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Will Grocery Chains Ever Recover?

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Investors hoping that things couldn't get worse for traditional grocery retail chains after last month's dreadful report from Kroger (NYSE: KR  ) , the largest of these struggling retailers by market cap, had their hopes dashed a bit on Monday. SUPERVALU (NYSE: SVU  ) reported a loss of $202 million for the third quarter. The loss was significantly worse than the year-ago profit of $109 million.

However, as the results of these traditional grocery chains continue to worsen even as the economy improves, the question investors need to ask is whether it would even be worthwhile for an acquirer to invest in them.

Economy on the upswing, grocery chains in reverse
All retailers, especially those in low-margin industries such as the grocery sector, had a pretty good excuse for eroding revenue and profit over the last couple of years as the economy crippled consumers. Unfortunately for the underperformers, the economy has improved significantly, and we are seeing that in earnings reports across the board, even in retail. Yet report after report from these grocery chains still often blame weak consumers for their woes.

At SUPERVALU, the troubling part is the continuous decline of operating margins, as it looks for new ways to gain customers and keep existing ones. While Foolish colleague Jacob Roche points out some positives that might present an opportunity for savvy investors, the industrywide margin disintegration, through pricing wars and inflation, has me reluctant to recommend any stock in the sector. It even has me reconsidering my favorite grocery stock, Winn-Dixie (NYSE: WINN  ) .

Winn-Dixie re-emerged from bankruptcy as a much smaller chain than many of its competitors, but also as a leaner one that has no debt. The stock has remained remarkably cheap at an enterprise value/EBITDA of 2.5. It trades at a significant discount to peers, and its valuation certainly implies that it wouldn't take long for a potential buyer to make back its investment.

Would you want to buy this?
Potential grocery chain suitors for Winn-Dixie that have been previously bandied about, such as SUPERVALU and Safeway (NYSE: SWY  ) , are both saddled with a very large amount of debt already. Even though SUPERVALU CEO Craig Herkert said on Tuesday's conference call that it was a buyer's market and not a seller's market, it is well-known that the company is still struggling with its $11.6 billion acquisition of Albertson's in 2006. Paradoxically, SUPERVALU has quietly been looking for bidders for Shaw's, a Northeastern chain of stores it acquired in the Albertson's deal. The company has quietly shopped assets in an attempt to lower its debt burden, which saw SUPERVALU pay $124 million in net interest expense this quarter.

Private equity has also been mentioned as a potential suitor for Winn-Dixie. Such firms would likely see the same discounted valuation that I see in Winn-Dixie, but will be wary of its minute profit margins. Since it emerged from bankruptcy in November 2006, the grocer's annual profit margins have exceeded 0.5% only one time. I think most private-equity shops can probably find plenty of investments that offer better returns with much less risk.

Sure, profit margins have always been small in the grocery industry, but will any of these chains be able to regain normalized margins for the sector? At one point, industry consolidation offered a much better opportunity to develop economies of scale and purchasing power. However, today these chains face much greater competition from the likes of Target (NYSE: TGT  ) , Wal-Mart (NYSE: WMT  ) , and Costco (Nasdaq: COST  ) . In fact, SUPERVALU even mentioned the significant hit to revenue it would take in the coming year to its traditional food distribution business as Target shifts to its own self-distribution operation. Matching prices with these big-box retailers is not going to be a fun game for these grocers over the next few years.

Still on hold
I've never been a proponent of buying a stock because it could be a target of a buyer, which is part of the reason why I have yet to buy Winn-Dixie. It definitely gets factored into the decision-making process, but more important is the business itself. Unfortunately, as the traditional grocery chains continue to report extremely poor quality earnings, the thesis that the industry has no real earnings upside in the near future becomes clearer. Investors are certainly expecting the worst in regard to the sector and especially Winn-Dixie, which sometimes proves to be a good opportunity to buy. However, for now I'm content looking for more favorable opportunities where sector growth is in better correlation with the upswing in the economy.

Andrew Bond owns no shares in the companies listed. Costco is a Motley Fool Stock Advisor pick. Costco and Wal-Mart are Motley Fool Inside Value picks. Wal-Mart is a Motley Fool Global Gains recommendation. The Fool owns shares of Costco, SUPERVALU, and Wal-Mart. You can follow Andrew on Twitter @Bond0 or on his RSS feed. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (13)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 14, 2011, at 8:07 PM, madmilker wrote:

    Andrew, it's in the hand of the boss!!

    "There is only one boss. The customer. And he can fire everybody in the company from the chairman on down, simply by spending his money somewhere else."

    - Sam Walton

    And with Wal*Mart putting less than 5% foreign in all their stores in China and there be 182 countries in this world that make stuff....that fact of the less than 5% ain't sitting well with all those workers that make stuff but not being able to have the nice people of China buy the items.

    抵制沃爾瑪將開 始2011年2月3日。

    Wal*Mart's deal on that port in Mexico has even got the nice people of India and South Africa spitting nails.

  • Report this Comment On January 15, 2011, at 3:34 PM, jlanganki wrote:

    The nice thing about Supervalu is it doesn't matter if they "recover". They have a fast growing Save-A-Lot format which accounts for 50% of their total store locations. In 5 years it will account for 75% of their locations if all goes to plan. The traditional grocery part of their business will continue shrinking over time as a percentage of their business. As long as they can continue pulling in a lot of cash to pay off their debt they should be in good shape.

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