With the economy picking up, we will see the first signs of rising consumer expenditures through stock momentum at grocers. As an investor relations consultant, I see particularly strong results for under-followed firms Dairy Farm (DFIHY.PK) and Publix Super Markets (PUSH.PK). These two firms are significantly undervalued and would highly benefit from greater press coverage. This will only occur when the negative investor attitude toward the market dissipates - as it should.
In the meanwhile, larger firms like Safeway (SWY) will receive a disproportionate share of the attention. In this article, I will run you through my DCF analysis on the company and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared with peers Kroger (KR) and Supervalu (SVU). I find meaningful room for upside.
First, let's begin with an assumption about revenue. Safeway finished FY2011 with $43.6B in revenue, which represented a 6.3% gain off of the preceding year. Analysts model a 7.9% per annum growth rate over the next few years, which I view as overly conservative in light of the fact that they are expecting around 300 basis points more for the S&P 500 (SPY).
Moving onto the cost side of the equation, there are several items to consider: operating expenses, capital expenditures and taxes. I expect cost of goods sold to eat 72% of revenue versus 25% for SG&A. I model capex trending from 2% to 1.5% over the next half decade. Taxes are estimated at 37% of adjusted EBIT.
We then need to subtract out net increases in working capital. This is estimated at 0.5% of revenue.
Taking a perpetual growth rate of 3% and discounting backward by a WACC of 7% yields a fair value figure of $28.46, implying 33.6% upside. It would not surprise me to see management use some of the firm's free cash flow to buy out struggling competitors.
All of this falls within the context of strong fourth-quarter performance:
[W]e exceeded the consensus estimates, as estimated by First Call, by at least $0.02. ID sales matched the performance that we had in the third quarter. Our gross margin rate was lower than last year but almost entirely the result of the LIFO charge, which I'll talk more about later. Our O&A expenses, as usual, were very well controlled. And then lastly, we took advantage of a low share price and purchased 43.3 million shares in the quarter.
From a multiples perspective, Safeway is equally attractive. It trades at a respective 13.9x and 10.2x past and forward earnings versus 25.4x and 9.7x for Kroger, and 5.2x forward earnings for Supervalu. Assuming a multiple of 15.5x and a conservative 2012 EPS of $1.78, the rough intrinsic value of Safeway's stock is $27.59.
Kroger is similarly attractive. As I explained in detail here, the company is likely to be bought out. It is cheaper than virtually every firm in the S&P 500 despite delivering top-line growth continually over the last quarter of a century. It has a significant number of grocery presence and still has plenty of room to penetrate high-growth geographies. It was also one of the few grocers to experience deflation from November to January. Assuming a bearish multiple of 14x and a conservative 2013 EPS of $2.18, the rough intrinsic value of the stock is $30.52. Accordingly, I strongly recommend an investment.
Like Kroger, Supervalu is overly viewed as a risky investment on the Street. Management has aggressively doubled down on its share repurchasing program and will help expand ROE through shutting down underperforming units. A $100M divestment of Burnaby and solid sequential momentum makes SUPERVALU a necessary investment in any grocery portfolio. The firm only needs to trade higher than 5.2x next earnings' year to appreciate in value. Accordingly, the downside is low, and far lower than what the retail investor acknowledges.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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