Moody's is overstating the credit risk of Supervalu (NYSE:SVU) with its B1 rating. Our fundamental analysis highlights a safer credit profile for SVU whose strong cash flows cover all operating obligations going forward. However, its liquidity profile would only service all obligations including debt maturities until 2018. We therefore rate SVU two notches higher at an HY1 credit rating, or a Ba2 equivalent using Moody's ratings scale.
Meanwhile, credit markets are grossly overstating SVU's credit risk with a CDS of 871bps and a cash bond YTW of 11.732%, relative to an intrinsic CDS of 396bps and an intrinsic YTW of 5.032%.
Cash Flow Profile
We produced a Credit Cash Flow Prime chart for Supervalu as we do for every company we evaluate. The chart provides a far more comprehensive view of credit fundamentals than traditional ratio-based analyses. It shows the cash flow generation and cash obligations related to the credit of the firm, adjusted for non-cash financial statement reporting distortions from GAAP. The blue line indicates the gross cash earnings (Valens' scrubbed cash flow number) expected to be generated based on consensus analyst estimates and Valens Research's own in-house research team. The blue dots above that line include the cash available at that time while the blue triangles indicate that same amount plus any existing, available lines of credit.
The colored, stacked bars show the cash obligations of the firm in each year forecast. The most difficult obligations to avoid are at the bottom of each stack, such as interest expense. The obligations with more flexibility to defer year to year, such as pension contributions and maintenance capital expenditures, are at the top of the stacked bars. All of the calculations are adjusted for non-cash distortions that are inherent in GAAP accounting, including the highly problematic and often misused statement of cash flows.
If the company generates and has cash levels that are above its obligations, the risk of default is extremely low. Even if the cash generated yearly is close to the levels of the stacked bars, a company generally has the flexibility to defer payments of various kinds. For example, it can allow assets to age a little longer, or it can cut certain maintenance costs such as maintenance capex. While decisions such as those can create other business concerns, the issue in credit risk is simply this: Does the company have enough cash to service its credit obligations?
SVU's cash flows would exceed operating obligations each year going forward. However, even its combined cash flows and cash on hand would fall short of all obligations including debt maturities in the face of its 2019 debt headwall. That said, despite a lackluster recovery rate, its stable ROA profile, operational sustainability, and capex flexibility should facilitate access to credit markets for them to refinance.
Like most people, senior executives and board members do what they are paid to do. This is why SVU's Form DEF 14A is key to understanding this company's fundamentals, something that credit agencies seem to be missing. Our Incentives Dictate Behavior analysis focuses on SVU's senior executive compensation and governance. This analysis is meant to help investors understand corporate governance, how aligned a management team may be with shareholder interests, and the potential consequences of a management compensation framework to the business.
SVU's short-term compensation is based on adjusted EBITDA, sales and adjusted overhead expense, while its long-term compensation is granted as stock options and restricted stock units that are based on the discretion of the compensation committee.
SVU management's compensation metrics are likely to drive them to expand margins and fuel top-line growth. Furthermore, they should be driven to improve asset utilization, which would lead to higher cash flows available for servicing operating obligations.
We provide analyses of companies' statements on earnings calls, termed Earnings Call Forensics. This analysis is meant to help assess a management team's confidence in its conference calls when discussing certain areas of the business such as operations, stability, strategies, its ability to manage business risks, and especially, its liquidity and solvency.
In the case of SVU, the analysis of its Q4 2016 earnings call highlights highly questionable markers from management. Management appears concerned about its ability to drive market penetration with its private label brands and about the potential of its capex investments. Moreover, it appears to be exaggerating its efforts in making investments to improve customer experience and may be concerned about the potential of its wholesale business.
Ultimately, a company's credit risk (or lack thereof) is driven by cash available against cash obligations. SVU's credit risk is being grossly overstated by credit markets and overstated by Moody's. Given SVU's strong cash flows and improved ROA profile, ratings are expected to improve while credit market spreads are expected to tighten once the company's fundamentals are recognized.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Cheska Pablico. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
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.