(By Mani) Media reports say Cerberus Capital Management is seeking finance to buy struggling supermarket operator Supervalu Inc. (NYSE: SVU), one of the largest companies in the U.S. grocery market with annual sales of approximately $35 billion.
Reuters reported that Cerberus is seeking $4 billion to $5 billion in debt financing from banks and investing equity of $800 million to $900 million. No official bid has been made; however, the extent of details make this seem credible.
"With the share price at ~$3 (up from ~$2), and an implied $4 takeout price based on the Reuters article, it appears the market thinks there is a 50/50 probability of a deal," UBS analyst Jason DeRise wrote in a note to clients.
However, buying Supervalu is a risky option for private equity due to the retailer's continued under-performance in a very challenging industry.
Eden Prairie, Minnesota-based Supervalu states it is considering options to unlock value for shareholders, including selling all or part of the company. The company, which serves customers across the United States through a network of approximately 4,400 stores, said it has received a number of indications of interest and is in active dialogue with several parties.
A sell-out may be unlikely. "Our view is that it is unlikely anyone would be willing to buy just the traditional business for a premium valuation because of the risk and uncertainty of the turnaround. Likewise, selling the stronger parts (Save-A-Lot and distribution) would leave shareholders with a very weak business, unless a material premium is paid. If SVU wants to sell the business, it will likely need to do so in one piece," DeRise noted.
Another issue is that Supervalu cannot accept bids below its debt to EBITDA, otherwise its debt to EBITDA will increase. It may try to sell the entire business in one piece, but there is a low probability of either part or all of SVU being sold. The company currently expects debt reduction for fiscal 2013 to be in the range of $400 million to $450 million.
"We estimate SVU's debt to EBITDA including both on and off balance sheet pensions is 4.6x for all of SVU compared to a 4.9x market price implied EV/EBITDA (including pensions)," the analyst said.
A Supervalu shareholder would hope the challenged parts of the business, such as Albertsons, would be sold while retaining the favorable parts of the business. Unfortunately, the valuation a buyer would be willing to pay for the challenged parts of the business may be lower than the debt burden attached to it. Unless it can sell the challenged traditional business at a higher EV/EBITDA than its debt/EBITDA, the company will hurt its debt/EBITDA profile.
On the other hand, selling the higher multiple businesses such as Save-A-Lot would pay down debt faster, and leave the remaining businesses with a lower multiple.
The debt burden means Supervalu would likely struggle to accept any offer at or below fair value for any part of the business, essentially requiring a premium to make a deal happen.
"The current state of the business requires significant investment to turn the business around. Therefore, it is unlikely a buyer would be willing to pay a premium. Strategically, SVU may be willing to exit the traditional food retail business, but its high debt levels may prevent that from happening," DeRise said.
The primary risks to Supervalu are increasing price competition and rising food inflation. The old conventional wisdom that food inflation is good for food retailers is no longer valid. Risks of rising food inflation due to a poor U.S. harvest could undermine Supervalu's ability to drop prices vs peers without substantial reductions in gross margin.
In addition, the pricing war got fierce in the industry, and Supervalu has been losing market share to lower-priced rivals such as Kroger Co. (NYSE:KR) and Safeway Inc. (NYSE:SWY).
Moreover, the strategy of carrying more groceries by club stores like Costco Wholesale Corp. (NASDAQ: COST) and mass retailers such as Wal-Mart Stores Inc. (NYSE:WMT) hurt the prospects of Supervalu, whose pricing remains too high relative to competitors, resulting in lower customer traffic.
Meanwhile, Supervalu has been cutting costs and reducing cap-ex for years. Specifically, the company is cutting prices across the store and ramping up marketing to communicate the improved prices.
In addition, secular challenges facing conventional grocers such as the need for additional capital investment, underfunded pensions and heavy debt load could distract buyers.
As a result, iStock views that a private equity deal to buy Supervalu would be a huge risk for Cerberus. However, only Cerberus knows if owning Supervalu actually makes sense for them.