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Food Fight

(Guest Commentary by Rick Konrad – January 20, 2010)

Dear Subscribers and Readers,

For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary.  Rick has been a regular guest commentator for several years and offers his unique insights to us twice a month.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick follows up on his initial discussion on SuperValu, and why its equity and debt remains very attractive (with a focus on its balance sheet).   Rick also discusses the challenges facing the grocery industry.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on (please see “New Year's Resolutions” for his last commentary).  Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years.  A more complete profile of Rick is available on his blog.  You can also email Rick at the following address if you have any questions or thoughts after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Rick has also run the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had graded CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

"The problem is the truth hurts. And it's even harder to admit that you're wrong."

One of the hardest things in this world is to admit you are wrong. And nothing is more helpful in resolving a situation than its frank admission.”-Benjamin Disraeli

I hardly expected immediate gratification but I certainly did not expect to perform a face plant in my initial thoughts of the year with Supervalu Inc. (SVU)

As I reminded all of us in my previous post (“New Year's Resolutions”):

I think one of the prevalent biases that most of us exhibit is to think that actions and decisions require greater justification than inaction, than failing to decide, than leaving things status quo. If our actions do not pan out, or cause us to take a loss, we frequently regret having acted. If, on the other hand, we decide to maintain the status quo and leave things as they are within a portfolio, and our investment does not pan out, we still suffer regret, but for most of us the regret is less.

Don't fall into this trap. Don't let the cost basis of a stock ever influence your decision making. The valuation of the business is a function of future cash flows, not the past. Holding every stock in your portfolio should be justified on this basis…what does the future hold. Anchoring your thinking about a stock based on the price that you paid is illusory.

Most of us in the value investing realm have gotten caught in situations just like this. Lots of great value ideas have come out of long base stocks, businesses that appeared to be going nowhere, fell out of favor, and sat there in the portfolio staring you in the face.

One of my good friends once said to me years ago, “Interesting style that Konrad has. He'll buy a stock. He'll then take like two years of grief from clients owning it. Then the next day, there's a takeover and he makes all his money.” Same friend also said: “I should wait for you to buy a stock… wait a couple of years, and then I'll buy it.”

In retrospect, I should have waited till the earnings release. Needless to say, Q3 earnings disappointed badly coming in about 25% below street estimates. SVU lowered earnings guidance by 10% to $1.25-$1.35 (previously $1.40-$1.50).

As management indicated in the conference call:

Our results this quarter are not indicative of the earning power you should expect from our Company. Our shortfall was driven largely by disappointing trends in sales and margins. Our identical store sales of negative 4.9% came in well under plan. The largest headwind came from our Northeast banners which as a group pulled down corporate ID's by more than 150 basis points in the third quarter. While this was an improvement on a sequential quarter basis, these banners were generally in the negative high single digits. Shaw's, Acme and Shoppers continue to see strong price competition in each of their markets.

Modest good news in that same store sales decline of -4.9%. Though clearly not performance to be proud of, the trend is getting somewhat less negative from -6.4% in Q2 and -7.2% in Q1.

Better news in that the wholesale part of the biz representing about 25% of sales has shown improving profitability year over year.

Additional good news came from the balance sheet:

Moving to our balance sheet, we have reduced total outstanding debt on a fiscal year-to-date basis through last week by nearly $700 million. We continue to manage working capital well with both retail and supply chain taking out about one day's worth of inventory this year. We will retire the remaining $392 million of Albertson's 7.5% bonds which mature in February and we expect to end fiscal 2011 with less than $200 million drawn on our credit lines which total $2.3 billion of available capacity. In fiscal 2012, our bank debt and public bond maturities are only about $300 million. The Company remains in compliance with our debt covenants with trailing 12-months EBIT of $1.1 billion excluding impairment and certain other costs, depreciation and amortization were $0.9 billion, and rent expense amounted to $0.4 billion for the same 12 months. Our revolving credit facility requires the maintenance of two financial covenants, a leverage covenant and a fixed charge covenant.

Looking forward to the end of fiscal 2011, we would expect the leverage covenant as defined in our revolving credit facility to be approximately 3.5 times with a covenant maximum of 4.25 times, and the fixed charge coverage covenant to be approximately 2.6 times with a covenant minimum of 2.2 times.

With $186 million in cash, and over $2 billion in revolver ability, and continued generation of free cash flow, in my opinion this is not a repeat of A&P stores. In fact, management announced that it raised its debt reduction target by $200 million to $850 million.

The CEO clearly understands the issue at hand:

“Our performance is still not close to my expectations and we continue to take action to change the trajectory of our business,,,will invest in price, leverage our buying power, and enhance retail execution…”

Part of the problem is top line, as is the story with just about every grocery store: consumers are spending less, trading down, and cherry-picking.

Management elaborated on the overall economy and the impact of inflation:

While the macroeconomic environment is showing some signs of improvement, consumer behavior is decidedly mixed. Prices continue to be top of mind for consumers and many shoppers remain financially stretched. An astounding 43 million Americans now rely on food stamps to make ends meet. This is about one in every seven households, and EBT (Electronic Benefits Transfer-an electronic debit card version of food stamps or welfare benefits) usage is up by more than 46% over the past two years. These trends are linked to unemployment which has been above 9% for 20 consecutive months. A core tenant of our vision is that pricing of SUPERVALU's traditional stores to be fair and no longer serve as a disincentive for customers to shop our banners.

As I said before, I believe that thrift consciousness we're seeing in food retail is a secular shift, and we are positioning SUPERVALU to be a long-term partner of choice for communities we serve. Inflation is another challenge on the horizon. In the third quarter we saw 100 basis points of inflation. While inflation has happened in perishables like meat, dairy and produce, it has been slower to surface in the center of the store. Retail increases through the holiday season were masked in part by promotional subsidies. However, with all of our major vendors announcing their intentions to pass along rising input costs, we expect center store prices to rise throughout this calendar year.

The price increase from our suppliers range from 3% to 4% in the low end and 14% in the high-end and we are passing these along to our consumers. Where possible, however, we will leverage our scale to mitigate these increases and negotiate hard to keep prices down. We recognize the challenges inherent in making targeted price investments during a period of rising inflation. These efforts will take time. We have begun to take deliberate actions to implement new programs, methodically change the way we conduct business and improve price and value perception in those markets where we have been out of line.

Comparing SVU's finances to those of the departed (dearly would be inappropriate) A&P suggests very little comparison:

Cumulative Cash Flow From Operations ($millions)

Trailing 4 Qtrs 1,327 -157
Trailing 8 Qtrs 2,575 -108
Trailing 12 Qtrs 4,390 -178

The competitive landscape remains challenging. In this weekend's Sunday NY Times, an article highlighted the entrance of companies like Target (TGT) and CVS (CVS) into the grocery “food fight.” Here is a link to the NYT story (subscription may be required)

As the article indicates,

Target invested $500 million last year alone in a new push on groceries, retrofitting some of its general merchandise stores with full-blown food sections. Sales and traffic at stores with the new grocery areas are about 6 percent higher than at similar stores without them, the company says.

Walgreens began making over some stores in Chicago and New York a year ago, and added up to 500 food items. CVS/Pharmacy last year redesigned about 200 of its stores in urban areas like Boston, Detroit and New York, and expects to make over about 20 percent of its 7,100 stores in all.

As a result, people who typically went to the grocery store once a week to stock up are instead stopping by places whose food items used to be limited to a bag of chips or a can of soup. And retailers are viewing it as an opportunity to increase sales by getting people in their stores more frequently.

Though the risks remain high (as we indicated two weeks ago) we still think that there is significant upside potential here. Obviously, seeing some additional cost savings, and especially improved comp store comparisons would go a long way to stabilizing the stock.

If the heat is too high for you in the “equity kitchen” there are interesting opportunities in SVU bonds. There are 8's of 2016 trading in the low 90's for a yield of about 9.5%...a great yield for a company levered at 3.5 times. Other grocery bonds of this ilk have much greater concentration, smaller geographic footprints and are one quarter the size in terms of SVU's almost $40 billion in sales. In addition, there is an attractive 7.5% May 2012 issue which offers a yield of almost 5.7%, quite attractive for two-year paper. This is the next maturity due after the February 2011 maturity which is soon coming due. Remember that $2 billion revolver and the free cash flow in this operation.

In short, this is going to be a prolonged food fight. As of my previous post, we did not own the stock. I couldn't stand it any longer. I, my family, or clients are currently long the equity of SVU and looking for bonds.

For those of you hurt by my review, I sincerely apologize. I had no idea that the quarter would come in as poorly as it did. I was clearly early which I view as essentially the same as being wrong. Let's hope good food, doesn't go bad.

Disclaimer: I, my family, or clients own a position in Supervalu Inc but none of the other securities mentioned in this post.

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