I recommend a short position in Fairway Group Holdings (FWM) for a potential return of 24-60%. FWM is a grocery chain focused on selling fresh produce, organic products, and conventional groceries in the New York metropolitan area. FWM’s former PE sponsors, Sterling Investment Partners, took FWM public in April 2013. Sterling and the management team used the IPO proceeds to pay preferred stock dividends and raise cash to finance expansion. FWM has positioned itself as a specialty food seller on the cusp of a fantastic growth story buy tying itself to the nascent, but crowded organic food trend. The bloom is off this organic rose and the market has steadily and swiftly knocked the stock from $25 down to $14.49 since it reported a pedestrian 1% same store sales comp on November 7^th. The stock is down 20% YTD (it has sold off much faster than I could put together a write-up) and is 10% from its IPO offer price (priced at $13 and closed at $17.35). Despite the recent price action, FWM is still priced for perfection, but its growth prospects are not as alluring as they might initially appear.

Corporate History

Depending on which press release you read, Fairway was founded in 1933 (according to SEC filings) or 1940 (according to media articles regarding Sterling’s acquisition in 2007) by Nathan Glickberg on Manhattan’s Upper West Side. Sterling bought an 80% stake in early 2008 for approximately $150MM with an eye on expanding beyond the company’s four stores. Today there are fourteen stores in New York, New Jersey, and Connecticut, and the company plans on opening four more stores by the end of 2015. Sales per square foot has steadily fallen as FWM has expanded to locations with larger footprints – urban formats are approximately 40,000 sq ft (gross) and suburban formats are approximately 60,000 sq ft (gross). This trend will continue to adversely affect comps and FWM’s growth trajectory.

Growth – Without the Hormones

Although FWM has reported 17-20% annual revenue growth, this growth is driven by new stores. Existing stores very much resemble other grocers with their 32% gross margin (WFM = 36%, SFM = 30%, TFM = 34%) and 1-1.5% comps. It is unclear why FWM should trade at such a higher forward multiple (37x):

Perhaps it is their growth plan, which Charles Santoro, the chairman and Sterling partner, so modestly described in the Q4 conference call:

“Since 2007 we believe we have approximately tripled our market share in this area and still have an extremely large runway for near-term growth representing potentially multiple times our current size. Our broader surrounding market from Boston to Washington DC represents some 65 million people and approximately one-quarter of all US GDP. We believe we can successfully operate at least 90 stores in this Northeast corridor alone comprising a potential $4 billion to $5 billion market opportunity for Fairway. Longer term we believe our Fairway brand and differentiated platform has very strong national appeal.”

He probably also mentioned India and China, but maybe the COO put his finger on the mute button? Capital intensive businesses predicated on distributing perishable (farm-to-shelf!) products do not scale easily or quickly. In fact, FWM only just recently signed a lease to build a central production facility in the Bronx.

So where is FWM building their stores? FWM is pursuing a two-pronged strategy of selling into urban neighborhoods like Chelsea and Hudson Yards (near the High Line for those familiar with the area) and up-and-coming middle class suburban neighborhoods. The recently opened (Oct 2013) Chelsea store has not exactly panned out as management imagined. Although they are pleased with the transaction count, the average basket size is quite low and seems to be used by the grab-and-go crowd. The high turnover is good for the business, but optimizing the SKU count and product mix will be a near term challenge and likely weigh on sequential comps.

Back to the suburbs. The suburbs present the obvious and inevitable growth opportunity, but the New York metropolitan area is an exceptionally competitive region. In addition to conventional grocers that generally don’t operate in urban areas, better capitalized and stronger brands (e.g. WFM) have already scouted and leased the best real estate. I mapped out Whole Foods’ tri-state area stores and you will notice that they have surrounded NYC and are already in towns with the demographic profile most likely to eat fresh produce and organic food:

It’s not like Whole Foods is going to stand still while FWM grows. Perhaps this is why Fairway shoppers have the pleasure of shopping next to a scrap metal plant in Stamford, CT:

FWM’s growth strategy is not aggressive enough to justify its 37x 2015E multiple. The math is straightforward. FWM plans on opening 2-3 stores per year, but its growth rate will fall as the retail base grows. The new central production facility and SG&A investments will support higher EBIT margins in the future, but top-line growth will also fall as the store mix skews towards suburban formats. FWM’s urban formats are quite successful and have contribution margins of 18.5% compared to 11.5% for suburban formats.

Is Fairway Winning Hearts and Minds?

Presented without comment:

Herbert Ruetsch (Chief Executive Officer): The thing that is most interesting to me -- Charles mentioned we tripled our likes on Facebook. Our likes on Facebook match up with Whole Foods, who has -- in the New York area, who has a long, strong presence in social media. So we're making extraordinarily quick progress here and we're very excited about it. And it's a lot more productive than using paper, radio and some of the traditional forms of media.

Charles Santoro - Executive Chairman: And I would also point out, our Facebook engagement is multiples of what our competition is. [indiscernible] more store base.

Related Party Transactions / Corporate Governance

Generations of Glickbergs are all over the SEC filings. Howard retained a 20% stake in Fairway after selling the majority stake to Sterling and exacted some delicious concessions. Howard maintains an ownership interest in several of the properties that lease space to FWM. He currently serves on the board and is the vice chairman of development and reports solely the board of directors. Below is a table of payments to Howard (note that preferred dividends and the IPO bonus are one-time payments):

If this idea interests you, you might notice that I calculate EBITDA differently than the adjusted EBITDA that FWM reports. My EBITDA calculation is standard and based off GAAP measures, but FWM’s EBITDA bridge adds back store opening costs and whatever else they can consider either non-core or non-recurring. I also chuckled when they referenced 4-wall EBITDA as the numerator in their ROIC calculation.

Anecdotes from Shoppers

Yelp provides good insight into how FWM is perceived by its shoppers. In general, shoppers like going to Fairway and are impressed with the selection of produce, cheeses, and coffee. If shoppers post a negative review, it is often because of poor customer service or the general atmosphere of the stores. Complaints about the atmosphere and other shoppers are more likely to occur in urban format stores.  

I shopped at the Stamford store as part of my due diligence. I was quite impressed by the produce display and selection. Prices for produce were slightly higher than what you would see at an average grocery store, but less than at Whole Foods. A significant difference between Whole Foods and Fairway is that Fairway offers “normal” brands and would have cross-over appeal to customers who aren’t shopping to buy organic. However, organic insensitive customers would not have much reason to shop at Fairway unless it was the closest option.

Unfortunately, I did have a bad experience in the liquor store, which is a feature at some suburban formats. I saw that they were selling Founder’s Curmudgeon (highly recommended), which was a quite a surprise because it not widely distributed and is only sold from April to June. Also, the beer was not refrigerated. Amid my excitement, I overlooked these details and spent $25 on two 4-packs. I later called Founder’s quality control coordinator and he told me that I bought year old, unrefrigerated beer.  The QC guy said he would follow up on why it was improperly stored.

Valuation

Much like SFM, FWM’s valuation is one of many 2013 IPOs leaves me scratching my head. Although I don’t like to short growth/glamor stocks with a discernible catalyst, my model output is crazy and without the massaged and adjusted EBITDA numbers the Street is modeling, this is terribly overvalued. The continued sell-off leads me to believe that the re-pricing is continuing to play out and that a lower growth multiple is justified.

Risks

Sterling is a control investor and there is no specific event driven catalyst. The low public float could ignite a short squeeze. Currently the borrow is quite reasonable (< 1.5%), but availability might be tight.