It's Time To Check Out Supermarket Stocks

By Jonathan Berr | October 16, 2013 AAA

For an industry that ‘s supposed to have been decimated by behemoths such as Wal-Mart Stores (NYSE:WMT) and Target (NYSE:TGT), the nation’s grocery chains have been holding up much better than those companies that were supposed to eat their lunch.

Shares of Supervalu (NYSE:SVU), owner of Shop `N Save, Save-a-lot and Farm Fresh, have surged more than 230% since the start of the year, as the Eden Prairie, Minn., company benefited from cost-cutting. Stil, expectations for the chain remain low heading into Thursday's earnings report. Revenue is expected to fall more than 51% to $3.88 billion. Earnings per share is expected to drop to 9 cents per share. One reason for the decline is that Supervalu is much smaller than it used to be having unloaded its Acme, Albertsons, Jewel-Osco, Shaw's and Star Markets chains earlier this year.

Kroger (NYSE:KR), the largest supermarket operator, recently reported solid earnings thanks to the growth in its private label brands. Shares of the operator of its namesake stores along with Ralph’s and Fry’s have jumped more than 58% this year. Safeway (NYSE:SWY), which Barron’s recently noted was “once a stock market pariah,” has roared back this year, gaining more than 83% this year.

Perhaps, the Pleasanton, Calif., company is reacting to pressure from activist investor Jana Partners. Whatever the reason, Wall Street likes what it sees. The company’s latest earnings, which were issued late last week, were also better than Wall Street expected. Safeway also is slashing costs, shedding its underperforming Dominick’s chain in Chicago and its stores in Canada.

Net income fell 58% to $65.8 million, or 27 cents per share, compared with $157 million, or 66 cents a year earlier. Sales rose 1.1% to $8.62 billion. Wall Street expected the company to earn 16 cents on revenue of $8.52 billion. Same-store sales excluding fuel rose 1.9% on a continuing operations basis. Shares of Safeway, the number two supermarket operator, have gained 81% since the start of the year, fueled in part by a customer loyalty card program and an 11 basis point gain in market share.

The company, of course, has plenty of challenges. It was forced to absorb some of the rising costs for meat and dairy products. Even so, operating margins excluding fuel are expected to raise 10 to 15 basis points this year compared with 2012.

“While we did not find the quarterly results entirely satisfactory, we achieved some significant milestones during the quarter,” CEO Robert L. Edwards said in the earnings conference call. “Through the actions taken, we have established a strong foundation and momentum, which should allow us to achieve our goal of increasing sales and profitability and continue to demonstrate our commitment to create shareholder value.”

Given their huge run-ups, it’s hard to find bargains in the supermarket sector. Supervalu and Safeway are trading above their average 52-week price targets while Kroger is valued near where analysts think it could hit over the next year. Some analysts are more optimistic. Analysts at Deutsche Bank have a $46 dollar price target on Kroger while Jefferies expects the stock to hit $45. The shares recently traded hands at the $41 level. These same firms are also more optimistic than their peers about Safeway. Deutsche Bank’s target on the stock is $40 while Jefferies is $35, above the $33 where it recently traded.

Kroger is a slightly better stock here, trading at a price-to-earnings multiple of 13.67 versus Safeway’s 15.18. The Cincinnati-based chain also is expected to post revenue gains in the next few quarters compared with Safeway’s declines. Investors should wait for the shares to pull back some before pulling the trigger. As for Supervalu, it’s hard to imagine the stock continuing its meteoric rise. People should take a pass on the stock.

The Bottom Line

Supermarkets can't discount the threat posed by big box retailers, but investors can't assume that they will be pushovers either. In fact, Wal-Mart has found the grocery business to be much harder than it expected. For investors, the rewards of owning these shares are many and the risks, while there, are relatively few.

Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.

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