Erik Kobayashi-Solomon: Hi. I'm Erik Kobayashi-Solomon, co-editor of Morningstar's OptionInvestor. Today it's my great pleasure to welcome Michelle Chang, who is an equity analyst covering groceries here at Morningstar.
Michelle, thanks for coming.
Michelle Chang: Thanks for having me.
Kobayashi-Solomon: So just recently I wrote a bullish option piece about Supervalu, a grocery store that you cover. So, the first thing is, I know that Supervalu borrowed a bunch of money back in '06-'07, when borrowing money seemed like a pretty good idea and bought Albertsons Stores. They've got this big debt overhang. I'm just wondering how they're handling that debt right now and how they look in terms of financial health.
Chang: Sure, Supervalu is certainly more leveraged than its peers. Debt to EBITDA at the time of the acquisition in 2006 was around 4.4, but we've seen that come down a little bit to 3.5 times in 2009. They've been steadily paying down their debt, and we expect that to continue. The company is targeting about $600 million of debt pay down this year, which we believe is achievable. And so we expect leverage metrics to come down over our five-year forecast horizon.
Kobayashi-Solomon: So it seems like they're doing okay with, kind of, working down the debt.
Chang: They're working through it, yes. And we also anticipate that they'll be in compliance with all their debt covenants, so there isn't a huge amount of concern, but we do like to see them deleverage their balance sheet a little bit more.
Kobayashi-Solomon: So just in terms of valuation, what's kind of your best-case scenario, worst-case scenario, where do you see these guys ending up?
Chang: Well, we do place a higher margin of safety around our fair value estimate because of…
Kobayashi-Solomon: That's because of the debt.
Chang: On the upside case, we expect a modest amount of square footage growth of around 3% annually and comps – identical same-store sales – to rebound a little bit more robustly in the near term, which would drive margin expansion beyond what they've done historically.
Kobayashi-Solomon: Okay. So we got the best-case scenario. What do you see is the worst-case scenario and where does your fair value kind of lie between those?
Chang: On the worst case, we would see store closures, and so square footage would actually decline over the next five years. I mean, margins would stagnate pretty much in the same range that they are currently.
Kobayashi-Solomon: I see.
Chang: Our fair value estimate of $25 a share pretty much is right in the middle between those two upside and downside scenarios. So, we don't forecast any square footage expansion over the next five years. Inflationary, same-store sales growth, and a little bit of margin expansion as conditions improve and as some of these initiatives take hold.
Kobayashi-Solomon: I see. So, it seems like a pretty conservative scenario, I mean, both best case and worst case. Normal seems…
Chang: Well, I think, it's a realistic sort of expectation.
Kobayashi-Solomon: Let me ask you another thing. Just recently people have been talking about price pressure, people have been banding about the word "deflation." Where do you see Supervalu in terms of that dynamic? Is that really germane for them?
Chang: Well, pricing pressure among all grocery operators has really been the big dominant story over the past year or even year and a half now.
Kobayashi-Solomon: I remember people talking about it a lot in 2009.
Chang: Yes, 2009, a lot of operators spent majority of their time putting through broad price rollbacks to really retrench and cater to a new more price-conscious consumer.
Kobayashi-Solomon: Right, sure.
Chang: What we're seeing through 2010 is the pricing pressure still being the predominant headwind that retailers are facing.
Kobayashi-Solomon: So where do you see the price environment right now?
Chang: Well, the good news is that, the pricing pressures that we saw in 2009, especially in the back half of the year, are moderating. On the flip side, they aren't necessarily getting better, either. We've seen couple quarters ago some operators were looking for slight inflation in the back half 2010, and that seems to be a less likely proposition at this point.
Kobayashi-Solomon: I see. So it's not as if you're saying huge deflationary pressures, you're just not saying a lot of reflation, is that right to paraphrase?
Chang: Correct. Yeah, that would be a good way to put it.
Kobayashi-Solomon: So another thing that I want to ask about that may actually work into the whole deflationary story. I went into my local Target the other day, and I was greeted by rows of refrigerated products and then even some vegetables and so forth. How do the presence of these kind of non-traditional grocers, these Walmarts and Targets, how do they affect a Supervalu?
Chang: Mass merchants are certainly focusing on the consumable portion a lot more. And it's certainly a threat to the traditional grocery store operators. Take a look at Walmart as a great example. Over the past 10 years they've been able to grow from a fairly small presence in the grocery space to being the largest operator within grocery.
Kobayashi-Solomon: I think by revenues they're actually a grocery store now.
Kobayashi-Solomon: Walmart, like it's right at that 50%, 51% of revenues in grocery.
Chang: Yup. Exactly. So this has placed tremendous pressure on traditional operators, and we can see in the results that, the results of that pressure. Generally speaking, we don't think that the traditional grocery space is a very attractive business. It's very hard to create an economic moat in this space with virtually non-existent switching cost for consumers. They're largely driven by price. On the other hand, I think, a lot of the pessimism that we've…
Kobayashi-Solomon: It's just kind of overblown.
Chang: Yeah. Well, it's well priced into the stock...
Kobayashi-Solomon: Right, sure.
Chang: …and so while these aren't necessarily great businesses for the longer term we do see upside.
Kobayashi-Solomon: They seem cheap now, right?
Chang: We upside in the near term.
Kobayashi-Solomon: See, this is what I like actually is that, you're not going into this – the story, the Supervalu story, with rose colored glasses. I mean, you're talking about the debt – the debt load and a wider margin of safety and all of that, and it seems like an interesting idea.
Chang: Yeah, absolutely.
Kobayashi-Solomon: Michelle, thanks for coming.
Chang: You're welcome.
Kobayashi-Solomon: And thank you for joining us. Please stop by the Morningstar OptionInvestor website where we have many more great investing ideas based on Morningstar's fundamental research.