Investors hoping that things couldn't get worse for traditional grocery retail chains after last month's dreadful report from Kroger
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
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
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
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.