Stock Pitch: SuperValu [NYSE:SVU]

Recommendation

I recommend a short position on SuperValu (NYSE:SVU), a grocery wholesaler and retailer in the United States.
The stock is currently trading at $20.52, and I believe there is still 0.5%-17.3% downside from this point due to
the impact of Amazon’s acquisition of Whole Foods, declining revenues in the company’s corporate segment,
and likely lower than expected cost synergies in its acquisition of Unified Grocers.

Catalysts to decrease share price in the next 6-12 months include general news about the retail operating
landscape, news about the transitional service agreement (TSA) wind down timing, and the company’s first
earnings report after the acquisition of Unified Grocers.

Key upside risks include higher-than-expected revenue growth and/or margin improvement, increases in the
company’s corporate segment revenue, and Unified Grocers synergies at or exceeding management
expectations. However, for reasons I will outline later, these risks are unlikely to occur.

Company Background

SuperValu (SVU) is a grocery wholesaler and retailer in the United States. It operates three business segments:
Wholesale, Retail, and Corporate. Its wholesale division serves as a primary grocery supplier to 2,072 stores and
a secondary supplier to 262 stores. Its retail division currently operates 217 stores under five banners. Its
corporate segment provides back-office professional services to Save-A-Lot, Albertson’s, and New Alberton’s.

Total Revenue in FY2017 was $7.7 billion, with EBITDA of $382 million (5.0% margin). In the last 3 years, the
company’s revenues have fallen by roughly 3% a year. In FY2017, wholesale accounted for 61.7% of revenues
and retail accounted for 36.8%. Its corporate segment contributed 1.4%, but makes a large impact on EBIT and
EBITDA due to its margins.

In the last twelve months, the company has acquired Unified Grocers, a west coast focused wholesale grocery
and specialty foods distributor, and sold Save-A-Lot, a discount supermarket chain that accounted for 26.4% of
sales in FY2016. These two events highlight the management’s focus on the wholesale segment of the business.

The company is currently trading at an EV/Sales multiple of 0.16x and an EV/EBITDA of 5.51x.

Investment Thesis

Currently, the market has a negative view on SuperValu, which is down 41% in the last twelve months. The
company is also trading significantly below the multiples of its peers. However, I believe there is still significant
downside potential in the stock for the following reasons:

1) Amazon’s acquisition of Whole Foods will greatly affect SuperValu’s wholesale and retail business. On
the retail side, Whole Food’s prices are going down significantly, which allows shoppers who could not
previously afford it to shop there. This will take market share away from SuperValu’s retail banners, and
further drive down its margins. While only 37% of the company’s revenues come from retail, this
squeeze will also impact its wholesale segment. Roughly 40% of the revenue from this segment comes
from accounts with 1-9 stores. If these chains are forced to shut down, SuperValu’s wholesale revenues
will be severely impacted. In addition, one of management’s objectives for retail is to decrease prices
and to have more promotional events. This will drive down gross margins and is already apparent in
FY2018’s Q1 Earnings, where retail’s gross margins dropped 0.4%. A 1% decrease in retail gross margins
over the next 5 years will imply a share price of $18.82, 8.3% discount to SVU’s current price.

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Stock Pitch: SuperValu [NYSE:SVU]

2) The corporate segment of the business provides the best free cash flow margins to the company.
Because of this, the wind down of transactional service agreements (TSA) will significantly reduce the
profitability of SuperValu. After the wind down of the TSA with NAI and Albertson’s LLC, the corporate
segment will only have the TSA with Save-A-Lot. The annual base charge will be $30 million, a notable
decrease from $179 million in FY2017, and will only last until FY2022. If we assume that the TSA with
Albertson’s winds down in two years instead of three, we get an implied share price of $19.62, a 4.4%
decrease from its current price.
3) There is a significant amount of downside in SuperValu’s acquisition of Unified Grocers. Since 2008,
Unified’s member base has dropped 5% a year and spend per customer has dropped by 2.6% a year.
SuperValu’s wholesale revenues have also been decreasing, down 3.2% and 2.9% in FY2016 and FY2017
respectively. This means that the combined company will still struggle with organic growth. Worse yet,
the transaction had an implied EBITDA multiple of 9.6x, almost double SuperValu’s own EBITDA
multiple. Considering the two companies have similar financial profiles, it seems SuperValu overpaid for
Unified Grocers. Management is predicting $60 million in cost synergies by year three. As most synergy
projections are optimistic, I assumed $51 million in synergies for my base case. This implies a share
price of $19.39, a 5.5% decrease from SuperValu’s current share price.

Each of these reasons have a direct impact on the valuation and implied stock price of SuperValu. Cumulatively,
these three drivers imply a share price of $16.97, a 17.3% decrease from SuperValu’s current share price.

While some of these drivers may not be realized, each reason still shows a significantly different view of the
stock than the market. If none of these drivers are realized, the implied share price of the stock is $20.43, which
is a 0.5% discount to its current stock price. This appealing risk reward profile supports a short position of
SuperValu.

Catalysts

Catalysts in the next 6-12 months could include:

• News of significant retail activity (M&A, Bankruptcy, etc.)

• Indication of TSA wind down time
• FY2018 Q2 Earnings

The first catalyst is important because it will give us a sense of the future landscape of retail. If any major
activities, such as a string of retail bankruptcies or mergers occur, the market will start to recognize the
increasing competition in the retail space, which directly affects wholesale. The market will also get a sense of
the effects of increase competition, whether that is through decreasing sales, decreasing margins, or a
combination of both.

To get a better grasp of how changes in retail will affect share price, I have included a sensitivity table below. It
compares the 5-year change in retail spend per store and change in gross margin using the base case operating
model and discount cash flow analysis.

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Stock Pitch: SuperValu [NYSE:SVU]

While we use a large range of values for gross margin change and spend per store change, the relevant values
are -1.5% to -1% and ($1.8) to ($0.6) respectively. Historically, there has been no proof that gross margins or
spend per store will increase. In fact, the contrary is true. In the base model, I used -1% for the gross margin
change and ($1.8) for the change in spend per store to get $16.97.

The second catalyst is the indication of TSA wind down time. In the annual report, management states that the
wind down could take 2-3 years. In the most recent earnings call, Mark Gross, the CEO, stated that TSA related
revenue will be down $40 million to $140 million in FY2018. At this pace, it seems the wind down will be 3 years
rather than two years. However, any indication that this wind down will occur faster than expected will likely
result in a decrease in stock price.

The last catalyst is the FY2018 Q2 earnings. This will be the first time SuperValu will release financials related to
the Unified Grocers acquisition. Management is projecting $60 million in cost synergies 3 years into the
acquisition. To better understand the impact of these cost synergies on SuperValu’s stock price, I have laid out a
3-year achieved cost synergies sensitivity analysis using the base case operating model and DCF.

From this, we can see how important the realization of cost synergies is to SuperValu’s stock price. According to
a McKinsey report analyzing mergers and acquisitions, only about 85% of projected cost synergies are realized.
Because of this, I used 3-year realized cost synergies of $51 for my base case assumption.

Valuation

For this stock pitch, I have mainly relied on using a discounted cash flow model to obtain implied stock price.
Nevertheless, I have included a list of comparable companies below to help us get a better idea of where
SuperValu stands among its peers. I don’t think it makes sense to value SuperValu this way because of its
financial profile. Its low EBITDA margins and revenue growth have given it very low multiples compared to peers.
Using comparable companies analysis will almost guarantee an inflated valuation, but the comps are useful for
understanding why SuperValu is trading on these low multiples.

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Stock Pitch: SuperValu [NYSE:SVU]

The biggest takeaway from the comps is that revenue growth is highly correlated to EV/EBITDA multiples, which
tells us that the market values growth in this sector very highly. This further supports the short thesis, as
SuperValu is having a lot of difficulty generating organic growth. While the stock is only trading at 5.51x
EV/EBITDA, AMICON Distributing, the peer with the closest financial profile is trading at a similar multiple
(5.87x).

The discounted cash flow analysis presented below uses the following assumptions:

• Unified Grocers store decrease of 5% a year and sales per store decrease of 2.6% a year
• Primary wholesale: increase of 415 stores and sales per store decrease of $0.21 over projected period
• Secondary wholesale: increase of 90 stores and sales per store decrease of $0.20 over projected period
• Retail: increase of 25 stores and sales per store decrease of $1.80
• Wholesale: gross margin down 0.2% over projected period
• Unified gross margin down 0.4% over projected period
• Retail gross margins down 1% over projected period
• TSA wind down in FY2019E
• Tax rate of 22%, in-line with historical levels
• 11.5% discount rate using WACC, 2% terminal UFCF growth, and standard discount periods

The DCF model down to NOPAT is included below:

Investment Risks

The main risk factors for this a short position are:

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Stock Pitch: SuperValu [NYSE:SVU]

1) Higher-than-expected revenue growth and/or margin improvement

2) Increases in corporate segment revenue
3) Unified Grocers synergies at or exceeding management expectations

I will address each risk below:

Higher-than-expected revenue growth and/or margin improvement

As we have seen above, revenue growth and margins in this sector are valued very highly by the market. If either
of these metrics end up being materially higher than anticipated, the stock price could appreciate significantly.
Looking at our earlier retail sensitivity for guidance, flat margins and spend per store over the five projected
years will result in a stock price of $29.71, a 44.8% increase over the stock’s current price.

However, the likelihood of this occurring is extremely low. SuperValu’s wholesale revenues have declined about
3% annually and its retail revenues have followed a similar trend, with a 3.6% decline in FY2017. Unified Grocers
also has declining revenues. In terms of margins, management has stated that on the retail side, they are going
to invest more in prices and promotions, thereby reducing the margins of the business. On the wholesale side,
management has also emphasized differentiation through pricing.

Increases in corporate revenue

While the corporate segment of the business only accounts for 1.5% of overall sales, it is very important to
SuperValu due to its high gross margins. If revenues in this segment rise due to additional service agreements,
the stock price could increase dramatically.

Again, I do not think this is very likely. All service contracts in this segment have originated from SuperValu’s
divestments and usually only last around 5 years. Given the low probability that SuperValu will continue to
divest parts of its business, there probably will not be any more service agreements. Outside of divestments,
there is little incentive for retail chains to use a competitor’s back office services.

Unified Grocers synergies at or exceeding management expectations

Management is projecting $60 million in cost synergies by FY2020. In our base case, we predicted $51 million in
cost synergies. If the realized synergies are at or above management’s expectations, the stock price will likely go
up. If we reference the synergy sensitivity above, we can see that the implied stock price at $60 million in cost
synergies is $18.36, which represents a 10.5% discount to its current price. This risk is largely mitigated unless
the cost synergies reach $80 million.