Supervalu: A Good Value in Grocery Stocks

Grocery stocks
Grocery stocks

The grocery market has been rough in the last decade. Big-box stores such as Wal-Mart(WMT) and Target(TGT) have been crowding into the space as a means of drawing repeat traffic to their locations. And non-traditional players such as CVS Caremark(CVS) and Walgreen(WAG) have expanded their grocery offerings as well.

The increased competition has put a lot of pressure on traditional supermarket chains. Margins are thin -- from about 1% to 1.5% for solid operators -- and competition is fierce.

Before you dismiss a potential investment in the grocery business, consider taking a cue from the lady in line in front of you, the one whose shopping cart is brimming with markdown bargains.

Start Your Engines, Shoppers

Bargain-shopping investors should take a stroll down the aisles of Supervalu(SVU). The company trades at about seven times this year's earnings. It also offers a 3.9% dividend. Even better, it has a clear way to massively increase shareholder value as the company deleverages.

Supervalu operates a variety of grocery chains across the U.S., including Albertsons, Jewel-Osco, Shaw's and Save-A-Lot. (Peers Kroger (KR) and Safeway (SWY) are also publicly traded.)

A few years ago, SUPERVALU took on a huge slug of debt to acquire the Albertsons chain. That debt has been weighing on the company since, eating up more than 50% of operating earnings in the last four quarters. But Supervalu is in turnaround mode now under CEO Craig Herkert, a former Wal-Mart veteran, and is looking to clean up its balance sheet and improve its operations.

Here are four strategies Supervalu's pursuing to improve its operations.

1. Cashing In on Cheap Grub

Supervalu is putting a lot of stock in its strongest chain: hard discounter Save-A-Lot.

Unlike Supervalu's conventional stores, Save-A-Lot sells a limited selection of merchandise at sharply reduced prices -- as much as 40% cheaper than traditional grocery chains, the company says. There are about 1,300 Save-A-Lot stores right now, and the company plans to add 160 more outlets this year.

Another thing the Save-A-Lot franchise has going for it is that some 70% of these stores are licensed rather than owned outright. That allows the parent company to focus on maximizing return on capital, rather than investing its own cash.

2. Catering to the Locals

Local products make stores feel more oriented to the local community. So Supervalu is also focusing on a hyperlocal approach to draw customers into its locations and appeal to local preferences and desires.

3. Looking at Labels

Supervalu is also intensely focused on realigning its cost structure. Instead of its range of disparate store-level private-label brands, the company is creating a national-level brand that spans its stores. The company is also bringing up its sales of private-label goods to the industry average. Such private-label sales are attractive to retailers because they carry higher margins that traditional branded goods.

4. Paying Down its IOUs

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On the balance-sheet side of the investment thesis, the company is committed to paying down its debt. That deleveraging should accrue benefits directly to shareholders. With the company's market cap at just $1.9 billion, the stock is trading at around three times free cash flow. The company reduced its net debt by $885 million last year and has promised to shed $500 million to $550 million more this year. That deleveraging would provide a substantial increase in book value.

While Supervalu's $6.7 billion in debt might look scary, just $1 billion of it matures in the next three years. The company is planning to pay that off with operating cash flow, a move that it should be able to manage. And it still has plenty of time to deal with the remainder of the debt.

So this looks like a classic deleveraging situation in an industry that is lackluster but stable. Management predicts earnings of $1.20 to $1.40 per share for the year. That puts the stock trading at a P/E ratio of just 6 to 7. That's cheap, and this company doesn't need to perform miracles to double in price.

Sacrifices May Have to Be Made

We can paint a rosy picture of the future, but, of course, the stock's performance still hinges to some extent on the turnaround. So we'll need to see that work out favorably. But with a P/E of 7, Supervalu is being priced for negative growth. So we have a margin of safety here.

The company has cut its dividend from years past, but the yield is still sizeable at current stock prices, and the company seems committed to keeping some dividend. While the payout only cost about 13% of Supervalu's free cash flow over the last four quarters, the company could cut the payout if things became really dire. I don't expect it, but if the company became cash-starved, then it could happen.

While this grocery business does have some spots on it, you don't often get to buy a boring but reliable business at such a cheap P/E multiple. And with a clear catalyst to unlock value for shareholders, I think this stock is poised for great returns in the future.

Jim Royal, Ph.D., owns shares of SUPERVALU. The Motley Fool owns shares of SUPERVALU and Wal-Mart. Motley Fool newsletter services have recommended buying shares of and creating a diagonal call position on Wal-Mart, as well as buying calls on SUPERVALU.