I am recommending the purchase of Supervalu (SVU), an out-of-favor grocery retailer with well-known issues more than reflected in its depressed stock price.  We believe SVU offers substantial upside relative to downside risks and multiple ways to win.  We will briefly review the business, but for more detail, I would refer readers to the company website, which has a decent fact book and other investor presentations that provide a good overview of the business and its strategy.

SVU has a long history in the retail and wholesale grocery business and has been public since 1967.  Over the years, SVU grew organically and through acquisition, but its current predicament can be traced most immediately back to its mid-2006 $16 billion purchase of Albertson’s retail grocery business, which included the Acme, Albertsons, Jewel-Osco, Shaw's, and Star Market banners, the related in-store pharmacies under the Osco and Sav-on banners, 10 distribution centers and certain regional and corporate offices.  This acquisition was transformative for SVU, and not in a good way, as they clearly overpaid, saddled the company with a massive debt load and then failed to execute on the integration effectively.  Meanwhile, the industry backdrop has only become more competitive.   The stock was approximately $33 when the deal was announced in early 2006 and then ran up to over $48 in mid-2007 before it subsequently collapsed to its current level some one-eighth of its prior peak.

Today, SVU really has three distinct businesses, (1) traditional retail grocery, (2) the Sav-A-Lot (“SAL”) chain of hard-discount stores, and (3) the Independent segment, which operates a wholesale distribution business to independent grocery retailers.  Our analysis of these three businesses is hampered somewhat by the fact that SVU reports only two segments, Retail Food and Independent as it lumps SAL with traditional grocery in the Retail Food segment.

In the traditional grocery business, SVU operates 1,102 traditional retail food stores that range in size from 40,000-60,000 square feet, carry some 40,000 SKUs and operate under a number of different banners in different geographies.  SVU’s largest markets are:  Chicago (operating under the Jewel-Osco banner), Los Angeles/San Diego (Albertson’s), Boston (Shaw’s and Star Market), Philadelphia (Acme), Seattle (Albertson’s), and Washington/Virginia (Farm Fresh and Shopper’s Food & Pharmacy).  SVU has been rationalizing the traditional grocery segment while trying to reposition it (more on this later).  Since the Albertson’s deal, SVU has closed/exited a net 186 traditional stores while reducing square footage by about 6%.

SVU owns 397 hard-discount food stores operating under the SAL banner and licenses an additional 935 SAL stores to independent operators.  SAL stores are typically much smaller than a traditional grocery store (15,000 square feet) and narrower in focus, with only 1,800 SKUs, primarily high-volume private branded food items in a single size for each product sold.  The SAL stores carry a small assortment of competitively priced national brands as well as certain meats, fruits, vegetables and a complementary assortment of general merchandise.  According to SVU, SAL “holds the number one market position in the hard-discount grocery-retailing sector based on revenues and is increasingly focused on remedying the issue of ‘food deserts’ in urban and rural areas by placing stores in neighborhoods that are underserved by traditional grocery stores.”  Unlike the traditional grocery segment, SVU is investing to grow the healthy SAL unit adding 50+ stores annually with the majority continuing to be licensed operations, which obviously are more capital-efficient.  Today, most of SAL’s footprint is east of the Mississippi, with strong positions in the Midwest and Southeast.

Albertson’s was a huge deal for SVU, basically doubling the size of the company.  Albertson’s had itself been built by acquisition and really never integrated properly.  The Great Recession laid bare the inefficiencies and competitive weaknesses of SVU, necessitating an operational turnaround for the traditional retail grocery business.  In May 2009, Craig Herkert joined SVU as CEO after serving five years as CEO of the Americas for Wal-Mart Stores.  Herkert has had his work cut out for him given the extremely challenging industry backdrop, relentless competition and relatively poorly positioned SVU operations.  Taking a long-term view, Herkert has installed new talent, streamlined operations, sold non-core businesses, and reduced debt, all while implementing a new strategy for the traditional retail grocery business.  We will discuss the new strategy briefly, but first, let’s dispense for the time being with the SAL and Independent (wholesale) businesses. 

SAL grew its comps over 3% last year, is expanding its footprint and has a solid, dollar-store type business model with attractive ROICs and a long runway of potential unit growth.  SVU does not break out the SAL financials separately, but this business is obviously considerably more valuable than the traditional grocery business.  Management and the Board are no doubt well aware of this fact, which has been raised with them before, most recently on the last earnings call when an analyst asked about the potential for a spinoff of SAL to monetize its value.  Although I am not suggesting that SAL deserves a dollar store multiple, the fact that such comparables trade at 8.5-10.5x forward EBITDA provides a lot of potential upside for SAL given that SVU trades at only 4x. 

The Independent business is neither exciting nor a growth business, but it is a steady, relatively defensive and cash-generative business that could be attractive to private equity and frankly probably should be private.  With $310mm of EBITDA and $60mm of capex, a receptive high yield market with low prevailing interest rates, this type of business could readily fetch 6-6.5x EBITDA, a modest multiple but a huge improvement from the roughly 4x multiple at which SVU trades.  The possibility strategic moves with SVU’s more attractive assets should provide enhanced flexibility and possibly even a floor on the stock while also offering an incentive for an activist to become involved.

In the core traditional grocery business, the company describes its repositioning as follows:

The Company is focused on its business transformation plan to become America's Neighborhood Grocer, which draws upon the Company's "8 Plays to Win" strategy. Key drivers of this strategy include simplification of business processes, generation of incremental funding for further price investment and a greater focus on meeting the demands of each neighborhood.  A key tenet for improving sales through the "8 Plays to Win" strategy, is the implementation of an overall pricing philosophy referred to as "fair pricing plus promotion."  Under this strategy, the Company will offer lower, more competitive everyday pricing on non- promoted items while continuing to offer compelling weekly promotions to attract customers. As the strategy unfolds, price investments necessary to fully implement "fair pricing plus promotion" have, and are expected to continue to, initially reduce identical store sales until such time as unit volumes increase.  Another element of the Company's strategy is to better match the offerings and experience of each store to its surrounding community, what is referred to as "hyper-local retailing".  Store directors have been given more authority over the items they display and promote so their store better reflects the neighborhood preferences and creates a more relevant in-store experience for customers.  The Company also believes it can increase sales through greater sales of its private label products as the competitive prices for such products drive additional sales. The Company has launched Essential Everyday, its national-brand-equivalent private label offering. Essential Everyday's clean packaging and appealing graphics complement the Company's other recognized private label brands such as Shoppers Value, Culinary Circle and Wild Harvest. Essential Everyday has been introduced across a number of categories, and additional items are being introduced each quarter.  To provide funding for planned price investments, the Company is improving its operations through the introduction and implementation of a number of business support tools. These tools enable management to design more effective promotions, determine more appropriate display sizes, order product quantities that better match sales forecasts, and take actions to improve product availability--all based on historical data.

As indicated above, SVU has its work cut out for it as it implements processes to improve a business long under-managed.  As the company realizes cost savings from its streamlining and efficiency initiatives, it is reinvesting those savings back into the business, largely in the form of more competitive pricing.  SVU recently rolled out this “fair pricing plus promotion” strategy to the important produce section.  Although representing only 10% of sales, this is an important department that can drive consumer impressions and traffic.  The initial results have been encouraging, and management is continuing to roll out this and other initiatives.  However, while it is absolutely necessary to restore SVU to price competitiveness, this effort will continue to pressure comparable store sales, a key metric for analysts and investors and a reason why the stock has been so weak.

For competitive reasons, SVU does not provide much detail about the relative performance of the various banners it operates in different geographies.  Nevertheless, it stands to reason that a sprawling chain like SVU that operates numerous banners in multiple disparate markets, will have differing levels of performance.  Indeed, many observers of SVU believe its competitive challenges are most acute in a few discreet markets such as Chicago (Jewel-Osco banner) and New England (Shaw’s and Star Markets banners).  I actually view this as good news insofar as it potentially provides another route to value realization by potentially existing or selling under-performing banners/geographies.

Despite its apparent cheapness, SVU’s stock has largely been left for dead.  It is one of the worst performers in the S&P 500 year-to-date, and in fact it is being booted from the index at month-end, which likely will pressure the stock in the short-term.   I believe this could represent another good buying opportunity.  As indicated by the valuation metrics below, SVU already incorporates a poor outlook, has high short interest, and most of the analysts that cover it are negative or neutral on the stock.  With that much pessimism and short interest, SVU should be levered to any good news, which would include simply meeting its recently provided fiscal 2013 guidance, which many analysts have viewed skeptically.  I should also note that some amount should be added to debt to reflect underfunding of SVU’s pension obligations, but I do not believe this materially changes the thesis, and the appropriate amount is certainly subject to debate.  In any event, SVU’s cash contributions to pensions and its pension expense levels are expected to remain relatively stable in the near term and are reflected in current GAAP financials.

We believe CEO Herkert is making all the right moves to position SVU for long-term sustainable health.  Unlike retailers such as Sears that have starved their stores for capital, SVU has maintained a reasonable level of store investment (~2% of retail sales) in a core store base that is not growing while also investing in the growth of the Sav-A-Lot chain.  If CEO Herkert is successful in these efforts, SVU could easily double or even triple from current trading levels over the next few years.  However, even if the turnaround takes longer and remains elusive, the board has the ability to monetize SVU’s other more valuable assets, which also is potential upside catalyst.  Finally, in the absence of either of these alternatives occurring, we believe an LBO or involvement by an activist could serve as a potential catalyst for value to be realized.  In the meantime, holders can clip a 35-cent annual dividend (5.7% yield) that is well-covered while they wait.

In an effort to keep the writeup manageable, I will defer discussion of some of the details until the comment thread, but I will touch on the key risk, which in my mind is SVU’s considerable debt load, a legacy of the Albertson’s deal.  Though more leveraged than I would like, I believe SVU’s debt load is manageable at 3.5x Debt/EBITDA and with over $1 billion in operating cash flow.  Moreover, SVU has only $520 million of maturities in the next two years, which it can easily pay down through free cash flow.  Hopefully, this provides enough time for SVU to demonstrate results, but turnarounds of this sort, in this competitive of an industry, invariably take more time and are more difficult than imagined as Herkert no doubt has already seen.