Deal or No Deal…Confessions of a SuperValu Long

This post is about a company that has been all over the headlines lately. As I tweeted two weeks ago, I went “all-in” on SuperValue (NYSE: SVU) when the stock traded at $2.38 (my average cost is north of that figure). Why did I put all of my chips on the table? After “running the numbers,” I concluded that deal or no deal, SVU offers substantial upside.

SuperValu is yet another example of a company doing a transformational deal at the top of the market only to see the economy fall precipitously into the deepest recession anyone in my generation (or the one preceding) has ever seen. What happened? The company acquired Albertson’s in a highly levered transaction that increased the company’s debt seven-fold…in 2006. Despite elevated levels of debt, an economy that was screeching (not slowing) to a halt and increased competition from the likes of WalMart (WMT) and Target (TGT) – the company survived. While management did cut the dividend sending the stock lower, the move was needed to ensure the company made it through the challenging environment it faced.

The company traces its roots back to 1870 when it was B.S. Bull and Company, a dry goods wholesaler. In 1954 the company changed its name to SuperValu to more closely align it with its successful retailers. The company went public in 1967. As noted above, the company acquired Albertsons in 2006 which more than doubled its footprint making it the 3rd largest grocery retailing company in the US. As you can see, this is a company that has been around long enough to see more than its fair share of hard times. My guess is that it is not going away without a sizable fight.

The bear case is pretty simple: The grocery segment is under intense pressure from warehouses and discounters. For example, Costco (COST) saw same store sales grow 6% in the 3rd quarter, while traditional stores such as SVU and Safeway saw flat or negative sales. In addition, convenience and drug stores have begun adding groceries to their list of product offerings (however, these players aren’t typically price competitive). Together, these competitors pose substantial risk to “traditional” grocery store operators which will make it increasingly difficult to earn an adequate return on capital.

I believe SVU’s valuation is too compelling to ignore. The shares effectively trade like options. At a current price of $2.68, the market cap is just $570 million. The enterprise value – in my view, the more important figure – is $6.7 billion or 0.19x sales and 3.8x adjusted EBITDA. These metrics compare to its peers’ multiples of 0.23x and 6.2x for sales and adjusted EBITDA, respectively.

Historically, food retail sales have been positively correlated with GDP growth and negatively correlated with rising unemployment. Not surprisingly, over the past five years SVU’s sales have decreased. However, as the employment situation improves (in line with recent BLS data) and GDP expands (subject to the Fiscal Ciff getting worked out), SVU should see its sales stabilize (if not improve).

How bad has the “Great Recession” been to SVU? There are several telling numbers that bear reviewing. Total sales were $44.6 billion in FY2008, sales this year are projected to be $34.6 billion – representing a peak-to-trough decline of 22%. Gross margin and EBITDA peaked at 22.9% and 6.1%, respectively, in FY2007. Analysts estimate margins will decline this year to 21.7% and 4.5%, respectively. Similarly, Safeway (SWY) has seen its profit margin decrease 160bps over the past few years. However, SWY’s margins still stand 500 basis points higher than SVU as a result of its higher prices and customers who have relatively higher incomes. This suggests that SVU has room to expand its margins…even in this environment.

Key Stats for SVU

Revenue and Gross Margin

SVU’s EPS from continuing ops was $2.89 in 2008 (the stock trades below that number today), analysts peg that number at $0.51 this year.

SVU is hardly a lost cause. Management has embarked on a number of strategic initiatives that should improve the company’s results. SVU could go a step further by taking a page from the apparel retailers’ book. Ann Inc. (ANN) is a prime example. Having determined that less is more, ANN remodeled its stores to a smaller format which subsequently improved margins. While SVU’s Save-A-Lot stores average 15,000 square feet, the traditional stores still average 40,000 – 60,000 sq. ft. Having shopped at both TGT and WMT grocery stores, I have seen how retailers can reduce square footage and maintain a high level of sales. Using their competitors’ model, SVU should be able to reduce floor space while maintaining sales. This would provide an opportunity for the company to sublease the excess square footage creating a new source of revenue.

Continuing the real estate theme, SVU has 24.3 million square feet of OWNED retail space. At the end of fiscal year 2012, land and buildings were on the balance sheet for $4.80 billion while total PP&E stood at $6.1 billion (net) at the end of the most recent quarter. There have been estimates that traditional retail stores cost $10-$15 million to build. Replacement value alone would imply a share price significantly higher. Using the assumption that the company owns 38% of both its traditional retail and Save-A-Lot stores, SVU is sitting on real-estate worth at least $5.8 billion (based on the middle of the range). This means that the business, with over $34 billion in sales and well known brand names, is being priced at just $832 million (or 2.4% of sales). A more conservative analysis, using cap rates of 7.25% (applying SVU’s outstanding leases at approximately $10.08 per sq. ft.) would place the value of SVU’s OWNED real estate at $3.4 billion or $140.00 per square foot (you be the judge if that is too low). This would imply the market values the business at just 9.4% of sales. There are frictional costs involved with selling the land, however, the transactional costs should be minimal relative to the deal value.

The stock has been volatile of late, primarily a result of on-again and off-again rumors of a deal. News of a busted deal will likely send the stock lower from current levels, but any downturn would be a buying opportunity. Unlike the airlines, SVU doesn’t need a merger to survive. As the new strategy takes hold and the self imposed price competition abates, operating margins should rise from the current cyclical lows. Further, as the economy recovers from the after affects of the recession, store sales should see a rebound.

This investment is more of an execution story than an acquisition play. With shares down 68% YTD, debt refinanced and no near term maturity issues (only $177 million matures in the next year and a half), the downside looks to be fully priced in. The stock started the year at $8.42, if the shares only recover to half that price, investors would realize a return of 58%. There could potentially be much more upside than that based on a scenario analysis I performed using current analyst estimates as a base.

SuperValu Scenario Analysis

Scenario Analysis

As I mentioned earlier, I’m long the stock and plan to stay long…deal or no deal.

3 thoughts on “Deal or No Deal…Confessions of a SuperValu Long

  1. SVU value as and LBO was always in the CRE. Demising and subleasing space would not work if they want to continue operating the grocery store component. They could become a Landlord and lease vacated stores to 2 or tenant tenants but that is capital intensive ($200,000-500,000) per sublease tenant (or they take a big hit to the per square foot rental rate).

    I can’t really get in to arguing your profit margin graphics other than to say that full service grocers net profits are generally very low. Average 3-4% from my experience dealing with grocers as a tenant. They rely on high significant amounts of sales to be profitable. Something that you correctly conclude could be goosed by having less SF but is particularly difficult to cause in execution. They need to keep their focus on closing underperforming stores and utilizing better metrics to target their surrounding demographics.

    Unfortunately, SVU full service grocers do not do a good job of targeting or creating an exciting value proposition to consumers. While management likes to point to significant capital improvements in the last ten years most of that capital was used to goose the companies value. Kind of how I might slap some new paint & a slurry coat on a parking lot for $50,000 to increase my properties asking price on market by $500,000. Buyer’s think the prettiness means care when in reality they need to put on a new roof in 2 years for $300,000. Amazingly these simple tricks work at our lowly level but also worked at this level thanks to debt available and psychology at the time of LBO in 2006. SVU needs to invest significant $ to create excitement in the brand & make people want to choose to shop there.

    Save-a-Lot is a very different concept. It is limited assortment and targets a significantly down market demographic. We put one in to a location with population of about 30,000 and income of roughly $32,000. They bitched and moaned that the demo was too high class for their offerings and was significantly concerned that shoppers would prefer the Walmart Supercenter two stoplights away. I argued that was a dumb thing to try and negotiate me with, but in reality they do actually feel that way and only recently, due to strength in sales at the brand, are they looking to larger, higher income locations. (The secret is ppl, however poor, hate the idea of buying meat & produce at Walmart – interviewing shoppers will tell you that).

    In reality, the two brands – full service & limited assortment are drastically different and require different strategies. If SVU simply replicates SAL at Albertsons locations they will close even more quickly.

    SVU needs to look in to selling off CRE or forming a holding company to operate it as a Landlord. Of course, that business will just get very expensive in a few years & if they can’t get their retail strategy correct what does that tell you about their ability to choose & invest in the proper tenants to take the space? Not a good combination.

    I say they sell off big portions of the portfolio, close stores, use the money to pay down debt or double down on successful brands/locations. If they can reinvest that money into renovating & perfecting a number of locations to a new standard & pinpoint a strategy to rollout to the stores they keep.

    Or, do sale/leasebacks, rape the CRE for cash, a portion which you pay back over time, and walk away.

  2. Pingback: Indecent Proposal for SuperValu? | Stone Street Advisors

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