Description

After its 1999 purchase of American Stores, Albertson's is the second-largest grocery store chain in the country (behind only Kroger). Albertson's now operates more than 2,500 stores in 37 states. Just over half of those locations combine food and drugstores and have bakery, floral, and video departments. More than 800 outlets are stand-alone drugstores. To compete against some of the larger warehouse store formats, Albertson's also runs about 30 no-frills discount warehouse stores under the Super Saver and Max Food and Drug names.

Let's look at ABS a few different ways.

PROFITABILITY:
*ABS's 5-year average net profit margin is 2.6% versus 1.6% for the overall industry. A 2.6% net profit margin is outstanding for a grocery store.


FINANCIAL STRENGTH:
*ABS debt/equity ratio is 0.87 versus industry average of 1.24.


FUNDAMENTAL VALUATION:

5-year range for ABS ... current for ABS ... industry average

*PSR 0.2 - 0.9 ... 0.24 ... 0.30
*P/E 9.0 - 31.2 ... 9.4 ... 19.1
*P/BV 1.5 - 6.0 ... 1.5 ... 3.3
*P/CF 4.7 - 17.8 ... 4.8 ... 7.1


Reasons for the undervaluation of ABS:

1) The merger with American Stores has not gone as smoothly as desired. As a result, SG&A is a bit higher than previously estimated. ABS management is working feverishly to reduce this figure.
2) Comps (i.e., same store sales growth) remain a bit sluggish in comparison to Safeway (SWY) and Kroger (KR).


My commentary:

Virtually every analyst on the Street has a HOLD rating on ABS. I have personally spoken with four analysts from four different major firms (Bear Stearns, PaineWebber, DLJ, and AG Edwards). In a nutshell, it's the classic situation with analysts: while they like ABS at these prices, they're looking for more "visibility." In other words, they'll wait for ABS to report numbers in line with estimates and the stock price to advance 20-30%, then they'll start to raise their recommendations. Analysts cannot step out of line with the other analysts for fear of having egg on their face.

While many are disappointed with ABS's recent disappointments, no one questions the company's decision to purchase American Stores. The major grocery companies know that they must either expand via new store openings and acquisitions or be acquired in this day of major consolidation.

ABS has established itself as an 800-lb gorilla in key markets across the nation (California, Texas, Florida, and Illinois, among others). Its name is becoming increasingly valuable as it retains the Albertson's name in new store openings and existing store makeovers.

ABS has two main problems: soft sales and high expenses. The high expenses will be wrung out by management (a relatively simple objective...it's just a matter of finding where to cut). Management is already working on the problem of soft sales by lowering some prices and introducing higher-margin services (see catalysts below); these two will likely offset one another and allow ABS to retain its high margins.

The bottom line: I'm convinced that ABS has both the position in the industry and the financial strength to exercise its plan. With the stock of this grocery store giant at $21.25 (at historical lows by virtually all fundamental measures), I see little downside risk and significant upside potential. ABS will simply not trade at this depressed level for long. It will either climb or it will be purchased (there are in fact some European companies with the financial wherewithal and the desire to purchase a large, entrenched American grocery chain). In the meantime, the stock offers a 3.58% dividend yield to pay you while you wait.

Catalyst

1) Albertson's will launch about 190 new food-and-drug-combination stores, 115 stand-alone drugstores, 250 fuel centers, and remodel roughly 260 stores.
2) Once the integration of American Stores with ABS is complete (my prediction is that this is two quarters away) and SG&A is more in line with traditional figures, EPS will be much more predictable...which will in turn drive analyst upgrades and investor optimism.
3) American Stores traditionally had some of the lowest margins in the business. Now, as part of ABS, margin expansion is a realizable goal of ABS's management.
4) Currently representing only 18% of sales, ABS is charging ahead with its (higher margin) private label initiative. This will drive significant margin expansion.
5) ABS will add more traffic by adding fuel centers to many of its stores.
6) The company is doing other things to drive more traffic, such as providing in-store banks, dry cleaning departments, car washes, drive-through pharmacies, and Starbucks kiosks.
7) Last but not least, ABS management has vowed to save approximately $250 million in costs in 2001 alone.