Is It Time to Drop Supermarket Stocks?

Earlier this month, SUPERVALU, (NYSE: SVU  ) the parent of Albertson's and Jewel Osco supermarkets, suspended its dividend and said it will consider selling all or part of the company. Now, The Wall Street Journal has reported the company has begun sending out due-diligence information to potential bidders. The news that insiders are resisting a plan to reduce their say on the sale makes the future look even less promising; a bruising fight over a deal can only hurt the stock more.

SUPERVALU has practically fallen off a cliff since its latest disastrous earnings report -- and it's taken along its top competitors, Kroger (NYSE: KR  ) and Safeway (NYSE: SWY  ) . Safeway, which is fighting hard to boost sales, reports results tomorrow. Zacks consensus is calling for nearly 20% EPS growth.  Following SUPERVALU's news, it had better beat those expectations, or it will be punished like Kroger, which actually beat EPS estimates by a good margin when it reported last month.

So the other grocers are getting a beating by association, but it's not totally undeserved. The macro trends are merciless this year: cheap shoppers, the return of food inflation, and big-box competition are hitting them all hard. But at least one competitor is managing better than the rest.

Grocers are faced with competition from drugstores and discounters for shoppers who are indifferent about where they pick up their food. And the big-boxers can afford to beat on the grocers by using the one-stop-shop convenience as a club. Wal-Mart and Target are both aggressively competing to underprice grocers, while dollar stores are expanding food selections. Citi's regular food pricing surveys have found average prices of a typical grocery basket dropping in recent weeks, more so at the big boxes than the grocery chains.

Grocery store sales are up 3.8% year to date over 2011, according to the latest Commerce Department numbers, but the momentum has slowed. Sales growth is nearly flat recently, up 0.1% in June over May, and May's tally was 0.2% below April's.

Now, a crippling drought has led the Agriculture Department to cut its crop estimates, a sign that food prices could rise in the near future. That's a problem when shoppers are as price-sensitive as they are now. That means more margin pressure for grocers and a very tough environment.

So should we bag the grocery store stocks completely? No, because this segment of retail is not disappearing. Unlike consumer electronics or books, there is no killer app changing the way people shop for food. Pork chops and bananas are still selling the same way they have been since the advent of refrigeration made big grocers possible. People don't order online or run to warehouse clubs for a quart of milk or dozen eggs, so there will always be a place for grocery stores.

But there's no doubt that place is shrinking -- witness SUPERVALU's troubles -- and Kroger looks like a likely winner in the consolidation under way. Kroger only gets a three-star CAPS score, but the number of Fools who believe it will outperform outnumber the naysayers almost 10-to-1.

As Morningstar's analysts have noted, Kroger is gaining market share while Safeway and SUPERVALU haven't shown growth in same-store sales (excluding fuel) since 2008.  Yes, Kroger does have a rich valuation, as Morningstar acknowledged, at a P/E around 20. But it's trading near the bottom of its 52-week range, down almost 14% for the year, and it's way off its $27 consensus target.

"Kroger has the best chance among its peers to be left standing to reap the rewards of margin expansion inherent after the industry moves beyond the consolidation phase," concludes Morningstar.

And that makes sense for the consumer-based reason explained above. When all is said and done, shoppers still need a neighborhood grocer. The question is who will be smart enough to survive the shakeup. And the consensus is that Kroger has the best odds.

There are other retailers that are beating the odds in these tough times. The Motley Fool has identified a couple of merchants that are managing to grow revenue and change the ways of retail. Check out our report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." This limited-time report is completely free of charge, so claim your copy now by clicking here.

Fool contributor Mercedes Cardona does not own shares in any of the companies mentioned in this article. Follow her on Twitter and on her website. The Motley Fool owns shares of SUPERVALU. Motley Fool newsletter services have recommended buying calls on SUPERVALU and creating a bull call spread position in Wal-Mart. The Motley Fool has a disclosure policy.
We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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