick with Kroger and Whole Foods, the leaders in their respective segments.

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Robert Hanley owns shares of Supervalu and Whole Foods Market. The Motley Fool recommends Whole Foods Market. The Motley Fool owns shares of 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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