Description

The Penn Traffic Company (PTFC) – Long                                           December 2008

 

Introduction

An investment in Penn Traffic (PTFC) represents an extremely compelling opportunity to buy a profitable regional grocery store chain generating $900 million in annual sales and positive EBITDA, run by competent management and a highly incentivized board committed to maximizing value for themselves and other shareholders… all for what appears to be a negative enterprise value. Further, the 91-store chain’s profitability is depressed by significant field-level and corporate overhead, the majority of which a strategic acquirer would likely be able to remove. Management is acting in the interest of shareholders, and an eventual takeout is a very real possibility. While the stock last closed at just $0.50, we believe that fair value today (as a standalone entity) is perhaps ten to twenty times this price, and that in the likely event of an eventual acquisition, shareholders could see upside into the $20’s. And yet despite the potential for enormous reward, following PTFC’s freshly closed divestiture of its wholesale distribution segment, which transforms PTFC’s balance sheet and completely changes the company’s liquidity profile, this investment carries a surprisingly low level of risk. 

This inefficiency exists both because PTFC is a post-reorg equity trading on the pink sheets with no research coverage, and also as a result of PTFC having stumbled operationally, financially and strategically following its emergence from bankruptcy in April 2005. However, under new and improved management and under the close watch of a heavily committed activist shareholder, the company regained current filing status earlier this year and just recently announced the sale of its wholesale distribution business, which will result in PTFC’s balance sheet shifting from potentially distressed to one with a net cash position. New management and a newly motivated board of directors began a fresh restructuring about a year ago, several years after the company’s emergence from bankruptcy, and have achieved the following to date:

(1)   Closed a capital-intensive, struggling bakery operation;

(2)   Sold or closed 20 underperforming stores (vs. 111 total stores at emergence);

(3)   Outsourced the majority of its product procurement to large grocery distributor C&S Wholesale in order to improve margins and reduce working capital; and

(4)   Sold its valuable wholesale distribution division to C&S.   

It has essentially shed assets and sold or closed stores which were not earning acceptable returns, except in the case of the wholesale division, which was sold to shore up the balance sheet to ensure that the company could ride out the current recession if necessary and eventually realize full value for shareholders. 

The stock’s liquidity is an issue, although liquidity should improve somewhat, now that filings are current and management has begun hosting quarterly earnings calls. Finally, I believe that management and the board are now highly incentivized to maximize shareholder value, making a sale of the company in the relatively near term the most likely outcome, with a successful turnaround the second most likely outcome. And if neither occur in the near term, then we have theoretically paid nothing for a defensive business which also owns a substantial amount of real estate (19 of 91 stores are owned). 

 

Before I get too far into the details and history, I will lay out some very basic numbers. The stock traded as high as $24.25 in June 2007, so while the currently tiny market cap may appear to be a deal-breaker for many, at a moderate grocery retail multiple of 0.20x EV/Sales, PTFC would sport a potentially more relevant market cap near $200 million. 

Summary Capital Structure & Statistics		As of	Adj. for	Pro Forma
($ in millions)		11/1/08	Divestitures*	11/1/08
Share Price (12/19/08)		$0.50		$0.50
Shares Out		8.6		8.6
Market Cap		$4.3		$4.3
Revolver		$17.0	($17.0)	---
Term Loan		$6.0		$6.0
Supplemental Real Estate Facility		$25.1	($15.0)	$10.1
Accrued Interest		$0.5		$0.5
Mortgages Payable		$3.9		$3.9
Capital Leases		$9.1		$9.1
Total Debt Outstanding		$61.6	($32.0)	$29.6
Convertible Preferred (converts @ $16.12)		$10.0		$10.0
Pension Liability		$4.4		$4.4
Adjusted Total Debt Outstanding		$76.0		$44.0
Cash		($32.9)	($15.8)	($48.7)
Net Debt / (Cash)		$43.1	($47.8)	($4.7)
Net Cash per Share				$0.54
Enterprise Value (TEV)		$47.4		($0.4)
LTM Sales		$1,186	($226)	$960
LTM EBITDA		$20.0	($7.6)	$12.4
LTM CapEx		$10.1		$10.1
Run-Rate Net Interest Expense		$6.7	($3.2)	$3.5
TEV/Sales		0.04x		“free”
TEV/EBITDA		2.4x		“free”

*Adjustments assume the following:

$43 million gross proceeds for the wholesale business, with zero cash taxes, as per CFO.  

$7.5 million gross proceeds for two stores sold after 11/1/08, with $1.7 million est. taxes.

$1 million (total) estimated fees and expenses related to above transactions. 

No corporate overhead allocated to divested wholesale segment (conservative). 

No improvement in retail EBITDA from recent procurement outsourcing initiatives. 

No improvement in corporate overhead from recent cost cutting initiatives. 

Note: the company has promised an 8-K with pro forma information for the sale of the wholesale division, so some of my pro forma analysis may prove inaccurate. For instance, the company disclosed gross proceeds from the transactions of $43 million and $7.5 million, and that they intended to pay down $32 million in debt; they did not disclose how much cash would be left over after fees and taxes, except that they expected no cash taxes on the wholesale transaction, and that the gain on the two stores was $4.5 million (implying perhaps $1.7 million in taxes, at most). Also, while the CFO implied that profitability would actually improve following this transaction, it was undisclosed how much, if any, of the company’s $32 million in LTM unallocated corporate overhead may go away following the sale of the wholesale division, and so to be conservative I have assumed above that profitability (before and after interest expense) declines until more detailed pro forma detail is disclosed. 

 

History

PTFC’s history is long, if not glorious, with the company having existed in one form or another since 1854. It is headquartered in Syracuse, NY. The company has twice filed for Chapter 11 bankruptcy protection in the past ten years. The first time was in March 1999, following an accounting scandal at its bakery unit, less than four months after which it emerged under a pre-pack arrangement. However, on May 30, 2003, PTFC again found itself in bankruptcy, this time as a result of stiff competition from Wal-Mart in its Ohio and West Virginia markets. This time PTFC remained in bankruptcy for 22 months, during which time it exited the Ohio and West Virginia markets, shrinking from 213 stores and $2.3 billion in sales to 111 stores and $1.3 billion in sales at emergence in March 2005, with its remaining stores located mostly in upstate New York and western Pennsylvania. It is important to note that neither bankruptcy reflected weakness at PTFC’s current store base, as these remaining stores have performed at consistently profitable levels. PTFC operates stores under the following banners: P&C Foods (mostly in central and upstate New York), Quality Markets (western Pennsylvania and western New York) and Bi-Lo Foods / Riverside Markets (all in Pennsylvania). 

Upon emerging from the most recent bankruptcy, the company appeared to have made significant progress. Several reputable value/distressed funds snapped up bonds during the bankruptcy, which converted to new equity, and some of these investors continued to buy new equity in the open market after the stock began trading. Despite a lack of current financials and an ongoing SEC investigation related to vendor allowance accounting, as well as the management team refusing to speak to investors before striking options, the stock traded in the high teens. 

PTFC’s fiscal year end is around the end of January, following the retail calendar. I will refer to the year ending January 28, 2006 as “2005”, and so on. Projections in the disclosure statement, dated February 4, 2005, are summarized below. Note that 2004 results were historical, although still estimated, by the time the projections were released. 

Disclosure Statement Projections		52 weeks	52 weeks	53 weeks	52 weeks
($ in millions)		2004	2005	2006	2007
Revenue		$1,291	$1,353	$1,428	$1,449
Growth			4.8%	5.6%	1.4%
Retail Comps		-1.5%	2.5%	1.4%	1.4%
Gross Profit		$341	$360	$385	$396
Gross Margin		26.4%	26.6%	27.0%	27.4%
Operating Expenses		$296	$312	$329	$335
% of Sales		22.9%	23.0%	23.0%	23.1%
EBITDA		$45.0	$48.6	$56.7	$61.9
EBITDA Margin		3.5%	3.6%	4.0%	4.3%
EBIT (FIFO)		$23.2	$30.2	$38.3	$41.8
EBIT Margin		1.8%	2.2%	2.7%	2.9%

With approximately $45 million in net debt at emergence and 8.5 million estimated new shares outstanding, buying the newly issued stock where it was trading during the summer and fall of 2005 (in the range of $15 to $18 a share) seemed a promising investment, implying a valuation of 3.5x to 4.1x current EBITDA and 3.8x to 4.4x trailing, as well as 0.13x to 0.15x sales. Recent acquisitions of other regional grocers (summarized below) had taken place in a range of 5.3x to 7.9x trailing EBITDA and 0.18x to 0.24x sales, multiples which implied valuations of $21 to $36 per share for PTFC. Perhaps most importantly, downside risk seemed mitigated by owned real estate, which I will discuss later. 

Comparable Transactions	Fresh Brands	Marsh	Foodarama		Penn Traffic*
($ in millions)	FRSH	MARSA	FSM		PTFC
Transaction Type	Strategic Acq	LBO	MBO		None (yet)
Location of Stores	WI, IL	IN, OH	NJ		NY, PA, VT, NH
Equity Purchase Price (Mkt Cap)	$35	$88	$54		$153
Total Transaction Value (TEV)	$121	$298	$295		$198
LTM Sales	$682	$1,723	$1,216		$1,291
LTM EBITDA	$23	$38	$42		$45
LTM EBIT	$10	$11	$20		$23
TEV / LTM Sales	0.18x	0.17x	0.24x		0.15x
TEV / LTM EBITDA	5.3x	7.9x	7.0x		4.4x
TEV / LTM EBIT	11.6x	27.8x	14.7x		8.5x
* Immediately after emergence; using $18 share price.

Additionally, the projections forecasted accounts payable to remain at a level equal to approximately 37% of inventory indefinitely, reflecting the shorter payment terms imposed by PTFC’s vendors during bankruptcy. However, it seemed more reasonable that PTFC’s payables would return to at least 60% of inventory as terms with vendors recovered, seeing as peers maintained payables equal to 60% to 90% of inventories. PTFC itself had maintained payables near 60% of inventories before its first bankruptcy. With $123 million of inventory at emergence, the opportunity to generate cash from working capital seemed to be quite large as payment terms normalized, potentially generating up to $28 million, or over $3 per share, in extra cash. Also, if PTFC was this conservative with respect to its working capital projections, it seemed the operating projections might be conservative as well. Since bondholders involved in the bankruptcy process were now buying shares in the open market, and management had yet to strike options due to an ongoing SEC investigation into vendor allowance accounting, one could suspect that projections were intentionally conservative. On an absolute basis, low single-digit comp store sales and an ultimate 4.3% EBITDA margin did not seem heroic goals. 

Finally, there was the potential that PTFC was sitting on significant “hidden” value in the form of owned real estate.  PTFC owned 21 of its stores, five shopping centers and five distribution centers, the combined market value of which was rumored to be at least $100 million or potentially up to $200 million, in which case the real estate alone might be worth more than the total enterprise value of the company.  A sale-leaseback transaction was rumored to be under consideration, which given the low cap-rate environment, would have created significant value at the rumored valuations. In summary, PTFC’s new equity seemed to present an attractive risk-reward opportunity, materially undervalued with respect to both its assets and cash flows. It was actually written up on VIC in February 2006, when the stock traded at a price of $16.35. 

What Happened?

New shareholders had high hopes based on the investment thesis outlined above, however the following two and a half years were instead extremely frustrating to shareholders. The old management team continued to delay disclosing its financials and refused to speak to investors, hiding behind the SEC investigation and seemingly almost trying to drive the stock down in order to more profitably strike options. The filing deadline set by PTFC’s lenders was extended first from August 2005 to December 2005, but this was only the first of many delays, which were to become quarterly events during 2006 as the deadline was repeatedly extended by three months at a time. The company did finally host brief conference calls in October 2006 and February 2007, updating investors with summary unaudited financials, which were running well below the projections contemplated in the disclosure statement. Not until the summer of 2007 did PTFC finally file 10-K’s for 2005 and 2006. 

Meanwhile, there was significant management turnover, as the job became too large for the original team. In late 2006, PTFC announced the replacement of its CEO, and in early 2007, PTFC announced that the CFO was also being replaced and that a search for a new CFO was ongoing. In the meantime, restructuring advisory firm Conway, Del Genio, Gries & Co. loaned the company a temporary CFO and embarked on overhauling the company’s financial organization, in an attempt to bring PTFC’s audited financials and SEC filings up to date. 

As investor patience wore thin, Bay Harbour, a hedge fund specializing in distressed debt and equity investments, publicly pushed for change after encountering stubborn resistance when trying to speak to management in private. The threat of a proxy contest eventually resulted in Bay Harbour being granted two board seats, effective June 2007. Bay Harbour had accumulated 23% of PTFC’s stock for an average price near $15 a share and had become (and remains) the company’s largest shareholder.  

In August and October of 2007, PTFC finally released 10-K’s for 2005 and 2006. However, as time wore on and hope became more remote for a transaction or some other immediate event stemming from Bay Harbour’s new influence, PTFC’s stock began its descent from a peak around $24 in the summer of 2007. As the credit crisis unraveled, unlisted and illiquid securities were particularly punished, and amidst an informational vacuum with respect to 2007 results, PTFC continued to fall. Ultimately, the company was able to file its 2007 10-K on time and host another investor call in April 2008, but by this time, the company had lost its audience. During the Q&A following management’s statements, there were only two callers with questions: a fixed income prop trader from RBC and a reporter from the Syracuse Post-Standard. 

Following is a summary of actual operating results during the period of 2005 through Q3 2008, adjusted to exclude extraordinary expenses. Note that 2006 had 53 weeks. 

		52 weeks	53 weeks	52 weeks	39 weeks	39 weeks
($ in millions)		2005	2006	2007	11/3/07	11/1/08
Revenue		$1,281	$1,294	$1,220	$915	$881
Growth		-0.7%	1.0%	-5.7%		-3.7%
Retail Comps		-1.4%	-1.7%	-0.3%	-0.2%	-1.3%
Ending Retail Stores		110	106	103	103	93
Gross Profit		$335	$333	$328	$248	$227
Gross Margin		26.1%	25.8%	26.9%	27.1%	25.8%
Operating Expenses		$306	$310	$299	$224	$212
% of Sales		23.9%	24.0%	24.5%	24.5%	24.1%
Adjusted EBITDA		$28.9	$23.3	$28.5	$24.4	$15.2
EBITDA Margin		2.3%	1.8%	2.3%	2.7%	1.7%
Adjusted EBIT (FIFO)		$5.1	($2.6)	$2.3	$4.3	($2.0)
EBIT Margin		0.4%	(0.2%)	0.2%	0.5%	(0.2%)

While adjusted results came in significantly below the disclosure statement’s projections, unadjusted results were far worse. The company spent an additional $2.7 million in 2005 in legal expenses related to the SEC investigation, approximately $10 million in extraordinary cash expenses in 2006 (legal fees, severance, professional fees and other) and a whopping $15 million in extraordinary cash expenses in 2007. The 2007 expenses included over $7 million in professional fees alone paid to various advisors, which covered very deep audits going back several years, catching up on Sarb-Ox compliance and also additional tax preparation work covering the past several years. Also included was $4.8 million spent on advisory work to evaluate an acquisition. While the company will not discuss this deal, it is generally known that PTFC spent a good portion of 2007 attempting to combine with Tops Markets, a 71-store chain based in Buffalo, NY, which was being auctioned by Ahold as Ahold divested its non-core US assets. Eventually, Morgan Stanley Private Equity prevailed in the bidding for Tops, paying $310 million to acquire Tops in December 2007. YTD 2008 has seen extraordinary expenses remain elevated, over $8 million, including increased legal costs to settle a legacy SEC investigation, as well as somewhat reduced professional fees.   PTFC also continues to pay Karabus, a well-regarded retail consulting firm claiming clients such as American Eagle (AEO), A&P (GAP), Big Y Foods, Bloomingdale’s, Duane Reade and others. 

The combined result of PTFC’s margins falling below expectations following emergence from bankruptcy, and its additional cash expenditures to cover various legal, restructuring advisory and M&A due diligence bills, resulted in liquidity becoming stretched by the end of 2007. Lenders were reluctant to extend further credit on reasonable terms due to PTFC’s inability to bring current its financial filings. In order to maintain breathing room for some remodels and a few other small capital projects, PTFC raised new money in December 2007 in the form of a $10 million convertible preferred issue placed with three of its largest stockholders: Bay Harbour, King Street and CR Intrinsic (a division of SAC Capital). The preferred stock is convertible beginning in December 2008 at $16.12, which was the trailing 45-day average closing price for the stock at the time this financing was done. It is obviously very far out of the money. The convert yields 8%, cash or PIK, at the company’s option. I would note that the financing was actually done on highly attractive terms from the company’s perspective, particularly given the state of the capital markets and PTFC’s delayed filing status, and that Bay Harbour seems to have taken precautions in light of its two board seats to avoid the appearance of a conflict of interest relative to its fiduciary duty to other common shareholders. 

As for PTFC’s lenders, the endless waivers relating to missed filing deadlines are too numerous to catalog, but PTFC retained lender support throughout its restructuring.  While this recently became an issue, as PTFC faced the conditional maturity of its credit facilities in April 2009 and was unlikely to satisfy conditions which would have automatically extended the loans through April 2010, this has all been rendered moot following the sales of PTFC’s wholesale division and two stores for over $50 million in gross proceeds. PTFC announced today that its credit facilities have been extended through April 2010. 

The vendor allowance issue which plagued the company has finally been resolved. The US Attorney for the Northern District of New York and the SEC had both been investigating since before PTFC’s emergence from bankruptcy. PTFC completed its own internal investigation on June 1, 2006, with the board retaining independent counsel to conduct this investigation. The independent counsel found that certain employees had sporadically recognized vendor allowances prematurely in an effort to overstate profits. They also found that these practices had largely ceased by the time PTFC filed for bankruptcy in March 2003. As a result of this investigation, PTFC fired its Chief Merchandising Officer and VP of Non-Perishable Marketing on February 3, 2006. The SEC then levied individual charges against these same two individuals on September 17, 2007, alleging that they intentionally deceived PTFC’s accounting staff to overstate company profits during a period beginning in Q2 2000 and ending around Q4 2002. The US Attorney pressed criminal charges against these individuals on the same date. PTFC continues to cooperate in these investigations (which means ongoing legal bills), but most importantly, the company settled with both the SEC and the USAO in September and October 2008, respectively, in each case incurring no fines or monetary penalties. 

Importantly, PTFC was able to attract a highly competent CFO, Tod Nestor, in May 2007. Nestor had previously been the Treasurer and VP of Strategic Planning at American Eagle Outfitters, Inc. (AEO). Before this, he worked in various financial management roles at large consumer companies including Heinz, Bacardi and Pepsi. Interestingly, he also spent time working at Stern Stewart & Co., where he was indoctrinated with the EVA approach to capital allocation. He also has an MBA from Wharton. On paper, he is a significant upgrade from his predecessor, and based on a detailed conversation with him, I found him to be a highly competent and motivated manager who has not only overhauled PTFC’s entire financial reporting infrastructure (with a lot of external help), but also put all of the company’s assets through rigorous evaluation. For instance, all retail stores were analyzed to maximize returns based on one of four options: (1) status quo, (2) sale of the store, (3) sale and conversion of the store to a wholesale distribution customer, or (4) store closure and liquidation. This was clearly not an academic exercise, as options 2 through 4 have been elected in the case of 20 of the company’s 111 stores. While he allows that this will be an ongoing process, the company believes that the existing store base reflects the results of this extensive asset review. When asked why he had left a $5.5 billion market cap company and a history of employment at top-tier consumer companies to take on the challenge and headache of bringing PTFC’s financial infrastructure out of the dark ages, he responded that he simply loves turnarounds. He is also significantly motivated to realize value for shareholders, due to an attractive cash bonus scheme triggered in the event of a change of control, which I will discuss in greater detail later. 

I focus primarily on the CFO because it is his role which needed the most improvement. Greg Young, the CEO, also seems competent and well-incentivized. He began his career at PTFC, originally in its P&C Foods division, where he held various positions for 25 years before leaving to join A&P in 1999. At A&P, he rose to Group VP of A&P Super Foodmart before leaving to join C&S Wholesale in 2003. At C&S, Young was the General Manager of C&S’s retail division. He was brought back to PTFC in 2006 and served as the company’s COO before being promoted to CEO last fall. Perhaps Greg Young’s largest contribution to PTFC has been his ability to negotiate an extremely favorable string of transactions with his former employer, C&S Wholesale. The remainder of the senior management team is relatively new, mostly joining in late 2006 or early 2007 and coming from A&P or C&S Wholesale. Worth noting, in June 2007 PTFC hired Lynn Leitzel as Chief Information Officer from Weis Supermarkets, a Pennsylvania-based 153-store chain, where he held a similar position. This position had been unfilled at PTFC since early 2006, which had cost the company considerably in terms of pricing optimization. 

A brief discussion of the sale of the wholesale division is warranted. The purchase price represents multiples of 0.19x LTM Sales and around 6x LTM EBITDA, even before the allocation of any corporate overhead to the segment. When compared to the price Blackstone paid to buy Performance Food Group earlier this year, also 0.19x Sales for a much larger organization in a much better credit market, this seems to have been an excellent price, especially since PTFC was essentially a distressed seller. 

PTFC’s management works for the board. With 23% holder Bay Harbour occupying two board seats and the PBGC (pension group) and King Street holding another 37% of the company’s shares combined, the board is acting on the behalf of these major shareholders, the priority for each of whom is to maximize (and realize) shareholder value. Management has accepted compensation arrangements which align their interests with shareholders. In addition to being eligible for significant cash bonuses in the event of a change of control above a certain price ($10 a share), the team’s compensation is highly incentive-based relative to achieving the company’s board-approved operating plan. Base salaries are pegged to the 25^th percentile of a group of (generally larger) competitors, whereas bonuses are pegged to the 50^th percentile of this same group. However, bonuses are only received in the event that the company at least achieves its plan. In 2007, despite improved results compared to the year prior, no management bonuses were granted, as the internal plan was not reached. 

Where Does PTFC Stand Today?

Today, PTFC operates 91 stores and is solely committed to its retail segment. PTFC’s operated stores are generally clustered, providing local economies of scale with respect to advertising, distribution and operations management. Stores in less densely populated areas (of which there are a good deal) are generally situated along sensible distribution paths. Local market shares are strong, with approximately a 22% market share good for the #2 position in its home market, the greater Syracuse area, behind Wegmans (over 35%) but comfortably ahead of Price Chopper (11%) and Wal-Mart (10%). They also have strong local presences in Jamestown, NY (six stores), Erie, PA (five stores), Chautauqua county along the Lake Erie coast (five stores), St. Lawrence county (five stores), Watertown, NY (four stores), Johnstown, PA (four stores) and Ithaca, NY (three stores).  The stores are generally stocked on a customized basis, with certain markets having more seasonal assortments due to proximity to vacation destinations (e.g. the stores along Lake Erie in Chautauqua county). 

Another important point is that unlike some regional competitors more concentrated in urban areas (e.g. Tops Markets), PTFC’s more rural store footprint has already endured the entrance of Wal-Mart into the vast majority of its local markets. Wal-Mart’s more recent entrance to certain urban markets in the region will generally not continue to impact PTFC the way it may impact some of its competitors. For instance, Wal-Mart has only one Buffalo location with grocery, whereas over 55% of Tops Market’s stores are in the greater Buffalo area. As Wal-Mart expands in Buffalo, Tops Markets will feel additional pressure. PTFC has fortunately already endured Wal-Mart’s entrance into Syracuse as well as into its more rural markets. In support of this assertion, data published by Metro Market Studies shows that as Wal-Mart expanded into the greater Syracuse area, Wal-Mart gained three points of market share from 2005 to 2006, raising its grocery share in the area from approximately 6% to 9%. Adjusting for changes in store count, #1 Wegman’s and #2 Penn Traffic’s market shares each fell by about 1%. #3 Price Chopper also lost share. While not the most enjoyable exercise, using the “store locater” function on Penn Traffic’s website as well as for some of its competitors (including Wal-Mart, where you can adjust to isolate only Wal-Mart locations with grocery offerings), and then plotting all store locations using mapquest or some other online mapping program, proved very helpful in understanding the local market competitive landscape in much greater detail than is otherwise available. 

While returns on capital do not seem attractive on a consolidated basis, at the segment level, both PTFC’s retail and distribution businesses have earned very attractive returns, reflecting the company’s strong local positioning. I will discuss later my methodology and reasoning for pro forma allocation of corporate overhead. Using my assumptions, as well as the company’s segment disclosure to allocate profits and assets, the retail business earned a pre-tax return on invested capital (ROIC) near 22% in 2007. This compared favorably to similar returns at larger, publicly-traded grocers, which ranged from the mid single digits to the mid 20’s. I am defining pre-tax ROIC as EBIT divided by tangible capital employed (fixed assets plus net working capital). There are many ways to look at returns on capital, but I think this methodology is most applicable for this business. 

Returns on Invested Capital (Primarily Retail)	Kroger	Safeway	Supervalu	Great A&P	Winn Dixie	Weis  Markets		Penn Traffic Retail*
	KR	SWY	SVU	GAP	WINN	WMK		PTFC
2007 EBIT	$2,325	$1,840	$1,698	$311	$38	$69		$22
Fixed Assets, net	$12,498	$10,570	$7,533	$1,901	$396	$505		NA
Net Working Capital	($225)	$247	($372)	$76	$257	$64		NA
Tangible Capital Employed	$12,273	$10,817	$7,161	$1,977	$653	$569		$102
Return on Invested Capital	19%	17%	24%	16%	6%	12%		22%
* Estimated based on 10-K segment disclosure and pro forma allocation of corporate overhead.

The distribution business also earned an attractive return, with PTFC earning over a 50% ROIC in 2007, compared to returns in the 20’s to 40’s at larger, publicly-traded food distributors. PTFC’s business earns this higher return due to its role as consultant and sublessor to a sizeable portion of its distribution customers. I also believe that this higher return suggests that a significant portion of PTFC’s unallocated overhead may have been in support of the distribution segment, which may lead to better pro forma EBITDA for the remaining retail business. 

Returns on Invested Capital (Primarily Distribution)	Sysco	Nash Finch	Spartan Stores		Penn Traffic Distribution*
	SYY	NAFC	SPTN		PTFC
EBIT (LTM)	$1,831	$89	$62		$6
Fixed Assets, net	$2,857	$197	$183		NA
Net Working Capital	$1,211	$220	$12		NA
Tangible Capital Employed	$4,068	$417	$195		$11
Return on Invested Capital	45%	21%	32%		54%
* Estimated based on 10-K segment disclosure and pro forma allocation of corporate overhead.

While PTFC has made enormous improvements in its financial infrastructure, I believe that they are also making strong progress on the operational front. To best handicap whether cash flow and earnings will improve, stay constant, or decline in 2009 and beyond, it helps to understand why EBITDA has been stuck in the $20 to $30 million range for the past four years. 

The biggest reason has been inefficient product pricing. One of a grocer’s most important functions is optimizing the way it prices its goods, covering decisions on timing and pricing, and ranging from full-price goods to promoted goods to markdowns and clearance. On the October 2006 investor call, management discussed that following the departure of certain managers formerly in charge of overseeing PTFC’s pricing optimization systems (using systems from retail software provider DemandTec), the systems were removed in early 2006, and pricing decisions were made more or less blindly. Management estimated on this call that this decision cost PTFC 100 basis points in margin during 2006. I estimate that this may have negatively impacted EBITDA by $10 million in 2006, based on over $1 billion in grocery segment sales. These systems were reinstalled beginning in 2007, but they were not completely reinstalled until half way into the year. While it seems PTFC has not been able to push through commodity increases during 2008, as has also been the case for its peers, in a more stable commodity environment we should see PTFC recoup some of this previously “lost” margin. 

Another tailwind in 2009 and beyond may include the reduction of administrative expenses, which management mentioned during their recent earnings call would be a primary target for cost savings. Administrative payroll and benefits decreased 9% to $29.2 million in 2007, while the number of salaried employees at year-end was 14% lower than the prior year. It has remained elevated in 2008, but the company has identified several areas where they expect to reduce costs in 2009, including $1.5 million just from lowering insurance costs company-wide by buying on a centralized basis. 

Finally, upon evaluating all assets in 2007, PTFC decided to shut its unprofitable bakery operation and also to outsource the procurement of product, beginning with outsourcing the purchasing function of its wholesale distribution segment to C&S Wholesale, the leading grocery distributor in the northeast and the #2 food distributor nationally, serving over 5,000 stores across 12 states. The rationale for this shift, which began in March 2008, is that C&S buys significantly better (in terms of price, selection and quality) which should help reduce PTFC’s cost of goods (price) as well as optimize sales (selection) and reduce shrink (quality). PTFC expanded this relationship this fall to include the sourcing of much of its retail product. This is hard to quantify, but it should absolutely have a positive impact on PTFC’s gross margin in 2009. PTFC’s retail segment cost of goods was $668 million on an LTM basis, which includes both product cost and warehousing and freight costs. Reducing product costs by just half a percent could imply another $2 to 3 million in savings. 

While the current environment is certainly challenging with regard to more discretionary product, between lower COGS from the new C&S partnerships and lower corporate expenses, PTFC should be able to grow EBITDA off a depressed base going forward. 

Before moving on to valuation, I will discuss PTFC’s most recent balance sheet, which follows:

($ in millions)	2/3/2007	2/2/2008		11/1/2008
Cash	$24.7	$20.9		$32.9
Accounts Receivable	$35.1	$37.5		$30.5
Inventory	$100.0	$89.2		$52.0
Prepaids & Other	$8.5	$7.3		$6.7
Current Assets	$168.3	$154.9		$121.8
Capital Leases	$9.9	$8.3		$7.5
Fixed Assets, Net	$96.5	$78.4		$64.6
Intangible Assets	$25.2	$15.4		$12.1
Other Assets	$7.7	$5.4		$3.7
Total Assets	$307.5	$262.4		$209.7
Current Portion of LT Debt & Cap Leases	$1.8	$1.9		$50.4
Accounts Payable	$34.7	$34.2		$17.4
Other Current Liabilities	$49.7	$47.1		$41.0
Deferred Income Taxes	$13.5	$11.5		$7.4
Liabilities Subject to Compromise	$2.7	$2.5		$0.0
Current Liabilities	$102.4	$97.1		$116.2
Capital Leases	$11.0	$9.0		$7.8
LT Debt	$52.4	$50.2		$3.4
Defined Benefit Pension Plan Liability	$22.2	$6.3		$4.4
Other Non-Current Liabilities	$26.8	$30.7		$30.5
Total Liabilities	$214.7	$193.3		$162.4
Preferred Stock	$0.0	$10.0		$10.0
Common Equity	$92.7	$59.2		$37.3
Total Shareholders’ Equity	$92.7	$69.2		$47.3
Total Debt + Preferred	$65.2	$71.0		$71.6
Less: Cash	$(24.7)	$(20.9)		$(32.9)
Net Debt	$40.5	$50.1		$38.7
Underfunded Pension	$22.2	$6.3		$4.4
Adjusted Net Debt	$62.7	$56.4		$43.1
A/R Days	10	11		10
Inventory Days	38	37		22
A/P Days	13	14		7
A/P as % of Inventory	35%	38%		34%

Beginning with working capital, it is clear that there remains ample room for improvement. The most significant opportunity, and the one most obviously attainable, remains extending vendor terms to industry standard. Publicly traded grocers maintain payables of 45-90% of inventory, with most above 60%. Most recently, accounts payable at PTFC were still under 34% of inventory. Bringing this number to 60% suggests the opportunity to generate close to $14 million in cash, or over $1.50 a share. Management mentioned on the recent earnings call that they specifically intend to bring PTFC’s payment terms more in line with its peers. The company is fortunate to have a director, John Burke, who was Nestle’s VP of Credit Collection from 1991 to 2004. Burke has served on the creditors’ committee in several bankruptcies. PTFC management should not lack for experience when negotiating with its vendors. However, given the deterioration of PTFC’s liquidity position since emergence, vendors had not previously been willing to extend terms to industry norms. The CEO’s comment on the recent call that they intend to “get the terms we deserve” implies that the company understands that its current working capital position is not competitive. Now that PTFC has current audited financials and no liquidity concerns, increasing payables will be an easier task, and I would expect to see significant progress in this area in 2009. 

Payables Leverage	Kroger	Safeway	Supervalu	Great A&P	Winn Dixie	Weis  Markets		Penn Traffic*
	KR	SWY	SVU	GAP	WINN	WMK		PTFC
Accounts Payable / Inventory	81%	85%	114%	50%	45%	65%		34%
* Consolidated, includes retail and distribution segments.

The company’s fixed assets are significant and may provide valuable downside protection. PTFC has sold several stores and also sold and leased back its distribution facilities since emerging from bankruptcy in efforts to optimize return on capital, however the company still owns 19 stores and two shopping centers containing owned stores. These stores represent additional sources of liquidity, should the company need it. 

At 2.2x adjusted net debt / EBITDA (including the underfunded pension liability), PTFC was moderately leveraged. At November 1, 2008, debt consisted of $17 million outstanding on a $100 million revolver, a $6 million term loan, $9 million of capital leases, $4 million of mortgage debt and $25 million drawn on a $28 million supplemental real estate facility. Adding in the $10 million convertible preferred and the $4.4 million defined benefit pension plan liability, and then netting out $33 million in cash, results in adjusted net debt of about $43 million. As discussed in my introduction, following the sale of two stores and the wholesale distribution business, I believe net debt is now negative (net cash). 

PTFC’s debt has been expensive. To the extent the company continues to show operational progress and is able to reduce leverage through the generation of free cash flow (from both operations and working capital improvements), while I am not counting on it, I would expect current borrowings eventually to be refinanced with much less expensive debt. PTFC is currently paying a minimum of 15% on its real estate facility, which reverts to LIBOR + 10% if LIBOR exceeds 5%. The credit facility is more reasonable, around LIBOR + 2.75%. The convertible preferred PIKs at 8%. 

While leverage was not extreme, liquidity was becoming an issue, as vendors required a high level of LC’s, impacting availability, and tight covenants loomed in February 2009. This is why the recent sale of the wholesale division for a good price is such a critical event. 

Valuation

(1) From the Perspective of an Acquirer

The key to my analysis, and the primary reason I believe PTFC is extraordinarily undervalued, is the following assumption:

While the large amount of field-level and corporate overhead may be necessary for an independent 91-store grocery chain primarily spread across two large states, it is largely expendable in the case PTFC is acquired by a competitor. 

In its 10-K filings, the company segments the financials of the business into the Retail Food and Wholesale Food Distribution segments, as well as a “Reconciling Items” column. Reconciling Items includes small revenues and costs from PTFC’s contract hauling business, but is mostly comprised of substantial unallocated overhead costs. One line item in the footnotes stands out: “payroll, benefits & payroll taxes associated with the administrative staff.” I have confirmed with the CFO that this line item does not include any store-level costs (e.g. store managers), so very little of this should be allocated to the grocery business. I assume for conservatism that should an acquirer purchase PTFC, it would need to spend a portion of this unallocated overhead on additional regional managers and teams, as well as potentially adding somewhat to its corporate overhead costs. I was able to discuss these potential costs with a veteran grocery executive who was recently the SVP of Operations at a large, acquisitive super-regional grocer. He estimated that an acquirer, depending on its existing store footprint, might want to organize PTFC’s stores into four regions of approximately 25 stores apiece, and that each region might require a regional manager and a team of three to four support staff in charge of overseeing various store functions (deli, bakery, meat, produce, etc.) He estimated annual salaries of $100,000 for the managers and $60,000 for the other staff members, plus 30% for benefits, and then additional travel expenses reimbursed on a per mile basis. Given the relative concentration of PTFC’s stores, these costs would likely not be extensive. There could be additional expenses if each region established a separate office, although practically he thought the regional teams could likely base out of back office space within existing grocery stores with extra room. He thought incremental corporate overhead would be small. Any way one cuts it, it seems difficult to imagine an acquirer spending more than $5 to $10 million in incremental field and corporate overhead to support PTFC’s 91 stores, and this number could potentially be significantly smaller. And yet PTFC reported a whopping $28.3 million over the last twelve months for “payroll, benefits & payroll taxes associated with the administrative staff,” with the total EBITDA contribution from the “Reconciling Items” column being negative $32.2 million. Reducing this loss only to $10 million would result in pro forma EBITDA of $30.7 million, which is the base from which I am evaluating the business from the perspective of an acquirer. 

I believe that potential acquirers will evaluate PTFC based on EBITDA and sales following industry standard, so I have paid most attention to these metrics in valuing PTFC’s business. However, it is highly important to note that maintenance capital expenditures are likely only about $10 million (PTFC only spent $7.9 million in 2007 under some capital constraint), substantially less than reported D&A around $25 million. This discrepancy exists due to the effects of fresh-start accounting on fixed assets and depreciation. Also, as mentioned before, I expect PTFC’s vendor terms to improve from low levels. This should further increase FCF, if only temporarily. Even before taking into account any potential for reduction in working capital, adjusted unlevered, pre-tax FCF on an LTM basis was approximately $20.6 million from an acquirer’s perspective. This is of course before accounting for any improvement resulting from recently announced initiatives. 

Based on the trailing financials outlined above, I am valuing the company based on EBITDA. I assume a wide valuation range of 3x to 6x EBITDA. This compares to publicly traded grocers currently trading in a range of 4.2x to over 6.8x EBITDA, and fairly recent M&A deals in a slightly higher range. 

As for the $10 million convertible preferred, I have treated it as debt if it would be out of the money, and I have treated it as equity on an as-converted basis if it would be in the money (i.e. if the implied stock price is above $16.12), which serves to increase shares outstanding by about 620,000 shares, or 7%. 

			EBITDA Multiple
			3x	4x	5x	6x
LTM EBITDA to Acquirer			30.7	30.7	30.7	30.7
Enterprise Value			92.0	122.7	153.4	184.1
Less: Net Debt & Pension Liab			(43.1)	(43.1)	(33.1)	(33.1)
Plus: Proceeds from Wholesale division sale			43.0	43.0	43.0	43.0
Plus: Proceeds from sale of two stores			7.5	7.5	7.5	7.5
Less: Taxes on gain from sale of two stores			(1.7)	(1.7)	(1.7)	(1.7)
Less: Estimated fees on all transactions (2%)			(1.0)	(1.0)	(1.0)	(1.0)
Market Cap			96.7	127.4	168.1	198.8
Diluted Shares @ 12/5/08			8.6	8.6	9.2	9.2
Implied Share Price			$11.21	$14.77	$18.18	$21.50
Implied Adj Unlevered FCF Multiple			4.5x	6.0x	7.4x	8.9x
Implied TEV/Sales Multiple			0.10x	0.13x	0.17x	0.20x

One additional point is that PTFC’s current initiative to reduce working capital through better vendor terms could generate $13 to $14 million in cash for the company, adding over $1.50 a share to the valuation. 

One relevant, recent transaction is of course Morgan Stanley’s acquisition of Tops Markets. Because Tops was a small part of Ahold’s US Grocery segment, and because certain Tops stores were closed or not included in the acquisition, financials for these 71 stores are not publicly available. Morgan Stanley paid $310 million, or $4.4 million per store, for Tops. Simply applying this multiple to PTFC’s 91 stores would imply a valuation of almost $45 a share for PTFC. However, this is too ambitious, since Tops stores are larger and in more urban locations, and therefore likely generate significantly higher sales and EBITDA per store. Dated trade journal articles suggest that Tops’ stores averaged approximately 55,000 square feet in size, versus 36,000 for PTFC’s stores. Making a simplistic adjustment for PTFC’s smaller average store size, we can derive that Morgan Stanley paid an equivalent price of $2.9 million per store for Tops. This valuation in turn implies a $30 stock price for PTFC. It is not perfect science, not knowing the profitability of the Tops stores, but it is an important transaction to consider in that (1) it is recent, (2) Tops operates in the same region, (3) the deal was of similar size, and (4) Tops is not considered to be a particularly good operator. As evidence of this, I learned from a former CFO of PTFC that while PTFC was probably losing a small amount of market share to Wal-Mart, Wegmans, Price Chopper and others as it posted negative comps in 2005 and 2006, it consistently took market share from Tops. 

 

While I believe that PTFC also would make an attractive LBO candidate in a better credit market, a financial buyer would need to value the business based on consolidated EBITDA, including excess overhead, and as a result the price a financial buyer would be willing to pay would not be anywhere near as high as that which a strategic buyer could pay. 

 

(2) Consolidated (status quo)

While my thesis is based on the premise that PTFC will eventually be acquired by a competitor, it is important to determine that the current price still represents a bargain if PTFC for some reason remains a standalone company. On this basis, I value PTFC at 3x to 6x EBITDA using the same adjusted LTM pro forma number outlined previously, except I assume PTFC’s substantial field and corporate cost structure is maintained. 

			EBITDA Multiple
			3x	4x	5x	6x
LTM EBITDA, PF sale of Wholesale division			12.4	12.4	12.4	12.4
Enterprise Value			37.1	49.5	61.9	74.3
Less: Net Debt & Pension Liab			(43.1)	(43.1)	(43.1)	(43.1)
Plus: Proceeds from Wholesale division sale			43.0	43.0	43.0	43.0
Plus: Proceeds from sale of two stores			7.5	7.5	7.5	7.5
Less: Taxes on gain from sale of two stores			(1.7)	(1.7)	(1.7)	(1.7)
Less: Estimated fees on all transactions (2%)			(1.0)	(1.0)	(1.0)	(1.0)
Market Cap			41.8	54.2	66.6	79.0
Diluted Shares @ 12/5/08			8.6	8.6	8.6	8.6
Implied Share Price			$4.84	$6.27	$7.70	$9.13
Implied TEV/Sales Multiple			0.04x	0.06x	0.07x	0.08x

The valuation range of $5 to $9 implies that this is an extraordinarily attractive investment even if the company is not acquired. However, I still believe a sale is much more likely than not. 

 

Why a Sale Is the Most Likely Outcome

Consolidation of the grocery industry in the northeastern US has been expected for some time. A&P (GAP) discussed this frequently leading up to its 2007 merger with Pathmark, and the combined company continues to make public its expectation for additional consolidation. For what it is worth, A&P management has previously included PTFC on a “long list” of potential acquisition candidates in the northeast. While A&P is the most obvious consolidator in the region, Tops Market (backed by Morgan Stanley) also seems likely to pursue a roll-up strategy. One clue is the chain’s recent appointment of Greg Josefowicz to its board of directors. Josefowicz was the CEO & Chairman of Borders (BGP), and currently serves as lead director of much larger retailers Winn-Dixie (WINN) and PetSmart (PETM), as well as sitting on the board of Telephone and Data Systems (TDS). He has significant experience managing grocery integrations from his long career at Albertson’s and Jewel-Osco, prior to his stint at Borders. It does not seem that a standalone Tops, a private company with 71 stores, would draw such a high-profile director without there being an ambitious agenda. Another clue that Tops may be pursuing acquisitions is that according to the Buffalo News and other local papers, in late March 2008, Tops secured a $1.2 million grant from New York State and announced plans to expand its headquarters from 145 employees to 285 over the course of this year, and in September Tops announced the leasing of additional office space. Finally, 116-store chain Price Chopper (a subsidiary of the family-owned Golub Corporation) has also recently showed that it is open to large acquisitions, having made public statements to the effect that they were closely evaluating the Tops deal. As for compatibility, Tops’ significant market share in the Buffalo and Rochester markets in western New York would fit well with PTFC’s strength in the Syracuse market. Price Chopper’s store footprint, with strong market shares in the Albany and Utica-Rome markets in eastern New York, would also be a good geographic complement to PTFC. 

While it is important to have multiple potential acquirers with compelling strategic rationales for acquiring PTFC, it is also helpful to have a willing seller with a management team and board whose incentives are aligned with those of shareholders. Most relevant is an agreement with PTFC’s top 13 managers disclosed on February 28, 2008, which stipulates certain cash bonuses for management in the event PTFC is acquired before it is able to issue options or restricted stock to its senior managers. The filing discloses exponentially increasing payouts depending on price. For example, the CEO receives the value of approximately 52,000 shares if PTFC is acquired for between $10 and $14.99 a share; 70,000 shares if PTFC is acquired for between $15 and $19.99 a share; and 87,000 shares if PTFC is acquired for north of $20 a share, putting his potential payout at over $1.7m in the case of a deal at $20 and over $2.6 million in the case of a deal at $30. Importantly, there is no guaranteed bonus for management if the company is acquired for less than $10 a share. 

Finally, the board includes two representatives from Bay Harbour, which currently owns 23% of the equity (estimated cost of $28.5 million, or almost $15 a share), $5 million of the convertible preferred issue, and also purchased a $7.9 million position in the company’s real estate loans, for a combined total exposure (at cost) of over $41 million. Other large holders include the Pension Benefit Guaranty Corp, which has held a 22% stake since emergence, and King Street, which owns about 14% of the company, half of which it received in exchange for bonds bought during the bankruptcy and half of which has since been purchased on the open market for an average of $16.49 a share. The company is essentially being run to maximize value for these major holders, each of whom has a significantly higher cost basis, and all of whom will likely require a major liquidity event such as a sale of the company to exit their investments. 

 

Risks

Execution vs. Competition

PTFC’s markets are highly competitive, and a significant decline in profitability due to loss of market share or a highly promotional retail environment would clearly erode EBITDA and free cash flow and diminish the price a purchaser would pay to acquire PTFC. What makes this downside scenario unlikely in my view is that PTFC’s remaining store base has already absorbed Wal-Mart’s entry into its markets, and the surviving (strongest) stores are competing adequately. Also, the low to mid-priced focus of PTFC’s stores somewhat insulates them from the trade-down effect which might negatively impact grocers which rely heavily on higher-priced prepared foods, like Whole Foods or Wegmans, in a weakening consumer environment. 

Potential for Mixed Incentives of Certain Board Members

Bay Harbour held a $7.9 million piece of the $25 million outstanding on the real estate loan facility at the end of Q3, and half of the $10 million convertible preferred, so may occasionally appear conflicted with respect to any board decisions which impact different layers of the capital structure differently. It is still unclear whether Bay Harbour will take pro rata repayment of the real estate loan (which is being paid down to $10 million from $25 million) or leave its piece intact. In any case, the cost of its equity investment (about $28.5 million) exceeds considerably the cost of its investments in other parts of the capital structure ($12.9 million combined, or less). It seems that all key decision makers are aligned in their incentives to maximize PTFC’s equity value. Also, the December 2007 financing having been completed on attractive and fair terms leaves no reason to suspect that any of PTFC’s directors will shirk their fiduciary duties to other shareholders. 

Liquidity

While liquidity in the stock is highly irregular due to the stock trading on the pink sheets and the majority of the float having been swallowed by four institutions, it appears there is currently stock available at extremely attractive prices as small hedge funds prepare for year-end redemptions and liquidations, and other shareholders lock in tax losses before year-end. 

Catalysts

- Awareness that PTFC’s balance sheet is “fixed”

- Improvement in earnings, working capital and cash flow in 2009

- Increased trading liquidity resulting from better transparency from current SEC filings and management hosting regular quarterly earnings calls

- Sale of the company

DISCLAIMER:

Readers are advised that this report is issued solely for information purposes and should not to be construed as an offer to sell or the solicitation of an offer to buy any security. The opinions and analyses included herein are based from sources believed to be reliable and written in good faith, but no representation or warranty, expressed or implied is made as to their accuracy, completeness or correctness. Readers should verify all claims and conduct their own research and analysis before investing in any securities. Investing in securities can be speculative and can carry a high degree of risk, potentially resulting in the partial or complete loss of principal.  

Catalyst

Awareness that PTFC’s balance sheet is “fixed” / Improvement in earnings, working capital and cash flow in 2009 / Increased trading liquidity resulting from better transparency from current SEC filings and management hosting regular quarterly earnings calls / Sale of the company