Supervalu: Overreaction To Earnings Creates A Value Investor's Dream

| About: SUPERVALU Inc. (SVU)

Summary

Supervalu shares have declined significantly due to the market plunge, as well as short selling and an overreaction to a recent earnings report.

The environment for retailers has not been great, but investors are being too harsh as Supervalu put in a relatively strong quarter.

This stock is trading at rock bottom levels, it has an upcoming spin-off catalyst and it could be viewed as defensive, especially if the economy slows.

Supervalu just filed to spin off its Save-A-Lot division to shareholders which (based on peer valuations) could soon unlock significant shareholder value.

At these very undervalued levels, the company could once again be ripe for activists and for a private equity buyout.

Supervalu (NYSE:SVU) shares were showing some strength and trading for about $7 in late December. However, this stock has been hit hard by the market plunge as well as by short sellers and a major overreaction to a recent earnings report. For a number of reasons, this appears to be a great buying opportunity, so let's take a closer look:

Supervalu is a major force in the grocery business with about 3,400 stores and around 35,000 employees. The Save-A-Lot division, which has over 1,000 stores, is a higher growth business. Save-A-Lot is a low price chain that competes with dollar stores. Save-A-Lot had sales of about $4.6 billion, while Supervalu had total sales of around $17.8 billion in the past year. Supervalu just filed a form 10 with the SEC on January 7, stating that it plans to move forward with a spin-off of Save-A-Lot. This move should unlock significant upside because Save-A-Lot has growth and major expansion potential. Because of this, it is likely to achieve a much higher valuation when it trades as a stand alone company or if it were sold to a private equity firm. Supervalu has said that shareholders will get about 80% (or maybe more) of the Save-A-Lot spin-off.

However, Supervalu could also decide to spin off Save-A-Lot by selling it to a private equity firm. A Reuters article says a number of private equity firms are interested in buying Save-A-Lot. That means Supervalu could use about 20% of the proceeds to pay down some debt and then use the rest (or about 80%) of the proceeds to give shareholders a major dividend. The article also notes that a spin-off of Save-A-Lot could allow it to take advantage of typically high public market valuations for discount stores and it states:

"Eden Prairie, Minnesota based Supervalu has received interest in Save-A-Lot from several private equity firms, and has told them that it will consider offers once it registers the unit with regulators for a spin in early 2016, the sources said this week."

We have a very irrational market right now that has created fear and even some panic selling with investors. It has also given short sellers an opportunity to attack stocks with little resistance, at least temporarily. Historically this kind of market action has been a buying opportunity because eventually investors realize that the world is not ending (and even if it is ending, cash will be worthless as well). Many companies have recently reported positive news and still saw a stock price decline. For example, General Motors (NYSE:GM) recently boosted its earnings guidance, raised the dividend, and increased a share buyback, and yet the stock is down since that news came out a few days ago. This kind of response is totally irrational and shows that fear, short sellers, and short-term thinking is ruling the market for now, rather than common sense and long-term investing. The recent decline in Supervalu after it announced earnings also appears to be completely irrational. Supervalu reported Q3 earnings of 16 cents per share which met analysts estimates. It also matched revenue estimates of $4.1 billion that were issued by Factset, but missed another analyst estimate of $4.2 billion. This miss off the higher revenue estimates is about a 2.8% difference, and yet the stock has dropped by about 30% in just the past few days since earnings were released. I don't think a 2.8% "miss" on revenues warrants a 30% drop in the share price, especially when the bottom line numbers met estimates. That is just another reason why I see this as a major buying opportunity.

It is worth noting that Whole Foods Market (NASDAQ:WFM) missed earnings estimates last quarter. The stock went down sharply but then rebounded back within a couple of weeks. I think we could see a similar rebound in Supervalu as soon as the market stabilizes. The reality is that the retail sector has been challenging for the entire industry whether it is groceries, or clothing with Macy's (NYSE:M), or jewelry with Tiffany (NYSE:TIF). I believe that the initial market reaction to Supervalu's earnings report is way too harsh (possibly manipulation by short sellers) and a complete overreaction that will reverse itself in the coming days and weeks. I believe Whole Foods could report another miss when it reports earnings on February 10, and so could other companies in this sector. That could make investors realize that Supervalu actually had a relatively strong quarter which again does not warrant a 30% plunge in the share price. You would think Supervalu had posted a major loss with this type of decline in the share price, but the company posted a solid profit.

Analysts expect Supervalu to earn 73 cents per share in 2016, and about 80 cents per share in 2017. That means this stock is trading for just about 6 times earnings, which is well below the industry average. Many other retailers in this industry have PE ratios that are between 15 to 30 times earnings, so that means there is significant multiple expansion upside for Save-A-Lot when the spin-off is completed. This division competes with firms like Costco (NASDAQ:COST) which enjoys a PE ratio of about 30 times. Some analysts believe the value of the Save-A-Lot division alone could be worth as much or more than the total current market capitalization of Supervalu. A Barron's article which details the shareholder value that could be unlocked with a Save-A-Lot spin-off states:

"Peter Andersen, a money manager at Congress Asset Management, which owns Supervalu shares, thinks that Save-A-Lot could command as much as 10 times fiscal-2016 estimated Ebitda, putting its multiple closer to those of dollar stores and other food discounters. He estimates that Save-A-Lot can generate $220 million this year in Ebitda, and values the chain at $2.2 billion, about equal to Supervalu's total market capitalization."

One other thing I want to point out is that Supervalu shares were not down in pre-market trading on the morning it announced earnings last week and it was also initially trading up as soon as the market opened. Short sellers have been active in this stock and I believe Supervalu shares have clearly been manipulated and targeted by shorts in the past few days. According to Shortsqueeze.com, there are now about 19.5 million shares short and this is about a 44% increase since last month. I think this is another sign that Supervalu has been the victim of a short attack. It is not that hard to take a stock that has been weakened by tax-loss selling in December and then further hit it on earnings day, especially when the stock market has seen the worst plunge in the start of the year that we have ever experienced. I noticed that on one day after earnings, Supervalu shares had dropped by about 7%, when only around 3 million shares had traded. This means that less than 15 million dollars worth of stock had traded and yet this caused a 7% decline in a company with a market cap that is well over $1 billion. That is like the tail wagging the dog and it makes no sense in the long run. This shows that even one large short could have the firepower in his account to manipulate this stock lower, especially in a very weak market that is full of fear and negativity and margin calls. However, in the long term, fundamentals will come back into focus and this includes the fact that Supervalu is profitable, extremely cheap with a PE ratio of just about 6 times earnings, and it also is extremely oversold now which means it could be overdue for a strong rebound. Finally, Supervalu said it could complete the spin-off in the first half of this year, and that means investors might not have to wait long for what could be solid gains. Shorts that have been targeting Supervalu in recent days could help spark a major short covering rally and I am buying more stock in anticipation of this since the 19.5 million shares short all have to be covered at some point.

Analysts have set price targets between $6 to $12 per share for Supervalu. Deutsche Bank (NYSE:DB) has set the lowest price target of $6, which still implies almost 50% upside. A Morgan Stanley analyst has a price target of $8 which implies a near double. This Morgan Stanley analysis was updated after the recent earnings report and it is based on a sum-of-the-parts valuation of the company that reflects their "base case", but their bull case valuation is $11 per share. Just over a week ago, TheStreet.com published an article that suggested Supervalu shares could have significant upside and set a 6 to 12 month price target of $12 per share. The analyst noted that the net debt to EBITDA ratio continues to improve and that Supervalu generated about a 23 to 24% return on investment in each of the past couple of years. The article stated:

"Supervalu shares are a compelling buy, and detailed analysis shows they have the potential to rise 100% from recent levels. Investors should consider adding this retail stock to their portfolios."

Supervalu is just too cheap to ignore and while the recent market drop has been painful for all investors, it does not make sense to panic sell at these bargain level valuations, but rather to buy and hold for what should be much higher prices when common sense returns, a spin-off occurs, and shorts cover so that they can lock in gains and move onto their next victim.

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Disclosure: I am/we are long SVU.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.