Description

Fleming is in the wholesale grocery distribution business and also operates
as a grocery retailer.It seems odd to recommend a stock that has gone from
under 10 to over 30 in less than a year , but I believe that in early '03
FLM will be a $60 stock .
The Fleming turnaround started with the hiring of Mark Hansen from Walmart
in November 98. The previous Fleming had a number of structural problems.
1 / On the wholesale side their costs were too high.The average dollar
volume per full line distribution centre was around $350 mn against the need
to for $500 mn plus to achieve an acceptable rate of return .
2 / Their distribution focus was wrong and out-dated.In 1998 77% of their
distribution sales were to conventional supermarkets .This was unfortunate
since this group was losing market share to both supercentres and to
convenience stores.
3 / Their retail effort was badly run and , again , occupied the wrong
space.
4 / Given their poor operating performance FLM's debtload was too large
placing the company under significant financial risk.
Hansen came in ,reviewed the business and set out the following goals .
1 /
Cut costs - This is central to his plans. His culture of thrift if executed
properly would allow FLM to pass on lower prices to customers and to cement
pricing advantages for their food 4 less stores ( more later ).
2 / Change the sales mix on the wholesale side and refocus towards growing
sectors.
3 / Shut down their conventional supermarkets and focus on what they call
their price impact formats .
A strategic plan was put in place that is now well under way, and
which required significant charges in 1999 and 2000. The last of these
charges will take place in 2001 and should amount to around $ 20 mn.IMO the
FLM that emerges bears no resemblance to the FLM of old , and has very
visible growth potential that is not yet reflected in the stock price.
So how has Hansen done in terms achieving his goals?
1 / Cost-cutting :
2000 was really the year when the changes started to kick
in.The core of this was a move towards centralised procurement.FLM believe
they have what is now the second largest purchasing location in the country
.With this comes lower costs.
The second key plank was to improve productivity in the distribution
centres.Partly this was achieved through consolidation into larger
facilities as sales per distribution centre rose from $389 mn in 1998 to $
550mn in 2000 and should be around $635 in 2001. Average sales per full-line
distribution centre associate rose from $1.22 to $1.37 .Total distribution
weight per load also improved meaning that total operational expense as a %
of sales dropped 36 basis points from 7.43% to 7.07% between 1998 and
2000.To take this to the next level FLM took a look at their distribution
facilities and decided to further refine their approach to encompass what
they believe is a unique 3 tier distribution system.
1 / These are facilities designed for slower turning SKU's that turn at less
than half the speed fo regular groceries.These carry aroud 18,000 SKU's.
2 / Specialised centres that carry around 8,000 SKU's and focus on the
special needs of convenience store operators .
3 / Flow through centres which are designed for top speed.With almost no
storage or handling involved vendors goods come in are loaded into a
distribution lorry and sent straight out.
In locations where this system is in place it has achieved good
results.The upshot of all this is that total selling and admin expense as a
% of sales declined 77 b.p from 8.67% in 1999 to 7.9% in 2000.In the first
quarter of 2001 the good news continued :
1 / selling and admin as a % of sales fell to 7.42%.
2 / on an annualised basis inventory turns rose to 21 x from 17 x in 2000
3 / Operating income as a % of sales rose to 1.84% from 1.52% in q1 '00.
In the conference call on May 9 Hansen said that he expected these
trends to continue because (a) they had not yet fully gone over to central
procurement and (b) they had not yet fully rolled out the 3 tier
distribution system.First quarter EPS were 41c vs a street concensus of 34c.

The second major thing that Hansen wanted to do was to grow and change
the mix of the wholesale business.In 2001 the share of traditional
supermarket sales will be about 50% down from 77% as recently as 1998.This
is important because it is estimated that the market share of this group
will decline 12% between 1995 and 2005.The biggest reason for this change in
business mix is the $4.5bn ( 3.2 bn incremental ) deal to supply K-mart with
substantially all of their groceries .This is a 10 year deal .This will
probably be extended to include $1 bn of health, candy and tobacco
products.FLM estimates investment requirements of $200 to supply K-Mart ( 50
mn capex , 150 mn working capital ).FLM estimates that by 2003 this deal
will produce $180 mn in savings , of which $120 will be passed on to other
customers via lower prices.How will these savings be achieved? I spoke to
the company about this and they gave me a whole series of things but a
couple of examples should make the point: firstly , this will provide a
perfect opportunity for Fleming to employ inventory efficient flow-through
techniques ;again, part of the deal was that K-mart would abandon its own
private label and adopt FLM's private label.This is important because for
FLM the margins on these sales are significantly higher.On top of this it
allows them to reduce their SKU count because they no longer have to store
KMart private label items which had often sat in warehouses for long periods
of time.
Another benefit of this deal is that it gave FLM the opportunity to
expand their business with other customers.By using K-Marts buying power in
general merchandise FLM is in a position to pass these savings on to other
customers. The wider deal encompasses tobacco , candy and health and beauty
products all of which are very important to convenience store operators.
This is a sector that FLM is vigorously persuing. It is about a $40 bn
opportunity with only 1 major player .It still has organic growth and FLM
believes that it can take $4 bn of this market over time.The recent purchase
( mildly accretive ) of convenience store distributor Minter-Weissman is an
attempt to kick-start this process.
The K-Mart deal attracted a fair amount of criticism in some quarters.
1 / It was claimed that FLM did not have the geographic scope to execute.
This has been addressed by recent purchases/ leasings of warehouse
facilities in Fort Wayne , Grand Rapids and New Jersey.
2 / The second claim was that even if FLM had the geographic scope then
logisically it would not be able to execute.Fair comment given everything
going on at the company BUT
(a) They have been planning thia with KMart for over a year and both
parties were pretty confident.
(b) Although this raised the scale of their wholesale business from $11bn
to $14.5 bn ( $17 bn by end 2001 ) the facilities are large enough to
accomodate $28 bn of sales .-( this extra volume capacity requires little or
no cap-ex so there is good operational leverage here ).
(c) Most importantly in the first quarter FLM started supplying the KMart
contract from 6 of its distribution centres with no major problems .They are
on track to complete the whole conversion on time and are very confident
that this will not be a problem for them.
3 / Another criticism was that the deal made FLM very dependant on one
customer whose record has not been stellar of late . Again , fair comment
but in riposte even KMart has not managed to shrink its sales over time
.Also IMO the new management seems to be doing a better job and it may well
be that KMart can prove a blessing in disguise if it can get its act
together .More conservatively , I am comfortable projecting flat sales for
KMart going forward.
FLM management is projecting 3-4% organic growth going forward but I
suspect that they can do a little better than this over the next decade
.This is a highly fragmented business .At year end 2000 despite being the
2nd largest player FLM had only 10% of the wholesale distribution market
.Being the low cost wholesaler it is not too fanciful to imagine them taking
a little more market share over time.
Now comes the exciting part! As mentioned earlier FLM will have exited
the supermarket business by the end of Q2 '01. Instead they are focusing
their attention on what they call price impact stores.These are low price
stores that carry a narrower assortment of goods than traditional grocery
stores ( 13-15,000 sku's versus 25,000 ).They are very spartan in design
with goods being offered to the customer still on the palate .The economics
of this business are great and can best be seen by way of comparison with
traditional grocery stores.
Price Impact Coventional
cost to build $6mn (2mn inventory) $8mn
average weekly sales $450,000 $325,000
ebitda per week $29,250 $22,750
average sku's 15,000 $30,000
Generally these stores offer prices 10% lower that the nearest large
supermarket competitor. Their prices are comparable to a Wal-mart.Wal-mart
is clearly the big guy on the block in this market and the obvious question
is how are FLM going to compete if they come after them .The first answer is
that FLM are so small it is not worth Wal-mart bothering with them.At year
end 2000 FLM had only 30 price impact stores. Their intention is to take
this number up to 130 by the end of 2003. The small store base is important
because it means that FLM can pick and choose their spots in the early years
.Over time , they think that there is market potential for 400-600 of these
stores.If the business ever approaches that scale they will inevitably come
face to face with Walmart in a great many locations. Management , while
recognizing the threat ( Hansen is ex Wal-Mart ) is quite sanguine about the
prospect .They point out that their prices are as cheap as anyones , and ,
more importantly , by emphasizing meat and fresh produce as much as they do
in their Food 4 Less format their business is differentiated. As evidence of
this management points out that in areas where they do currently compete a
Wal-mart their stores hold their own and perform in line with other FLM
stores.IMO this concept has great growth potential and the best part is we
already know it works. Going forward this will be the driver of earnings and
, if management executes , could deliver strong growth fo the next 5 to 10
years.
Valuation:
Unlike a lot of other stocks reviewed in VIC this is not a
stock that immediately jumps off the page and looks screamingly cheap. To
believe in this you have to believe that management can suuccessfully pull
off the K-mart deal and roll out their price impact stores. I am prepared to
make that bet. In terms of EPS management guidance is for $1.96 in '01 ,
$2.55 in '02 , and $3.30 in '03. Goodwill amortization will be around 50c in
'01 and a touch less going forward .Adjusted EPS ( that is backing out
strategic plan restucturing charges) have gone from 85c in 1998 , to $1.12
in '99 , to $1.56 in 2000.If current forecasts are correct ( and I believe
they will be low )the growth rate out to 2003 will be about 30% .And that
growth should be set to continue.At that point there will only be 130 price
impact stores .So what will the market pay for this? I believe that at the
end of '02 ( with another 18 months of progress to improve visibility ) that
the market will give this company a relatively modest 15 multiple of 2003
estimates of $ 3.80 ( assuming elimination of goodwill amortization ).This
suggests a stock price of 57 from todays 31 .Ultimately, this may prove to
be just the start .IMO this has a chance of being a 10 year home run where
we get strong earnings growth and a rerating to a growth stock multiple over
time.
Risks:
1 / Fleming is heavily indebted .Fleming has always carried a lot of debt
.Over time , new management intends to reduce the degree of leverage in the
balance sheet , but in the short term as FLM pushes ahead with the plans
outlined gearing may rise somewhat more .At the end of Q1 shareholders
equity stood at $493 mn while long-term debt and capitalised leases stood at
$1.7 bn .However EBITDA coverage in Q1 stood at 2.63x , which seems
comfortable given the improving picture .In light of this improving picture
FLM has been able to reschedule some of its debt on more favorable terms and
has received upgrades from Moodys and a change in outlook from stable to
positive from S&P.
2 / Inability to implement the K-Mart deal.
3 / The company may not be successful with further price-impact rollouts.
4 / Management may spread themselves too thin.This is probably the biggest
risk.There is a huge amount of change at this company ,and a lot of moving
parts. IMO this is because there is such clear opportunity , but this much
change always entails risk.

Catalyst

As the strategic charges drop out and the picture becomes clearer I believe
that the market will re-rate this company .In 5 years time it is quite
possible that the market will grant this company a true growth stock
multiple.