Possible Takeovers Loom for Grocers

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Competition in the grocery business has racketed up in recent months. This has made matters go from bad to worse for top names like Safeway (NYSE: SWY), Supervalu (NYSE: SVU), and Kroger (NYSE: KR). Accordingly, many have entered the depressed territory where possibly the only way forward is to sell the business to a suitor with capital and connections. Below, I review the industry.

Safeway: A Bet on the Long-Term

Over the last six months, Safeway has lost more than a quarter of its market value. It now trades at only a respective 8.3x and 7.6x past and forward earnings despite being forecasted 9.6% annual EPS growth over the next five years. According to research done by Kantar Retail, however, consumers are dividing up their shopping list across more stores. This is putting pressure on grocers that will struggle to expand margins in light of the increased competition.

At the same time, the company has still delivered strong results against expectations. EPS of $0.45 represented an 18% y-o-y return despite a nominal top-line decline. Management has also taken the appropriate steps to deleverage by nearly $500 million so that interest rates could come down and margins could expand. However, there is risk that management could under-invest in storefronts if it uses too much on debt reduction - a decision that did not fare well for peers Supervalu and Kroger.

All in all, near term trends look challenging. The forecast for nearly 10% annual EPS growth appears more on the high-side given that EPS fell 5% annually over the last five years and competition is getting only more intense. However, the current PE ratio is still well below the historical 5-year average of 11.9x. In the long term, multiples will expand as earnings grow to provide a solid return on investment. With a dividend yield of 4.4% and a beta of 0.75, risk is relatively mute.

Possible Takeover Plays: Kroger & Supervalu

Kroger and Supervalu are also relatively cheap at a respective 9.5x and 3x forward earnings. The latter, however, is really, really struggling with a loss of $5.06 per share over the twelve trailing months. Despite this weak performance, analysts still expect the company to be in positive territory by 2013. These same analysts, however, recognize the collapsing story and rate the stock a 3 out of 5 where "5" is a "sell."

Unlike Supervalu, Kroger is an ideal takeover candidate. Free cash flow has fallen from $1.1 billion in the TTM ending 2Q10 to $607 million in 2Q12, but the yield is still excellent on average over the market cap. While leverage is relatively high at a debt-to-equity ratio of 2.1x, it wouldn't take much for a takeover bid to be accretive to a suitor. And, as weak as FCF trends have been, they are weaker at Supervalu, with FCF falling from nearly $800 million in February 2010 to only half that amount just two years later. From a competitive standpoint, Kroger thus has room to gain against its peer.

Results have also been strong for Kroger of late. It recently increased its profit growth expectations to upwards of 11% - a 300 bps improvement. The introduction of a $500 million share repurchase program that is $160 million higher than its previous one showcases management's confidence over the long-term fundamentals.

Ultimately, however, just as there is potential to create value for Kroger through a takeover, there is room to create value for Supervalu through selling various parts. The company recently put itself up as a potential sale, and rumors have speculated about a takeover from KKR or Ron Burkle. The latter is a billionaire who made his fortune in groceries, while the former is a private equity business with a solid history in turning around struggling operations.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of 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.If you have questions about this post or the Fool’s blog network, click here for information.

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