The market's response to the IPO of Albertsons (NYSE:ABS) will say a lot about Wall Street appetite for a few staples at a time when investors seem to favor risk-off trades over consumer discretionary and more cyclical sectors.
Weak job figures on Friday meant volatility in early trade in the U.S., which reverberated across Europe and the U.K., although most indexes shrugged off concerns and closed in positive territory. It looks like today will be another good day for investors, although traders are wary of the risk in owning high-beta stocks at a time when talk of portfolio rotation is back with a vengeance and trends for certain asset classes remain unclear.
"The idea is that both the bond market and dollar have been trading 'flat' within fairly tight ranges since early this year. Since virtually everything that happens within the equity markets can be explained by the trends of the bond market and dollar... we should be paying particular attention to both as we shift into the final quarter of this year," read a note from the trading desk of RBC Capital Markets on Friday.
The bond market has sent mixed signals since mid-August, while the U.S. dollar has been looking for direction for some time - with remarks from the Fed, the reliability of China's data and emerging market risk all weighing on its relative value against all the other main currencies.
Kroger Vs Albertsons
Risk need not be a bad word, yet portfolio managers might have to adjust their risk/reward projections if volatility persists - so, it makes a lot of sense to focus on fundamentals in more defensive sectors. In this context, you could outperform the market betting on utilities, which are seemingly on a roll in the wake of more accommodative monetary policies and a multitude of other factors. The sector has clearly given signs of life with National Grid (NYSE:NGG) and PG&E Corporation (NYSE:PCG), for example - the stock of the latter has risen over 10% since early September, while NGG's ADR has also greatly outperformed the market over the period.
The debt of some utilities signal stress, however, so how about the food industry, which is notoriously less cyclical than other sectors?
I do not dislike Kroger (NYSE:KR), the largest supermarket chain in the U.S., which reports its third-quarter results on 3 December.
Earlier this month it raised 2015 EPS guidance to between $1.92 and $1.98, which yields a forward P/E of up to 18.6x - some 17% higher than the forward P/E for the S&P 500. That premium isn't much for a stock whose level of risk is properly reflected in its forward dividend yield of 1.1%, in my view.
Its return on invested capital (ROIC), on a rolling four-quarter basis, was 14.24% in the second quarter but is expected to rise this year, which testifies to an efficient use of capital. Its ROIC is over five percentage points above its weighted cost of capital. Its net leverage at 2 times is sustainable, although its growth rate isn't exactly break-taking - revenue growth should outpace U.S. inflation only by about a couple of percentage points this year. The group, however, is trying to be smart in order to gain market share and is well positioned to deliver on its promises - as it says, its long-term financial strategy:
"continues to be to use cash flow from operations to repurchase shares, fund its dividend, increase capital investments, and maintain its current investment grade debt rating."
On the face of it, Kroger looks like a more palatable equity investment than Albertsons, whose IPO is in the process of being priced. The deal currently carries an indicative price range of between $23 and $26, which implies an equity value of up to $12.3bn. The first warning comes from its capital structure: its market value, based on a stock price of $26, would be very similar to its net debt position.
Albertsons is selling 65 million shares - about 13% of its total shares outstanding upon the completion of the offering - to pay down debt and that's hardly ever a great way to entice new investors to commit to a rights issue. Bear in mind that leverage can easily destroy value in the retail sector, and the debt-funded acquisition of Safeway last year left it in a critical position.
Yet Albertsons is expected to deliver annual run-rate synergies of about $440m by the end of fiscal 2015, and annual synergies of about $800m from 2018 - taking into consideration these elements and trailing net losses in the region of $329m, its stock would trade on a forward P/E of 110 times if it was priced at the top end of the range.
Of course, trading multiples tell only one part of the story, and Albertsons remains a restructuring play, but if its plan doesn't go according to plan, it could be a very hard day in the office for the bulls. On a pro-forma basis, the group would have generated 2014 sales of $57.5bn, trailing adjusted EBITDA of $2.4 billion and free cash flow of $1.5bn. Then, taking into account synergies of $440m this year, its stock could trade at up to 8.2 times EV/EBITDA, which is in line with Kroger's EV/EBITDA multiple, but its forward net leverage doubles that of Kroger and would still hover around 3.3x once proceeds from the IPO are factored in, according to my calculations.
Furthermore, the problem with leverage in the sector is that Kroger could continue to invest in deeper price cuts to put more pressure on its rivals' trading profit margins.
Finally, my attention has also been caught by Performance Food Group (NYSE:PFGC), another food play whose stocks got off to a decent start on Friday, when they closed up 10% on their first day of trade. The third-largest food distributor in the U.S. had priced its IPO well below the range, and although it might look attractive, intraday trends on Friday suggest that if volatility spikes it could be much less defensive than it should be.
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.