MINNEAPOLIS - Supervalu here will increase its debt load by more than six times its current level with the pending acquisition of Albertsons, but some analysts said they are optimistic that the company will gain enough additional cash flow to reduce it quickly.
Scott Frost, a New York-based analyst with HSBC, London, said the amount of debt will be less important than Supervalu's ability to integrate the stores it is acquiring. "The real question is whether the $1.8 billion of operating cash flow Supervalu anticipates is going to be realized," he said. "If the cash flow materializes, then the amount of debt doesn't seem to be excessive. But if it doesn't materialize, then the amount of debt becomes larger relative to cash flow, increasing the leverage and reducing flexibility."
Bob Lupo, an analyst in the Red Bank, N.J., office of BB&T Capital, Richmond, Va., told SN he does not view Supervalu's debt-load as a detriment. "Supervalu is a good operator with a good management team, and it is getting a pristine company at a great price, and I like its strategy for developing and growing the operations it's acquiring," he said.
"There are definitely opportunities for Supervalu to reduce the debt over a two-year period if it can execute its plan. Given the assets Supervalu is acquiring and the price it's paying, and anticipating the free cash flow those operations will generate and the plan to reduce debt by $400 million in the first year, I'm bullish on its prospects."
Eric Larson, an analyst with Piper Jaffray here, said the increased debt will boost Supervalu's debt-to-capital ratio to 65%, compared with 38% before the deal closes. "That leverage will decrease Supervalu's flexibility in coming years," he said.
Supervalu said it believes it can reduce debt sufficiently to regain an investment grade rating by mid-2008 - two years after its acquisition of a portion of the Albertsons assets is completed this summer. Supervalu anticipates losing its investment grade rating once the transaction closes.
Under terms of its agreement with Boise, Idaho-based Albertsons, Supervalu will assume $6.1 billion of Albertsons debt, including $700 million in capital leases. Supervalu said it plans to fund approximately $2 billion of the transaction with new debt from a $4 billion revolver from the Royal Bank of Scotland, and that $2 billion, combined with its current debt of $1.6 billion and the Albertsons debt of $6.1 billion, will leave Supervalu with debt of approximately $9.7 billion at closing.
Jeff Noddle, chairman and chief executive officer of Supervalu, said Supervalu expects to generate sufficient free cash flow to support debt service requirements and improve its overall credit profile to investment grade within two years after that. "You have seen this management over the last five years significantly de-lever our balance sheet to get ready for a really transformational transaction such as this," he told analysts in a conference call, "and we are going to do those same things going forward, with the same capital discipline, with the goal of returning to investment grade."
Supervalu said it intends to finance the deal with a combination of stock and debt - 20% stock and 80% debt. According to Pam Knous, executive vice president and chief financial officer, "We utilized a greater portion of debt as it is the most cost-effective way to effect this transaction. And we clearly believe this leverage is manageable. The combined entity generates strong [operating] cash flow, allowing us to pay down at least $400 million after one year."
Supervalu's current debt rating is BBB from S&P and Fitch and Baa3 from Moody's.
S&P said Supervalu's corporate credit rating would be lowered to BB-minus with a stable outlook once the deal is completed - a reflection, it said, of "the substantial execution challenges of acquiring a company larger than itself; maintaining corporate overhead functions for the other two buyers [Cerberus Capital Management and CVS Corp.] for a period of time, and operating with greatly increased financial leverage.
"[However], the company has the potential to generate substantial free cash flow over time, allowing for gradual reduction of debt leverage. If management executes its plan successfully, the company should be a solid competitor within the industry and be able to reduce leverage more quickly than anticipated, resulting in upgrade potential.
"Although Supervalu would acquire Albertsons' most successful divisions and would choose to minimize execution risk by leaving existing operating management in place, its 'portfolio' management approach could be problematic in a larger organization. Moreover, the integration would take place during a time of intensifying competition in the supermarket industry.
"However, if successful, the acquisition would result in a company with high-quality assets, solid market positions, broad geographic reach and a diversity of formats ... [that] would also provide a means of growth for Supervalu, whose wholesale business is undergoing attrition."
Moody's said Supervalu's rating may be downgraded based on "the control and integration challenges involved in more than doubling the company's revenue base; the high fixed charge burden for cash interest, cash taxes, capital investment and dividends; and Supervalu's unprecedented willingness to substantially increase its risk profile for the potential benefit of shareholders."
If the deal closes as currently contemplated, Moody's said it is likely to assign the company a corporate rating of Ba3.
ECONOMIES OF SCALE
Among positive factors influencing its assessment, Moody's said, will be the good results at the acquired Albertsons divisions; the economies of scale that are expected; and the potential of Supervalu's Save-A-Lot banner; plus the long-term stability of Supervalu's management "and the substantial progress Supervalu has made at transitioning from a lower-margin grocery distributor to a higher-margin supermarket operator."
While the Albertsons transaction could enhance Supervalu's competitive position, Moody's said, the company will "nonetheless continue to face the challenge of maintaining the market share of its supermarket operations and of replacing the annual sales attrition of an estimated 2% to 4% of its wholesale customers."
Fitch said it has also put Supervalu on a negative rating watch, noting its rating could drop to the low BB range.
According to Fitch, although the supermarket sector is highly competitive, Albertsons "is a higher-margin business and helps to buffer Supervalu from the contracting wholesale business."
However, with debt rising to $9.7 billion, "credit metrics are anticipated to weaken significantly from current levels," Fitch said.