Supervalu - Leverage Remains High After Save-A-Lot Divestiture Amidst Continued Challenges

| About: SUPERVALU Inc. (SVU)

Summary

Supervalu is selling its discount Save-A-Lot business in order to tackle its debt load.

While the move reduces absolute debt levels, relative leverage ratios remain high as the remaining core operations continue to be under pressure.

Smaller scale operations, high leverage and secular headwinds continue to cast a lot of doubt on the long-term outlook.

Supervalu (SVU) is shrinking, being left with a retail and wholesale operation. The company has been facing hard times for years now amidst large losses in the past, forcing the company to continue to shrink its operations.

The company is now selling its discount retail operations in order to raise some much needed cash. While the sale will reduce absolute and relative leverage ratios for now, the remaining core continues to be under pressure. Given the still sizable debt load, even after taking into account proceeds from the Save-A-Lot sale, and the secular headwinds, shares offer no appeal unless you might be able to time a potential buy-out.

A Struggling Business Is Shrinking

Supervalu is a business which posted sales of $17 billion for its fiscal year of 2016. While this sounds like a large business, Supervalu is a relatively modest player in a very competitive grocery business. The company has been shrinking for quite some time now, creating additional challenges on top of fierce competition from much larger and better capitalized competitors.

Supervalu's business is comprised of three segments. In the fiscal year of 2016, the wholesale business generated $7.9 billion in sales. It furthermore owns a $4.8 billion retail operation and $4.6 billion discounter, named "Save-A-Lot".

Despite the difficult market conditions, Supervalu managed to post operating earnings of $454 million in the fiscal year of 2016 and adjusted EBITDA of $771 million. Note that while operating margins of 2.6% look relatively solid, given the thin margins in the industry, debt servicing costs are high. Nearly half of these operating profits were used to pay $196 million in interest payments.

The company ended the year with just $57 million in cash and total regular debt of $2.3 billion. This net debt position of $2.2 billion translates into an elevated 2.8 times leverage position. Including pension and capital lease obligations, net debt surpasses $3 billion, resulting in leverage ratio which is approaching 4 times.

With sales growth being negative for all three segments in 2016 expectations have been low going into the fiscal year of 2017.

Selling The Goose?

First quarter sales for the fiscal year of 2017 fell by 3.9% as reported in July, with earnings metrics being pressured as well. As these softer results were accompanied by a profit warning in September, pressure was surely building to reduce leverage and that is what Supervalu has done.

In October, Supervalu announced the sale of its Save-A-Lot business in a $1.365 billion cash deal. That suggests a 0.3 times sales multiple based on the 2016 results. The segment generated $129 million in operating earnings and saw $71 million in depreciation charges based on the 2016 results. The $200 million EBITDA number suggests that Supervalu received a 6.8 times multiple for that business. It should be mentioned that momentum of the chain has been particularly weak in the first half of 2017.

Based on the second quarter results, Supervalu has $57 million in cash as debt, pension related liabilities and capital lease obligations surpass $2.93 billion, for a roughly $2.9 billion net debt load. If we assume no transaction costs related to the sale of Save-A-Lot, net debt could fall towards $1.5 billion.

Of course the company is much smaller going forward as well. The remaining wholesale and retail operations posted sales of $12.7 billion in 2016, operating earnings of $324 million and $202 million in depreciation and amortization charges. The EBITDA number of $526 million suggests that while absolute leverage has come down a lot following the deal, leverage ratios still come in at roughly 3 times EBITDA.

The 267 million outstanding shares trade around $5 following the latest news flow, for an equity value of $1.3-$1.4 billion, giving the overall business a roughly $2.9 billion valuation. This is equivalent to 5.5 times 2016's EBITDA for the retail and wholesale business combined.

While that valuation looks relatively appealing, Save-A-Lot is a better regarded asset of the business. At the same time, Supervalu might incur some tax and transaction related costs as well, thereby not delivering a $1.5 billion pro-forma net debt load. It should furthermore be said that developments in the fiscal year of 2017 are very weak. As a matter of fact, sales are falling by mid single digits as the retail operations posted a loss for the second quarter.

So far the EBITDA contribution of the remaining business is falling short by $50 million already in the first half of this year compared to the 2016 numbers. This suggest that EBITDA of the retail and wholesale business likely comes in at $400-$450 million. At the midpoint of the range, leverage increases already to 3.5 times, not solving the debt issue at all as the core remains in serious trouble.

Even if a 6.8 times metric would be justifiable for the remaining assets, being the same multiple for the Save-A-Lot deal, the overall valuation for the remaining business would work out to be $2.9 billion. That is equivalent to the pro-forma valuation at the moment, indicating no upside for investors. At the same time, the business is facing continued decay from much better capitalized traditional competitors as well as online competition of course.

Avoid

While buyout rumors oftentimes appear in a name like Supervalu, time is not in your favor, nor is it your best friend being an equity investor in the firm. Absent a one-time premium, if the business indeed gets taken over, investors should expect slow decay as the business is simply not well positioned to compete effectively in this market.

The recent move to reduce the company and its debt load is to be applauded. While absolute debt levels are coming down, relative ratios are coming down just very modestly based on the erosion seen in the operating performance in recent quarters. Given the still elevated debt load, the small scale of operations and the fierce competitive field, I simply stay away.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.