Follow up to the small cap post - and some notes on SuperValu

My blog post suggesting that small-cap stocks were mostly to be avoided roused the animosity of many readers. The problem was that many of my readers see themselves as value investors. A surprising number run small funds and my post was an attack on their world view.

Their logic is that it is impossible for a small fund manager to add value by analysing Hewlett Packard*, Vodafone*, Google* or Total* but by being small and diligent and nimble they can add value by picking small caps. They tell themselves (and possibly their clients) this story every day - it brings meaning to their life. They can add value. By saying just avoid small caps I was asserting that their rationalizations were bullsh-t. No wonder they bristled.

My restrictions were somewhat limited - I was only wanting to avoid buying small caps where the possibility of a go-private transaction was underpinning the price. In other words small caps in safe jurisdictions with good balance sheets and open registers were mostly to be avoided. Private equity mostly can not or will not buy financial institutions (with rare exceptions such as JCFlowers) - and there is some value in smaller financials. Likewise some companies that are already so levered that a debt-financed private equity bid is impossible are potentially interesting. Some German two-class-of-shares mid-caps are also interesting. But even these are at best partial exceptions to my rule of small caps being relatively expensive.

Still the rationalizations of the small cap value managers reminded of Woody Allen's zinger about rationalizations being more important than sex. "When was the last time you went 24 hours without a rationalization?"

Most of the comments posted wound up revolving around SuperValu - the grocer that owns Albertsons and others and which has been distressed and whose stock price reflects that distress.

One of my readers points out just how cheap it looks relative to potential. He figures the pain (and there has been considerable pain) is more or less over and the stock should race. Without a lot of work I can't even express an opinion on that.

But I will note that the first question when analysing a business is "what will they look like in three, five, ten years". Warren Buffett tells us that when he buys businesses he likes to look out decades. I am a little more flighty than that (and I can always dump the stock) so I tend to look 3-5 years out. Call it the "Wayne Gretzky school of value investing" - look at where the puck is going to be and ask if it is cheap against that.

And when you look out three to five years the biggest determinant of how they will look is what the competition will do to them.

Whatever: on this metric SuperValu is difficult. The grocery market is not growing much in aggregate in the US except through food inflation. And the competition at the bottom end is fierce. I would rather wrestle grizzly bears than compete head-to-head with Walmart. And at the top end the competition is also evil. (The Wholefoods store in Chicago where I irregularly shop is very nice. Certainly nicer than the average Albertsons.)

Sales are going backwards. That does not look like it is going to change - although plausibly the rate of decline may drop. This unquestionably a difficult story where a strained company is fighting with superior competitors. When small caps are cheap (and they do get there fairly regularly) there is no need to take on difficult stories. When to find value you need to go headlong into difficult stories then you are probably deluding yourself about there being value there in any general sense (although there may be value in specific instances).

The focus on SuperValu (a truly difficult story) was confirmatory of my view that on-average small caps are particularly difficult at the moment. [I should note however that SuperValu is something that would not appeal to most debt-funded private equity shops. The company is shockingly levered - and my general restriction against small-caps does not apply here.]

Metrics

I have a few metrics I think about with grocers. The main one is EV (meaning market cap plus debt) to sales. My rough rule of thumb is that an EV to sales of under 0.25 is outright cheap (and only seen either when the whole market is distressed or an individual company is distressed). You have to have a very high quality company to want to pay more than 0.5 times sales. These numbers have to be adjusted for retailers that own much of their property (Walmart, Tesco).

The logic is as follows: grocery retailing is a 5 percent margin business give or take a bit. $100 of sales at an EV to sales of 0.5 is $50 of EV. That $50 of EV would have $5 of operating profit associated with it (5 percent margin on $100 of sales). Now imagine the company had no debt and thus no interest bill. Take out tax at 30 percent and you have $3.50 in after tax earnings. That is for $50 of EV (which in this case is $50 in market cap). The price earnings ratio would be just over 16.6.

To pay more than 0.5 times sales you have to argue that unlevered this company is worth more than 17 times earnings. That is possible if there is a lot of growth potential or the margins are sustainably fat. But 0.5 times sales is a price above which I need to be finding rationalizations to maintain my interest.

When non-distressed grocers with solid market positions trade at 0.25 percent of sales (which is very rarely) they are half that price which is cheap by most measures.

Here is the last quarterly balance sheet for SVU:

	December 3, 2011				February 26, 2011
		(Unaudited)
ASSETS
Current assets
Cash and cash equivalents		$	196			$	172
Receivables, net			747				743
Inventories			2,616				2,270
Other current assets			226				235
Total current assets			3,785				3,420
Property, plant and equipment, net			6,226				6,604
Goodwill			1,306				1,984
Intangible assets, net			887				1,170
Other assets			581				580
Total assets		$	12,785			$	13,758
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable and accrued liabilities		$	2,720			$	2,661
Current maturities of long-term debt and capital lease obligations			396				403
Other current liabilities			643				722
Total current liabilities			3,759				3,786
Long-term debt and capital lease obligations			6,203				6,348
Other liabilities			2,078				2,284
Commitments and contingencies
Stockholders’ equity
Common stock, $1.00 par value: 400 shares authorized; 230 shares issued			230				230
Capital in excess of par value			2,860				2,855
Accumulated other comprehensive loss			(379	)			(446	)
Retained deficit			(1,450	)			(778	)
Treasury stock, at cost, 18 and 18 shares, respectively			(516	)			(521	)
Total stockholders’ equity			745				1,340
Total liabilities and stockholders’ equity		$	12,785			$	13,758

The last SuperValu balance sheet had $396 million of short term maturities and $6.2 billion in long term debt. There is a couple of hundred million in cash - which is such a minimal number I am going to ignore it. (There is 200 thousand dollars cash per store - a number that looks small relative to obvious cash needs including just balances in the till.)

$6.5 billion in debt give or take a little. The market cap is 1.35 billion according to Yahoo! EV is thus 7.8 billion. Last year sales were something like 37 billion (and on a very steep decline of about 10 percent per annum). This year they will be something like 35 billion. EV to sales is just over 0.2 - and will be probably close 0.25 when (and if) they can stabilize sales. This is the bottom end of my EV to sales range but is not an outright distress type figure. Given most this EV is debt I would not be much interested in the debt at par (even though it yields 8 percent). That seems like not much upside and in distress this retailer is going to be worth less than 0.25 times sales.

If perchance the debt were to trade at 70c - implying an EV to sales in the mid-teens - then I might get interested in the debt.

The equity is another issue - one I address below.

My second metric for retailers is how much of a lean they are taking on suppliers. Grocers sell stuff fast - many sell their stuff faster than they pay the suppliers meaning they get free funding from them. If they get into trouble (or they want the cheap finance) they let their supplier obligations blow out. I wrote a post once about an Australian wholesaler (Davids Holdings) which let its supplier obligations blow out and nearly went bust. Not nice.

A rough rule of thumb is as follows. Most suppliers give you 30 day terms. If your payables are more than 30 days of sales you are taking a lean on your suppliers. If you take too big a lean they start getting stroppy and ask for cash-on-delivery or letters of credit or the like. Too much of a lean is pretty tightly defined: most grocers have payables of about 35 days of sales.

In the above table payables are 2.7 billion. That is less than a month of sales - SuperValu is clean on this measure. However note that the accounts payable have gone up as sales have gone down. Whilst the level is not a sign of distress the direction is not good (the reduction of debt is not as impressive as it looks).

Finally - and this is the measure that most bugs me - inventory turn is falling. Inventory is up year on year. Sales are down. For a grocer this is unremittingly bad news. Not only are they using capital less efficiently (getting less aggregate margin per square foot for instance) but slowly and surely the store is turning into one of those places you shop only if you like your groceries pre-packaged and just a touch stale.

Whatever - on the numbers as given this is not that cheap relative to EV and the metrics are going the wrong direction.

You could add - and one of my readers did - that the company is underspending on stores. Tired old stores with slow inventory turns and stale product - that is not the way to take on Whole Foods. And unless you are going to shave margins to nothing it is hardly a way to take on Walmart.

If I had to make a bet on this my guess is that it will have to restructure in some form. This might be a sale (for debt reduction) of a large part of the business or it may be Chapter 11. Whatever - this is not easy and not an obvious value stock.

Would I short the stock?

There is a big short interest in the stock. I think the company is probably going to continue to have a rough time. I am a short seller. The obvious question is "would I short the stock?"

Here the answer is surprisingly no. The company in aggregate is not cheap (EV to sales is going to wind up somewhere near 25 percent) but the equity is cheap. Why? Well if things go right (and things always can go right) and the company gets say 100bps more margin - then the stock looks staggeringly cheap.

There are 35 billion in sales. 1 percent margin increase is 350 million per annum. That is very meaningful relative to a market cap of $1.3 billion. Add in a big short interest and the stock could be very strong.

The leverage that makes this whole thing problematic works both ways. If the management can right this ship the stock could be a big winner.

Have the management done a good job

My bullish commentator thinks the management have done a good job. As far as I can tell he is right. They have shrunk the business (a lot), paid off a lot of debt, and it appears been pretty straight-up-and-down about it. I am a little irked by the falling turnover (it will make the product stale) but that might just be the hand they were dealt.

I have not done a lot of work. I have not walked around these stores. I have not done any apple-freshness tests. But on the numbers I see no reason to believe management have not been pretty good.

That is a blessing and a curse. Good management will be necessary to salvage this situation. But if these stores have been well managed then getting a new broom in can't save the situation. You have to play the cards that are dealt.

Summary

If SuperValu is proof that there is value easily detectable in companies under $5 billion in market cap then - frankly - I think I will take my large caps.

I would not be long this without tangible on-the-ground evidence (from surveying up to 30 stores in different locations) that this really has turned around. Because at the moment this does not pass the Wayne Gretsky test of value. In five years it looks really really bad.

And I would not be short it either with that leverage without a decent understanding of their day-to-day liquidity and just how short-dated the situation is.

This one belongs in the too-hard basket. And half a day is wasted looking at another stock that ultimately I don't care about.



John


*For disclosure purposes we were once short Hewlett Packard but have covered, we are long Vodafone and Google - two of our biggest positions, and we were once long Total but have sold.