March 11 (Bloomberg) -- A takeover of Safeway Inc. at the industry’s lowest valuation in almost a decade may be the best that investors in the second-largest U.S. grocery chain can get.
Cerberus Capital Management LP agreed last week to merge Safeway with its Albertsons chain in a $40-a-share bid of cash, stock and asset sales. Kroger Co. also approached Safeway about buying part of its operations, according to people familiar with the matter. Even if Kroger offered $45 to buy the whole company, Safeway would still be getting the lowest profit multiple for a food retail deal of more than $1 billion since 2004, according to data compiled by Bloomberg.
Cerberus’s offer, which probably left some shareholders wanting more, is reasonable because Safeway’s business has deteriorated in the face of increasing competition from lower-priced operators, according to S&P Capital IQ. While Deutsche Bank AG said Kroger should make a counterbid for Safeway to bolster its position as the No. 1 U.S. grocer, Susquehanna International Group LLP said Kroger is more likely to settle for any assets Cerberus may divest to appease regulators.
“People were looking for more,” Bob Summers, a New York-based analyst at Susquehanna, said in a phone interview. The valuation is “more than fair. Safeway has been an underperforming asset.”
Representatives for Pleasanton, California-based Safeway, Cincinnati-based Kroger and New York-based Cerberus declined to comment.
Cerberus’s Albertsons chain last week said it would buy Safeway and its 1,335 U.S. stores to help it better compete with Kroger for grocery sales that IBISWorld Inc. estimated will decline 1.7 percent this year nationwide. Kroger may still play a role in the deal because the agreement includes a 21-day “go-shop” period designed to solicit other bids.
In the Cerberus proposal, Safeway shareholders will receive $32.50 a share in cash and about $3.95 in stock in Safeway’s gift-card unit Blackhawk Network Holdings Inc. About $3.65 more will come from the eventual sale of the company’s property development centers and 49 percent stake in Mexican joint venture Casa Ley.
The deal is complicated, with asset divestitures potentially taking years to complete, and there’s a risk investors could end up with less than $40 a share, according to Ajay Jain, a New York-based analyst at Cantor Fitzgerald LP. The property development unit will remain a drain on cash flow and a sale may not generate meaningful proceeds, Jain wrote in a March 7 note.
Today, Safeway shares fell 0.6 percent to $38.65.
Even if investors get the full price, the transaction will value Safeway at about 5.5 times its $1.6 billion in earnings before interest, taxes, depreciation and amortization in the last 12 months, less than the 9.9 median for similar-sized food-retail deals, according to data compiled by Bloomberg.
While the multiple is low compared to takeovers such as Kroger’s purchase of Harris Teeter Supermarkets Inc. this year at about 7 times Ebitda, it’s appropriate for Safeway, said Joseph Agnese of S&P Capital IQ.
Safeway posted a sales increase of just 0.2 percent in 2013 after a 17.3 percent decline in 2012 as Wal-Mart Stores Inc., warehouse clubs such as Costco Wholesale Corp. and online food sellers wooed away customers. Even after takeover speculation helped boost the stock 19 percent this year through yesterday, the company has the lowest Ebitda multiple among its peers, according to data compiled by Bloomberg.
“Fundamentally, Safeway was suffering,” Agnese, a New York-based analyst, said in a phone interview. “For anybody looking to acquire the stores, they’re picking up a chain that’s under a significant competitive threat. I think it’s a fair valuation.”
The complicated structure of the Cerberus bid suggests Kroger wasn’t interested in buying the whole company, said Andrew Wolf, an analyst at BB&T Corp.
“If Kroger really wanted the business, they could have just come in with a clean bid at the same valuation” of $40-a-share, Wolf said in a phone interview. “My take is they took a look and took a pass.”
Safeway is more of a “fixer-upper” and doesn’t fit the profile of what Kroger looks for in M&A transactions, said Summers of Susquehanna. Kroger President Michael Ellis said on a conference call last week that the company likes to buy well-run companies that it admires, such as Harris Teeter.
Implied volatility, used to gauge the cost of options, tumbled for three-month contracts to the lowest level in at least 10 years on March 7, the day after the sale to Cerberus was announced, according to data compiled by Bloomberg. The drop shows traders are betting the Cerberus deal will go through without any additional bidders, said Alec Levine, an equity derivatives strategist at Newedge Group SA in New York.
“The options are reflecting the complexity of the deal structure and the fact that Kroger is unlikely to make a counter bid,” he said.
Kroger could instead look to “cherry pick” any stores that regulators require Cerberus to divest to satisfy anti-trust concerns, according to Jason DeRise, a New York-based analyst at UBS AG.
The chain contacted Cerberus about buying some Safeway stores it may not want, said a person familiar with the matter, who asked not to be identified because the talks are private.
Kroger can’t yet be counted out as a bidder for all of Safeway. It should try to outbid Cerberus to prevent the creation of a tougher competitor that could erode its pricing advantages, Karen Short, a New York-based analyst at Deutsche Bank, wrote in a March 7 report.
A bid of $35 to $37 for Safeway’s core grocery business, as much as $4.50 more than Cerberus is offering in cash, would add to Kroger’s earnings even before assuming any synergies, Scott Mushkin, an analyst at Wolfe Research LLC in New York, wrote in a March 7 report.
That could value the entire company, including the Blackhawk unit and proceeds from divestitures, at as much as $45 a share, implying an Ebitda multiple of about 6.3, still the lowest in a decade and the second-lowest valuation on record for similar deals, according to data compiled by Bloomberg.
Safeway isn’t likely to fetch a much loftier valuation in a sale now because of its operating setbacks and the shortage of possible bidders, according to Tim Carroll, a Chicago-based managing director in the consumer and retail investment banking group of William Blair & Co.
“I would be surprised if there was another bid,” Carroll said in a phone interview. “It makes a lot of sense for Albertsons to buy this for a whole lot of reasons. Let them do the work, get it integrated, put their operating style into the system and then if that works, it wouldn’t surprise me to see an IPO or maybe Kroger gets to look at it again down the road.”
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