By David Sterman
The rules of a paired trade are quite simple. Find a good company and make a bullish investment while also finding a lousy company in the same industry and making a bearish short investment against it.
That logic surely applies when two companies appear comparably valued. But what do you do when the solid operator appears quite overpriced and the lousy operator appears to be far too cheap? Well, you have to turn the paired-trade theory on its head.
That's precisely the dynamic in place in the supermarket industry. Whole Foods (WFMI) is a very well-managed company with a stellar track record. Supervalu (NYSE:SVU) has clearly been the dog of the industry for quite some time. Yet this dog may soon have its day, and paradoxically is the better investment.
Differing business models ... for now
Whole Foods has single-handedly altered what consumers think of in terms of grocery stores. Its emphasis on healthy foods in an inviting shopping environment has allowed it to charge premium prices. That's why it can generate 5% EBITDA margins while most grocers must make do with 2% to 3% margins -- at best. And business at Whole Foods has rebounded impressively in 2010, despite a still-weak economy. Moreover, Walmart's (NYSE:WMT) aggressive push into groceries has surely hurt business at traditional supermarket chains like Supervalu and Kroger (NYSE:KR) to a much greater extent than Whole Foods.
That helps explain why Whole Foods is boosting revenue at a +10% clip (aided by store openings), while Supervalu's sales are shrinking more than -5% (partially due to selective store closings). But food retailing is a funny business. Grocery chains can -- and often do -- re-invent themselves. By upgrading stores, changing the merchandise mix and tinkering with pricing, they can alter their perception among consumers and draw back lost shoppers. And that's precisely what Supervalu is doing, spending more than $500 million in the current fiscal year to remodel stores. (Despite that spending, the company will still generate more than $1 billion in free cash flow this year, according to UBS.)
It will be likely be several years before consumer perceptions of Supervalu's stores can improve, so you shouldn't look for it to morph into an industry leader overnight. Nor should you expect this company to eventually be seen in the same light as Whole Foods, which has a strong grip on the premium end of the market. That said, as rivals like Supervalu and Kroger try to replicate the look and feel of successful grocers like Whole Foods, all of the players should see their operating metrics revert to the mean.
By the numbers
Even before Supervalu takes steps to improve results, its shares are already stunningly cheap by a variety of investment metrics. For example, it trades for less than six times projected earnings -- that's one-fifth of the multiple garnered by Whole Foods. And both of these companies are comparably valued in terms of enterprise value, even though Supervalu's sales base is four times as large and its EBITDA is twice as high.
Shares of Supervalu are also in the doghouse because of a stubbornly high debt load, which still exceeds $6 billion. The company's equity is worth less than $2 billion. And that, in a nutshell, is the primary reason why you should be bullish on Supervalu, even as its operations stumble right now. Any company with very high levels of debt often sees its equity come under pressure due to concerns about potential financial distress. But Supervalu, even with its subpar results, generates ample cash flow to cover its interest expenses and take down some principal. So over time, that debt load is likely to shrink, taking the total enterprise value down with it.
For example, let's say Supervalu reduces debt from $6 billion to $4 billion in the next three years, thanks to operating cash flow and selective asset sales. For its enterprise value to stay constant, equity would rise by a commensurate amount that the debt falls. That means its market value would rise from the current $1.8 billion to $3.5-4.0 billion. Shares would likely double from this -- without the company's enterprise value changing one iota.
There's a decent chance that Supervalu won't be around as a public company long enough to see that change. Rumors have popped up that private equity (PE) firms are sniffing around. Yes, this grocer has more debt than PE shops would like, but the cash flow capabilities relative to its existing debt load are awfully enticing. I have no idea if the rumors are true, but the logic is solid.
It's hard to see how shares of Whole Foods can rise any higher; it's already trading for nearly 30 times projected fiscal (September) 2011 results. If anything, shares are vulnerable to a slow downward drift, as other grocers start to replicate its business model. If you want to use a paired-trade strategy, that's the short side of it.
Meanwhile, on the long side, shares of Supervalu look significantly undervalued in the context of the grocer's still-strong cash flow. Management needs to proceed with some financial engineering to unlock shareholder value. But with shares now trading at levels last seen in 1990, they get the message.