A Boring Sector Harbors Explosive Opportunity

This article was originally published on Dec. 11, 2009, for the Opportunistic Investor newsletter.

 Supervalu  is one of the biggest grocery store owners in the U.S., with sales of around $44 billion in fiscal 2008 and 2009. In mid-2006, Supervalu bought Albertsons, a major competitor, and assumed a very large debt load to do so. They've been trying to digest Albertsons ever since, a process that should be near completion.

The grocery store business is mature, fragmented, and very competitive. Maybe 10 years ago,  Wal-Mart (WMT) entered the space in a big way, forcing a watershed change in the industry. Long story short, Wal-Mart quickly became the biggest grocer in the country, selling something like $150 billion of groceries, holding 15% of the entire market. This is larger than  Krogers (KR),  Safeway , and Supervalu (the next three largest players) combined.

Wal-Mart's vast cost and logistical advantages both lowered industry operating margins and forced traditional grocers to adapt. Many didn't and disappeared. However, for the most part, the bigger chains reached a sort of entente with Wal-Mart. Since they couldn't really compete on cost, they remodeled their stores, improved customer service, added ancillary services like better delis and flower shops, changed their merchandising (fresher stuff, ready-to-eat foods), and so on. In the last few years, the competitive landscape and industry margins stabilized, though threats from deep discount stores (Aldi) and warehouse clubs ( Costco (COST), Sam's) remain.

The Great Recession upset the delicate balance of power in the industry. Competition heated up, consumers spent less, and margins fell. Many grocery investors would probably be disappointed with their holdings in supposedly a "recession resistant" industry. Look at the stock price charts of SVU, KR, and SWY--they are not pretty.

What I See in Supervalu
The thing that first caught my eye was the P/E ratio. The company is guiding a little above $2 per share in earnings for the current fiscal year, and the stock is currently trading around $14. Is SVU really only worth 7 times depressed earnings?

My thinking is that it's not. Let's look at all the reasons why the stock is cheap today:

I've already mentioned that the entire industry is suffering. There are three main forces at work. One, grocery stores have been discounting and promoting much more than before, trying to drive traffic into their stores. Two, deflation in key categories like dairy or eggs has hit revenues and gross margin percentages have remained constant. Three, people are buying fewer items per trip, especially more lucrative "discretionary" items like baked goods or flowers. When combined, revenues and operating margins both fell. In an industry that makes less than 5% in operating margins a year, a measly 1 percentage point fall in margins is a huge hit to the bottom line.

SVU is suffering more than most, as it's laboring under nearly $8 billion of debt. With operating margins down and significant financial leverage, net income has sunk around 40% year to date.

On top of this, investors are extremely nervous about SVU's debt load. I don't really blame them, as any further deterioration in operating margins can really hurt leverage and interest coverage ratios. But, a result of this nervousness is the pessimistic P/E multiple of 7x that we see today.

How Things Can Play Out
There is no doubt that SVU and the overall industry is hurting today. However, when looking at the underlying problems, I don't see anything that isn't fixable. Actually, almost all the present issues are not because of a fundamental weakness in these companies' business models, but rather a result of the weak economy.

I believe the economy will gradually heal, and I expect grocery stores to bounce back faster than categories like big screen TVs or Caribbean cruises. I really see no reason why operating margins can't return to near the levels they were in 2007 or 2008.

During these years, SVU earned from 3.5% to 3.8% in operating margin. If we assume margins can return to near these levels, the company should earn somewhere between $3 and $3.50 per share, depending on the exact assumptions used.

And here is the kicker: The company will generate $700 million in free cash flow this year and will exit the fiscal year (which is Feb 2010) at around $7.5 or $7.6 billion in net debt. Free cash flows were abnormally high this year because the firm cut its capital budget to the bone in response to the recession. Assuming capital spending picks up, normalized free cash flows are closer to $300 to $400 million, at current margins.

That last point is absolutely critical. The company generates over $40 billion in revenues. Doing the math, each one tenth of one percent improvement in operating margins contributes between $25 and $30 million to incremental free cash flows, depending on your cash tax assumptions. Therefore, if the company can improve its margins to previous norms, free cash flows can increase between $250 and $300 million per year--a huge change.

Free cash flows are essential here, because they will be going straight to debt reduction. In two years time, if the story works out, net debt can be reduced by another $1 billion. Looking forward, using normalized margins, net debt will be only around 2.5 times EBITDA. This is a perfectly acceptable burden for this kind of business, especially since further cash flows will allow relatively rapid further delevering. Of course, with a smaller debt burden, interest expense will go down and net income will go up. I've already incorporated this into my hypothetical earnings projections. The bottom line is this: A recovery in margins basically automatically fixes the debt problem.

So two years from now, what would one pay for a relatively steady business, with moderate debt levels, earning $3 to $3.50 per share? I'd argue that it would be somewhere in the $30s, conservatively.

How to Play This
Despite what you might think, I'm going to steer clear of the common stock in this one. SVU shares are probably a decent bet, but the financial leverage makes me a bit nervous. Any further fall in revenues or margins will be very detrimental to its solvency ratios, and that's never a good place to be in.

Call options are now available for January 2012, and they look cheap to me. Here is a hypothetical:

January 2012 $20 strike options were recently trading for $1.10 bid; $1.40 ask. Let's assume you can buy these for $1.25 each. If we are right, and the stock trades to $30 per share by 2012, your options would be worth $10 each, for a profit of 800%. If the stock trades to $35, the profit potential is 1,200%.

I think this is an attractive risk-reward bet, certainly more attractive than a bet in the stock alone. If things don't work out, all you lose is your initial investment, which is the price of the option. If things do work out, the profit potential is simply massive. In most bets with payoffs of this magnitude, the odds of success are quite low. However, here, I think the odds are at least reasonable, if not good.

There are several options available for 2012, with strikes ranging from $15 to $22.50. I think these are all decent bets. The higher strikes are tailored for more risk-tolerant investors. As with most option trades, I would urge investors to be patient in accumulating a position, and to avoid betting too much. In something like this, a small dollar amount invested equals a big exposure.

Disclosure: the author is long SVU calls. Opportunistic Investor is long shares of Safeway SWY, which is a lower risk way to play the thesis we've outlined here. Look for a follow up article on Safeway in the near future.

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