TEXT-Fitch says U.S. supermarket sector faces margin risk
Sept 12 - The following discussion is an excerpt from Fitch's 'U.S. Retail Credit Insights,' newsletter dated Sept. 4, 2012, which is available at www.fitchratings.com. The supermarket sector may be entering a period of heightened competition as SUPERVALU Inc. SVU) accelerates its price investments, while discount and specialty operators continue to gain market share. SVU announced in July 2012 that it will be making additional price investments over the next 18 months, and financing these investments with additional cost reductions. This announcement came in the wake of weak operating results, and reflects management's desire to more quickly improve its price competitiveness in order to drive customer traffic and sales. However, Fitch expects SVU's newly aggressive pricing posture will worsen sales and margin trends over the near term. In the longer term, these price investments may not result in increased volumes, mainly because the entire grocery sector remains fiercely competitive as larger, better capitalized retailers such as The Kroger Co., Safeway Inc., and Wal-Mart Stores Inc. continue to invest in price reductions. Notably, Walmart is planning to take 100 basis points (bps) out of SG&A over next five years (which translates into $4.5 billion on a 2011 revenue base of $447 billion), and the bulk of these savings will likely be invested in pricing. Walmart is also continuing to encroach on traditional supermarkets with new and converted supercenters (130-135 planned in 2012), while Target Corp. is phasing fresh food into more of its stores, and other discount operators are expanding. As such, Fitch remains skeptical of SVU's ability to narrow its identical store (ID) sales gap against other operators. Other supermarkets could be forced to respond to SVU's price investments. Kroger is relatively protected, having the lowest prices among the Big Three supermarkets, and good value perception among its customers. Safeway's prices are also generally lower than SVU's but higher than Kroger's. Nonetheless, both Kroger and Safeway, in addition to regional supermarkets that compete with SVU, will likely feel a need to respond to SVU's lower prices so as to protect their market share in regions where they compete head-to-head. Safeway has greater overlap with SVU than Kroger, with Safeway competing with SVU in Chicago, Southern California, Washington D.C., Baltimore, the Northwest, and Las Vegas. For its part, Kroger competes with SVU primarily in Southern California, the Northwest, and Las Vegas. A renewed period of price investments across the sector could impact gross margins over the next 18 months, and this margin pressure could be exacerbated by higher food-price inflation due to drought-related crop failures in 2012, the impact of which will flow through the food chain in 2013. Supermarket gross margins have been in a secular decline for the past decade, and Fitch anticipates that this trend will continue as supermarkets strive to remain competitive with discount formats. EBIT margins, which had stabilized in 2011 following significant compression in 2009-2010, could also be pressured as 2013 approaches, unless companies can offset gross margin pressure with SG&A leverage. Kroger is in the best position to leverage expenses and sustain its EBIT margin, given its healthy mid-single-digit ID sales growth. Safeway will likely have to see its ID sales improve to the low single-digit range (from 0.8% in the second quarter of 2012) to be able to sustain its existing 2.6% EBIT margin, while SVU, as discussed in more detail below, will see additional EBIT margin pressure over the next 18 months. SUPERVALU Under Pressure On July 12, 2012, Fitch downgraded its Issuer Default Rating (IDR) on SUPERVALU and its subsidiaries to 'CCC' from 'B' reflecting SVU's deteriorating operating results, which indicate that the company's strategy of making gradual price investments to become more competitive is not gaining traction. There is also the potential for higher financial leverage should the company be sold. Fitch believes a complete sale of the business is unlikely, although a sale of the hard discount or independent business would weaken the company's business profile. SVU reported weak results for the first quarter ending June 16, 2012, as well as the fact that it is exploring strategic alternatives. First-quarter retail food (supermarket) ID sales were down 3.7%, and hard discount ID sales (Save-A-Lot) were down 3.4% while sales in the independent business (wholesale distribution) were essentially flat. These declines follow a 2.8% decline in consolidated ID sales in fiscal year 2012 and a 6% decline in fiscal 2011. Fitch believes that SVU's operating results will continue to weaken, and that its credit profile could be pressured longer term, with the maturity of $1 billion of 8% notes in 2016 representing a significant hurdle. Fitch expects ID sales will likely worsen and the gross margin will drift lower over the next two years due to accelerated price investments. This will be offset in part by some expense leverage as the company tackles its cost structure more aggressively. Fitch expects the EBIT margin will narrow from 2.6% in the fiscal year to end-February 2012 to the low 2% range over the next two years. EBITDA is expected to drop to $1.5 billion-$1.6 billion over the next two years from $1.8 billion in fiscal 2012. Adjusted debt/EBITDAR of 4.4x at June 16, 2012, may move only modestly higher over the next two years, reflecting management's commitment to repay debt with free cash flow (FCF), estimated by Fitch at around $400 million in fiscal 2013. Cash flow will be helped by a reduction in capex to $450 million-$500 million in fiscal year 2013 from $661 million in fiscal 2012, and the suspension of the dividend, which saves $74 million annually. Possible SUPERVALU Break-Up SVU's management has retained Goldman Sachs and Greenhill & Co. to help evaluate strategic alternatives, which could include selling all or part of the company. SVU has for the first time broken out its hard-discount division (Save-A-Lot), leaving it with three reportable segments--retail food, Save-A-Lot, and the independent business. A sale of the entire business would be complicated by the weak trends within SVU's core retail-food segment and its heavy debt load. However, the hard discount segment would be an attractive property to the right buyer, and the independent business is relatively stable, and could garner some interest. The sale of one or both of these properties could be deleveraging events in the near term, assuming they sold for more than 3.6x EBITDA (the current debt/EBITDA for the whole enterprise), and the proceeds were used for debt reduction. Applying a 6.0x multiple to Save-A-Lot's latest 12 month (LTM) EBITDA of $274 million implies a value for that business of $1.6 billion-$1.7 billion. Likewise, applying a more conservative 4.0x multiple to the slow-growth independent business' LTM EBITDA of $291 million implies a $1.2 billion value for that business. A sale of the company's traditional supermarket banners will be more problematic, given their weak operating trends and poor price positioning, both of which will be difficult to reverse. Certain markets where SVU enjoys a strong market share, such as Chicago and Minneapolis, could be attractive at the right price to a strategic buyer, while other markets or groups of stores could be of interest to adjacent supermarket chains. The company's strategic alternatives could also include downsizing by closing stores or pulling out of weaker markets. In fact, SVU has announced that it will be closing 38 supermarkets (19 of which are in Southern California), and 22 Save-A-Lot locations. Most of these stores will be closed by Dec. 1, 2012. Kroger Well-Positioned Kroger is performing well, with ID sales (excluding fuel) up 4.2% in first-quarter 2012, following an increase of 4.9% in 2011. EBIT margins narrowed in 2009 and 2010 (along with the rest of the sector), but stabilized in the 12 months ended May 19, 2012, at around 2.5%. EBIT margins are expected to be flat to gradually improving going forward, though as the sector becomes more competitive, the upside to the EBIT margin will likely be limited. FCF after dividends is expected to track around $600 million-$800 million over the next three years, helped by moderate growth in EBITDA and steady capital expenditures. Management is expected to direct essentially all of this cash flow and potentially some incremental borrowing to share repurchases and dividends, in order to manage lease-adjusted debt/EBITDAR at or close to 3.0x. Safeway Growth Challenged Safeway has experienced soft operating trends and has been more financially aggressive over the past year. The company reported a 0.8% increase in nonfuel ID sales in second-quarter 2012 following a 1% increase in 2011, as the effect of price inflation has been offset by lower volumes. The EBIT margin has stabilized in 2012, and stood at 2.6% in the 12 months ended June 16, 2012. Looking ahead, Safeway's ID sales performance will likely remain lackluster relative to Kroger's, and generating improvement in the EBIT margin will be difficult in the face of expense pressures and increasing competition. Safeway's adjusted debt/EBITDAR increased to 3.9x at June 16, 2012, from 3.3x at year-end 2011 due to incremental borrowings, the proceeds of which were used for accelerated share repurchases. Higher borrowings also reflected the seasonal nature of cash flow from the Blackhawk business, which has significant cash outflows in the first quarter and significant cash inflows in the fourth quarter. The increase in leverage was expected as Safeway had issued $800 million senior notes and arranged a $700 million term-loan in November 2011, with the intention of using a portion of the proceeds for share buybacks. At that point, Fitch had downgraded Safeway's IDR by a notch to 'BBB-' from 'BBB', given the company's temporary departure from its historical financial strategy. Fitch anticipates leverage will improve to around 3.4x at year-end 2012, which is in line with its prior expectations and consistent with the 'BBB-' rating. Fitch expects Safeway will achieve this by using FCF after dividends of around $700 million-$800 million, the proceeds from the sale of Genuardi's and seasonal cash flow from the Blackhawk business to repay $800 million of notes that mature in August 2012, as well as a substantial portion of its commercial paper borrowings by year-end. However, despite this expected improvement in leverage, there is limited cushion in Safeway's ratings for an operating shortfall caused by a competitive flare-up or an economic slowdown. Multiemployer Pension Plans Are A Long-Term Risk Fitch has published a new report, 'Multiemployer Pension Plans in Perspective' (August 2012), that highlights the key risks associated with these plans. Among Fitch-rated companies with the largest ongoing multiemployer pension plan (MEPP) exposure, the top three were Safeway, SVU, and Kroger. A key risk is that U.S. corporate MEPP contributions could, over the long term, grow at a rate that cannot be fully offset by smaller increases in wage rates or healthcare costs. This would result in a creeping increase in overall labor costs. Most MEPPs are significantly underfunded. While this liability is off-balance sheet, it is driving an increase in cash contributions to these plans over time. Fitch notes there also is a risk that the contributing employer will become insolvent, resulting in a larger liability for the remaining employers in a MEPP and lead to higher required contributions. However, there is little risk of a large lump-sum payment to cure an underfunding. From a credit standpoint, Fitch does not expect any near-term rating actions resulting from MEPP liabilities. Growth in MEPP contributions due to funding shortfalls, which can be exacerbated by employer insolvencies, could however result in further downward pressure on supermarket EBIT margins. Margins have already narrowed significantly in recent years, and further pressure could result in rating downgrades.