Schafer: Few good options remain for Supervalu

Supervalu has started acting like a company where the leadership finally concluded there was nothing left to lose.

The Eden Prairie-based grocery giant said last week that it has hired investment bankers Goldman, Sachs & Co. and Greenhill & Co. to review potential transactions that could create more value for shareholders. Selling the company, with all of its operating issues and more than $6 billion in debt, is thought by analysts to be so unlikely that it's not worth discussing. But parts of the company could be sold.

Supervalu also took steps to free up money to engage in some serious price competition with its peers. So while the board and its advisers consider selling pieces of the company, management is going after bigger and better-funded competitors on price.

These are not the winning strategies taught at the business schools. Competing on price with folks who have lower costs and more money usually leads them to crush you.

At the same time, not dropping prices means more of what has so clearly not worked, and that's got to be the worst option of all. So Supervalu's management team, led by CEO Craig Herkert, should get some credit for moving ahead with its best realistic option.

Supervalu, once best known as the industry's top grocery wholesaler, today operates mostly as a food retailer. The 2006 acquisition of Albertson's retailing business transformed the company by adding more than 1,100 stores. Today some of those acquired stores and brands, like the 180-store Jewel-Osco group centered on greater Chicago, are clearly valuable assets.

But the investment community later soured on the Albertson's deal. Too few strategically solid chains, too much operating complexity and way, way too much debt required to fund the whole thing.

Herkert arrived on the scene in 2009 after a series of senior roles at Wal-Mart Stores Inc. The results since have been consistent: Identical-stores sales always decline.

Herkert has been blasted twice by a trade journal columnist for his pleasant, happy-to-be-here tone as he chats up new programs. It's apparently annoying to trade paper editors that Herkert does not sound like a CEO heading for a crisis. With identical-store sales dropping every quarter, shouldn't he sound on edge if not apocalyptic?

In listening to the company's conference call with investors late Wednesday, Herkert did have a business-as-usual tone, even when responding to a bluntly asked question from analyst Ken Goldman of JPMorgan about whether options include bankruptcy.

"It's not being reviewed," Herkert responded, pleasantly enough. "We are a profitable company with solid cash flows of $1 billion. We continue to pay down debt on or ahead of schedule, so that is not a part of our strategic review."

Still, whatever complacency may have existed in the past, there is certainly a sense of urgency in what Supervalu is now trying to do. It started with a savvy refinance of some of its $6.3 billion in debt.

Supervalu has commitments to replace its $2.5 billion senior credit agreement with two new loans that are asset-backed. While the old terms included certain cash flow requirements, an asset-backed lender doesn't care as much whether the borrower generates cash so long as the assets backing the loan are valued at more than enough to pay off the loan. The upshot is that Supervalu can spend money without worrying that cash flow shortfalls will trigger a loan default.

Supervalu also cut its dividend to zero, saving about $75 million per year, and it is chopping its capital spending budget for the year to between $450 million to $500 million, down from $675 million. Supervalu has already been significantly underinvesting in its retail network, as new spending is well below depreciation expense. Now the budget is maybe 40 store remodels in the current year, down from 100 at the start of the year.

Tired-looking stores clearly won't help drive customer traffic or sales, but we get the message. That's a problem for 2014 or beyond. Supervalu's leaders need the cash to drive sales now, or none of them will be around in 2014.

The company is planning to repay more debt this year than it previously planned, but essentially all of the rest of the money that is being freed up is for one strategy, and that is to cut prices.

Supervalu calls it fair price plus promotion. Herkert was not available, but a spokesman said Herkert has been talking about lowering everyday prices throughout stores for nearly two years. "He wanted to make sure that they were pre-funded, so they were sustainable," the spokesman said. The idea is that Supervalu will not be the cheapest, but intends to be competitive in its markets.

According to analysts, Kroger stores overlap maybe 20 percent with Supervalu's, and Safeway's about 25 percent. Getting share gains from those companies with lower prices is not going to be easy. Both are outperforming Supervalu, and both have greater financial flexibility to respond to any pricing pressure with price cuts of their own.

That reality is hardly lost on industry analysts, and they have advised clients that there is plenty of risk in Supervalu's more aggressive price strategy.

Maybe the most pessimistic view came from Fitch Ratings and its analyst Philip Zahn. Last week Fitch whacked its credit ratings for Supervalu debt, which had already been speculative grade. Zahn said Fitch remains "skeptical" of Supervalu's ability to narrow the identical store sales gap over time. Any store traffic gains will lag the price cuts, he said, if they materialize at all. So in looking ahead he concluded that sales trends will get worse and not better, with margins and cash flow declining in turn.

Better options -- buying a competitor, dramatically expanding the company's best concepts, renovating a lot more stores, even selling operating assets -- would either be too expensive or pointless without first stabilizing the core retailing operation.

It goes without saying that Supervalu's new pricing strategy needs to work. Most of the analysts argued the investment bankers Goldman and Greenhill will come back to Supervalu's board with very few good options for selling even parts of the company. Not until potential buyers see some evidence that the sales declines are going to begin to flatten.

"Kroger has no interest" in acquiring any retailing assets from Supervalu, said Michael Keara, an industry analyst from Morningstar. "If Kroger is comping 5 percent [identical store sales] and you are comping negative 3, do the math. Kroger doesn't have to waste its capital to take you out of the market. You are going out of the market all on your own."

lee.schafer@startribune.com • 612-673-4302