Value investors often seek out companies that have hit rough times, causing Mr. Market to overreact and underprice the company’s securities relative to their intrinsic value. Last month, I came across an article in BusinessWeek about Supervalu Inc (NYSE:SVU), the fourth largest grocer in the United States (with approximately 2,350 locations nationwide). The article discussed negative analyst sentiment toward SVU resulting from negative same-store sales and customer count trends, compounded by the company’s massive debt load (the result of a poorly timed, highly leveraged acquisition of Albertsons in 2006). Of the fourteen analysts that follow SVU, at the time the article was published (last month), none rated the company a Buy, which is somewhat of an oddity and puts SVU in a unique position as one of the few companies in the S&P 500 to share this infamy. At the time the article was published, SVU was trading between $10 and $11. Today, the stock is down to $8.40 and making 52 week lows on almost a daily basis. I decided to look closer to see if this might be a case of the market overreacting.
On a quick perusal of SVU using Google Finance, I noticed that SVU’s P/E is nonexistent, meaning that the company has negative earnings which renders a P/E calculation meaningless. In looking more closely, we see that SVU’s negative earnings this most recent quarter is the result of a large non-cash write-down. When I see non-cash write-downs, especially of this magnitude, I check to see how common these “extraordinary” events have been in the company’s history. Some companies seem to have extraordinary events on a regular basis, and I don’t make an adjustment. In SVU’s case, they have had one other large write-down in 2008, but otherwise have not had a regular history of write-downs of this magnitude, so I adjusted that write-down to a more reasonable figure and calculated TTM earnings and found that the TTM P/E is just 5.5.
Normally I don’t like TTM P/E figures because earnings may be temporarily high or low, skewing the results. Instead, I look at the average margins for the last 10 years and try to get a sense of the earnings power of the company, and then use a normalized margin with current revenues to generate a more reliable denominator in calculating a PE10 figure. In SVU’s case, this is difficult because of the previously mentioned Albertsons acquisition which materially changed the company’s capital structure and gross and operating margins. It is unwise to use the four years since that transaction, as the effects of the recession and the acquisition transition period make it difficult to estimate the actual earnings power of the company with any reliability. Instead, we have to look beyond the earnings as they currently are and work on understanding the company’s path – an exercise fraught with potential missteps that could affect the reliability of the analysis.
So, what do we know about SVU? We know that halfway through last year, a new CEO came on board, Craig Herkert. Mr. Herkert came to SVU from Wal-Mart (NYSE:WMT), where he was President and CEO of Wal-Mart Americas. Given that Wal-Mart is one of SVU’s most important competitors, and what we know about Wal-Mart’s focus on improving operations with strong quantitative analysis and data mining, we can be confident in Mr. Herkert’s “training” for this role. Also, interestingly, Mr. Herkert began his career at SVU thirty years prior to coming back as CEO. Also, we can see that Mr. Herkert is prioritizing the deleveraging of the company, nearly tripling the rate of repayment. He has also committed the company to using the proceeds of asset sales to further deleverage. Moreover, Mr. Herkert has brought Wal-Mart’s focus on cost controls to SVU, having removed $100m from SG&A in 1H10 alone and a goal of another $60m in 2H10. This was achieved through SKU rationalization, leveraging the company’s purchasing power, expansion of the company’s private label business, and reduced headcount. In short, Mr. Herkert is the right man for the job, bringing a wealth of knowledge and a focus on detail. His responses in analyst calls are informative and he speaks openly of the challenges and opportunities, without skirting problems.
Unfortunately, the best captain can do little to improve a sinking ship. What do we know about SVU? We know that it has a long history of paying dividends. We know that is has had just four unprofitable quarters in twelve years, three of which were in the last two years and all three of which were the result of non-cash asset impairment write-downs resulting from the Albertsons acquisition. If we instead look toward Cash Flow from Operations, we see that SVU has had just three quarters with marginally negative CFO since the Albertsons acquisition. In short, this company’s profitability and cash flow from operations are historically positive, and combined with the rate of repayment of the company’s debt, we can rest somewhat assured that the company is unlikely to be pushed into bankruptcy anytime soon.
Once we are confident that the company’s debt load can be and is being dealt with, we can then take a longer-term view of the company to see what opportunities might exist. The picture that emerges is a company with opportunities over the next several years that should reward a patient investor with substantial upside. First, unlike its main competitors (Kroger (NYSE:KR), Safeway (NYSE:SWY) and Wal-Mart), SVU has not fully exploited the opportunities that exist in centralizing its supply-chain, merchandising and information technology. As this process completes, we should see improvements in margins. Second, the company believes there is room to grow its private labeling program, which it sees as a key component to its plan to improve COGS. Third, the company is in the process of divesting assets in which it cannot add value through its scale (geographically and by product), which will help the company deleverage and focus on its core operation. Fourth, the company is achieving success with its Save-a-Lot brand which operates in smaller locations with substantially fewer SKUs, which provides expansion opportunity in the event of a double-dip recession (this brand is targeted toward more cost-conscious consumers).
Beyond earnings growth, there is also the possibility of multiple expansion. Kroger trades at a P/E of 12 and Safeway at an adjusted P/E of closer to 17. This would double or triple SVU’s share price with no change in earnings. Mr. Market is pricing SVU as if it were in secular decline, which I disagree with. I see SVU as an opportunity to get a company with strong management and bright prospects for the lowest price in nearly twenty years (not to mention the massive amount of property it owns – approximately 25 million square feet worth – which you get for free).
Update 1: I thought I’d pass along another analysis (a pairs comparison too, which I like). David Sterman of Street Authority posted a nice comparison of Supervalu and Whole Foods (WFMI) on Seeking Alpha yesterday.
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.
Often, being the best operator doesn’t mean you are the best investment. Value investors are often betting on carefully considered reversion to the mean, and I think David’s article does a fair job of showing this in action. See his full post here.
Friend of the blog and MBA classmate, Saj Karsan of BarelKarsan.com fame published a great article yesterday comparing an investment in Supervalu to an investment in an LBO. Given today’s SVU love-fest, here’s an excerpt and a link to the original article in full.
The price of the entire Supervalu enterprise (debt + equity) is around $9 billion, against earnings before interest, taxes and non-cash writedowns of about $1.1 billion, for an EV/EBIT ratio of about 8. Since SuperValu has both the breathing room and the cash flows to make the debt repayments and capital expenditures it needs to, the company should see an increase in the market value of its shares even if its enterprise value were to fall.
Check out Saj’s full article here.
Author Disclosure: Long SVU. No position in WFMI.