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When SUPERVALU (NYSE: SVU ) first showed up on the radar for my Messed-Up Expectations portfolio, my first reaction was, "Run away!" At $8.33 per share, the market was pricing in big declines in free cash flow over the next several years -- more than 20% per year for the next five years.
That screamed "Trouble!" in a very loud voice. The market is expecting the company to fail.
And it has good reason to think that. I just about fainted when first looking at the financial statements and the last couple of earnings releases. Net debt of $7.5 billion. Same-store sales drop of 4.9% in the just-finished third quarter, and expectations of a 6% drop for the full year. Year-over-year declines in revenue for the last seven quarters.
The Big Not-so-easy
Yet there seems to be a big disconnect between what the equity market thinks -- SUPERVALU's headed straight to the rotting vegetable pile -- and what the debt market thinks. And this is where the messed-up expectation lies. Let me explain.
For a company that's expected to fail spectacularly, you'd expect the interest rates on its bank loans to be fairly high. For instance, when UAL entered bankruptcy at the end of 2002, it had a bank facility loan rate set at LIBOR plus 6.5%, or a total of about 7.9% at the time. SUPERVALU, on the other hand, is being charged LIBOR plus 1%, or a total of about 1.3%, on its bank facility loan. In the last quarter, it borrowed an additional $164 million on that facility.
Further, last May, it was able to ease the covenants for one of its term loans in exchange for an increase from LIBOR plus 1.25% to LIBOR plus 2.75%. Increasing an interest rate by just 1.5 points -- and keeping it so low -- is hardly the action of a bank that believes the company won't be able to pay back the loan.
Finally, management is expecting to pay off $850 million of debt this fiscal year. Last year at this time, management said it would pay off $700 million and actually paid $849 million. Maybe management is low-balling this year's projection. Regardless, these do not appear to be the actions of a company that's staring down bankruptcy.
The messy truth
Now, don't mistake me. This is not a situation where I'm saying the market just doesn't get it. SUPERVALU faces many challenges beyond its heavy debt load. These include: strong competition from Safeway (NYSE: SWY ) , Kroger (NYSE: KR ) , and Wal-Mart (NYSE: WMT ) ; a large drop in same-store sales; and higher food prices. Most of all, it has a store base that needs to be upgraded. The irony is that while it pays down its debt, it cannot spend a lot on upgrading its stores -- while if it could upgrade the stores, the expected higher revenue would bring in more cash to pay down its debt.
About the only bright spot for the company is that Jeff Noddle, the CEO who made the decision to buy Albertsons back in 2006 for $17.4 billion ($12.4 billion of which was from SUPERVALU, including the assumption of $6.1 billion in debt), is no longer with the company. Craig Herkert replaced him in May 2009. Ever since, Herkert has been working to streamline the company, pay down debt, and right the ship. It has been and continues to be a struggle, and right now the equity market doesn't think it will happen.
As of Friday's closing price, the market is expecting FCF to decline by 25.3% per year for five years, followed by 12.7% declines for another five years before flat-lining (using my standard hurdle 15% discount rate).
Yes, it's a different environment today, but since SUPERVALU has been saddled with Albertsons, it has actually grown FCF -- by 19.2% per year for the past three years -- not shrunk it, as the market is currently expecting. If SUPERVALU can just keep FCF at current levels, shares could be worth $23, some 200% higher than current levels. Of course, that kind of price increase probably won't happen until the company has paid down a lot more of its debt and shown it has at least stopped the bleeding of declining same-store sales.
However, as Seth Jayson, co-advisor of Motley Fool Hidden Gems, wrote when that portfolio service purchased shares of SUPERVALU, "SUPERVALU needs only to improve its performance from lousy to mediocre for its stock to offer a great potential payoff for investors." That's what I'm looking for here.
Investing in this company is a risky decision, and I'll be keeping a real close eye on results over the next several quarters. If debt repayment slows down, if the banks start to significantly increase what they charge, or if same-store sales continue to trend strongly downward, I'll revisit the decision and probably exit the position.
Tomorrow, the MUE portfolio will purchase approximately $340 worth of SUPERVALU, representing a 2% position. This is the most I'll put into the stock. If it does well, great. If it doesn't, I won't have lost too much.
I invite you to visit the MUE discussion board for more conversation on this pick and the others in my portfolio.
This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. Click here to see all of our Rising Star analysts (and their portfolios).