Shares of Midwestern grocery chain Roundy's (NYSE:RNDY) plunged 20% on Friday as investors reacted to a not exactly unexpected but still severe dividend cut. The company decided to chop the dividend roughly in half to strengthen its balance sheet during a challenging economic time, as they continue to struggle in the competitive supermarket sector, which is under pressure from not only industry peers and giants like Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST), but also nontraditional food sources that are becoming more mainstream such as dollar stores like Family Dollar (NYSE:FDO), Dollar General (NYSE:DG), and Dollar Tree (NASDAQ:DLTR).
While at first glance the dividend reduction looks draconian, it obscures the fact that the stock is still yielding more than 11% even after the cut. This is with a payout ratio that is now below 60% of the low end of the company's earning guidance for the full year, even including some one-time expenses mostly related to management changes. Excluding these charges, earnings are expected to be in the range of $1.05-1.12, giving the company a miniscule P/E ratio of around 4.
Furthermore, the dividend cut will free up some cash flow to help pay down its high debt load, which interest expenses on dwarf the cost of the dividend and nearly approach the total capital expenditures of the company. Whittling away at these expenses will have a much more profound impact on earnings and thus share price support than maintaining an unsustainable dividend.
If the company can successfully execute this strategy and begin funding its growth with cash flow and retained earnings rather than debt, it could further expand its promising growth initiative, the development of its Whole Foods (NASDAQ:WFM) style Mariano's Fresh Markets, which it has been rolling out in the Chicago area. I believe this concept could be expanded to the point where that business could be spun off and would certainly command a higher multiple than the rest of the company's core holdings of more staid stores.
Either way, the short term bad news of slumping earnings and drastic dividend cuts is undermining the long term potential of the stock, which is already trading at a compelling level even assuming no future earnings growth, much less the hidden potential if the Mariano's concept is successful, so I would look to pick up some shares while they're on sale.
Disclosure: I am long RNDY, COST. 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.