What if I told you that you could buy a stock trading at five to six times this year's earnings (cheap!), paying a sizable dividend, and being led by industry-veteran managers? Even better, this small-cap company has a clear opportunity to accrue massive value to shareholders, and it's already beginning to see results. The Motley Fool Hidden Gems team handpicked this stock late last year and then added it to the service's real-money portfolio.
You don't find stocks trading at single-digit P/Es without some issues, or at least Mr. Market's thinking that something's wrong. And that's the case here. Although this company operates in a tough industry with waifish margins, it is solidly profitable. It owes a lot of money, but has committed to paying down its obligations with its hefty cash flow. Still, the stock is approaching its five-year lows, so it must be a dog with fleas, right?
Wrong. Mr. Market isn't giving this company -- SUPERVALU (NYS: SVU) -- a fair shake. Here's why.
This company lives up to its name
You might not know SUPERVALU by name, but there's a decent chance you've been in one of its stores -- Jewel-Osco, Albertson's, Shaw's, and Save-A-Lot, to name a few. The company's 2,500 stores dot the U.S. and provide the usual assortment of grocery items.
The grocery business is tough, with traditional players such as Kroger (NYS: KR) , Safeway (NYS: SWY) , Publix, and others running solid operations. In the past decade or so, nontraditional players such as Wal-Mart (NYS: WMT) have moved into the space in a big way, followed more recently by Target (NYS: TGT) and Walgreen (NYS: WAG) , which are looking to attract grocery shoppers, who are known for providing regular traffic, to their stores in order to get them to buy nongrocery products while there. Even deep discounters Dollar General (NYS: DG) , Family Dollar, and Dollar Tree are appealing to bargain-conscious food shoppers.
That type of competition thins out the operating margins at traditional grocers, as you can see by the meager numbers below:
Source: Capital IQ, a division of Standard & Poor's.
Despite these low margins, SUPERVALU is projecting earnings of $1.20-$1.40 per share for the year, putting its forward P/E at just 5-6 times. That compares to P/Es of 9-15 times for traditional peers. SUPERVALU's first quarter saw earnings clock in at $0.35 per share.
The company's operating performance has lagged peers' recently. But under recently installed CEO Craig Herkert, an industry veteran from Wal-Mart, SUPERVALU has moved to right the ship. Here are just a few of the ways.
The company is working to increase the perception of its products as good value. SUPERVALU is creating a store brand that will span its store base, replacing the various store brands that already appear in its locations. Such brands provide higher margins for grocery stores, but they comprise just 19.3% of SUPERVALU's sales, well below peers. The company is working to increase that penetration by one percentage point annually over the next three years to get back in line with rivals.
The company is also allocating capital more efficiently, throwing money behind its hard-discount chain Save-A-Lot, which is seeing strong results. Save-A-Lot offers prices that run 13%-17% less than discounters'. Expanding that chain requires relatively little capital, since SUPERVALU licenses about 70% of its stores, but provides high-margin revenue. The company plans to open some 210 Save-A-Lot locations in 2011. It's also refraining from expanding its traditional grocery outlets and even exiting unprofitable markets.
In order to differentiate its offerings and respond to varying local preferences, the company is focusing on hyperlocal products, trying to source products from nearby areas.
Massive value creation
So the business looks cheap and things seem to be turning, but where's this massive value creation I was talking about? The company has committed to deleveraging, using its substantial operating cash flow to pay down its debt. SUPERVALU's takeover of Albertson's in 2006 piled $7 billion in debt onto the company, and the stock has cratered since then -- down from $45 in 2007 to just $7 today -- as huge interest charges and investor concern weighed on shares.
But since early 2008, the company has pared debt by $1.8 billion, or 21%. That has dropped interest charges by 26%, to $535 million over the past four quarters. The company reduced debt by $722 million last year and has promised to pay off another $500 million to $550 million this year.
While the company still does have debt of $7 billion, only $1 billion of that matures in the next three years, giving the company plenty of time to get things in order.
Every dollar that goes into debt reduction increases the book value of the stock -- and rapidly. With a paydown of $550 million, the company could goose book value by nearly 40%. Shares trade hands at just three times free cash flow, and the company now pays out a nearly 5% yield. Those are three tremendous reasons I own the company myself.
Foolish bottom line
While not without its issues, SUPERVALU is cheap and solidly profitable. With a turnaround in progress, an industry veteran with a pedigree from the world's largest retailer at the helm, and a clear path to increase shareholder value through deleveraging, SUPERVALU is the cheapest, best stock I see.
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At the time thisarticle was published Jim Royal, Ph.D., owns shares of SUPERVALU. The Motley Fool owns shares of Wal-Mart and SUPERVALU.Motley Fool newsletter serviceshave recommended buying shares of Wal-Mart.Motley Fool newsletter serviceshave recommended creating a diagonal call position in Wal-Mart.Motley Fool newsletter serviceshave recommended buying calls in SUPERVALU. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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