Delhaize Group (DEG or DELB.BR)  

Summary

Our fund generally focuses on smaller companies with Ft. Knox balance sheets and large & sustainable free cash flow yields.  We are often seeking a mid-teens FCF yield or higher on an unleveraged basis.  The objective is for the sustainable FCF to eventually drive up the share price to a more reasonable valuation through share buybacks, debt reductions, dividends, or accretive acquisitions.  Obviously, it is important we have a management team that cares about shareholder value.

We think Delhaize Group (ticker is DEG in U.S. dollars) (ticker is DELB.BR in euros) is an attractive larger cap stock with an unleveraged FCF yield of 10%, a “Ft. Knox” balance sheet, and a stable, cash-generative business model.  DEG is a Belgium-based food retailer with almost two-thirds of its total revenues and adjusted EBITDA generated in the U.S.  The Company operates supermarkets in Belgium, the U.S. (Southeast and Mid-Atlantic as well as Northeast), Greece, Serbia, Bosnia and Herzegovina, Albania, Bulgaria, Romania, and Indonesia.  The Company retails both branded and private label nutritional and household products, among others.  The Company operates different supermarket brands and formulas:  Food Lion, Bottom Dollar Food, and Hannaford supermarkets in the U.S.; Delhaize, AD Delhaize, Delhaize City, Proxy, Red Market, Shop n’ Go, and Tom & Co. in Belgium and Luxembourg; Maxi, Tempo, and Mini-Max in Montenegro; Maxi and Tempo in Serbia, among others. 

In May 2013, DEG reached an agreement with Bi-Lo Holdings on the divestiture of its Sweetbay, Harvey’s, and Reid’s chains (165 total stores) in the U.S. for $265m or about 200m euros.  This transaction is expected to close in first half of 2014 and will further reduce net debt.   The sale of these non-core banners will allow DEG to focus completely on its highest return opportunities in the U.S. segment.

As we describe in more detail below, notwithstanding the well-known challenges that “traditional” grocery retailers in mature markets like the U.S. and Belgium face, we believe DEG is a tremendous cash-generating machine, which we think can sustainably generate 600m euros of FCF per year or more in the future, even after making very significant capital expenditures of 600m euros per year to maintain and even improve its competitive position.  Management has spent the last three years plus investing in lower price positioning in its flagship Food Lion brand in the U.S. as well as its other brands and we believe that lower prices are what customers want in the post-recession world.  There is solid evidence that its strategy is starting to take hold as indicated by stronger traffic and items sold and comparable store sales in most of DEG’s major banners in 2013.  In addition, DEG has a “Ft. Knox” balance sheet, which is among the least levered in the grocery industry.

A major attraction to DEG is its laser-focus on FCF.  This quote from the 2012 Annual Report highlights this focus:  “Strong free cash flow generation is a life blood of any business and Delhaize Group is no exception.  Facing the difficulties in 2012 and preparing for coming challenges ahead, Delhaize Group has emphasized the creation of strong free cash flow.  The important of this key financial indicator cannot be overestimated”.  A second quote by then CEO Pierre Oliver Becker shows management’s mindset: “In 2013, more than ever before, our focus will be on accelerating revenue growth and on value creation.  Further price investments, selective store openings and comparable store sales growth should result in an increased top line while a ruthless discipline in our capital allocation in combination with a new strategic cost plan and focus on free cash flow generation should result in value creation.”

We believe that during 2014 and 2015, DEG’s cumulative FCF could enable the Company to retire all of its net debt and be debt-free by year end 2015.  We believe DEG could increase its adjusted EBITDA to about 1.5b euros in 2015 and trade for 6x adjusted EBITDA or about 9b euros, or about 90 euros per share, versus today’s price of 50 euros per share (+80%).

(Please note, all numbers herein are stated in euros, unless otherwise noted; latest exchange rate is 1.35 U.S. dollars to one euro).

DEG’s store base is summarized below:

(1)     U.S. stores include Sweetbay, Harveys, and Reids store chains of about 150 stores, which are scheduled to be sold to Bi-Lo Holdings in the first half of 2014;  the remaining U.S. store base will include Food Lion, Hannaford, and Bottom Dollar Markets, with a total of about 1,350 stores.

DEG’s has three segments: U.S., Belgium, and Southeastern Europe, which are summarized below:

U.S. Segment

The U.S. segment (64% of LTM revenues and 66% of LTM underlying operating profit) is dominated by the Food Lion chain, which has over 1,100 stores located in the Southeastern and Mid Atlantic U.S.  Second is the Hannaford chain is located in Maine with over 180 stores in New England states.  Third is the Bottom Dollar Food chain is located in Philadelphia and Pittsburg and with about 60 stores.  DEG’s U.S. segment revenues were 14.6b euros in 2013. The Company’s stores are heavily concentrated in a handful of states in the Southeastern U.S. including North Carolina (507 stores), Virginia (312 stores), South Carolina (130 stores), Georgia (91 stores), and Maryland (79 stores).

Food Lion has undergone a major five-phase repositioning program over the past three years.  Over five separate geographic phases, DEG has significantly strengthened Food Lion’s value proposition to customers, in part by repositioning stores with reduced prices to provide the value that customers wanted.  Sales volumes at Food Lion stores which have been repositioned have been positive.  DEG has sought to develop a unique selling proposition at Food Lion shaped around Easy, Affordable, and Fresh.  DEG has focused on the opportunity to increase share of customers’ wallets by leveraging customer loyalty, proximity, small store format, and tailor cut promotions.  DEG has also sought to improve Food Lion’s variety and quality of assortment, fresh products offered, and consistent execution.  The Company has made similar targeted price investments at Hannaford chain and continues to refine the operating model at Bottom Dollar Food.

Belgium Segment

The Belgium segment (22% of revenues and 23% of underlying operating profit) represents DEG’s historical home market and at end of 2012 operated a multi-format network of 840 stores in Belgium and Luxembourg.  Belgian segment revenues in 2013 were 5b euros.  The Company’s market share in Belgium is about 27%.

The Belgium segment has faced key challenges of increasing differentiation, containing SG&A, improving performance of integrated stores, increasing market share, and dealing with an increasingly competitive landscape. In Belgium, the Company has sought to improve the shopping experience (Quality, Freshness, Assortment), store remodeling, improving the price image through price investments and private label brands, growth of the affiliated network, and ecommerce.  The Company is seeking to differentiate the store experience with 46 remodels over past two years and developing a new Proxy format.

Southeastern Europe Segment

The Southeastern Europe (SEE) segment (14% of revenues and 12% of underlying operating profit) includes the operations of Greece, Romania, Indonesia, and Maxi-operations in four Balkan countries (Serbia, Bulgaria, Bosnia, and Herzegovina).  In 2013, 3.2b euros of revenues came from the SEE segment.  The Company’s market share in Greece is about 17%.

The SEE segment is a potential source of growth for the Company, despite key challenges including difficult macro-economic conditions in SEE, integration of the Maxi chain (acquired in 2011) in Serbia, non-performing peripheral assets, and increased competition in Romania.  The Company has sought market share gains in Greece through price investments; gross margin improvements at Maxi due to supplier negotiations, larger private brands, and new distribution center; acceleration of growth in Romania; and divestment of peripheral assets.

The New Game Plan

In January 2010, the Company initiated a major strategic plan called The New Game Plan (“the Plan”) under CEO Pierre Olivier Beckers.  The Plan had three key elements: Growth, Efficiency, and Sustainability.  The Plan’s stated goal of gross annual cost saving of 500m euros by end of 2012 has been significantly exceeded.  The Plan also sought to strengthen brand equity in DEG stores through: a) price competitiveness; b) private brand; c) convenience through technology; and d) sustainability. The Plan had a strong focus on improving profitability and generating FCF.  Many unprofitable stores were closed.  Cost saving were largely reinvested in the business through more competitive prices offered to customers.  The table above shows the improving trends for comp store sales as a result of the Plan at the U.S. and Belgium segments, DEG’s two largest segments:

Under the Plan, Food Lion has been completely repositioned over the past three years, in five geographic and stated phases.  The first phase was in the Raleigh and Chattanooga markets covering about 200 stores in 2011.  Second and third phases were completed in 2012 and repositioned over 600 Food Lion stores.  Phase four was initiated in Q2 of 2013.  Phase five was the final phase and was initiated in November 2013.  Each of the five phases of repositioned stores showed positive comparable store sales in Q4 of 2013.  U.S. segment comparable store sales were 2.4% in Q4 of 2014, the fifth consecutive quarter of positive comparable store sales.

At Food Lion, with the store repositions, the Company has sought to develop a Unique Selling Proposition to differentiate Food Lion, emphasizing Easy, Fresh, and Affordable.  Easy includes proximity, small store format, quick shopping, and good experience.  Fresh includes the variety and quality of assortment and consistent execution.  Affordable includes tailored promotions and private brands.

The Plan and the price investments in DEG’s stores put pressure on margins and gross margin declined from 25.7% in 2010 to 25.4% in 2011 to 24.5% in 2012 as Food Lion and other chains invested in price.  However, gross margin stabilized in 2013 and was nearly flat at 24.5% as the reposition program at Food Lion and other chains started to be fully cycled.

Under the Plan, the Company also sought to reverse a ten-year increase of SG&A expenses as a percentage of revenues, from 20.7% in 2006 to 21.5% in 2013 estimated.  DEG has also had a major focus on free cash flow generation through capital discipline, focus on working capital, and strict cost controls.

The Company continues to execute the Plan with key priorities in the following areas:

• revenue priorities include strengthening its banners, targeted price investments, and accelerating organic growth;
• free cash flow priorities include disciplined capital allocation, working capital improvements, and target 500m of FCF;
• cost priorities include continued focus on reducing complexity and enhancing efficiency.

Delta Maxi Acquisition

DEG acquired Delta Maxi (“Maxi”) in July 2011 for close to 600m euros which included operations in Serbia, Bosnia, Herzegovina, Montenegro, and Albania .  Maxi operated approximately 350 stores in Serbia and was its largest food retailer.  Maxi operated approximately 450 total stores in Serbia, Bulgaria, Bosnia, and Herzegovina.  The Company combined Maxi with its existing businesses in Greece and Romania to help make it a leading player in the region, which has a stronger growth profile compared to the U.S. segment and the Belgium segment.  Maxi represented the largest acquisition undertaken by the Company in the past ten years.  Maxi’s acquisition has helped make the company a stronger regional supermarket player in the Southeastern European markets.

Competition

The food retailing industry is highly competitive and Food Lion competes against high-end stores like Whole Foods and Harris Teeter as well as price-oriented competitors like Wal-Mart.  The concern is that traditional supermarkets like Food Lion are stuck in the middle and losing share to both high-end and low-end players.  However, under The Plan, Food Lion has responded by seeking to reposition its stores as low price, with convenient locations, strong service, and high-quality produce.  In the Triangle area of North Carolina (Raleigh, Durham, Chapel-Hill), grocery market shares in 2011 were Wal-Mart 23%, Food Lion 19%, Harris Teeter 16%, Kroger 9%, Lowes Foods 6%, and Sam’s Clubs 5%.  (Kroger recently purchased Harris Teeter for $2.5b as discussed below).  Food Lion has traditionally been known as a low-price player in its markets and under the Plan has sought to reestablish this position.  We believe Food Lion has substantially reduced the price gap with Wal-Mart under the Plan with lower prices on about 6,500 core items in its stores while emphasizing smaller and more convenient stores and fresh produce.  In fact, Food Lion has actually run TV ads showing comparison prices against Wal-Mart.  We believe Food Lion has strongly improved its value-proposition to customers in the past three years and this should improve its competitive position.  Food Lion’s convenient locations are potentially a strong competitive advantage in its markets.

Attractive Valuation For A Stable Franchise

DEG is trading at about 50 euros per share and has about 101m shares outstanding for a market value of about 5b euros.  DEG’s net debt is about 1.7b euros for an EV of about 6.7b euros.  We believe this EV is very attractive considering the Company generated 772m and 670m euros of FCF in 2012 and 2013, respectively.  Although both FCF numbers include some working capital benefits, we believe the Company can sustainably generate 600m+ euros per year of FCF over the next three years.  We believe 2013 adjusted EBITDA is about $1.4b euros, so DEG is trading at about 4.8x adjusted EBITDA for 2013.  DEG generated cash from operations of 1.3b euros in 2013, so DEG is trading at 5.1x 2013 cash from operations.  Management is effectively deploying cash from operations in a more focused, profit-oriented, and FCF-oriented manner.  We expect the strong generation of cash from operations and FCF and the effective allocation thereof to become increasingly clear to shareholders during 2014 and 2015, resulting in a much higher valuation.

From 2009 to 2013, the Company generated cumulative free cash flow of about 3b euros or almost 50% of the current EV.  We note this is after spending about 3.5b euros on capital expenditures or about 2.9% of total revenues, which is consistent with other retail grocery chains.  We believe DEG will generate strong free cash flows of 600m+ in 2014 and 2015.

We believe that during 2014 and 2015 cumulative FCF could retire all net debt, leaving DEG debt-free by year end 2015.  Further, we believe DEG could increase its adjusted EBITDA to about 1.5b euros in 2015 and trade for 6x adjusted EBITDA or about 9b euros, or about 90 euros per share, versus today’s price of 50 euros per share (+80%).

Steadily Declining Net Debt and Improving Balance Sheet

With the acquisition of Maxi in 2011, DEG’s net debt peaked at about 2.6b euros at year end 2011.  Since this time, however, the Company has used its strong free cash flow to steadily and rapidly reduce its net debt position to about 1.7b euros estimated at year end 2013, representing a 40% reduction from the peak level of 2.6b at year end 2011.  We expect net debt to continue to decline in 2014 and 2015.  The sale of non-core U.S. food retailing assets to Bi-Lo Holdings for about 200m euros is expected to close in the first half of 2014.  We also believe the Company can generate FCF of at least 600m euros in both 2014 and 2015.  Based on these assumptions, we believe DEG could nearly be debt-free by year end 2015, or in less than two years. 

We believe the Company’s “Ft. Knox” balance sheet will give its Board steadily increasing options to enhance shareholder value through dividends, share repurchases, accretive acquisitions, or internal growth projects.  We believe management has been much more disciplined in capital allocation under the Plan and we believe this new mindset, combined with DEG’s “Ft. Knox” balance sheet and strong free cash flow, will eventually result in a much stronger stock market valuation over the next couple of years.

Strong Q4 Results

DEG reported preliminary Q4 results on January 23, 2014 and they were very solid.  Consolidated revenue grew 3.0% at constant exchange rates with solid Q4 comparable store sales growth in the U.S. segment driven by continued strong performance at Food Lion despite retail deflation.  Q4 comparable stores sales growth was 2.4% in the Belgium segment and -0.6% in the Southeastern Europe (SEE) segment.

For Fiscal 2013, consolidated revenue grew 2.6% at constant exchange rates and preliminary underlying operating profit was approximately 770m euros at constant exchange rates.  Fiscal 2013 free cash flow was extremely strong at approximately 670m euros at constant exchange rates.

Management noted that U.S. volume growth was positive and was especially pleased with Food Lion’s momentum.  The phase repositioning undertaken at Food Lion almost three years ago was meeting management’s expectations and management was looking forward to further developing the Food Lion customer proposition in 2014.

Q4 Segment Results Show Evidence of Turnaround

For the U.S. segment, Q4 revenues increased by 2.8% to 4.3b euros and comp store sales growth was 2.8% despite retail inflation turning negative (-0.4%) due to additional price investments as a result of Phase 4 in Q2 and Phase 5 in November at Food Lion and an overall low inflationary environment.  At Hannaford, both comp store sales growth and real growth were positive as a result of price investments and increased promotions, despite a more competitive environment in the Northeast.

For the U.S. segment, 2013 revenues were 12.9b euros or an increase of 1.9% over prior year in local currency due to comp store sales growth of 2.0%.

For the Belgium segment, Q4 revenues were 1.3b euros, or an increase of 2.5% over prior year, with comparable store sales growth of 2.4% mainly driven by retail inflation (2.1%) and solid year-end sales.

For the Belgium segment, 2013 revenues were 5.1b euros, or an increase of 3.0% compared to prior year, resulting from comparable store sales growth of 1.8% and network growth.  For 2013, Belgium segments market share remained stable compared to prior year at 25.5%.

For the Southeastern Europe (SEE) segment, Q4 revenues increased by 4.5% to 852m euros, due to positive comparable store sales growth in Greece and expansion in Romania, partially offset by negative volume growth in Serbia.  Q4 comparable stores sales growth was -0.6% for the segment.

For the SEE segment, 2013 revenues increased by 5.1% to 3.1b euros, mainly as a result of volume growth in Greece and store expansion in Romania, which added 103 stores.  Comparable stores sales growth was -0.3% for 2013.

Strong Cash Flow Generation and Solid Business Model

The Company’s retail food store assets have generated large amounts of free cash flow over the past five years and this is after significant capital expenditures to upgrade and improve DEG’s global store base.  (Capital expenditures have averaged about 640m euros per year or about 3% of total revenues, consistent with industry averages).  From 2009 through 2013, DEG generated about 3b in cumulative FCF or about 50% of the current EV.  Much of this was through an extremely difficult economic environment.  We believe the local market orientation, established customer base, and price-competitive focus of DEG’s grocery stores will protect its business franchise and FCF going forward.

The local orientation of grocery stores and the Company’s long established market locations and customer relationships help to create a steady business model which can reliably generate revenues, adjusted EBITDA, and free cash flow, even under adverse economic conditions.  It also helps create a barrier to entry for new market competitors who are forced to try to take business from entrenched competitors.

Major Reposition Program of Food Lion and Other Banners Creates Stronger Value Proposition

Food Lion is the largest and most important DEG brand with about 1,100 stores in the U.S.  Under The Plan, management has aggressively repositioned the entire store base of Food Lion in five separate phases. Food Lion stores which have been repositioned are showing consistently higher comparable store sales and profitability.  The repositioning plan has included simplified and improved operations and lower prices so that Food Lion is more of a price leader in its markets.  We think this strategy makes sense and since the recession consumers want low prices in addition to convenient and well-merchandised stores.  We think the Company will realize stronger market share and growth over the next few years as a result of the investment program Food Lion has undergone.  The repositioned Food Lion stores are seeing meaningful uplifts in transactions, volumes, and comparable store sales growth.  Customer feedback has indicates improved perception of service levels in the stores and variety in fresh produce and private label.  Perception of price has also improved.

Industry Consolidation Prospects/ Strong Acquisition Valuation for Harris Teeter

Kroger’s recent purchase of Harris Teeter indicates the potential value in the grocery business.  Harris Teeter is an upscale regional grocer with 212 stores concentrated in the Carolinas and Washington, D.C. areas.  Kroger paid $2.5b for Harris Teeter which had annual sales in 2012 of about $4.5b or about 55% of revenues.  Kroger paid about 8x Harris Teeter’s LTM EBITDA.  These valuations are well above DEG’s current multiples of 30% of revenues and 4.8x EBITDA.  Kroger cited consolidation savings opportunities by retaining the consumer facing portions of Harris Teeter’s business while consolidating back-office type operations to achieve expense savings.  We believe in the slow growth environment for grocery retailing in the U.S. there is likely to be further consolidation as the largest players continue to seek scale to achieve cost savings in the absence of revenue growth opportunities.  We think Food Lion and Hannaford may be good consolidation opportunities for other players.

2013 Results Provide Solid Momentum for 2014

The Company’s performance in 2013 was very solid.  The Company generated total revenues of 22.7b, underlying operating profit of 770m euros, and free cash flow of 670m euros, after spending 565m euros on capital expenditures.  We estimate adjusted EBITDA for 2013 was about 1.3b to 1.4b euros.  The Company also sharply improved its balance sheet during 2013 as net debt went from 2.2b euros at year end 2012 to about 1.5b euros (our estimate) at year end 2013.  Gross margin during 2013 was relatively flat versus prior year after declining in previous years and SG&A expense as a percentage of revenues was also held steady.  Operating performance improved throughout the year, as evidenced by the comparable store sales trends shown in the chart above in both the U.S. and Belgium segments, with the strongest performance in Q4 for both segments.  We believe this reflects the completion of the five reposition phases at Food Lion and similar actions in the Belgium segment.  Overall, we believe the Company has strong momentum into 2014 in all of its three segments.

Lastly, we believe impact on margins from price investments at U.S. segment and Belgium segment, which were felt in 2012 and 2013, will likely moderate in 2014 as all five phase repositions are completed at Food Lion.  DEG will also benefit from continued cost reductions and improved comparable stores sales results in 2014.

Excellent Potential for Share Repurchase or Dividends

DEG has not repurchased significant shares to date.  However, as DEG’s balance sheet continues to deleverage, we believe a major share repurchase program will be more seriously considered.  DEG’s strong cash generation and under-leveraged balance sheet give management several levers to drive shareholder value if its stock price remains depressed.

Accrued Employee Benefit Obligations

DEG had about 200m euros of accrued employee benefit obligations at year end 2012.  These represent retirement plan obligations primarily to existing and former employees.

Conclusion and Target Price

Based on 6x our adjusted EBITDA estimate of 1.5b for 2015 and a projected zero net debt position at year-end 2015, we believe DEG could trade for a market cap of close to 9b euros or about 90 euros per share versus 50 euros per share today (+80%).  If DEG’s food retailing assets perform as we expect, we think our target prices can be achieved.  Further, DEG’s assets are well-established in attractive markets and could be attractive to a strategic acquirer.