Description

PriceSmart (PSMT) is an under-followed international warehouse club franchise with the potential to appreciate 40% or more in the next year. The company trades at 12x forward earnings and 6.6x forward EBITDA and is lead by Robert Price, who together with his father Sol Price, started the warehouse club industry in the U.S. in 1976 by opening Price Club with $2.5M. Seventeen years later Price Club merged with Costco, valuing Price Club at $2B. The company is growing same store sales in the high teens and with only 23 warehouse clubs across Central America and the Caribbean, PriceSmart has ample growth opportunities.

Why is the stock cheap? PriceSmart over expanded and got into financial trouble. Last year the company’s operations improved significantly, but a rights offering that represented an additional 70% of the float kept a lid on the stock. The rights offering ended Jan 31, 2006. Lastly company has limited or no Wall Street coverage.

Some more history is useful to understand why we have an opportunity today. PriceSmart went public in 1997 at about $16 per share and soared to over $40 by 2000 on investor hopes that PriceSmart would be the Price Club / Costco of international markets. It hasn’t worked out that way. Why? At the end of 1997 Robert Price removed himself from day-to-day operations and handed over leadership to a newcomer in the retail field. The company grew at a rapid clip, from 2 stores in 1998 to 26 in 2002, but ran into operational trouble. Management focused on revenue growth, not profits. The company over expanded and over extended itself, opening stores not only in Latin American but also Asia. Merchandising was poor. The company stocked inferior products and ran more like a grocery store than a warehouse club. Management discounted memberships, an important source of company income. An increasingly poor financial position led vendors to curtail credit, and as a result the company wasn’t able to maintain the right inventory on the shelves.

Robert Price took back over the CEO chair in April 2003 and hired a new CFO and controller in December, 2003. In 2004 Price hired a new president, Jose Laparte, who previously ran 72 Sam’s Clubs in Latin America. The company exited several unprofitable operations, most notably the Philippines, thereby focusing the company on one region: Central America and the Caribbean. Management improved product quality and availability and costs are under control. The results of its efforts are reflected in improved same store sales growth (see table below) and growth in membership accounts. The company grew its membership account holders by 11% in FY05 (Aug) and by 16% in the most recent reported quarter (Nov05). I believe significant improvements in earnings and cash flow will be next.

FY (Aug): Same store sales growth
2001: 4%
2002: 0%
2003: -7%
2004: -2%
2005: 14%
2006 YTD: 17%

The company’s overexpansion and resulting poor financial results put the company in an overleveraged, undercapitalized position. In September 2004, PriceSmart announced a financial restructuring, which is well summarized in this press release: http://www.pricesmart.com/IR/090304.htm

I won’t go over all the details here, but there are two points I’d like to note:
1. In October 2004 the Price’s exchanged their PriceSmart preferred shares and debt for common stock at prices ranging from $8-10. The Price Family thereby upped their equity stake from about 30% to 50%. The Prices control the shares either directly or through Price Charities, which is controlled by the Prices.
2. The company commenced a rights offering. Each right gave common holders the right to buy 1.5 common shares at $7 until January 21, 2005 and if that right wasn’t exercised, the right to buy 1.5 common shares at $8 until January 31, 2006 (the original rights expiration was December 2005). To the extent the company did not receive at least $25 million of proceeds from the rights offering, the Prices agreed to purchase enough shares of the stock at $8 to cover the shortfall.

The company raised $48m by selling 6.8m shares pursuant to the $7 rights exercise in January 2005. The $8 rights period ended a week ago and the company sold 2.5M shares for proceeds of $20m.

Importantly, I think the rights offering kept a lid on the stock in the past year. The number of shares exercisable from the rights offering was a large 70% of the float. The company has noticeably improved its operations, but the stock has remained flat.


Business model

COST has successfully demonstrated the warehouse business model.

Like COST, PriceSmart targets a particular margin and will lower prices to drive more volume rather than allow gross margin to increase, thereby leveraging fixed expenses. PriceSmart’s target GM% on warehouse sales is around 14.5%. Because of the large fixed costs in the business, incremental operating margin is about 10%. Pretax returns on capital I believe will approach 20%.

PriceSmart has adapted its stores to Latin American markets with smaller store sizes (around 50,000 sqft versus 100k + for Costco stores in the U.S.) and lower annual membership fees versus U.S. warehouse stores. PriceSmart’s advantage over local vendors is its ability to deliver high quality merchandise at very competitive prices, owing to the company’s low cost operating structure.

The company sources about half of its merchandise from in-country / local markets.

PriceSmart has no overlap with Sam’s Club or Costco, which has led some to speculate that PriceSmart would be an acquisition target for either WMT or COST. Both PriceSmart and Costco significantly downplay this possibility in comments to the media. More importantly, Costco and Wal-Mart’s absence likely allow for a more benign competitive environment where PriceSmart competes almost exclusively with local retailers.


Financial Model

Aug FY-end
($millions) FY04 FY05 FY06E FY07E
Revenue 544 619 714 785
Op inc (5) 6 18 25
Depreciation 12 10 9 9
EBITDA 7 16 27 34
Cash from ops 19 11 18 29
Maint capex 2 2 4 4
Free cash flow 17 (1) 14 25
*historical results exclude discontinued operations and charges
As of Nov-05 net debt was 7m (company Jan 31 raised $20m from rights offering)
Shares outstanding are 28.3m, including 2.5m shares from the Jan 31 rights offering

The published financial statements are messier than the numbers above and show significant operating losses for the most recent year, FY05. The reported net loss from continuing operations in FY05 was $23m, the operating income loss, $5m. I excluded asset impairment and closure costs to arrive at the +$6m in operating income for FY05.

I estimate revenue will grow about 15% in FY06 (Aug). I think 15% could prove conservative. For the first five months of the fiscal year revenues are up 19% y/y and same store sales are up 17%. The number of members grew 16% y/y in 1Q06 (Nov). I estimate revenue will grow 10% in FY07 based on 5% member account growth (versus 10-15% recently) and ongoing increases in sales per member / sales per square foot. I do not include the potential opening of new clubs, which would boost sales, but decrease near term earnings.

There are three key cost lines: warehouse cost of goods, warehouse SG&A and corporate SG&A.

The company targets warehouse gross margin at 14.5%.

In the most recent quarter warehouse SG&A was 11.0% of warehouse sales. There is a significant fixed component to warehouse SG&A such that incremental warehouse SG&A runs at about 5% of incremental warehouse sales, perhaps a bit less. The company believes it can keep corporate SG&A flat at $22m for at least the next year.

Putting this together, I would expect incremental operating margin to be about 10%. That figure was significantly higher at 15.6% in FY05 (Aug).

The company’s experience suggests that revenue per store can grow to $40m before the company needs to add a new location. Average revenue per store for the company was $28m in FY05, so there is significant room for the company to leverage its existing warehouse and corporate SG&A. Revenue per store today does vary significantly by market. For example, the company started to reach maximum capacity in Costa Rica, so they opened a fourth Costa Rica club November 18, 2005.

Membership income. PriceSmart charges a $25 per year membership fee, which it recognizes ratably over the year. Notice the strong growth in deferred membership income on the balance sheet. Membership accounts at Nov05 stood at 435,000, up about 16% y/y. Part of this is due to the company opening the new warehouse club in Costa Rica, but membership accounts were up an impressive 11%y/y in the Aug quarter (i.e. without the new club in Costa Rica).

The company’s capex is confined mostly to the no frills warehouse shell and inventory display. Note that in FY04 and FY05 the company only spent $5m combined ($2.5/year) excluding the acquisition of land and initial building costs for a new club in Costa Rica. That compares to annual depreciation expense of about $9m.

PriceSmart’s international tax rate is around 25%. For income it recognizes in the U.S. it pays about 40%.


New store model

Now that management has streamlined operations, I estimate the return on capital invested for a new store is 17% (pretax) in the second year of a store’s operation. My cash flow model for a new store shows a pretax IRR of 19%.
The IRR figure is higher because there is a significant fixed component of warehouse operating costs, so margins get more interesting after a store grows beyond the $25m I assume for the second year of a new store’s operation.

Assumptions for calculating the pretax cash return on investment in a store’s second year of operation:
Membership fees, year two: $0.5m (19k members x $25/year)
Warehouse club revenue, year two: $25m
GM% on warehouse club revenue: 14.5%
Cash warehouse club operating expenses: 9% of sales
=>cash operating income of $1.9m

Working capital:
Cash, % of sales: 2%
Inventory, % of sales: 16%
Accounts payable: 85% of inventory (about 14% of sales)
Net working capital, % of sales: 4%, or $1m
Land, building and equipment: $10m
=total investment of $11m

The company believes no additional SG&A at the corporate level will be required for additional stores for the foreseeable future.


Valuation

I use a 10x EBITDA multiple on FY07 numbers to arrive at a one year $12 target price, up about 50% from here. That multiple is in line with COST, WMT, TGT, which may seem aggressive. However, I think a 10x multiple is reasonable considering the revamped management team with Price at the helm, the likelihood of strong EBITDA growth (I estimate the company will double its EBITDA FY05 to FY07) and strong growth prospects beyond FY07. Also, PriceSmart’s international tax rate is only about 25% and the company has significant NOLs (see next paragraph). If you prefer a multiple of earnings, I think PriceSmart will earn about $0.70 in FY07.

NOLs. The company has $76m in federal and state NOLs. I expect the company to fully utilize these NOLs and estimate their present value to be about $20m, or about $0.70 per share.

As a side note, and of more interest to a control investor / acquirer, the company owns many of the store buildings and underlying land. Most of the land on the books was purchased about 5 years ago and today is significantly more valuable. The balance sheet value for the land at Nov05 was $43m. Net property and equipment was $156m at Nov05, of which $100m (gross) is buildings.

Catalyst

Rights offering overhang now behind the company
Big earnings swing from negative to positive
Continued EBITDA growth, which going forward will be more visible without discontinued operations
Company acquired by Wal-Mart or Costco