Consolidation, LBOs Ahead For These Grocers

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

Anyone watching grocery stocks this year could have heard a symbolic crash. Safeway (NYSE: SWY) was down 23.7%, and Supervalu (NYSE: SVU) was down 67.7%. But Kroger (NYSE: KR) actually rose 1%; and, strangely enough, Supervalu also gained more than 40% in the last month. What explains this seeming chaos? The market remains highly speculative from takeover activity, and, in Supervalu's case, private equity is starting to look at the parts--Albertsons, Acme, Cub, and Sav-a-Lot, to name a few--as worth more than the whole. Competitors are in a similar position.

Safeway & Supervalu are both Takeover Targets

While Safeway trades at a respective 8.5x and 7.7x past and forward earnings with a dividend yield of 4.4%, analysts still rate it closer to a "sell" than a "buy." This comes despite analysts underestimating the company's potential in 4 of the last 5 quarters by an average of 4.5%. Yet the company has still seen EPS decline by 5% annually over the past 5 years, so momentum doesn't look bright.

But present operations are still stronger than the market's assessment. The $3.9 billion company generated $939 million in free cash flow yield last year, which means an acquirer could essentially buyout all of the outstanding shares and pay off all of the interest payments quite quickly. Free cash flow in just 3Q 2012 was $505 million. Perhaps recognizing this value, Imperial Capital recently issued an "outperform" report for Safeway with a $23 price target--nearly double the prevailing price.

Fortunately, Safeway has also been aggressive buying back its stock to drive EPS accretion. The comapny earned $0.45 per share in 3Q 2012--an 18% improvement over the same quarter last year. It also gained market share in not only the food channel but across every outlet. And the margin decline was a result of one-time items.

While Safeway has not been fully shopped out yet, there is great clarity in the takeover discussions of Supervalu. Cerberus Capital Management already owns 650 Albertsons, so a buyout of Supervalu in its entirety could help unlock value. The P/E company has reportedly been seeking financing from Bank of America and JPMorgan Chase, and the deadline for a deal is within the next few days. I encourage buying; if the deal falls through, the company will probably receive a bid from KKR, which has strong experience in managing the grocery business. If it comes through, you have captured a nice premium. So, its a win-win situation.

Avoid Kroger

In my view, Kroger is no more than a "hold"--unlike its competitors. Free cash flow generation has fallen from an average of $890 million during the past 5 years to $607 million, which means a yield of less than 5% against the market capitalization. Meanwhile, the company trades at 3.4x book value--well above peer levels. And management's hesitance on giving 2013 guidance is also disconcerting to a potential suitor.

On the positive side, the company has consistently delivered better-than-expected performance in the last 4 quarters. Management has kept costs down while improving productivity, and the loyal household count has grown faster than household growth. This means the company is getting more repeat business, and this is complemented by market share gains. Store innovation has helped drive this trend. For example, the company has reduced the average checkout time from 4 minutes in the past to 30 seconds today. I believe this dramatic transformation will pay off big during the holiday seasons when families are in a rush to get the freshest food items.

All things considered, however, rising competition and inflationary pressures will keep investors on the sidelines. While the industry is likely to see great consolidation, Kroger is not likely to be a part of it. This means it will have to fend off  larger peers, and this will challenge the company's ability to boost free cash flow in a way that even justifies the current market cap.

TakeoverAnalyst 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.If you have questions about this post or the Fool’s blog network, click here for information.

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