Description
SUMMARY: Pathmark (PTMK)is a turnaround situation in which Yucaipa (Ron Burkle) is investing $150 mm and will oversee the turnaround. This fund has a 20-year track record of similar investments which were subsequently sold for huge profits. Using peer group multiples, my fixed-company EV/EBITDA valuation gets me to $11-$12/share and an EV/Sales valuation gets me to $15-$16/share. The stock currently is at $7.
OVERVIEW
Headquartered in Carteret NJ, Pathmark Stores operates 143 supermarkets in the densely populated New York – New Jersey and Philadelphia metropolitan areas (owns 15 and leases 128 stores). In October 1987, the company was acquired in a leveraged buyout which loaded up its balance sheet with debt. On July 12, 2000, the company filed for a Chapter 11 reorganization and emerged from bankruptcy on September 7, 2000. As part of the Plan of Reorganization, approximately $1 billion of its subordinated debt was cancelled and the holders received 100% of the new common stock. Pathmark’s market represents approximately 10% of the U.S. population. The key regional competitors include ShopRite, A&P and Foodtown.
CURRENT SITUATION
In the past three years, PTMK stock has tumbled from a high of $25 in 2003 to a low of $3.50 reached in October 2004 due to successive earnings disappointments as well as the overall sector being out of favor (Read: The Wal-Mart Factor). In its December 2, 2004 earnings release, the company had announced that it had hired Dresdner to look for “strategic alternatives” which, of course, means it was shopping itself. On March 24, 2005, the stock jumped to $6+ on the news that Yucaipa, a private equity fund led by billionaire Ron Burkle, will invest $150 mm in PTMK. In return, Yucaipa will receive 20 mm shares of common stock and two tranches of warrants. Tranch A - 10.1mm warrants; strike $8.50; three year term and Tranch B -15 mm warrants; strike $15; ten year term. Yucaipa has also agreed to provide consulting services to PTMK management for a period of five years. This deal is subject to shareholder approval. I calculate the Yucaipa investment at $6.25/share using a volatility level of 30% on the new warrants, which is where the existing warrants (PTMKW) trade. If this deal is approved by shareholders, Yucaipa will hold a 40% stake in PTMK.
In many ways, the Pathmark story is similar to Denny’s (DNYY) restaurant company which emerged from bankruptcy in 1998 with a highly leveraged balance sheet. Denny’s struggled to service its heavy debt load and as a result, under-spent on store maintenance and began losing its core customer base. Then in 2004, it successfully raised capital via an equity placement, and refinanced its high-coupon debt. This allowed Denny’s to focus on its business (rather than debt) and grow same store sales. As a result, the stock has appreciated more than ten-fold since January 2004.
Like Denny’s, Pathmark has a heavy debt load. Under-spending on capex has caused its store base to deteriorate. It has a well-recognized brand name like Denny’s and is getting an equity infusion from Yucaipa Capital. What’s more compelling here is that while Denny’s was fixed up by its existing management (with equity coming from passive investors), at Pathmark, the clean up will be done by a team of seasoned investors from Yucaipa who have a proven track record of turning around other supermarket chains and then selling them at a fat premium. For instance, Yucaipa acquired Dominick’s (DFF) for around $20 in 1997 and sold it to Safeway for $49 cash in 1998 for a 145% profit. Another example is Fred Meyer for which Yucaipa paid $27 per share in 1997 and subsequently sold it to Kroger for around $48 in stock in 1998, a profit of 78% in a year.
EARNINGS POWER
Where can this stock go? Well, lets tackle where earnings could go first and then we can decide on an appropriate valuation multiple. I went through the exercise of looking at Krogers (KR), Albertsons (ABS), Safeway (SWY) and Village Super market (VLGEA) which owns 18 Shoprite stores in NJ and is perhaps the best comp for PTMK as their markets overlap. I compared statistics of these four companies with PTMK, specifically looking at sales per square foot and rent per square foot. What I found most telling was that Pathmark, in spite of having similar format supermarkets as Shoprite and overlapping locations, lags in sales per square foot by a mile. PTMK’s sales per square foot are around $518 compared to Shoprite’s $776 (SWY $434, KR $393 and ABS $376).
Why such underperformance? In my view, PTMK has two key problems: One, it is undermanaged. Two, insufficient spending on capex has left its stores in disrepair.
Yucaipa will resolve the first problem. Ron Burkle and his team, as part of the equity investment, have agreed to oversee Pathmark for $3 mm per year (quite reasonable given the amount of money they are investing in PTMK). This team has proven track record of acquiring undervalued supermarket chains, fixing them, and then either selling them or IPOing them at a nice profit (for themselves as well as all shareholders). Also, as part of this equity deal, Yucaipa will nominate 5 of the 12 members on the Board. This is not a passive role, they are rolling up their sleeves and fixing what can be fixed.
The second problem of under-spending on capex is also being taken care of as the $150 mm received from Yucaipa will be mostly used on capital improvements – this company needs an image make-over and that is exactly what the money will be used for. Pathmark has already renovated approximately 100 stores in since 2000. Based on an average cost of $2mm per store (the co said $1.7-$2.5 in the last conf call), up to 50 stores can be renovated for a $100mm – this would still leave $50 mm free from the Yucaipa investment.
Let’s get back to the question of earnings power. The discussion below uses KR, ABS, SWY and VLGEA as the peer group.
Pathmark’s gross margin for the last 12-months stood at 26.2% versus average margin of 28% (high 32.1% for SWY and low 23.4% for VLGEA). The grocery business is all about turnover so a small increase in margins can unlock a lot of ebitda. If Pathmark’s gross margin gets up to the group average, it could mean an incremental $69 mm in ebitda. However, I am skeptical of this happening in the near term. Why? Because Pathmark has a long term agreement (expires 2013) with C&S which accounts for 60% of its purchasing needs. I sense that unless PTMK renegotiates this contract, its cost of goods sold will be tough to lower. This is purely a guess on my part. But let’s leave this area as upside potential which I won’t take into consideration in my valuation.
Let’s turn to SG&A. Pathmark’s SG&A as a percentage of sales stood at 24.7% in the last 12-months. The peer group average was 22.7% (high of 24.8% for SWY and low of 20% for KR). But again, what is most noticeable is that VLGEA, which happens to directly overlap Pathmark’s territory, has SG&A at 22% of sales - 250 basis points below Pathmark’s. Moreover, back in 2000, this percentage was roughly the same for both companies at 23%. Arguably, SG&A will be easier to tackle for Yucaipa than Cost of Goods Sold. If PTMK’s SG&A is cut to VLGEA’s level, it could mean an incremental $100 mm of ebitda. If that seems aggressive, lets just use the group average of 22.7%, which would unlock $69 mm of ebitda.
The long and short of it is that I can see PTMK with a potential to grow ebitda $80-$100 mm from its current level of $160 mm. The specifics of how, why and when will be revealed once Yucaipa has formulated its game plan (my guess is over the next 4-5 months).
VALUATION
I use EV/Sales as my key valuation metric (since I believe that ebitda is depressed). However, I back it up with a fixed-company EV/Ebitda valuation (for a reality check).
The current EV/Sales multiple for the group stands at 0.31x (VLGEA is a clear outlier at 0.11x - too illiquid a name otherwise I would be writing about VLGEA before PTMK). Taking out VLGEA, the peer group average is 0.38x (high of 0.43x for SWY and a low of 0.35 for KR and ABS).
Enterprise value ($3.991B x 0.38) = 1,517 mm - total debt $674.6 mm + cash 42.6 mm + $50 cash left over from Yucaipa investment = $934.7 mm. Divide by total shares of 60.2 mm (fully diluted including 20 mm Yucaipa shares and 10.1 mm Tranch A warrants ) = $15.53/share price target for the stock. However, if the stock goes above $15, Tranch B Warrants become exercisable and further dilute equity. This would be a wonderful problem to have if you are long the stock at $7.
Now EV/Ebitda. The current EV/EBITDA multiple for the group stands at 5.6x (VLGEA is again a clear outlier at 3.4x). Taking out VLGEA, the peer group average is about 6.4x (high of 7.4x for SWY and a low of 5.7x for KR). Using a fixed-up company EBITDA estimate of $250 mm – nah – let’s give it a hair cut of $50 mm and use $200 mm instead. Enterprise value ($200*6.4) = 1,280 mm - total debt $674.6 mm + cash 42.6 mm + $50 cash left over from Yucaipa investment = $698 mm. Divide by total shares of 60.2 mm = $11.59/share price target for the stock.
CATALYST
The company is hosting an investor dinner presentation on April 20 at a Goldman Sachs conference in New York City. This will be the first meeting with analysts since the Yucaipa deal was announced. I assume that the company/Yucaipa will have an opportunity to provide the Street with some color on the game plan in terms of boosting sales and profitability. Thereafter, the shareholder vote and earnings will drive the stock. The end game, based upon the past, will be to sell this company at a nice premium to their investment (surely Yucaipa is not doing this for the $3 mm per year on an investment of $150 mm)
ADDITIONAL FACTS
Wal-Mart has been the biggest problem for supermarket operators, taking away share from just about everyone in the sector. I believe that Pathmark is shielded from Wal-Mart given its concentration in urban and suburban locations in the NE where land is expensive. Moreover, the folks in NY, Philadelphia and NJ (where I happen to reside) don’t want a Wal-Mart in their towns because it attracts too much traffic. Another point to note is that Wal-Mart’s anti-union reputation could make it very hard for it to grow in the North East Region.
Not only does Pathmark enjoy below-market leases, it was one of the first supermarkets to develop the big-format stores in the tri-state area. There simply isn’t any space left in these areas to build new stores of such size. This severely limits the ability of new entrants in Pathmarks markets.
As of 12/2003, PTMK’s qualified and non-qualified pension plans were over funded by almost $50 mm – when was the last time you saw a company with an over funded plan? Based on the company’s actuarial assumptions and due to the over funded status of its pension fund, PTMK expects that it will not be required to make any contributions to its qualified plan for at least the next three years (from 2003 10-K).
Of the $500 mm (excluding capitalized leases) or so of PTMK’s total debt, $350 mm is fixed rate, 8.75% Senior Subordinated Notes due in 2012. This shields the company from impending rate hikes.
Catalyst
Pathmark is a turnaround situation in which Yucaipa (Ron Burkle) is investing $150 mm and will oversee the turnaround. This fund has a 20-year track record of similar investments which were subsequently sold for huge profits. The company is presenting at a Goldman Sach's sponsored dinner on April 20 to analyst and investors for the first time since the Yucaipa deal was announced.