Description

Summary of thesis:

PriceSmart (NASDAQ: PSMT) is a far of the radar company that operates a superb business in niche markets. At current levels, I believe an investment in PSMT offers a very attractive risk/reward profile for the long term value investor.

Simply, PSMT is a membership warehouse club retailer that operates in the Caribbean Islands and various Central American nations. For reference, PSMT was written up in early 2006 and that write-up provides a solid overview of the company, and where it stood at the time. Three and a half years later, PSMT is in a very different place, but again presents a compelling investment opportunity.

Despite an almost $500mm market cap, PSMT is covered by a single analyst at a two man shop (Kansas City Capital Associates, affiliated with Oppenheimer and Co. for trading/execution purposes). The analyst began covering the stock somewhat incidentally after holding the stock in his PA, and is a generalist / special situation focused, not a retail specialist. PSMT does not host conference calls, does not attend investor conferences, and offers little commentary in its earnings releases. In short, PSMT is run like a private company and is largely treated as such by Wall Street.

At the current valuation - 10x normalized after-tax pre-growth CapEx FCF with no net debt on its balance sheet - I believe an investor pays nothing for same store sales growth, new store growth, expansion into new markets, or the highly likely scenario that the end game for PSMT is a buyout by WMT, a major European retailer, or an enterprising financial buyer. All of those are free, along with a 3% dividend yield to boot. Controlling shareholder / CEO ownership of ≈50% should inspire confidence in sound stewardship of the company.

Business Description:

PSMT owns and operates US-Style membership warehouse clubs in Latin America and the Caribbean. The company was founded by Sol and Robert Price, founders of the Price Club (later merged with Costco) - the first membership warehouse club in the US. Robert Price continues to act as CEO of PSMT.

PSMT operates 26 warehouse clubs in 11 countries and one US territory:

PSMT's markets are characterized by a heavy concentration of small businesses that lack sufficient buying power to allow direct purchase from suppliers. For those small businesses, PSMT acts as their primary supplier of inventory. PSMT also sells to individuals looking for large quantities of high quality products at low prices.

Competition:

In all of PSMT's market, the company is the only operator of membership warehouse clubs. When expanding in new markets, PSMT maintains that same standard. In its existing markets, PSMT competes primarily with local establishments, as well as a consortium of supermarkets and hypermarkets owned by WMT through a JV venture. From speaking with industry insiders, my view is that PSMT possesses an extremely strong competitive position in its markets.  

Strategic assets:

PSMT has two key strategic assets, fortifying the company's competitive position and likely making the company more attractive to potential acquirers:

• 1) Membership base: PSMT has ≈640,000 accounts and more than 1,000,000 cardholders. Those accounts represent a loyal customer base that pays an annual fee for the right to shop at PSMT stores. In Costa Rica alone, PSMT has ≈120,000 accounts and ≈200,000 cardholders. Somewhat related, PSMT's stores occupy prime locations in their respective markets.
• 2) Miami distribution facility - export/import infrastructure: PSMT has developed an automated system for the registration of the products it exports from the US and imports into the various countries where its stores are located. Largely all products leaving the US and entering PSMT's countries of operations require documentation and registration for export/import - the processes involved therein can be laborious and costly. Based on conversations with industry insiders, it appear PSMT's system has streamlined this process to a degree potential competitors would have much difficulty matching.

Why the opportunity exists:

Aside from the relatively obscurity of the company, the relative illiquidity of the stock, and the fact that the company had to close one of its Honduras stores for a day recently due to a military coup, the present opportunity in the stock exists for two reasons:

• 1) Same store sales growth has slowed significantly, and the company may soon put up a negative SSS number
• 2) Q209 earnings came in slightly below expectations

With regards to the weak SSS numbers, I believe it is purely a function of the weakening economy in PSMT's markets, and not reflective of any loss of market share. To be sure, SSS were not terrible for the most recent quarter - at +6.2% any domestic retailers would be envious. However, PSMT had been comping at strong double digits for a few years, and the company's June number of +1.4% certainly spooked some people.

With regards to disappointing earnings, I believe headlines indicating an 18% decline in net income resulted in investor overreaction. Q208 numbers benefited from a $2.0mm expense reversal, benefitting EPS by $.07. However, on a normalized basis Q209 operating income was $.2mm higher and Q209 EPS was $.01 better.

Growth prospects:

Earlier in the company's history, PSMT was considered a high growth entity, potentially comparable to COST. In recent years, PSMT has added new stores on a very limited basis and the market has accepted that PSMT is not going to replicate COST's growth in international markets. However, the pendulum may have swung too far to the other side, with the market now assuming that PSMT possesses zero potential for growth.

PSMT's CFO views the company's growth prospects as limited. He expects PSMT will be very selective in adding new stores within its existing markets, and he is oft to quote Sol Price's support of "intelligent loss of sales" - i.e. PSMT has no designs on unprofitable growth. While limited growth potential does cap the potential upside for PSMT equity, I believe that the company's position and philosophy also provides investors with assurance that the company will not allocate capital towards ill-ventured growth initiatives that may destroy value.  

Certain industry insiders have a somewhat 'conspiratorial' view on PSMT's public position towards growth. Their view is that PSMT takes the public position that store growth is limited in order to communicate two messages to potential competitors: 1) Do not enter out markets as they cannot absorb additional capacity; 2) If you have thoughts of entering our markets, you are best off simply buying our company. Plainly, these industry insiders believe that PSMT's public position is disingenuous and that it is quite likely that there is substantial capacity for additional stores.

PSMT has outlined some specific growth plans: the company is likely to open a new store in Trinidad late in calendar 2009 and may open a new store in the Dominican Republic in 2010. Management is also looking at opportunities to expand the square footage of existing stores.

PSMT has stated its intention to explore the Colombian market. The purchasing power of Colombia is roughly equal to the purchasing power of all existing PSMT markets combined. The company will experiment in Colombia prudently, likely with a single store; however, should it prove successful, there exists the potential for very material growth in the market. A potential obstacle to success in Colombia is the lack of a free trade agreement between the US and Colombia.

Additionally, PSMT still floats the idea of pursuing opportunities in Ecuador and Peru. However, the company has no interest in entering Brazil where WMT already has a presence with Sam's Club.

Supposing that PSMT does have growth opportunities, the company has the balance sheet to finance new store growth and returns on capital employed are very attractive: construction of a new store costs PSMT $10mm-$15mm. Assuming the midpoint of those numbers, average store revenues of $50mm, and baseline operating margins of 4.5%, pre-tax unlevered returns on capital employed are north of 20%.

In reality, there is certainly a build up phase as a store matures; however, incremental operating margins on new stores are likely to be higher than 4.5%. The business model of PSMT - similar to COST and WMT - is aimed at leveraging their fixed cost distribution and other SG&A costs with additional sales at existing and new stores.

With the basic assumptions outlined above - and assuming news stores are all equity financed - each new store adds ≈$.05 in EPS and ≈$.06 in FCF.

With regards to a potential acquisition by a competitor, for years there have been rumors that WMT was interested in buying PSMT. I asked the CFO the question directly - would it make sense for WMT to acquire PSMT? His response, in essence, was that if WMT wants to enter their markets in a warehouse club format, they have the option to build or buy. He doesn't see the sense in WMT trying to build from scratch. In 2005, WMT acquired local operations in Guam, Honduras, and El Salvador - evidence that the company is surely interested in the region. PSMT's market dominance and the strategic assets of its membership base and distribution infrastructure should make it an attractive target for WMT.

Other industry people have said various large European retailers might be interested in PSMT. Alternatively, an enterprising financial acquirer could find opportunity with the company.

The basic point is this - a successful investment in PSMT is not at all dependent on the view that the company will be acquired. But with the Price family holding 50% of PSMT shares and Robert Price age 66, there is a distinct possibility thereof.  

Valuation:

The table at the beginning of the write-up highlights the key valuation metrics for PSMT.

Importantly, NOPAT understates true economic earnings of PSMT insofar as maintenance CapEx  materially outstrips D&A - maintenance CapEx is only $5mm-$6mm vs. D&A (for LTM period) of $12.7mm. Currently, PSMT pays a dividend of $.50 annually; however,  the CFO expresses no reservations of running the company for cash - assuming zero growth opportunities are identified - and increasing the dividend accordingly. On a pre-growth CapEx basis, PSMT trades at 10x FCF.

Given the quality of the business and various opportunities for earnings growth, I believe PSMT is very attractively valued at current levels. Simply, 11.5x LTM NOPAT and 6.5x LTM EBITDA for an unlevered business of PSMT dominance and quality is quite compelling. The stock is not dirt cheap; but the soundness of the enterprise, the strength of the balance sheet, and the strategic attractiveness of PSMT to various potential suitors provides what I believe to be a substantial margin of safety.

I can't apply a precise target, but I can say that I like to own the stock at $16, and I feel that the odds are with me that I make a good return on my investment. Also, should July's SSS print come in negative (as I expect it may), the market will probably give investors another opportunity, as it did post Q209 earnings, to pick up shares below $14 - obviously, I like the stock even more at those levels.

Catalyst

Valuation as its own catalyst

Earnings growth through continued membership growth, SSS growth, and new store growth

Strategic or financial buyout