Leaders upbeat as analysts fret over debt levels

Supervalu now has four quarters of operation as a combined company under its belt since its high-profile purchase of 1,124 supermarkets and food/drug combo stores from Albertsons in June 2006. And the track record Supervalu has notched thus far seems to justify the faith that chairman and chief executive officer Jeff Noddle placed in the merger, which he called a transformative transaction.

For the first quarter of fiscal 2008, ended June 16, 2007, Supervalu reported record sales of $13.3 billion compared with $5.8 billion in the first quarter of fiscal 2007, record net earnings of $148 million compared with $87 million last year and diluted earnings per share of $0.69 compared with $0.57 last year, a 21 percent increase.

“On all fronts, this was a highly successful first year, which sets the foundation for the next two years of our journey following the acquisition,” Noddle said in the company’s earnings release. “The double-digit increase in our first-quarter earnings completes a full year of double-digit accretive results. We are now beginning to execute our business plans that will maximize the full potential of our transformed company, including the delivery of synergies.”

Nevertheless, Supervalu’s pre-acquisition “legacy” stores remain plagued by low same-store results. In a July 24 conference call with Wall Street analysts, Noddle acknowledged the impact of competition and other factors, but expressed confidence in the long-term outlook.

“Our identical-store sales on a combined basis increased 1.2 percent in the quarter, with the acquired properties at 1.7 percent and legacy Supervalu at negative 0.4 [percent],” he said. “We attribute this to a combination of factors including: competitive activities in certain markets, the pressured consumer, as well as its inflationary impact to our pharmacy sales related to price reductions for several major generics—another industrywide dynamic that will play out over the next several quarters.”

Nevertheless, Noddle predicts a full-year same-store sales gain of 1 percent to 2 percent companywide.

For most investment analysts who follow the company, the picture is more nuanced. Most remain leery about the high debt levels Supervalu assumed when it bought the crown Jewels of Albertsons’ supermarket operations. Wall Street also seems to hold nagging concerns about the fact that Supervalu took on such a debt-laden, expensive expansion in national reach and store count in a time of unflinching competition, with Wal-Mart relentlessly adding supercenters across the country, warehouse club stores and no-frills discount food stores gaining ground, European discount food retailer Tesco preparing to enter the U.S. market in Texas, and such high-end natural foods brands as Whole Foods rapidly gaining share.

Against this backdrop, most analysts are taking a wait-and-see attitude before they can endorse Supervalu’s new business model completely.

The combination—one of the largest in U.S. supermarket history—cost Supervalu $17.4 billion in cash, stock and roughly $6 billion of assumed debt. In return, the company overnight doubled in size to $44 billion in annual sales and more than 2,450 stores. It also expanded Supervalu’s retail reach to 42 states, absorbed Albertsons’ best-practice expertise in combo-store and pharmacy marketing through such operations as Jewel-Osco and Sav-on, and brought into Supervalu’s empire Albertsons’ stores that were performing at higher operating margin standards than those of Kroger or Safeway, according to investment analysts First Call’s 2006 estimates.

In addition, Noddle told investment analysts in July, “We are well-positioned to leverage our new scale and achieve the $150 million to $175 million of synergies by the end of the third full year anticipated since the acquisition of the Albertsons premier retail properties. Fiscal 2008 is off to a very good start with strong business plans to build upon this first year of success.”

The deal made Supervalu a highly leveraged company, noted Lehman Brothers analyst Meredith Adler soon after the merger was announced. In the initial aftermath of the acquisition, the deal also prompted Fitch Ratings to downgrade Supervalu’s credit rating.

Despite the concern, Lehman, Fitch and other company-watchers found plenty of silver linings in their long-term outlook. Following the release of Supervalu’s fourth-quarter results earlier this year, Adler noted that same-store gains were coming “faster than expected, [thanks to] better in-store operations with a greater focus on customer service, cleanliness and improved employee moral.”

Citigroup retail analyst Deborah Weinswig, for her part, expressed praise for Supervalu’s Premium Fresh & Healthy marketing and store-makeover theme, but impatience with what she characterized, in a Sept. 11 report, as the slow rollout of the format.

Noting that the remodeling initiative would “slowly…improve [the] store base,” Weinswig noted, “We are excited by SVU’s Premium Fresh & Healthy program, which incorporates store remodeling and merchandising efforts focused on fresh perishable products.… However, since November 2006, SVU has launched less than two dozen PFH stores.”

Weinswig also warned that “intensifying competition could pressure margins” at the supermarket giant, at least in the near term. “Supervalu continues to face fierce competition from other non-supermarket food retailers, discounters/supercenters, warehouse clubs, drug stores, dollar stores, convenience stores and restaurants,” the report noted. “The highly competitive retail environment could lead the company to lower prices in order to drive market share, which could have a negative impact on operating margins.”

Specifically, Weinswig reported, “prices at SVU’s newly acquired Albertsons banners, on average, are 24 percent higher than those at WMT [Wal-Mart],” compared with an 8 percent price premium to Wal-Mart at rival Kroger Co.

“With expanding supercenter penetration [by Wal-Mart] and with Tesco’s 4Q07 entry, SVU will likely be pressured to rethink its pricing strategy,” Weinswig noted. She added that “customers are trading down to lower-cost items” as the economy weakens.

Those concerns aside, Weinswig advised Supervalu investors to hold onto the stock to await the unfolding of “the full potential of both its Premium Fresh & Healthy and private-label initiatives” in the face of “strong competition and macro-economic headwinds.”

Joseph Agnese, an analyst with Standard & Poor’s, noted in a July 24 report that Supervalu’s recent earnings picture “benefited from acquisitions and a more favorable retail food environment, despite a sign