Still the Only Sale in the Supermarkets

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Supermarket chains have been one of the slowest groups to recover from the recession. As many consumers reduced their spending and began searching for the lowest prices on necessities, supermarkets were forced to oblige them. Price wars began in earnest, which made already razor-thin margins even thinner.

While the economy and corporate earnings have been improving over the past year, last week's earnings report from Kroger (NYSE: KR  ) shows the grocery industry still has a long way to go. While Kroger's third quarter was mainly in line with analyst expectations, the company downgraded its revenue guidance for the upcoming quarter, and really spooked investors by reporting another 13-basis-point decrease in gross margins.

Pricing power is at the heart of the grocers' problem; in the current environment they seem to have little. It's as if a giant game of chicken is being played and neither Kroger nor any of its competitors wants to be the first to raise prices.

On the cost side, Kroger reported that it was seeing inflation in perishable goods and produce, while deflation remains persistent at the center of the store in the grocery department. In a strong economy inflation can be a positive for grocers that can pass through the costs with an additional markup to consumers. However, since grocers are flinching in this game of chicken, it appears that margins are going to continue to contract.

Even more troubling for grocers is the megadiscount retailers, like Wal-Mart (NYSE: WMT  ) , Costco (Nasdaq: COST  ) , and Target (NYSE: TGT  ) , that are continuing to move into the grocery space at lower prices. No company wants to compete with this group of retailers on price.

Bargain bin still open
While I don't particularly like investing in this space because of these difficulties, I still believe that shares of Kroger competitor Winn-Dixie (Nasdaq: WINN  ) are too cheap. Since I last reported on the company, operating results have not improved much, and in fact its third-quarter trend was pretty awful, following the industry trend.

Winn-Dixie lost nearly $77 million for the quarter, about $40 million of which was related to discontinued operations and store closing costs. However, the grocer continues to clean up a balance sheet that boasts $130 million in cash, which provides a liquidity cushion. The company does not expect to borrow from its credit facility in fiscal 2011.

From a fundamentals perspective, there is not a lot to like, but the stock is still extremely cheap, if it can turn around operations. Winn-Dixie trades at an enterprise value/EBITDA of just 2.6 and its price/tangible book value is 0.6. Safeway's (NYSE: SWY  ) EV/EBITDA is 5.2, and it trades at a price/tangible book of 1.8. Kroger trades at 5.4 and 3.3, respectively.

At these discount levels, the potential remains for an acquirer to swoop in and take over Winn-Dixie's nearly 500 stores spanning five states in the Southeast. Rumors have swirled around Safeway and SUPERVALU (NYSE: SVU  ) in the past as possible buyers.

Hold your nose?
I don't recommend buying stocks based on a potential acquisition, but I believe the possibility is strong in this case. Winn-Dixie is not only cheap and has ample liquidity, it also has significantly valuable tangible assets such as real estate, trucks, and its products. On the company's most recent conference call there was something we haven't seen from the company in years: some optimism and talk of profit improvement. While I am not that optimistic, I don't believe it can get too much worse for shareholders at current valuations.

I'm not quite ready to buy any stock in this sector after Kroger's very poor report last week, even one as cheap as Winn-Dixie. However, I can't dissuade value-seeking investors from pulling the trigger. I might soon be right behind, but by then it may be too late.

Andrew Bond owns no shares in the companies listed. Costco is a Motley Fool Stock Advisor selection. Costco and Wal-Mart are Motley Fool Inside Value selections. Wal-Mart is a Motley Fool Global Gains pick. The Fool owns shares of Costco 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 (5) | Recommend This Article (9)

Comments from our Foolish Readers

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 December 09, 2010, at 5:26 PM, expoiltthespread wrote:

    it sounds like you are doing some pretty good "007" work on this one.. you might be right

  • Report this Comment On December 09, 2010, at 6:17 PM, mk2010 wrote:

    Don't like the stock. I owned it before they filed bankruptcy. They still are having problems....they keep going and going and going....

    Costco, walmart and target are your best bets in this sector.

    Fool on!!!!!

  • Report this Comment On December 09, 2010, at 6:18 PM, mk2010 wrote:

    Wegman's is not public. What a shame!!!!!

  • Report this Comment On December 09, 2010, at 9:51 PM, xetn wrote:

    What do you think will happen to the stock price if the current price inflation of many food commodities continue to escalate? For example: corn up 29%, soybeans up 22%, orange juice up 17%, and sugar soared 51% during the months of September and October alone.

  • Report this Comment On December 16, 2010, at 11:32 AM, harrisob22 wrote:

    Yes, Costco, Walmart and Target are selling a lot of groceries, but Kroger is showing that traditional supermarket formats can compete. Walmart has been giving away groceries to gain marketshare, hurting their same-store sales figures for 2010. If you can get the same prices plus better service in the smaller formats, customers will obviously go there. The big three - Kroger, Safeway and Supervalu -- have the volume to compete on price, and they will once the "rollbacks" cease. You can't go on giving away food forever.

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