Description

Short Thesis 

SWY just sold its best asset, its Canadian grocery operation (60% of net income), in a highly dilutive deal.  Investors are distracted by the deceivingly high headline sales price, but they have not crunched the numbers to determine how dilutive it is.  Pro forma for the transaction, SWY is significantly overvalued.   EPS estimates should reset materially lower, and the P/E should compress, as investors realize that they are likely holding the next bankrupt US grocery chain.

Pro forma for the transaction, SWY is trading at 14x P/E vs pre-deal it was trading at 10x.  But, the remaining business is much worse and deserves a lower valuation.  The remaining business is primarily a US grocer in a sharp secular decline with ZERO “core” FCF.  My EPS is ~$1.70 pro forma for the capital structure changes described below (buyback + debt reduction).  Using a 10x P/E, in-line with SWY’s valuation pre-deal, leads to a target price of $17 or -30% downside to the stock.  Ultimately the US grocery business could be a zero.

To get into the weeds for a moment, the crux of the opportunity is that EBIT margins in Canada are four times higher than the US, while EBITDA margins are only two times higher.  So, selling Canada has created a disconnect between valuation based on EV/EBITDA and valuation based on EBIT, P/E and FCF.   SWY looks somewhat cheap on EV/EBITDA (4.8x vs 5.4x pre-deal), which is what people are focusing on right now, but it is very expensive on P/E (14x vs 10x pre-deal).  Similarly, SWY has gotten more expensive on other metrics:  EV/EBIT has gone from 11x to 13x.  The levered non-core FCF yield is the same at 14%, but only because I generously assume that virtually all of the stock comp and the property gains belong to the US operations.   If you exclude the non core property gains, the FCF yield is 8% vs 10% pre-deal.

I’ll make the hopefully obvious point that earnings and cash flow matter more than EBITDA.  SWY deserves to trade at a superficially low 4x EBITDA because very little of the EBITDA converts into earnings and FCF.  Few on the sell side have started to do the math of what pro forma earnings and cash flow will look like.  When they do, they’ll realize that SWY is significantly overvalued.

SWY is one of the largest conventional grocers.  It was written up on VIC as a long in May, so you can read the business description and the bull case there.  I have a dramatically more negative view of the business: it is a highly levered, structurally disadvantaged business, losing market share with steadily declining margins and cash flow, and management is terrible.  I know there is an active discussion thread on SWY.  I considered commenting on the thread, but I decided that the short case is worth its own submission. 

Last week SWY announced that it is selling its Canadian operation to a Canadian grocer for C$5.8bn in cash, or ~10.6x 2013 EBITDA.  After tax proceeds are C$4.0bn in cash, or ~36% of SWY’s market cap.  This is a transformative transaction for SWY because SWY Canada was SWY’s better business in terms of growth and margins, and it accounted for 45% of EBIT and 60% of Net Income.  SWY will use $2.0bn of the proceeds to reduce debt (Net Debt/EBITDA goes from 2.7x to 2.3x, but debt/EBIT goes up from 5.7x to 6.4x), and they will use the “majority” of the remaining proceeds for buybacks.  They will also use cash for unspecific growth initiatives. 

In my analysis below, I assume SWY uses $1.9bn for buybacks at the current price of $24, and I assume they do all the buybacks immediately at the closing of the deal in Q4.  Obviously I am being very generous.  It will take a long time to buyback the stock, but for simplicity I want to look at EPS pro forma for all the capital structure changes.   I also think it is very likely that SWY will not execute on the full buyback, and instead that it will hoard cash in light of the inevitable pressure on cash flow.

The sale was a terrible mistake.  I have long held management in low regard, and this transaction solidifies their ineptitude.  The only acceptable explanation is that management expects Canada to fall off of a cliff – either way it is not good for SWY.  The sale price of 10.6x EBITDA sounds like a huge multiple because SWY itself was trading at 5.3x EBITDA.  As a result SWY’s stock initially popped 30%.  Management cited this multiple premium themselves when they explained why they did the deal.  But, this is the wrong way to look at it. 

First, the transaction is highly tax inefficient. The after tax proceeds are only C$4.0bn, or 7.5x EBITDA.  SWY voluntarily gave up 16% of its market cap to pay taxes.

Second, EV/EBIT is a much more relevant metric (as are P/E and P/FCF…  basically any metric other than EV/EBITDA), and on this basis SWY actually sold Canada for a dilutive price.  The price is 9.5x EBIT vs SWY consolidated is currently trading at 11.6x EBIT.  How can this be given the huge EBITDA multiple paid for Canada?  Because, as I mentioned above, SWY Canada generates a lot more EBIT per dollar of EBITDA than the US operation does.  The EBITDA margin is 8.0% in Canada vs 4.4% in the US, but Canada’s EBIT margin is 6.3% vs 1.7% in the US.  This example glaringly illustrates the importance of leveraging fixed costs to make a profit in a business with low margins and high fixed costs.  SWY US has low margins, so D&A eats up 62% of EBITDA.  Canada has higher margins, so D&A only eats up 20% of EBITDA.  This is the crux of why this is a bad deal, and why the deal is dilutive to EPS.  Also, to be clear, SWY is reducing debt, but it isn’t de-levering.  On a Debt/EBIT basis, leverage is actually increasing from 5.7x to 6.4x. 

Third, as I mentioned, Canada is a better business than the remaining US business.  The grocery market in Canada is a cozy oligopoly (or at least it has been until the recent entrance of WMT and TGT), while the US is brutally competitive.  EBIT in Canada has been roughly flat in the last two years with relatively healthy margins, while EBIT in the US dropped 30% and margins are razor thin.  The relatively OK-ish results in Canada have been masking an absolute train wreck in the US, and obviously SWY is only left with the US after this transaction.  I expect that pressures on the US business will be ongoing.

It goes without saying that retail is competitive, and grocery retail is brutally competitive.  SWY faces significant headwinds as a conventional grocer with high prices, an undifferentiated offering, high cost union labor ($15/hr vs WMT at $10/hr), and other high fixed expenses.   SWY has been and will continue to lose market share, with low-end customers migrating to WMT, TGT and the dollar stores for significant savings and convenience, and high-end customers migrating to WFM, COST, Trader Joe’s for quality and differentiation.   By my estimate, these 5 competitors have doubled their market share of groceries from 15% to 30% in the last 10 years and they are continuing to grow faster than the market.

Numerous statistics show that SWY is getting squeezed.  The table above shows that SWY’s average ID sales have been ~0% in the last 5 years vs average annual growth in US grocery store sales of 3.2% per the US Dept of Commerce.  These trends have shown no signs of abating: in 2012 SWY grew 0.5% while the US grocery market grew 3.1%.  The reason for the market share loss is simple: there is a lot of competition which is better and/or cheaper.  SWY’s prices are 20% higher than WMT for the same basket of goods and 10% higher than KR.  (Several sell side analysts publish monthly pricing surveys).  SWY is undeniably a bad value, and customers are voting with their feet.  In particular, WMT has doubled its market share of groceries nationwide from ~10% to ~20% in the last 10 years.  In the last 5 years, WMT’s grocery sales are up 32% vs SWY’s grocery sales are down -5%.

SWY management likes to claim that it is modestly gaining market share, but they use Nielsen as a benchmark and Nielsen does not include Costco, Whole Foods and Trader Joe’s (these retailers choose not to participate -- WMT only started participating last year).  It is absurd for management to use a benchmark that does not include it main aggressors.

The competitive pressures show up in SWY’s EBIT.  SWY has to cut prices/gross margin to stay relevant (G/M has declined for 5 years in a row), and there is a deleveraging effect on its high fixed cost base.  EBIT dollars and margins have been declining steadily for four years, including in 6 of the last 8 quarters, and I don’t see any reason why these trends will abate.  Below, I lay out the trend in EBIT and my forecast for SWY’s three businesses.  Importantly, this exhibit shows how the relative stability of Canada and the growth of Blackhawk have muted the effect of the declines in the US on the overall business.  Ironically, by IPO’ing a minority stake in Blackhawk this year and by selling Canada, SWY is only putting more scrutiny on its worst business.

Management is Terrible

So what is management’s plan to fix SWY?  Management has identified four initiatives to boost ID sales and to stop EBIT from declining:  1) “Just 4 U” online loyalty program, 2) expanded fuel rewards, 3) “wellness initiative” and 4) center store remodels (i.e. change the flow of stores to direct traffic to higher margin items – they are planning to remodel 250 stores, or 16%, by yearend).

I find that each initiative is underwhelming: they are either (a) already failing to meet expectations (“Just 4 U”), (b) necessary just to be relevant today and to keep up with competition (fuel rewards and wellness), (c) too small to matter (center store remodels, fuel rewards and probably wellness), (d) or just talk (wellness initiative).   The reality is that the structural headwinds are so great that there is very little that SWY management can do other than to let the business gracefully shrink and to milk the declining cash flows.

Management’s track record of delivering the benefits of past initiatives is horrendous – they have missed guidance for 6 years in a row! 

Management appears to be in denial and tries to cover up the disappointments.  As mentioned above, they claim they are gaining market share when they are clearly losing share.   Management also changes the goal posts to make it look like they are hitting their targets.  For example, for 2012 SWY guided to EBIT margin improvement of “+/-5bps” and claimed they achieved +4 bps, but this included a 12 bps legal benefit.   For their 2013 guidance, they have quietly footnoted that they expect 0-10bps of improvement off of a 2012 base which excludes the 12 bps legal benefit in 2012, so they want it both ways (you can see this sleight of hand on pages 11-12 of their March investor day slides).  For another example, in Q1’12 SWY booked a 14c property gain which enabled them to beat EPS by only 2c in what would have otherwise been a terrible quarter.  On the conference call the CEO said the property gains were actually assumed in their EPS guidance, even though they had never said that before.

To make matters worse, the 20 year CEO Steve Burd stepped down in May.  Rather than bringing in an outsider with a fresh perspective, the board elevated the President and former CFO to the CEO role.  His appointment was expected, but nonetheless a disappointment.  He is generally held in as low regard as the old CEO.

Finally, to complete the saga of management ineptitude, we have this disastrous sale of Canada and management’s justification that the sale price is 2x SWY’s own EV/EBITDA valuation.  This comment completely reveals that management has no ability to value its own business, much less to operate it.  An alternative explanation getting some play is that SWY management thinks the Canadian business is headed for a fall, so they sold at the peak.  If this is true, it simply reveals that SWY was overvalued in the first place.

I’ll highlight a few other points that are relevant, but tangential to the core thesis:

Pension: As has been mentioned elsewhere on VIC, per a CS report in 2012, SWY has an absolutely staggering $8bn of off balance sheet multi-employer pension plan liabilities (depending on the methodology for measurement).  This is in addition to SWY’s $914mm of on balance sheet pension liabilities.  I try not to take too much of an academic view of pension liabilities – they are not exactly like debt which I’d add to the EV, but at the same time they are real liabilities that have implications for long term cash flows.  Regardless, the large liabilities are clearly a negative.

Low capex: SWY completed a store remodeling program between 2004-2008, and as a result capex is running below normal.  Management’s capex forecasts imply capex/sales of ~2.3% vs the long term average in the grocery industry of 3-3.5%.  Given SWY’s low margins, this small difference means that FCF is overstated by ~$325mm, or over 60%.  The stores are generally in good shape, but some of the early remodels are going to need work soon (7-10 years is the typical remodel cycle).  In reality, I don’t think SWY is ever going to remodel its stores again because it won’t be able to afford to.  In 10 years, SWY stores are going to look like K-Mart’s do today.

REIT: there has been a lot of speculation in the last 6-12 months around the idea of creating a REIT in the US or Canada.  SWY officially ruled out doing it in the US, but left the door open for Canada.  Obviously that’s off the table now.

HAWK: SWY owns 76% of Blackhawk (ticker: HAWK).  SWY IPO’d a minority stake in April.  HAWK is small, but not totally trivial: it accounts for just under 20% of net income pro forma, and the implied value of SWY’s stake in HAWK is worth ~$4 per share based on HAWK’s trading price.  I look at valuation for the pro forma SWY with and without HAWK.  The conclusion is the same either way.  SWY has said it has no plans to fully divest HAWK.   If you are not familiar with HAWK, it offers pre-paid gift cards.  HAWK charges retailers like Best Buy a 9% commission for distributing plastic gift cards primarily through grocery stores.  HAWK might be an interesting short on its own because it faces very real headwinds from price competition and on-line disintermediation.  

As mentioned above, pro forma SWY is trading at 4.8x EBITDA (vs. 5.3x pre-deal) and 14x EPS (vs 10x pre-deal).   The FCF yield of 13.6% is comparable to the valuation pre-deal but only because I am generously allocating all the property gains to the US business (ex property gains, the FCF yield drops to 8% from 10% pre-deal). 

Bulls like to point to the high FCF yield, but this is very deceiving.  The “core” FCF yield is 0% when you exclude property gains and assume normal capex levels.  I am assuming property gains of $200mm, so that’s 5 pts of the FCF yield (i.e. the FCF yield is 8% ex property gains).  The FCF benefit from below normal capex is $325mm; this is the difference between a capex-to-sales ratio of 2.3% vs 3.0%.  So, that’s 8.5 pts of FCF.  It is also important to recognize that SWY is highly levered, so the unlevered FCF yield is only 8%, which is not so impressive.   Final point is that FCF in the US grocery business is shrinking around -10% per year.  I’d argue that you would need a 20-25% FCF yield to compensate you for the declining cash flow.

If you strip out HAWK and calculate the value of the stub US grocery business, the multiples are a shade cheaper.  Interestingly, the FCF yield is a shade lower.  The reason is that HAWK’s FCF yield is high at 15% the way I am calculating it, i.e., float-related working capital is a large source of cash flow while HAWK is growing.  Arguably this is not a sustainable source of operating FCF, but nevertheless it is FCF which is going to be in SWY’s numbers.  

The valuation of the US grocery business ex-HAWK really highlights the absurdity of SWY’s current valuation: 13x EPS and a 13% levered FCF yield for a business where EBIT and FCF are dropping around -10% per year.  The “core” FCF yield excluding property gains is only 6%.  If you take it one step further and assume “normal” capex, the FCF yield is -6%. 

I’d argue that pro forma SWY should be worth $17 for -30% downside to the stock based on a 10x P/E, in-line with its pre-deal multiple.  Ultimately the US grocery business could be a zero.

This posting is solely for the evaluation of club members and is not a recommendation to buy or sell this stock.  The views expressed are those of the author individually and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time. 

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