Introduction

Fairway, the Company, is the famous high end New York City based and focused grocery chain that specializes in having a wide selection of gourmet items at lower prices than competitors such as Whole Foods (“WFM”)  aka “Whole Paycheck.” Fairway, the stock, is a busted IPO that went public before it was ready for prime time at $13 a share and quickly popped to the high $30s, where it was trading at an almost $1.6 billion valuation for a mere 15 stores and 39x 2014 Adjusted EBITDA. This valuation was obviously made possible by the success of comparable companies in the high end food and organic category such as Whole Foods ("WFM"), Chipotle ("CMG") and The Fresh Market (“TFM”).  The Company has massive operating and financial leverage as well as a financial sponsor that must exit at some point – most likely in a sale of the Company. The stock is a long at $6.77 a share despite its recent run due to m&a rumors.

Fairway’s Recent History and Ownership

Kvothe wrote an excellent short piece during the hype after the IPO which is what brought the stock to my attention as the valuation seemed stretched and the sell side analyst community was all in for the bulls.  Jefferies, to cite one bull turned bear, had a $30+ target and a buy and a few months after the IPO lowered the rating to a sell/hold and a mid single digits target – quite a switch for a business that did not change that much in such a short time frame.  So what happened to Fairway the business? The short answer is that the Company didn’t execute against an aggressive growth strategy and unrealistic expectations. After the IPO, Fairway proceeded to miss earnings estimates and the stock was driven down to $2 by the end of the year as tax loss season and high financial leverage took its toll. The simple fact is that most of the bear case came to pass. Comparable store sales missed in part due to competition and in part due to rapid expansion that created a format that did not optimize revenue and margins. I was short the stock until the high single digits and then started to look at the stock as a long.

The Company is controlled by Sterling Partners, a Greenwich based private equity firm, which bought a controlling stake (now approximately 30%) from the founding Glickberg family. While there were numerous insider deals with the founding family, those are also baked into current numbers and are in the past not the present.  It is not that unusual for a closely held retail chain to have separate family controlled entities that hold the real estate and other assets away from the operating business for tax reasons and family dynamics. These deals may have just been part of the cost of rationalizing the business for institutional ownership or to buy peace with the Glickbergs (think family members on the payroll etc.). Whatever the reason, the cost is a sunk cost in terms of current valuation and operating cash flow.  Margins should begin to trend upward as these deals roll off. The Company has also been criticized for private equity fees that are also a thing of the pre IPO past. The board compensation is heavily weighted toward restricted stock that has a 3 year cliff vest, which means that board members lose all their shares if they leave the Company before the end of term. At current levels, board compensation is low in terms of actual cash.  The bottom line is that both the board and Sterling have large equity stakes and have interests that are firmly aligned with public shareholders.

If Sterling was guilty of anything in running this business, it was buying into an overly aggressive expansion plan, which built out large box formats without an optimization strategy.  The previous CEO was fired for his sins as Sterling obviously can’t fire themselves.  To Sterling’s credit, they realized the need for adult supervision and brought in the current CEO, Jack Murphy, who was the Cofounder and CEO of Fresh Fields when Goldman owned it and merged it into Whole Foods– a home run private equity investment.  He has a lifetime of achievement in the grocery business, most recently at Earth Fare. At that company, he worked with Dorothy Carlow who he brought over to Fairway to be the Chief Merchandise Officer. She has been described by one insider,”as a marketer who knows how to manage the cash register.” Earth Fare was another grocery brand that needed to be turned around due to competition from Whole Foods and others.  I have met the team and spoken with board members about the process of bringing them into the Company and am convinced that they are the right people for the job of turning Fairway around. The CFO and COO are also impressive. This team is far stronger than one has any right to expect for a company this small.  I encourage VIC members to listen and read the Company’s PowerPoint presentation from the recent ICR conference (link).  It outlines their turnaround plan which is already bearing fruit as comps have stabilized and margins are improving. This improvement combined with an end to tax loss selling is part of the reason the stock has rallied off the $2 lows to the mid single digits. But in many ways the sock is a safer buy up here as the negative trends have been halted and are started to reverse– proof of life.

It is easy to focus on the negatives of Fairway as discussed above. However, the Company has many positives as well – a storied brand that is under penetrated both with its skimpy 15 store base and geographically (New York metro area focus). There should be many national chains that have an interest in acquiring the Company. Wal-Mart has looked at buying Gourmet Garage, which has a similar NYC area niche, and Kroger has repeatedly been mentioned as an interested suitor. It does not take much to imagine how the Fairway name and products could end up being a gourmet store brand to a national chain with thousands of boxes, a store within a store or even just a high end brand run separately from a national chain – that still reaps some of the benefits of scale buying power (one of the areas of low hanging fruit that Carlow mentioned in her early meetings was to join a buying cooperative to gain some pricing power in commodity goods like paper towels that they simply must carry). Deal Reporter wrote last week that the chain was being quietly shopped (and yesterday’s spike on massive volume indicates that someone believes it with gusto). While I have no doubt that Sterling would like to exit at some point (they sold about 20% of their holdings at $13 on an overallotment option on the IPO), they either were unable to or unwilling to sell shares in the post IPO range of $13-30 before the long slide to current levels.  By all accounts, Sterling appears to believe in the long term value of the franchise which may be good or bad depending on your point of view. For those who want a quick pop to $10 or so in a sale – which is doable, I wouldn’t hold your breath. For those who believe that Jack and Dorothy can do what they have done together before with Earth Fare and Fresh Fields – and fix a far better brand than they have had to work with before. I encourage you to look at the 8k when they were hired which details the heavy equity weighted compensation. So while the shorts (and I was one of them) were right that the stock was ahead of the business at the time of the IPO, that doesn’t mean that the operating vision of growing an under penetrated chain was necessarily wrong, just the execution.

There is other low hanging fruit on the execution side.  The distribution center was built for double the current 15 store count, but can be leveraged as the business grows again. Jack has said that there is no reason that market and the chain cannot be 100 boxes which shows you how big he is thinking.  The Company has the systems in place to give management the real time data they need to win at retail and manage costs. The Company simply did not use the data, which is better than not having it. Even though Fairway does not have national economies of scale in bulk items, it is able to purchase fresh meat and produce and other high end items in a cost effective manner – they have the same gross margin as Whole Foods but at lower prices to the end customer. Bloomberg’s business intelligence survey found that Fairway was the lowest priced grocery chain in NYC, which is their model to sell better quality goods for less. In Dorothy's view too many retailers are chasing Whole Foods in organic. She believes organic is overdone as a concept and quality of food is what matters.  In food quality (especially for the money), Fairway crushes Whole Foods and others. The Company has also wasted marketing dollars on traditional media. Dorothy is taking dollars away from traditional media to invest more in apps and in store promotions. Fairway has also lagged in the internet home/office delivery segment that Fresh Direct dominates and Amazon is chasing.  Taking back share in this segment will also be a focus. Finally even though Fairway private label goods are some of the best in the industry (think olive oil, balsamic vinegar, etc.), they have only 10% penetration of sales, another logical area of both sales and margin improvement.

Cash Flow and Valuation

Before diving into the numbers and the tables below, it is worth nothing the high multiples that growth consumer stocks can get once they start growing again. There are numerous examples, but look at the appreciation of Lululemon (“LULU”) over the past year after its fashion stumbles and CEO misstatements to see what can happen when a consumer growth stock that slips regains its footing. LULU is a pretty good comparison as its private equity partner, Advent, bought back into the stock (at vast multiples of their original cost basis) and helped right the ship. LULU trades at almost 20x trailing EBITDA. Sterling appears to be playing the same role at Fairway, making aggressive management and operational changes. Whole Foods and Chipotle also had their fits and starts, but buying the right consumer name when they slip up can be very profitable. The bottom line is that at current valuation levels, you are getting the company as it exists for fair to cheap value with a call option on growth and an eventual sale. Part of the benefit of a private equity controlled business is that their mandate is to exit eventually.

Through a combination of increased competition and cannibalization, Fairway comparable store sales have been trending flat to slightly negative since 2010, excluding the one time hit from hurricane Sandy in 2012.  That said, the Company has some of the most productive boxes in all of food retail with average sales per square foot of about $1,000 in line with Whole Foods and double The Fresh Market. Kroger does only $634. Gross margins have been fairly constant at about 32.5% over the past five years. S,G & A should also be relatively static as it was expanded for a larger store base than they currently have the resources to develop.  The Company has plans to build out five more stores over the next 2-3 years. Assuming average square feet of 40,000 and 1,000 in sales per square foot, each store should generate roughly $40 million of revenue per store, bringing total revenue to roughly $1 billion. Assuming a 32.5% gross margin which is the average since 2010, but 114 basis points better than last year’s debacle while keeping cash store expense constant at 19.5%, yields a 13.0% incremental store EBITDA margin. Under this methodology, Fairway should add $200 million in revenue and $26 million of store EBITDA margin that should all or mostly drop to the bottom line as the S,G&A and distribution center were built for a 30 store chain are leveraged. The Company generated $42.2 million in adjusted EBITDA in 2014. Adding an incremental $26 million in store EBITDA and getting the rest of the store base back to 32.5% gross margins (a 1.14% improvement or $9.1mm on $800mm in revenue) should drive adjusted EBITDA to $77 million in 2-3 years for a 7.7% EBITDA margin which is still below TFM and WFM, which are both in the 9-10% range due to greater S, G & A leverage. There is currently $218 million of net debt and the market value of equity is $293 million for an enterprise value of $511 million, so you are paying about 6.6x 2016/2017 EBITDA and about 12.0x trailing, which seems about fair value. According to Bloomberg, Whole Foods trades at 13.5x trailing EBITDA and 11.4x 2016 EBITDA and The Fresh Market trades at 11.5x trailing and 8.0x 2016 EBITDA. This valuation does not account for what could be saved in operating expense if the Company were owned by a larger chain or if they were able to grow the store base more rapidly. There is about $65 million of trailing S, G &A.  Assuming half of that would not be needed by an acquirer, my $77 million of EBITDA might look more like $110 million to the right buyer.  It is hard to see someone paying less than 6x that adjusted number or $659 million, less $218 of debt and that gets you $10.16 a share. A 10x multiple would be $1.1 billion or $20.27 a share. If no one buys Fairway and the Company can trade at the same 6-10x range of $77 million in EBITDA then the value would be between $5.63 and $12.73 a share. We are essentially on the low end of that range now despite the recent run. Basically. modest execution to a 20 store Fairway should get you a double in the stock without any deal as it should trade at the high end of the range.

The Company’s financial and operating leverage can also work in reverse.  If the Company can’t grow and EBITDA is stuck at $42.2 million or worse and trades at 6-10x then the range of value drops to $0.81 to $4.70 per share which is clearly what the market was projecting at year end. There is obvious risk in the status quo, the Company is leveraged about 5x and tight on covenants, though they have several options for cures should things grow tighter. The debt is relatively inexpensive for a Company this leveraged at LIBOR (with a 1% floor) plus 4% so repricing it or diluting common holders with a raise would be expensive, but doable. The pricing of the debt has firmed from the low to mid 80s to the $93-94 range after operations stabilized and the Company met year end guidance.  

It is worth spending a little time on the accounting here.  The Company uses many add backs to get to its adjusted EBITDA line. Each line item in its own right seems reasonable – depreciation, stock based compensation, IPO fees, etc. However taken in aggregate, there appear to be a lot of recurring non-recurring charges. But bank adjusted EBITDA from the Dec 31, 2014 10q is even higher than management’s at $45.6 million (vs. $42.2 million). So for what it’s worth, the supposedly conservative banks with almost 5 turns of leverage are using the roughly the same metrics – only looser.  Given the rapid growth and build out of S,G & A, the metric is helpful when looking at what steady cash flow would be if Fairway stopped expanding its store base.  My assumption is that to get to a 20 store base that Fairway after interest and CapX will generate little in the way of excess free cash flow though the new boxes will have a skinnier cost of build ($10 million or less).

The reason for spending so much time on Sterling and the new management team is that if they don’t execute, the stock is probably fairly valued here. However in this scenario, the chain will probably still be sold and it is hard to see it going for much less than current values. Taking out $32.5 million of S,G & A from current levels yields $75 million in pro forma EBITDA. I put a low 6x multiple on that number to get $450 million in enterprise value or $5.34 per share, but since every multiple point adds $2 in value so there is a bit of play. At 10x, you get $12.24 which seems like a stretch in a no growth scenario. The stock is a call option on a sale and/or future growth. If over the long term, Fairway can leverage its existing S, G & A (having it creep up 10% or so to $72 million and build out the incremental 15 stores to fully leverage its distribution center at $40 million of revenue per store and move up gross margins 50 basis points to 33.0% than EBITDA goes to $151 million. 6-10x that number yields a range of value for the stock of approximately $16 - $30 per share. That growth is what the bulls were thinking post IPO. They just paid too high a multiple on that hope. Today the horse has the right jockey to hit those numbers and you are not paying that high a multiple.

Financial Forecast

Valuation