Description

"Stocks of companies selling commodity-like products should come with a warning label: ‘Competition may prove hazardous to human wealth.’”

This Warren Buffett aphorism summarizes how we think about our short book.  The company detailed in this write-up is a good example of this philosophy in action.

Thesis Overview

Smart & Final Stores, Inc. (“Smart & Final” or “SFS”) is a warehouse-style grocery chain based in Commerce, California.  SFS shares are listed on the New York Stock Exchange and currently trade for roughly $14.50 per share ($1.1B market cap).  Though investors view Smart & Final as a growth company and award it a commensurately rich 25x earnings multiple on 2016 estimates, we believe a new competitor poses an existential threat to the company which should be reflected over time in deteriorating sales trends and a single-digit share price.

Three Ways to Win

In business, there are three ways – and only three ways – to win.  A company can win on quality, it can win on service, or it can win on price.  To be successful, a clear-headed business owner must pick which of the three fits his or her company best and then relentlessly work to maintain the company’s edge in that discipline.

Smart & Final seeks to win on price.  Founded in Los Angeles in 1871, SFS serves value-focused customers via an easy-to-shop, no-frills experience.  Smart & Final currently operates 290 grocery stores spread across the western United States with the bulk (nearly 80%) in its core market of California.  The company’s three banners include (i) legacy Smart & Final stores (30% of locations, 12,100 SKU’s, average size 16,000 square feet), (ii) updated Smart & Final Extra! stores (50% of locations, 15,800 SKU’s, average size 27,000 square feet), and (iii) Cash & Carry stores (20% of locations, 8,500 SKU’s, average size 20,000 square feet).

The numbers show how SFS beats out the competition.  Grocery stores in the US tend to offer between 30,000 and 50,000 SKU’s; by operating with less than half that figure, SFS generates improved sell-through per SKU which helps Smart & Final negotiate better terms with its suppliers.  The volume-per-SKU advantage is doubly-true for SFS because in addition to selling to households, the company also sells to business customers (individual restaurants or small restaurant chains) who purchase in bulk and account for roughly one-third of sales.

Finally, while lower-priced private label (i.e., store brands) accounts for about 20% of sales across the US grocery industry, private label represents 30% of SFS sales.  With fewer SKU’s, better inventory turns due to its business clientele, and a higher proportion of private label sales, Smart & Final (as noted in its latest 10-K filing) can offer prices that are “substantially lower than that of conventional grocers and competitive with that of large discount store operations and warehouse clubs…with no membership fee requirement.”  It’s a compelling combination.

The Killer A’s

When business historians reflect on the competition-crushing disruptors of early-21st-century industry, Amazon.com, Inc. (NASDAQ: AMZN; “Amazon”) will surely be the first company that comes to mind.  Amazon has annihilated big box retailers of books, electronics, toys, and clothing.  It has staked out a dominant position in cloud computing services.  Now Amazon appears to have designs on transportation, food delivery, healthcare, and industrial distribution.  The one major lesson in business today is to avoid competing with Amazon at all costs.

We wonder, however, if the same business historians might highlight not one “Killer A,” but two.  For around the world, another disruptor has laid waste to its competition with a radical focus on low prices.  That company is Aldi.

Aldi is a global discount supermarket chain based in Germany.  Originally formed in 1913, the company split in the early-1960’s into “Aldi Nord” and “Aldi Sud” which each manage Aldi stores in an identical manner but have divided global operating territories between them.  Aldi Nord operates in northern Germany as well as in France, Denmark, Benelux, Iberia, and Poland; Aldi Nord also owns the Trader Joe’s brand in the US.  Aldi Sud operates in southern Germany and Ireland, the UK, Australia, Hungary, Switzerland, Austria, Slovenia, and the US.  Between the two, there are more than 10,000 Aldi stores globally with annual sales approaching $100 billion.

Aldi’s focus on low prices is unrelenting.  To maximize inventory turns, Aldi stocks only 1,500 SKU’s.   Private label is more than 90% of sales.  Stores are company-owned and purpose-built – and no detail is too small to be noticed.

In particular, Aldi has a keen focus on employee efficiency.  Floor plans are designed to minimize how long it takes to clean them.  The height of stairs is proscribed to the centimeter so employees can get up and down them quickly.  When the company found its check-out process to be too slow, it designed a proprietary motor that was three times faster than any available.  Customers bag their own groceries and pay a 25-cent fee to use shopping carts that is refunded when the carts are returned, eliminating the need for baggers and extra personnel to gather carts in the store parking lot.  Aldi’s core model is to engineer business processes that save time, and therefore money.

The model works extraordinarily well.  Aldi targets wealthier, higher-wage markets in developed economies where the cost savings from more-efficient (and fewer) employees is most evident.  In general, Aldi seeks to be at least 20% cheaper than any competitor across a basket of goods.  When paired with its “blind taste test” marketing strategy that demonstrates its products are indistinguishable from name-brands but sell for much lower prices, Aldi has crushed incumbent grocers as it has taken share in market after market across the globe.

The Aldi Effect

An important example of Aldi’s impact on legacy grocers is the UK.

Aldi first arrived in the UK in 1990, but did not step on the gas until after the global financial crisis of 2008-09.  In the years that followed, the company swiftly and brutally took share from the five major incumbent British grocers – Tesco plc (LSE: TSCO; “Tesco”), J Sainsbury plc (LSE: SBRY; “Sainsbury’s”), Wm Morrison Supermarkets plc (LSE: MRW; “Morrisons”), Waitrose, and Asda.  Consistent with its approach in other markets, Aldi’s price points are considerably below those of the incumbent grocers (see Exhibit A).

Exhibit A

Source: mysupermarket.co.uk

The results have been striking.  Same-store sales for the publicly-traded British grocers (Asda is a subsidiary of Wal-Mart Stores, Inc. (NYSE: WMT)) have gone badly negative and stayed there (see Exhibit B).  Stock prices have followed suit; Tesco, the largest and most-famous of the incumbents, has seen its share price slashed by two-thirds since the beginning of 2010.  The aforementioned Mr. Buffett, whose Berkshire Hathaway Inc. (NYSE: BRK/B) at one point owned more than 5% of Tesco shares, called his investment in the company “a huge mistake.”  Sainsbury’s and Morrisons too have seen their stock prices battered over the last half-decade.

Exhibit B

Source: Public filings

And the carnage has not stopped.  Aldi’s same-store sales are up 15%+ year-on-year with 80 new stores opening in 2016.  Tesco professes to face a stark “turnaround” in its business.  Third-party analysts refer to an ongoing grocery price war with consumer prices falling 5% this year.  Aldi has entered the market, and we think there’s little competitors can do but batten down the hatches in an effort to weather a storm that seems to have no end.

California

In March of 2016, Aldi opened its first store in southern California.

The total number of Aldi stores in southern California now stands at twenty-seven, all opened in the last four months.  The company has declared its intention to have forty-five by year-end.  In addition, Aldi has opened a distribution center sixty miles east of Los Angeles.  Aldi’s template is to provision one distribution center for every 120 stores, and to follow with a second distribution center to bring capacity up to 200+ stores between each pair.

In short, Aldi is coming for Smart & Final’s home market of California.  Even worse, Aldi competes purely on price – making it a direct competitor to Smart & Final’s value-oriented model.

The coup-de-grâce, however, is where the stores are opening.  We measured the distance between the twenty-seven new Aldi stores and SFS’s store base.  Twenty-six SFS stores are within twenty miles of a new Aldi, nineteen are within ten miles, and eight are within five miles.  As Aldi’s store density rises, those figures will likely worsen.

Smart & Final appears to be a well-run, growing business with structural advantages against the competition.  But as we’ve seen elsewhere, when a “Killer A” enters a new market, there is little the incumbents can do.  Two-thirds of SFS sales – and a higher proportion of profit – are from household customers.  That is all at risk.  As Aldi builds out its store base, we expect SFS’s same-store sales to stall and then go negative, its profit growth to diminish, and its multiple to contract.  The entrance of Aldi into a new market doesn’t come with a warning label, but for the incumbents that may be affected such as Smart & Final, perhaps it should.

Post-Script

We wrote this thesis several weeks ago. In the interim, SFS posted its Q2 2016 results in which the company slashed guidance and delivered its first negative comp in years - a shortfall that badly blindsided the market. Guidance for 2016 same-store sales was lowered to -0.5% to +0.5%. Shares are down about 10% from that point ($16 per share to $14.50 per share).

To us, however, this is just the beginning.  Aldi today threatens about 15% of SFS’s EBIT.  Twelve months from now, Aldi will threaten 60% of SFS’s EBIT.  Twelve months after that, it will be 90%.  And Lidl, the other famous hard discounter from Germany, is anticipated to enter the US in late-2017 or early-2018.

There will likely not be a one-day crack when SFS’s stock declines 50%.  But over the next 2-3 years, we think investors will see a steady drumbeat of underwhelming comps, disappointing growth, and multiple contraction.  Q2 2016 was an alarm bell, ringing loud for all to hear.  The competition is here - and it’s time to batten down the hatches against the oncoming storm.

Disclaimer

The author of this posting and related persons or entities (“Author”) currently holds a short position in this security.  Author may short additional shares, or buy to cover some or all of Author’s shares sold short, at any time.  Author has no obligation to inform anyone of any changes to Author’s view of SFS US.  Please consult your financial, legal, and/or tax advisors before making any investment decisions.  While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note.  The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in SFS US.  READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE.  As with all investments, caveat emptor.

Catalyst

Rising competition causes comps, sales, and profits to disappoint, resulting in the market awarding the company a much lower multiple on reduced bottom-line expectations.