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Shares of Supervalu (SVU) are on sale on Monday after analysts at Goldman Sachs (GS) are seeing more downside potential. While I feel Goldman's bearish advice could be too aggressive, investors are listening to their brokers, triggering a selling wave in Supervalu's shares on Monday. I remain on the sidelines.

Goldman Turns Bearish

Analyst Stephen Grambling downgraded Supervalu from "Neutral" to "Sell", while lowering his price target by two dollars to $6 per share. Based on Friday's closing price, the target implies that shares have some 13% potential to the downside, prompting shares to fall already 7% on Monday.

According to Grambling, there are headwinds which create turnaround risks. While management has been able to show some changes, there are some negative factors which could undo those performance improvements.

Cuts to the food stamps program, a reduction to the transition services agreement, and tougher competition are all factors which could hurt the company. As a result, Goldman cuts its earnings forecasts for the years 2014-2016.

Valuation

Supervalu ended its second quarter of its fiscal 2014 with $81 million in cash and equivalents. Total debt stands at $2.99 billion, resulting in a net debt position of around $2.9 billion. Sales for the first six months of the year were virtually unchanged at $9.19 billion. At the same time, gross margins rose by some 130 basis points to 14.9% of total sales.

These improvements were largely undone by net interest charges which doubled to $300 million over the period, although they fell sharply in the second quarter following the deal announced at the start of the year. The company posted GAAP earnings of $125 million after recording gains of $191 million from discontinued operations. At this pace, annual revenues could come in around $17 billion, as earnings are seen around break-even.

Factoring in losses of 7% on Monday, with shares exchanging hands at $6.40 per share, the market values Supervalu at $1.7 billion. This values equity in the firm at merely 0.1 times annual revenues. Given the financial difficulties, Supervalu does not pay a dividend at the moment.

Some Historical Perspective

Troubled by the leverage of the firm, long-term holders in Supervalu have seen very poor returns. Shares peaked around $50 in 2007 and have fallen all the way to $2 by the end of last year. Ever since, shares have recovered, trading as high as $8.50 per share about a month ago, after which shares have lost a quarter of their value again. Between the fiscal 2010 and 2013, Supervalu has seen its revenues fall by nearly 60%. The company posted losses of over a billion dollars in each of the past three years.

Investment Thesis

Note that Supervalu's investors have made a huge negative scalp which almost bankrupted the company. In 2006, Supervalu, led by Cerberus Group, bought Albertson's in a total deal value of $17 billion.

Earlier this year, Supervalu sold a lot of these supermarkets for a paltry $100 million to the same Cerberus Group. Supervalu sold the majority of the stores bought in the 2006 deal, but Cerberus would furthermore assume $3.2 billion in debt, cutting Supervalu's net debt position roughly in half.

Supervalu has been struggling amidst the debt incurred from the 2006 deal in combination with increased competition from the likes of Kroger (KR) and Wal-Mart (WMT), which have gradually scaled up their operations.

With the deal and new management in place, investors finally had something to look forward to, trading with year to date gains of around 150%, even after the latest correction.

For now, the trick is to stabilize the business, with revenues of around $17 billion, while steadily reducing debt by boosting earnings. Reporting any meaningful earnings will still be tough given the relatively large debt position of the firm.

At current levels, shares are not just a gamble anymore, but the $1.7 billion valuation is too high to call it a gamble, like shares were at $2 per share. The valuation for now seems fair, but given the leverage involved, investors ought to focus on the enterprise valuation. Combined with the debt, the enterprise valuation of Supervalu increased to some $4.6 billion, valuing the business at a quarter of annual revenues.

I remain on the sidelines. While a short position might be too aggressive, this does not automatically translate into a long opportunity for investors.

Source: Supervalu: Goldman's Bearish Stance Seems A Bit Aggressive