Stocking up on Supervalu

FORTUNE -- It's hard being a grocer these days. With consumers pinching pennies and Wal-Mart poaching customers, all the major chains have been squeezed -- none more than Supervalu. Sales at the country's third-largest grocery company -- which owns Shaws, Albertsons, Jewel, among other chains -- fell by 6% to $8.7 billion in its last quarter. Profits dropped 54%. And its shares have tumbled 52% over the past year.

The problem is that as grocers fight each other with price cuts, Supervalu (SVU, Fortune 500) has tried a Goldilocks approach: trim prices enough to attract shoppers, but not too much that profits get squeezed. It hasn't worked. Worse yet, the tough times come as Supervalu continues paying down huge debts from its $7 billion acquisition of Albertsons during the boom years.

A Supervalu turnaround may be a while off, say analysts, if it comes at all. But Tom Villalta of the Austin-based Jones Villalta Opportunity Fund is betting that the grocery chain can at least right itself -- and he expects to profit as it does. It's about being greedy when pessimism is high -- and Supervalu investors are plenty pessimistic.

"There are so many analysts that are negative on this company, that I can't help but think (earnings) estimates are skewed downward from what they should be," says Villalta, manager of the $6 million fund, which has beaten the S&P 500 (SPX) by 20 percentage points since its 2008 launch. Villalta's firm has also managed separate client accounts for more than a decade from Austin, Texas.

Indeed, as Supervalu's stock has plunged, analysts have given up hope: none of the 14 analysts covering Supervalu rate the stock a "buy." Its price to earnings ratio has fallen to 5.5 -- less than half that of its competitors like Safeway (SWY, Fortune 500) or Kroger (KR, Fortune 500). Villalta doesn't expect those competing chains to grow that much faster than Supervalu in coming years. Accordingly, he thinks once Supervalu stabilizes, its earnings multiple can rise from its distressed level -- helping boost the stock price.

And Villalta thinks Supervalu will eventually stem its losses. He expects earnings per share can grow by 1% over the next few years -- hardly a lofty goal, he contends.

In November, Supervalu kicked off a three-year improvement program to attract shoppers its currently losing to discounters like Wal-Mart (WMT, Fortune 500) and high-end chains like Trader Joe's or Whole Foods (WFMI, Fortune 500). It's being rolled out in phases across Supervalu's businesses, and includes initiatives like winning better prices from suppliers to cutting the number of items it carries. CEO Craig Herkert is leading the effort after being recruited in 2009 from Wal-Mart, where he was CEO of its Americas group. Supervalu is also expanding successful parts of its business, most notably its Sav-A-Lot stores. The chain carries mostly private label brands and heavily discounted national labels, and has been the one bright spot at Supervalu the past few years. So far this fiscal year, 79 Sav-A-Lots have opened and the company is on track to open 100 by the end of the year.

But Villalta says investors can profit from Supervalu even if you ignore its growth opportunities and focusing on its rock-bottom valuation.

To illustrate the point, he brings up a common valuation ratio called enterprise value -- simply a company's market capitalization plus any debt minus cash. Supervalu carries a lot of debt from its Albertsons acquisition, but as it aggressively pays down those debts -- it's repaid nearly $2 billion in the past two years alone -- its stock price would need to rise in value to keep enterprise value constant.

"Given where valuation is at the time," says Villalta, "even if company just stood still, the stock makes economic sense."

Villalta estimates that shares could fetch $18 to $19 in the next couple years.

"That sounds lofty, but where would it put it compared to competitors?" he says. In fact, Supervalu's revenues are nearly four times those of Whole Foods and yet the two command similar enterprise values. Furthermore, Villalta says if the stock doubled from current levels, it might mean Supervalu has no growth in earnings but is rewarded a multiple in line with its competitors. Or it has a minimal amount of growth, but continues to pay down debt and is rewarded with a steady enterprise value.

Either way, investors should profit. "It all ends up to looking like it has less downside risk than upside, he says. "And the upside is more than ample to reward the downside."