Food has a reputation as a product that is not only recession-resistant, but certifiably recession-proof. No matter the state of the economy or point we are in the business cycle, people have to eat.

Of the traditional grocery chains, Kroger (NYSE: KR) is the largest player, with a single-digit market share, and has done a solid job of maintaining profitability in the face of intense competition. It has focused on growing internally and keeping operating costs low, which it passes on to shoppers in the form of lower prices. The company constantly remodels stores too, but this eats too much into free cash-flow generation and as a result, it doesn’t have much investment appeal.

SUPERVALU Inc. (NYSE: SVU) took a different approach and attempted to acquire its way to scale and higher profitability. Back in 2006, it bought out archrival Albertson’s in a $17.4 billion deal that was funded with more than $7 billion in debt to become the second largest industry player. With the benefit of hindsight, the deal was ill-timed, as it occurred just as the economy was heading into once of its worst recessions in decades.

The move nearly doubled sales, which hit $37.4 billion in 2007. Sales rose for a period after the deal was completed but they have been on a downward trend the past couple of years. For 2010, sales are projected at $37.6 billion and could fall below 2007 levels by 2011. The near-term issue is that same-store sales are falling at existing stores. This is attributed to a lack of remodeling of older stores and higher prices from the more disciplined players cited above.

I don’t mean to be negative, but this is a company with some issues to work out. In particular, challenging current fundamentals and a hefty debt load have sent this stock into the bargain bin. But at less than six times earnings, significant upside exists as its food sales are still relatively stable and it can sell non-core divisions to pay down debt. The firm also remains cash-flow positive and sports a high dividend yield. In short, at the low valuation, the potential rewards outweigh the operating risks.

There is no question that the hefty debt load taken on to acquire Albertsons has hurt. It leaves SUPERVALU with less ability to remodel stores and lower prices. Debt is currently more than 90% of total capitalization and is considered excessive when the ratio gets higher than 60%. Debt and negative store performance are two of the primary reasons that investors have largely abandoned the stock. The share price has drifted below $10 per share and is at its lows for the year. In fact, the stock it at its low point over the past 12 years and has plummeted from more than $40 per share before Albertsons was acquired.

Overall though, debt levels remain very manageable and SUPERVALU is still generating a lot of cash flow because many of its stores are still operating decently. Last year, it generated more than $1 billion, or about $4.73 a share in free cash flow. This leaves plenty of capital to pay down debt and also pay a generous dividend yield of almost 6.0%.

Management is also well aware of its operating challenges and is addressing them. It is cutting spending to core necessities and also cutting back on capital expenditures by not opening new traditional grocery stores. Instead, it will focus on remodeling older ones and opening new Save-A-Lot stores at the discount end of grocery store chains. Wal-Mart (NYSE: WMT) has proven that value pays no matter the economic climate, and SUPERVALU is focusing more on this strategy.
 
Finally, SUPERVALU is selling non-core assets to generate more capital. It operates a food distribution business that competes with privately-held U.S. Foodservice and Sysco Corp. (NYSE: SYY). The group posted almost $9 billion in sales last year and could potentially be sold for billions. Sysco trades at an enterprise value-to-sales ratio of 0.5 and suggests a potential value north of $4 billion for SUPERVALU’s supply chain operations.

Action to Take —> SUPERVALU will need to see a sales rebound to stem the slide in its share price. The market is waiting for an inflection point for sales, so all it has to do is stabilize for a quarter or two for investors to start returning to the stock. If it can, the stock could easily double from current levels.

And there is even further upside: the forward P/E multiple is less than six, practically in the bargain-basement. The P/E averaged 16 in 2006 before the merger and only needs to return to 12 for the stock to double. The dividend yield can’t be counted and I would be happy to see management cut it to focus on paying down debt, but it is easily covered by cash flow production. In other words, there is potential for SUPERVALU’s stock to bounce back big from its current lows.

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