Don't let it get away!
Keep track of the stocks that matter to you.
Help yourself with the Fool's FREE and easy new watchlist service today.
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.