Coming off strong fourth-quarter results, Safeway (SWY) appears to be well positioned to gain market share. Despite sequential deceleration for Supervalu (SVU), Safeway has limited downside given its significant discount to peers and industry takeover chatter. Kroger (KR) similarly offers attractive risk/reward and is, accordingly, rated a "buy" on the Street (ratings source: T1 Banker).
From a multiples perspective, Kroger is the cheaper of the two. It trades at a respective 12.3x and 10.8x past and forward earnings with a dividend yield of 1.9%. Safeway, meanwhile, trades at a respective 15.5x and 15.5x and 12.5x past and forward earnings with a dividend yield of 2.5%. To put this under context, consider that Safeway is trading at only 40% of its 3 Digit MG Group PE multiple. And Kroger is trading at only a quarter of its historical 5-year average PE multiple! Smaller firms, such as Arden Group (ARDNA), are also likely to generate strong returns as consumer expenditures return to normal. Takeover activity across the industry will further close Arden's discount to intrinsic value.
At the third-quarter earnings call, Kroger's management expressed a positive outlook:
Based on the consistency of our results over the course of this year, we have the confidence to raise our earnings and sales guidance for the year. Identical supermarket sales increased 5% without fuel for the quarter. This continues Kroger's industry-leading trend of positive identical sales growth for 32 consecutive quarters. Consistent identical sales growth lets us know that our Customer 1st strategy is connecting with customers in a meaningful way…
Our third quarter performance was broad-based across the company. Each of our 18 retail divisions had positive identical sales, excluding fuel. Every department achieved positive identical sales as well, led by growth in natural foods, deli and produce.
The company has delivered top-line growth every year since 1987, but is still cheaper than 99% of companies listed in the S&P 500 (SPY) measured by the forward price-to-sales ratio. It is also the largest grocery store chain and still has impressive room for expansion into high-growth geographies. Over the November to January period, Kroger was one of the few grocers to actually experience deflation (0.7%). This nice decline in selling price compares with 1.5% for peers. Based on this favorable backdrop, I expect takeover offers to draw near for Kroger.
Consensus estimates for Kroger's EPS forecast that it will grow by 13.6% to $2 in 2012, and then by 11% and 7.2% in the following two years. Assuming a bearish multiple of 14x and a conservative 2013 EPS of $2.18, the rough intrinsic value of the stock is $30.52, implying 27.6% upside.
Safeway is also worthy of consideration. The company beat expectations for the recent fourth quarter as total sales increased 6.2% over last year. Higher fuel prices and greater ID business were the organic drivers of top-line momentum. Despite 1% inflation for the November to January period, the company still experienced overall low inflation for 2011 as a whole. I anticipate Safeway to continue to benefit from strong secular trends in the West Coast. Management recently issued $800M worth of senior unsecured notes, which nicely complements its double-digit free cash flow yield. Consequentially, investors should expect to hear news about capital allocation in the approaching fourth-quarter earnings call. Over the next three years. ROIC is likely to stay roughly flat at 9% as net debt increases by around $1B.
Consensus estimates for Safeway's EPS forecast that it will grow by 11% to $1.72 in FY2011 and then by 7% and 8.2% in the following two years. Modeling a 3-year CAGR of 8.7% for EPS and then discounting backwards by a WACC of 9% yields a fair value figure of $25.42, implying 10.8% upside.
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