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This article is part of our Rising Star Portfolios series.
Would you be interested in buying a stock trading at around six or seven times this year's earnings, operating in a recession-resistant industry that consumers use day in and day out, and paying a 4% dividend? Yeah, this stock actually exists today. Appropriately enough, it's called SUPERVALU (NYSE: SVU ) , and it's going to be the latest addition to my Special Situations portfolio. In a moment, I'll tell you what qualifies this stock as a special situation.
SUPERVALU is one of the largest grocery chains in the United States and operates locations under banners such as Albertsons, Jewel-Osco, Shaw's, and Save-A-Lot. There's nothing fundamentally earth-shattering about the business, but industry rivalry has certainly been heating up, even more now that cash-constrained consumers are pinching pennies. That's put SUPERVALU in a difficult spot, since its costs have been above that of peers.
In the midst of the recession and its aftermath, many consumers have turned to deep discounters such as Dollar General (NYSE: DG ) , Family Dollar (NYSE: FDO ) , and Dollar Tree. Even big dog Wal-Mart (NYSE: WMT ) has been affected by these players, but it's also responsible for heating up the rivalry in groceries. Wal-Mart has moved into groceries in a big way through its supercenters, as has Target.
While food carries lower margins than many retail items, it gets customers into the stores on a regular basis. That's part of the reason why nontraditional players such as Walgreen (NYSE: WAG ) have been moving into the space incrementally.
To help counter those threats, SUPERVALU has taken a series of moves under recently installed CEO Craig Herkert, a veteran of Wal-Mart. First, the company is expanding its Save-A-Lot chain, a hard discount format with a limited selection but low prices. Prices can be up to 40% less than traditional grocery stores -- and even 13% to 17% less than discounters. The brand has nearly 1,300 locations, of which some 70% are licensed rather than corporate-owned. SUPERVALU intends to bump the Save-A-Lot store count by 160 locations this year, while holding the line on its traditional grocery stores. The licensee model also helps conserve capital.
Second, the company is trying to reinforce the perception of its products as good values. For example, SUPERVALU is creating a private-label brand that will span all its stores, rather than having each banner carry its own store labels. Although its current private-label penetration rate of 19.3% sits below that of its peers, the company expects to increase that rate by 1 percentage point annually over the next three years with these higher-margin products.
Third, the company is creating what it calls "hyper-local" stores, which will carry some local products and stock shelves according to local preferences as ways to draw customers.
Why I'm buying
SUPERVALU's stock has hammered investors since 2007. Back then, shares traded at more than $40; now they sit at a wimpy $8 and change. The company's 2006 takeover of Albertsons saddled it with some $7 billion in additional debt, which left it paying more than 40% of its operating earnings to interest.
Despite reporting a loss of $1.5 billion over the past year, because of a $1.9 billion writedown of goodwill, the company actually generated $566 million in free cash flow. At the current stock price, the company is trading at a little more than three times free cash flow. And the company has committed to deleveraging -- that's the special situation -- and that move has the opportunity to unlock serious value for stockholders.
SUPERVALU reduced its debt by a net $885 million last year and has promised to reduce its debt by an additional $500 million to $550 million this year, a move that would increase book value by 41%. Of its $6.7 billion in debt, just $1 billion matures in the next three years, and the company should be able to cover that handily with operating cash flow. So there's still a lot of time left here despite the high debt levels.
With the company projecting earnings of $1.20 to $1.40 per share for this year, compared with an adjusted figure of $1.40 last year, the shares looks very cheap at a six to seven multiple. The company also appears committed to its dividend, which is a meaty (bad grocery pun!) 4.1%. So tomorrow I'll be buying $500, or about 3% of my total capital, of SUPERVALU.
Of course, this turnaround might not turn. Same-store sales in the fourth quarter were down a hefty 5%, and the company is still projecting -2.5% to -1.5% comps for the year. For comparison, in their latest quarter, Kroger (NYSE: KR ) put up comps of 4.6%, and Safeway (NYSE: SWY ) put up 3.5%. SUPERVALU's low comps are built into its $1.20 to $1.40 per share earnings estimates.
But there are other reasons to have confidence. Herkert is an industry veteran, with more than 30 years in retail including his stints at Wal-Mart and Albertsons. And the company is focusing on deploying capital smartly.
For me, the appeal of a deleveraging play is that the company has a sure-fire prospect for its investments dollars (e.g., paying down debt). But SUPERVALU is also making strategic investments for the future. Even a stabilization and a very modest return to growth could see this stock double or more in just a few years. So I'll be joining Motley Fool Hidden Gems, which identified this stock late last year, and my fellow Rising Star Jim Mueller in adding SUPERVALU to 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. See all of our Rising Star analysts (and their portfolios) here.