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
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
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
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
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
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 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
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.