Supervalu's Fundamentals Continue to Deteriorate

 Supervalu's fundamentals continue to deteriorate, and prospects for an operational turnaround are becoming more difficult as the competitive environment is still intensifying. We see no fundamental reasons to own the stock at its current price. The shares moved higher in late October as speculative buyers took positions, because various media outlets reported a buyout deal may be imminent. Thus far, however, efforts to sell the company as a whole have attracted little interest. There does seem to be some interest from various strategic buyers, but only for specific assets. There is speculation that buyout firm Cerberus Capital Management may make an offer to acquire the firm as a whole, but only to break up and then sell the parts of the business. The apparent choices that Supervalu's board faces are an operational turnaround instead of an outright sale; selling off parts of the business themselves; or leaving the breakup task to Cerberus Capital.

The prospect of an operational turnaround is extremely difficult. Same-store sales and profit margins at Supervalu's core supermarkets are in a free-fall and are also declining at the company's hard-discount Save-A-Lot format. We don't see fundamentals improving at either segment anytime soon, given that Wal-Mart is accelerating the rollout of its small-format Neighborhood Market stores, a major competitive threat to both segments. Moreover, Target now sells groceries at nearly all of its units, and all the dollar stores we cover are expanding square footage roughly around 7%, while increasingly using food as a loss-leader category to drive customer traffic. The outlook for Supervalu's independent segment (wholesale and delivery) remains bleak because the regional and independent grocery store operators it serves are fast becoming businesses of the past.

Supervalu could sell selective assets that should yield the maximum value for shareholders and use the proceeds to pay down long-term debt and other liabilities, which total about $8.5 billion. Although the process of multiple sales would obviously take much longer than a potential single transaction to Cerberus, selling the assets methodically should yield the maximum value for the firm and shareholders. Other than in Illinois, in the top 10 states by unit count, Supervalu is at a store density disadvantage against its traditional supermarket peers Kroger, Safeway, Ahold, and Delhaize. Its supermarkets in California, Washington, and Oregon could possibly be of interest to either Kroger or Safeway. Stores in Massachusetts, New Jersey, Pennsylvania, and Maryland could attract Ahold, while Delhaize could be interested in the Virginia supermarkets, where Supervalu holds a dominant store count position. Based on the most recent comparable transaction--the $106 million that Ahold paid Safeway for the 16 Genuardi's Family Markets in Philadelphia--Supervalu could get about $6 million per store. At that price, keeping Jewel-Osco but selling all of the other 618 supermarkets in Supervalu's top 10 states should yield approximately $3.5 billion in proceeds, as an example. We do not know the EBITDA margins of those stores.

Selling the firm as a whole to Cerberus is attractive because it involves just a single transaction, which clearly holds less future deal risk. In return, the company would forgo the likely higher premiums from the sum of the parts compared with a whole entity sale. The median global EBITDA multiples paid for food retail since 1997 have averaged about 7.4 times, but that reflects a period of stability before mass merchants and wholesale clubs started to enter the grocery business. We therefore view a takeout EBITDA multiple of about 4 times for Supervalu's enterprise value as a more likely scenario. News reports of possible sales to Cerberus moved Supervalu shares 50% higher, from $2 to $3, which already implies an enterprise value/EBITDA multiple of 4 times. Our current $2 fair value estimate calculates to a 3.9 times EV/EBITDA multiple. Still, investors seeking to capture a quick takeout premium should consider the real possibility of a lower transaction multiple if EBITDA margins do not stabilize. For example, Yucaipa only paid a 2.5 times multiple for the distressed Pathmark supermarkets in 2005.

The sum of the breakup value of each business should generate more value, since it would unlock a higher valuation premium for the Save-A-Lot format and take advantage of traditional supermarket competitors likely willing to pay a bit more to remove potential irrational pricing from a core trade area. Private equity firm Kohlberg Kravis Roberts is being cited by financial news outlets as a potential acquirer for Supervalu's higher-margin and better-return Save-A-Lot format. Still, we doubt that Save-A-Lot will command the recent 9 times that private equity paid for small-format Dollar General since comp sales and margins are falling, and now Wal-Mart is accelerating small store openings. We remain hard-pressed to find a suitor for Supervalu's wholesale business and would anticipate a much lower EBITDA multiple than the historical 5.9 times median paid for food wholesalers.