Where’s the value in Supervalu?

Supervalu Inc., parent of Jewel-Osco and Albertson’s grocery stores, found a new trading home in the Standard & Poor’s Midcap 400 Index Tuesday after being removed from the market bellwether large-cap index, the S & P 500. The move was hardly a surprise after Supervalu’s market capitalization fell to slightly over $1 billion in recent months, compared with $3.3 billion just three years ago, and underscores concerns about the company’s ability to grow in a market saturated with both low-cost mega-retailers, such as Wal-Mart Stores Inc., and high-quality specialty stores, such as Whole Foods Inc.

A Goldman Sachs report Monday dampened investor confidence even further when its analysts advised investors to sell their holdings in the company during its inaugural rating of Supervalu’s stock. Low margins, stubbornly high operating costs, declining same-store sales and customers making smaller average purchases, referred to in the industry as “baskets,” have created a perfect storm for Supervalu.

“The problem is your sales are bad,” said Neil Stern, senior partner at McMillan LLP, a retail consulting firm in Chicago. “You’re layering same-store decreases on top of same-store decreases. (Supervalu) hasn’t cut costs, and they don’t seem to be substantially closer to turning the tide on sales.”

Supervalu’s strategy for turning this tide is worrisome to investors. On the company’s most recent earnings call earlier this month, Supervalu CEO Craig Herkert successfully quelled investor concerns about year-over-year losses and falling sales by reinforcing his company’s commitment to a fair-pricing strategy that he hopes will boost customer volume.

In order to execute this strategy and wring profits out of already thin margins, experts say, Supervalu will have to lower its operating costs. With lower volumes than its competitors, and pledges to increase its product quality, this could prove extremely difficult. Earlier this year, the company announced it would lay off 800 workers as a cost-cutting measure, garnering suspicion that more layoffs could ensue in the coming months.

However daunting Herkert’s strategy may be, it is not impossible to carry out. Stern pointed to The Kroger Co. as an example of a competing traditional grocery chain that has executed a similar vision, turning its business around by increasing once-lagging customer volumes in order to offset price reductions.

Despite these price reductions, Kroger drove upwards of $90 billion in FY2012 sales across its 2,460 American stores, recording a modest $600 million in profit. By comparison, Supervalu drove $36 billion in FY2012 sales across a nearly identical number of American stores, recording a $1 billion loss. While Kroger’s total annual sales have increased 37 percent since 2007, Supervalu’s have fallen 3 percent over the same period.

“Supervalu really needs to redefine themselves and come up with a really differentiated model,” said Technomic Inc. Executive Vice President Bob Goldin. “If you walk into a Whole Foods, and you feel a little bit of a buzz. The employees are motivated at Trader Joe’s, you kind of like shopping there. You go to a Wal-Mart and the shelves are really well maintained and their prices are great.”

The same isn’t necessarily true, he said, for Supervalu chains like Albertson’s and Jewel-Osco. “It’s just not an exciting place to shop.” Though Supervalu’s $6 billion in long-term debt is 30 percent lower than it was five years ago and the company has a relatively strong annual free cash flow of $395 million, skepticism remains about its ability to manage its debt.

If Supervalu doesn’t re-evaluate its business model and inject some excitement soon, both Stern and Goldin say the company could turn into a potential takeover target for a private equity firm. Such an outcome might be the best that investors can hope for, at least in the short term.

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