Supervalu Inc. (SVU): It's All in the Math

Overview


Supervalu (SVU, Financial) is one of the nation’s largest grocery retailers. It has approximately 2,400 traditional and hard-discount retail food stores located throughout the U.S. Unlike Walmart and Kroger, SVU’s business model relies on a collection of supermarket banners (Acme, Albertsons, Cub Food, Farm Fresh, Hornbacher’s, Jewel-Osco, Lucky, Shaw’s, Shop’n Save, Shoppers Food & Pharmacy and Star Markets, as well as Save-A-Lot). The company owns approximately 380 Save-A-Lot stores, with another 900 or so franchised. The remaining 1,100 or so stores fall under the remaining corporate banners. The average size of the Save-A-Lot stores is 15,000 square feet, while the average size of the remaining banners ranges from 40,000 to 60,000 square feet.


In addition to the retail stores, the Independent Business segment, formerly referred to as Supply Chain Services, acts as a primary wholesale distributor to 1,900 independent retailers, and as a secondary wholesale distributor to another 800 independent stores; this is in addition to serving the company’s own stores. This business makes Supervalu the nation’s largest publicly traded food wholesaler.







* 2012E refers to my estimates for the 2012 fiscal year which ends on February 25, 2012.


Investment Thesis


SVU presents a compelling investment opportunity due to its attractive valuation, significant downside protection and promising growth prospects. My analysis assumes a holding period through the end of 2015. The projected price of SVU at the time of exit is $21.2 per share (based on a conservative 4x EBITDA valuation). The company currently pays $0.0875 per share in quarterly dividends (totaling $0.35 annually). I’ve assumed that SVU continues paying this dividend throughout the holding period. With a $7.75 per share investment price, the expected IRR would be around 30.2% with an investment multiple of 2.9x.


SVU is trading at a very attractive valuation based on several metrics: Enterprise Value/EBITDA multiple, the price to equity ratio, as well as free cash flow and dividend yields. The enterprise value of the company is attractively valued at 4.5x EBITDA, which is at the low end of its historic range of 4-7x. In addition to the mispricing at the enterprise value level, the mispricing for the equity portion is even more pronounced with a free cash flow yield of over 37%. The forward P/E ratio (based on my estimate) of about 8.3x is lower than that of its competitors which are in double digits. Please also note that my EPS estimate of $0.93 for fiscal year 2012 is significantly less than the consensus of $1.23. The stock currently yields 4.5% which is higher than that of competitors (Safeway: 3.4%, Kroger: 1.9%, Walmart: 2.8%).


In addition to the attractive valuation, SVU has significant downside protection with a sizeable real estate portfolio, a stable wholesale business as well as the fact that it has remained operationally profitable throughout the recession and has the ability to generate significant amounts of free cash flow as evidenced by its exceedingly high free cash flow yield.


SVU also presents a growth opportunity through its focus on expanding the Save-A-Lot brand, which is the fastest growing hard discount retailer in the nation; SVU intends to double the number of Save-A-Lot stores over the next five years, either through company owned stores or through franchisees.


Analysis


The main catalyst for the stock over time is the aggressive debt pay down which would increase the equity value of the company. A significant portion of free cash flow is directed towards paying down the debt. In order to remain conservative, I’ve assumed that the annual same store sales growth, for both the retail segment, as well as the independent business segment, will remain at -3.9% throughout the holding period, even though management has indicated that it expects retail same store sales growth for the current 2012 fiscal year to be in the -1.5% to -2% range. Management expects the independent business segment, during fiscal year 2012, to be down 2% to 4% as a result of the sale of its logistics business last year, however, excluding the logistics business, guidance is flat. Thus assuming a -3.9% sales growth every year for the Independent Business segment is conservative.


The analysis also takes into account that the company will pay down $500 million in financial debt annually, which is in addition to the $150 million or so that is allocated to paying down capital leases (since capital leases are included in net debt when calculating the enterprise value of SVU). When calculating the implied share value at exit, I’ve used a 4x EBITDA multiple, which is at the bottom of the historic valuation range for SVU (4-7x EBITDA). EBITDA does increase over time by virtue of the new Save-A-Lot stores that open, which trumps the decline in sales and their negative impact on EBITDA.


In addition, the company currently pays a 4.5% dividend yield on the shares (assuming a $7.75 per share price). This dividend, which amounts to about $75 million annually, is comfortably covered by the $1.2 billion in cash flow from operations that I expect the company to generate. Looking at it from another perspective, assuming SVU earns $197 million during the 2012 fiscal year, then that would imply that the payout ratio is a reasonable 38%.


With regards to margins, the assumed operating margin for the retail segment is 2.5% which is significantly less than the 2.96% average for the last three fiscal years (after backing out non-cash one time charges against the retail segment in fiscal years 2011 and 2009). As for the independent business segment, the assumed operating margin is 3%, which is lower than the 3.43% average of the 2009 through 2011 fiscal years.


Thus, based on the assumptions above, it is safe to say that conservative assumptions were assumed in the underwriting of this investment, and that SVU can maintain its debt pay down schedule, pay the dividend and fund its expansion of Save-A-Lot as well as its capital expenditure program in general. The Company has assumed $700 million in capital expenditures for fiscal year 2012 (please note that SVU includes its scheduled capital lease payments for the year, which as previously mentioned are about $150 million, in its capital expenditure budget). As noted previously, capital leases are included in the net debt figure used to determine the enterprise value of the company.


Investment Highlights

• Attractive valuation. The company trades at an EBITDA multiple of 4.5x 2012E EBITDA (according to my estimate), which is towards the low end of the valuation range for SVU (historically between 4-7x). Even though the company is trading at a low price from an enterprise value perspective, based on EBITDA, the real mispricing is in the equity portion of the capital structure. This is evidenced by the forward free cash flow yield of over 37% that the equity trades at.
• Significant free cash flow. As mentioned above, the company trades at a very high free cash flow yield, which demonstrates SVU’s ability to generate cash. In addition to making the commitment to fund the aggressive expansion of Save-A-Lot, it has also pledged to pay down its debt aggressively, with $500-$550 million directed towards that effort.
• Multiple lines of business. SVU is known for its various supermarket banners; however, it generates very consistent cash flow from its Independent Business segment, which is expected to produce about $243 million in operating income during fiscal year 2012.
• Attractive dividend. One of the virtues of the decline of the stock price has been the 4.5% dividend that the stock yields, which SVU can afford as a result of its strong cash flow generating ability. The payout ratio for the company is about 38%.
• Significant real estate portfolio. SVU occupies 64 million square feet of real estate. It owns about 38% of that space, which amounts to about 25 million square feet. Based on my calculations, the average rent per square foot that SVU pays, for the leased properties, is approximately $9.7 per square foot. If you assume a capitalization rate of around 10%, then the estimated value of those properties would be around $100 per square foot. Assuming that the quality of owned real estate is similar to the leased real estate, would imply that the 25 million square feet of company-owned real estate is worth approximately $2.5 billion.
• Profitable even in a tough environment. Excluding one time write-downs, SVU has been able to remain operationally profitable, even during the recession.
• Proactive management. Many articles have been written about Craig Herkert’s (the CEO) efforts to reduce costs in innovative ways. One such example is an article in the Wall Street Journal about how Supervalu has been able to save $4-$6 million annually by increasing the average number of items per bag, thus reducing the number of bags used (in the grand scheme of things those figures don’t move the needle all that much, but it’s an example). Management has been focused on reducing the average item price, but has committed to doing so without hurting the profitability of the company by cutting costs and passing those savings along to the customers. Hence the company expects margins for the year to be flat.
• Save-A-Lot. The Company intends to double the number of stores for this banner over the next five years. Save-A-Lot is the fastest growing hard discount retailer in the nation and is a pillar of the Company’s growth strategy going forward.
• Debt pay down. The Company intends to pay down $500 to $550 million in financial debt in fiscal year 2011. This is in addition to the $150 million in capital lease payments that are scheduled to be made during fiscal year 2012. SVU has reduced net debt by over $1.7 billion over the last nine quarters (which includes fiscal years 2010 and 2011 as well as the first quarter of fiscal year 2012). This has been made possible as a result of its ample cash flow, as well as the proceeds from selling some assets (such as a logistics subsidiary which was sold for $200 million, and the proceeds of which were applied towards debt pay down).

Investment Considerations

• Negative same store sales growth. When the recession hit, SVU was slow to cut prices as a reaction to its competitors which were aggressive in doing so. As a result, customers migrated to lower priced competitors and this has resulted in retail same store sales growth turning negative. This trend continues till this day. However, the company has shown incremental improvement as a result of its cost cutting efforts which it has passed on to customers in the form of price reductions. Unfortunately, it takes time for customers to realize that a chain is trying to improve its price points. Retail same store sales were down 3.9% during the first fiscal quarter of 2011, with the company seeing positive improvement in all markets except Chicago. Full year retail same store sales growth is expected to be -1.5% to -2.5%, which would mark an improvement from the first quarter as management is confident in the positive trend shown with same store sale declines shrinking. In my analysis, and in order to be conservative, I’ve assumed that sales decline by 3.9% every year going forward.
• Significant debt load. One of the major concerns investors have about the company has been its excessive debt load, most of which was incurred during the company’s 2006 acquisition of Albertson’s. What the market doesn’t seem to notice is that its debt maturities are spread out over a very long period of time, with debts maturing as far out as 2031. Also, over the next three years, only $1 billion of financial debt will be maturing; regardless of that, the Company is intent on paying its debt down at an aggressive pace. This should help with the implied equity value of the business, as the debt portion of the capital structure shrinks. Also, earnings will improve as debt is paid down, since less interest expense is incurred.
• Shrinking margins. One of the biggest concerns about the supermarket sector has been its slim margins. For the whole year, SVU anticipates that its margins will remain flat. In my analysis, as is explained above, I have used conservative operating margin assumptions when compared to their respective three year averages.

Conclusion


At $7.75 per share, SVU is a high-reward, low-risk investment opportunity. Its valuation is attractive from an EBITDA, free cash flow, earnings and dividend perspective. In addition, the company is consistently profitable, has the ability to generate significant free cash flow that is used to fund its ambitious growth plans for Save-A-Lot, upgrade existing stores and pay down its debt at an aggressive pace (which in turn will significantly enhance the implied equity value of the company). It also owns a significant real estate portfolio, and has a very stable wholesale business. As mentioned previously, the real driver of equity value enhancement is the aggressive pay down of company debt.