You don't need to be a private equity fund to do an LBO. With many highly levered public companies, investors can replicate LBO strategies on their own. We are launching the "Own Your Own LBO" series to look at such opportunities, starting with Supervalu (NYSE: SVU).
Supervalu is a retail grocery chain with over 2,500 stores. The company has made many acquisitions over the years, most notably the $16 billion acquisition of Albertsons in 2006. Today, SVU's banners include Acme, Albertsons, Cub Foods, Farm Fresh, Hornbacher’s, Jewel-Osco, Lucky, Save-A-Lot, Shaw’s / Star Market, Shop ’n Save, Shoppers Food and pharmacies. SVU also has a supply chain business for independent grocers.
The Albertsons deal had a big impact on SVU. SVU paid 6.6x TEV / LTM EBITDA and 20x P/E for Albertsons and took on over $6 billion of debt. Since then, the company has struggled with operational challenges and an unfavorable macro-economic environment due to the recession and high unemployment. One key operational challenge has been SVU's high prices compared to competition. As a result of these headwinds, SVU's top line has been declining (see "Historical Financials" in the model below). Nonetheless, from 2006 through February 2011, SVU reduced total debt by $2.75 billion and is continuing to reduce debt further. Some of the cash for debt repayment has come from selling non-core assets, but most is from free cash flow.
SVU appointed a new CEO, Craig Herkert, in 2009. Prior to joining SVU, he was a senior executive at Wal-Mart (WMT) and served as CEO of the Americas since 2004. Before he joined Wal-Mart in 2000, he spent 23 years with Albertsons and its related companies.
SVU's motto is to be "America’s Neighborhood Grocer" and its strategy is focused on hyper-local retailing. It believes in decentralizing certain decisions to give its store managers more say in what brands to put on the shelves. Nonetheless, SVU maintains a centralized purchasing and management system across all of its banners. SVU's turnaround plan is called "8 Plays to Win" (see below).
SVU's 5 year stock price chart [click to enlarge]:
Following a significant fall in the share price over the last few years, SVU's low valuation is compelling. Despite certain challenges, SVU is still generating a substantial amount of free cash flow, $600 million annually (free cash flow is defined as EBITDA, less CapEx, less interest, less cash tax). Even after a $74 million annual dividend and a $110 million pension contribution, SVU has ~$400 million of free cash flow annually that can be used to pay down debt (and thereby increase equity value). In a classic LBO, a private equity fund buys a company that has high debt and then uses the company's cash flow to pay down debt and increase the equity value. SVU is a similar opportunity.
SVU closed at $7.03 on November 24, 2011 and it is approaching the 52-week low of $6.26. Currently, it is trading at 4.23 TEV / LTM EBITDA, 5.62 forward P/E (guidance midpoint) and has a 4.98% dividend yield.
- Potential For ~2x and ~20% Return with Conservative Assumptions - Assuming SVU can continue to repay debt, without any growth or any multiple expansion, SVU has the potential to generate a ~2x return over the next 4 years.
- Base Case Assumes No Growth - In order to achieve a 2x return in SVU over the next few years, the company does not even need to grow. In fact, the Base Case even assumes that EBITDA decreases 4% next year. Due to the economic environment, the return analysis assumes no growth to be conservative. Should there be growth, then the returns could be higher.
- Low Valuation - SVU is trading at a low valuation of ~4.2 TEV / LTM EBITDA. Although the multiples for the retail grocery sector are low in general, ~5x TEV / LTM EBITDA, SVU is trading at a discount to this level. If SVU experiences multiple expansion, the stock price should increase to a higher level than assumed in the Base Case.
- Deleveraging Opportunity - SVU is currently generating ~$600 million of free cash flow (EBITDA, less CapEx, interest and cash tax). After $74 million in annual dividends and $110 million of annual pension contribution, SVU has ~$400 million for annual debt repayment. Currently, SVU has a market cap of $1.5 billion and $6.6 billion of net debt. Because the market cap is 19% of the TEV, the deleveraging will have a significant impact on shareholder value. An annual debt repayment of $400 is equal to 1/4 the current market cap and should increase the equity value by that amount, assuming the TEV / EBITDA multiple stays the same.
- Dividend Yield - SVU pays a quarterly dividend of $0.0875, or $0.35 annually. At the current share price of $7.03, the dividend yield is 4.98% annually. Considering that the dividend represents a $74 million annual use of cash while the company has ~$600 million of pre-dividend free cash flow, there is good cash flow coverage of the dividend payment. SVU has substantial debt, but with no large near term maturities, the dividend seems safe.
- "8 Plays to Win" - The Base Case assumes no operational turnaround. However, SVU's management has launched a turnaround and growth plan that it calls "8 Plays to Win." Should management succeed with this program, the company's financials could improve and provide additional upside for the stock price. Most importantly, SVU needs to focus on lowering prices to remain competitive. SVU is undergoing a shift from relying on promotions to drawing customers into their store to a more balanced approach of lower everyday prices, plus promotions. Should the company succeed in lowering prices in a way that does not have a meaningful impact on margins, the company's revenue decline could end and it may experience growth.
- Continued Revenue Contraction - Revenue has declined for over two years. SVU has been losing customers, in part, because its pricing has not been competitive. SVU's management has been been talking about "investing in price," meaning using the reduction in costs to fund a reduction in pricing to become more competitive. However, SVU may not be successful in reducing price effectively and may continue to lose customers and revenue. For this reason, the Base Case assumes a 4% decline in EBITDA in 2012.
- Food Price Inflation - If prices continue to rise and SVU cannot pass on the increase to its customers, its margins will be impacted.
- Competition - The retail grocery segment is very competitive and, as discussed above, SVU's pricing is currently seen as not competitive.
- High Debt - Although SVU's debt load seems manageable, especially without upcoming large maturities, the high debt load is a potential risk.
- Pension - As of February 26, 2011, SVU had a pension obligation of $2.5 billion and pension assets of $1.9 billion. It appears that the pension was underfunded by $619 million. In FY 2012, SVU projected a pension and post-retirement benefits contribution of $100 million, rising to $133 million in FY 2016. SVU is assuming a 7.75% return on its pension assets, which is high. There is a risk that SVU's pension will not return the projected amount and will be more unfunded than expected. In this scenario, SVU may need to use additional cash for pension contributions instead of debt repayment. The models below assume $110 million of annual pension contributions. SVU's pension disclosure are not sufficient and it is expected that SVU will disclose more data about the pension in the future. However, this is an important risk factor.
- Why is this security mispriced?
SVU's revenue has been declining for over 2 years, its pricing is not competitive compared to other grocers and it has limited growth opportunities. Furthermore, it has a high debt load compared to its peers. As a result the market is currently valuing SVU at a very low valuation.
- What is the market ignoring about this security?
The market is ignoring the cash generating capabilities of SVU, even in a tough environment, which can continue to fund the company's deleveraging. Even if SVU's multiple does not expand, the deleveraging should be a catalyst for share price appreciation. In addition, there are growth opportunities that we are excluding from our analysis, which could create additional upside.
- What are the key drivers for the security?
SVU's stock has been declining because of concerns about its above market pricing and concerns of market share loss, combined with concerns over the weak economic environment.
- What is the downside?
The main concern is that SVU cannot become more competitive and turn around its declining performance. Should that be the case it may not be able to continue to generate enough cash to continue deleveraging (currently ~$525 million annually). In such a scenario the dividend may also be cut, but it only represents a $76 million use of cash, so free cash flow would need to drop significantly for the dividend to be cut. The company has a manageable debt maturity schedule in the near term, but if it experiences cash flow problems over the long term then it may have difficulty meeting debt obligations. Additionally, SVU's pension is underfunded and has a seemingly unrealistic return expectation of 7.75%. Therefore, SVU may need to contribute more to its pension than currently expected. With an already low multiple, there is little risk of further multiple contraction.
- What is the upside?
If SVU continues to delever at the current run-rate, or even slight lower, then the stock could rise 1.9x in the next 4 years just based on the delveraging (assuming a constant multiple), which is the Base Case in the model. If SVU experienced multiple expansion to the industry mean and/or growth then the stock could rise further (see High Case).
- What are the upcoming catalysts?
The investment thesis is based on SVU continuing to delever, which will take time and will occur in small increments. We believe that this process will have a significant impact on the stock in the mid to long term, but may not be apparent in the short term. In the short term, quarterly financial results may provide a catalyst for the stock. SVU's top line has been declining and if it halts the decline, the sentiment regarding SVU may change which could act as a catalyst for the stock.
Valuation and Model
The model presents:
- Valuation overview
- Returns analysis
- Historical financials
- Comparable companies analysis
The returns analysis presents 3 scenarios. The return in the Base Case is projected to be a 18% IRR through 2015 and a 1.93x multiple. The range of returns is from a Low Case multiple of 0.82x to a 34% IRR and 3.20x multiple in the High Case. We think that the most likely outcome is in the range between the Base Case and the Upside Case, so the expected returns are 1.93x - 3.20x over this time period.
In this scenario, SVU's financials continue to decline in 2012. EBITDA decreases -4% in 2012 compared to LTM September 10, 2011. EBITDA then stays flat for 2 years and increases 1% in 2015. Debt repayment, a key driver of returns, decreases to $329 million for the next three years because of the lower projected EBITDA (debt repayment in 2011 is expected to be over $525 million in 2011, so this is a conservative assumptions). SVU continues to be valued at 4.23x TEV / EBITDA, which is the current multiple.
Through 2015, SVU managed to repay $1.3 billion of debt, which is the main driver for the increase in equity value. In addition, SVU continues to pay a $0.35 per share annual dividend.
In the Base Case, SVU's stock is projected to increase to $12.16 in 2015. The cumulative return is $13.56, after adding dividends. In this scenario, SVU is expected to generate a 1.93x return and a 18% IRR.
Although the Base Case is conservative (EBITDA decline in 2012, less debt repayment than current run-rate, no multiple expansion), the Low Case is even more conservative. It assumes that EBITDA continues to decline each year through 2015 (though at a slower rate each year). As a result, the debt repayment is even lower. Furthermore, the TEV / EBITDA multiple is expected to decrease to 4.00x, from the current 4.23x.
In the Low Case, SVU's stock is projected to decrease to $4.38 in 2015. However, the cumulative return is $5.78, after adding dividends. In this scenario, SVU is expected to generate a 0.82x return and a -5% IRR.
The High Case assumes that SVU is able to turn around its operations. EBITDA is projected to decline -2% in 2012 (less than -4% in the Base Case) and return to the LTM level in 2015. As a result, in the High Case SVU can repay $1.5 billion of debt over the period, as opposed to $1.3 billion in the Base Case. Furthermore, the TEV / EBITDA multiple is projected to expand to 5.0x in 2015.
In the High Case, SVU's stock is projected to increase to $21.12 in 2015. The total return is $22.52, after adding dividends. In this scenario, SVU is expected to generate a 3.20x return and a 34% IRR.
NOTE: The model here is meant to present a summary of potential returns and is for illustrative purposes only. The model is not intended to forecast specific annual financial results. Additionally, SVU does not report its fiscal year on a calendar year cycle.
The portfolio already has a long position in SVU. The portfolio is long SVU shares with an average cost basis of $7.25. Additionally, the portfolio sold January 19, 2013 $7.50 put options on SVU. We are considering adding to our SVU position.
Disclosure: I am long SVU through stock and options and may add to my position or reduce it at any time.