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By Siraj Sarwar

Recently, Supervalu (NYSE:SVU) announced an agreement for the sale of five retail grocery banners to Cerberus-Led Investor Group. As per agreement, it will sell 877 stores from Albertsons, Acme, Jewel-Osco, Shaw's and Star Market stores and related Osco and Sav-on in-store pharmacies to AB Acquisition LLC. Supervalu will receive $3.3 billion to reduce its debt by selling five of its supermarket chains. The new sale deed will provide a life-line for Supervalu, as it has more than $6 billion in long-term debt and capital lease obligations. Since the announcement of the deal, the stock gained about 40%. However, Supervalu is still trading way below its heyday valuation. The stock was trading for as high as $40, before the sub-prime crises. In this article, I look at the announced deal and the company's future business prospects.

Background on Deal

Supervalu is losing customers to discount competitors like Wal-Mart Stores (NYSE:WMT) and Kroger Co (NYSE:KR). Financial problems started with Supervalu when it acquired Albertson's. Supervalu, CVS Caremark (NYSE:CVS) and Cerberus bought Albertsons in a 2006 deal priced over $17 billion. Supervalu's portion covered $12 billion, nearly half of which was from the assumption of debt obligations. The deal stuck Supervalu with a massive debt. Supervalu's portion of the Albertsons's purchase includes over 1,100 stores, nearly most of which were part of chains the company is now selling.

However, 6 years after the Albertsons purchase, Supervalu is back to where it started. An operational turnaround would be a tough challenge as the margins in the retail business keep shrinking. I think Wall Street looks at this deal as a property play. Therefore, a lot of real estate firms are involved in the deal. The deal is seen as a real estate play for the purchaser, who will take on $3.2 billion of Supervalu's debt and $100 million in cash. The sale is expected to close by the end of March.

Turning around Supervalu's supermarket operations will be a challenging ride. Not only the traditional retailers are losing ground, but Supervalu is also losing its share in the market. This is due to low-price retailers such as Target Corp (NYSE:TGT), Wal-Mart and Costco (NASDAQ:COST). These retailers are supplying food at rock-bottom prices to attract shoppers. On the other hand, traditional grocers like Supervalu have relatively higher labor costs, which makes it hard to keep up with competition.

Nevertheless, I believe the deal will be good for Supervalu. At the moment, Supervalu's financial situation is not pleasing. The shareholders experienced substantial losses. The company's balance sheet desperately needs liquid assets to get out of solvency. The company needs a bulk of cash to create a balance between assets and liabilities. I believe the sale deed will fulfill that room in its balance sheet --at least for the short-term.

New Supervalu

Supervalu had initially wished to sell the entire corporation, but financing issues stopped that from happening. The sale of 877 stores is estimated to close at the end of March. When that takes place, Supervalu's business will mainly consist of the independent business segment. In addition, Supervalu will run a chain of 1300 Save-A-Lot stores and some of the leading regional retail food banners such as Cub, Shoppers, Farm Fresh, Hornbacher's. The company's grocery distribution business will stand for about 47% of Supervalu's revenue. The Save-A-Lot segment will bring about one-quarter of revenue and the other grocery chains will kick in 28%. Supervalu expects to produce annual revenues in excess of $17 billion compared to the previous year.

Competition

Figure in Million

Net Income

Operating Margin %

Long term D/E

Beta

Supervalu

-479

-1.54

Very High

1.16

Kroger

728

-0.5

1.8

0.37

Whole Food Market

465

6.36

0.001

1.03

Safeway

523

2.37

2.3

0.77

Source: Finviz.com

Supervalu's main industry peers are Safeway (NYSE:SWY), Kroger, and Whole Food Market (NASDAQ:WFM). Supervalu generated a stable gross margin of 22.21% in fiscal 2012 and 22.41% in fiscal 2011. However, the company is a loss-maker, and it keeps producing negative earnings. Whole Food Market, Safeway and Kroger generated operating margins of 6.36%, 2.37%, and -0.5%, and respectively. It is obvious from the operating margins that the grocery industry has very thin margins on sales.

Supervalu had a lot of operational burden and debt obligations. In addition, Supervalu paid a huge amount of interest. After the sale deed, the operational burden is likely to reduce along with the debt obligations and interest expenses.

Summary

The sale transactions symbolize the successful in-depth strategic review process commenced by the company. Subsequent to the sale, Supervalu will have three solid, market-leading business units with more reliable cash flows and much better EBITDA growth potential. I believe the company's biggest problem was its debt and interest payments on that debt. The sale agreement will reduce the debt burden by $3.2 billion. Consequently financing costs will also decrease.

In addition, Supervalu will begin negotiations for a new asset-based revolving credit facility of $900 million and $1.5 billion of term loan. The company will use the proceeds to replace existing asset-based revolving facility of $1.65 billion and $846 million of term loan. All these initiatives are likely to improve the company's balance sheet and cash flows. I think the company's operational burden will also reduce thanks to the sale of low-performing stores.

Now, Supervalu's business plan should include maximizing efficiencies across the company and continued focus on right-sizing operations. The stock can experience huge ups and downs during this process, but it currently offers a cheap entry point for long-term investors who can afford to take the risk.

Source: What's Going On With Supervalu?