Grocers Slammed, But Takeover Artists Loom
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
IHS Global Insight is now reporting that economic and retail sales reports indicate that the holiday retail environment has been better than originally forecasted. The combination of unemployment dipping below 8% and the housing market improving sets the tone for greater consumer expenditures. Consumer confidence has risen to the highest it has seen in 5 years. But has the upside already been factored into grocery stocks? Below, I provide my outlook on several producers in this area.
High Yields, Shareholder-Friendly Management To Drive Safeway (NYSE: SWY)
Increased competition has made it hard for grocers to expand margins alongside sales gains. Shares of SUPERVALU fell 7.7% on the announcement that Wal-Mart alone would be expanding its small stores--right now, even just on a small scale. In the third quarter, although Safeway beat earnings expectations by 24 cents on EPS of $0.66, the market still reacted negatively to the report that Safeway grew same-store sales by a mere 1% from greater volumes. Value is also being destroyed, as evidenced by the 7.4% return on invested capital, which is below the average cost of capital. The grocer's free cash flow generation fell from $1.7 billion on a TTM-basis by the end of 2009 to $921 million today.
As poor as the trend has been for Safeway, FCF is still yielding a terrific 23.3%. Shares trade at 8.8x forward earnings, and the PEG ratio is at 0.93x--implying future growth has not been reasonably factored into the market assessment. Imperial Capital recently rated the company "outperform" with a $23 price target, which is at around a 40% premium to the market assessment. Analysts forecast 9.4% annual EPS growth over the next 5 years--seemingly more than strong enough to close at least some of this value gap and drive outperformance. Holding the share price constant at this kind of growth would be unreasonable given how low multiples already are. If nothing else, Safeway provides a terrific 4.2% dividend yield.
There are several other reasons why one should be optimistic about Safeway. Management has been very aggressive on share repurchases. Gross margins may be on the decline, but they are not nearly as bad as what the market has made out, since half of the recent decline has come from isolated one-time events. Only 5% of margin contraction in the third quarter was explained by price changes. The important thing to grasp is that Safeway has been gaining market share across all outlets and in the food channel.
SUPERVALU (NYSE: SVU): A SUPER Takeover Target
SUPERVALU has gone through dramatic ups and downs over the last 12 months. Shares are 60.7% up from the 52-week low but also 67.5% down from the 52-week high. Though the company has lost $5.87 per share in the twelve trailing months, analysts, analysts expect EPS of $0.49 to be generated next year. Put differently, the company is valued at only 5.5x consensus EPS estimates. For now, however, investors can only see the losses that are being reflected in a -9.8% return on invested capital, which contrasts markedly with a bright 11% industry average. Though no analysts rate the company a "sell", only 1 out of 16 reported rates it a "buy"--the rest a "hold".
Although FCF has dipped from a high of $791 for the TTM ending 3Q10 to $153 million, the company is only worth $576.5 million. This means you are getting back what you paid for in only a few years. And management is also addressing working capital stresses by laying off 700 positions in November. It should not be surprising then that PE firms are circling the grocer. Speculation is rising that Cerberus Capital will merge the company's operations with Albertson's with joint financing from real estate firms.
I would consider buying the company over Kroger (NYSE: KR) for several reasons. This grocer has a ROIC of only 6.6% and is already in solid profitable territory. Despite generating $1.08 per share over the TTM, Kroger is still forecasted for $2.60 in EPS next year, which means it is valued at 9.6x forward earnings. Analysts forecast 8.9% annual EPS growth over the next 5 years. Assuming expectations are met, 2016 EPS will come out to $3.35. At a multiple of 13x, this translates to a future stock value of $43.55. Discounting backwards by 10% yields a present value of around $27. This is not a tremendous value gap and thus you may just be better off with SUPERVALU or Safeway.
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. Is this post wrong? Click here. Think you can do better? Join us and write your own!