Description

February 25, 2017

SpartanNash (NASDAQ:SPTN)

Business Description and Thesis

SpartanNash (“STPN”) is the sixth largest grocery distributor in the U.S., serving independent grocers, select national retailers, and food service distributors in the Midwest, Great Lakes, and Southeast regions.  In addition to wholesale distribution, SpartanNash acts as the primary distributor to the Defense Commissary Agency’s (“DeCA”) military commissaries and exchanges and also operates 145 corporate-owned retail grocery stores, primarily in Michigan, Nebraska, North Dakota, and Minnesota.  The business is the result of the July 2013 merger of Spartan Stores and Nash Finch Company and operates three segments: Food Distribution (49% LTM Sales and 71% LTM EBIT), Military (26% LTM Sales and 7% LTM EBIT), and Retail (25% LTM Sales and 22% LTM EBIT).

The market’s perception is that SpartanNash is a no-growth wholesale distributor saddled with an unprofitable military segment and a doomed retail business.  As a result, shares have fallen by half in the past twelve months and is a screaming bargain for a stable, highly cash generative business underpinned by substantial owned assets.  Our view is each of SpartanNash’s three businesses will produce revenues and earnings meaningfully higher than consensus expectations driven by a fast-growing Dollar General opportunity in Food Distribution, private label penetration and territory expansion in Military, and stabilization in Retail.

Reason for Mispricing

SPTN’s stock is down 40% year-to-date and 56% in the past year driven by a combination of industry and company specific factors:

1. Amazon’s entry into grocery with its Whole Foods acquisition has caused the stocks of nearly all grocers to fall, as investors fear a retail apocalypse in grocery.  Grocery stocks fell an average of 7% on June 16th when Amazon announced its acquisition of Whole Foods as investors anticipated the implications of Amazon’s entry into the already fiercely competitive grocery industry.  Grocery shares fell further in late August after Amazon announced its first price cuts at Whole Foods, and as a group, shares have failed to recover.

2. SPTN’s recent Caito acquisition has been poorly integrated, with sales down 1/3 organically from customer losses.  The deal was initially expected to be accretive to 2017 earnings, but turned out to be a major drag.  Additionally, the ramp up of Fresh Kitchen, SPTN’s foray into prepared foods, and customer onboarding has progressed slower than expected.

3. Investors are myopically focused on SPTN’s declining Retail (22% of EBIT) segment—which has suffered from ongoing comp declines, food price deflation, and margin pressure—instead of focusing on the growing and increasingly profitable Food Distribution business (71% of EBIT).  

4. Loss of management credibility, driven by a poor acquisition, management turnover (CFO Chris Meyers left after a year on the job), cuts to initial 2017 guidance, and most recently, dismal 2018 guidance.

Differentiated View

1. SPTN possesses an underappreciated Dollar General business, which generated ~$865M in sales in 2016 (25% of Food Distribution or 11.2% of consolidated sales) and continues to grow.  Despite more than doubling in the past two years, we believe this partnership has further headway with potential to sustain double-digit growth rates for the next several years.

First, SPTN can grow along with Dollar General, which has the potential to nearly double its footprint from 14,000 to 26,000 stores.

Source: Dollar General March 24, 2016 Investor Day

In 2017, Dollar General had exceeded its store growth objective of 1,000 new stores, growing from 13,000 to more than 14,000.  Notably, STPN has grown with its largest customer, supplying 14,100 Dollar General locations per its most recent 10-Q filing compared to 13,000 at the start of the year.

Second, STPN can grow within existing stores by selling more perishables into Dollar General, which has emphasized an increase in cooler (refrigerator) doors.  

Source: Dollar General March 24, 2016 Investor Day

Currently, Dollar General is averaging 17 cooler doors per location but has a pathway to 23 cooler doors per store; recent remodels have as much as 34 cooler doors.

Third, SPTN has a largely untapped produce distribution opportunity within Dollar General, which only has 300 produce/grocery test stores.  These test stores are comp’ing higher than Dollar General’s average base and may be rolled out to further locations, providing greater opportunities for SPTN.  Given SPTN is already making these trips to Dollar General locations, additional volumes per drop should equate to high incremental margins.

Assuming Dollar General makes steady progress toward 26,000 stores and 23 coolers on average, SPTN has the potential to grow its DG business by double-digits each year for the next several years.

2. After declining organically for nearly four years, SPTN’s Military business is on the cusp of a rebound, growing 2.7% in Q4 2017, following a 4.6% decline in Q1 2017, a 6.8% decline in Q2 2017, and a flat Q3 2017.  This rebound is driven by:

1. A $500M to $1.0B private label opportunity, which just began ramping in the Q3.  By year end, SPTN had 450 private label SKUs available, is adding 1,400 in 2018 and ultimately reaching up to 4,000 SKUs by 2020.

2. Additional commissary volumes in the Southwest, following the exit from an existing DeCA provider.  This transition began partly into Q3 2017 and should provide additional tailwinds into 2018.

Source: Company Website: http://www.mdvnf.com/service.aspx

Prior to obtaining the additional Southwest business, SPTN supplied 160 of DeCA’s 238 commissaries.  The addition of California, Utah, Nevada, and Arizona would add an additional 23 commissaries, an increase of 20% which we believe can contribute an incremental $300M-plus in revenues (LTM revenues of $2.1B prior to winning Southwest business).  

3. The end of deflationary trends, which negatively impacted revenue growth by 2-3% in 2016 and into H1 2017.  Recently, deflationary pressures have abated, providing a slight benefit in Q3 and Q4.  Meat and produce pricing trends continue to be inflationary and should provide a tailwind into 2018.

4. The combination of the three opportunities above can add an incremental $900M in sales over the next five years, growing sales from $2.1B to $3.0B (7.4% CAGR).

3. The Retail business is lapping three consecutive years of comp store declines following pressures from competitive openings, food deflation, and an elevated promotional environment.  We believe the Retail business will stabilize in 2018, due to the following:

1. A prudent capital allocation strategy by the SPTN management team, which is reducing its retail store portfolio by closing unprofitable stores. Store closures have resulted in a decline from 172 stores in 2013 to 145 today, with opportunities for further consolidation.  SPTN is one very few retailers focused on closing stores, which should result in a much cleaner store portfolio entering 2018.

2. Food inflation benefits similar to the distribution businesses.  The retail business is coming off a period of deflationary trends, which accounted for ~1.0% comp headwind in 2016, accounting for nearly half of the -2.4% comp.  These deflationary trends have stabilized, in Q2 and provided a 60 basis point inflationary benefit in Q3 and 77 basis points in Q4.  Meat and produce pricing trends continue to be inflationary and should provide a tailwind into 2018.

3. Continued industry consolidation and bankruptcies.  In the past several years numerous chains have filed for bankruptcy (Strack & Van Til, Marsh, Fresh & Easy, Haggen, etc.), resulting in heathier environment for incumbents going forward.  Impending bankruptcies for Bi-Low, which owns Winn-Dixie, and Tops Friendly Markets will lead to a further reduction in competition.

4. Stable geographic end markets.  SPTN’s company-owned retail locations operate in stable geographic markets which on average boasts unemployment rates below that of national average.

2. Fears of Amazon’s “disruption” to the grocery industry, and SPTN in particular, are overblown, as we see little to no near-term impact from its acquisition of Whole Foods.  First, SPTN and Whole Foods serve entirely different markets: SPTN is concentrated in the Midwest and Great Lakes regions while Whole Foods is concentrated in rural and coastal geographies.

Source: Company Investor Presentations

In the state of Michigan, which houses 87 of SPTN’s 145 retail stores, Whole Foods has only seven.  And in Nebraska, SPTN’s second biggest geographic exposure with 24 locations, Whole Foods has two.

Second, Amazon Fresh is years away from achieving scale, as Amazon currently has a mere 3 million square feet of warehousing—the vast majority of which are outside SPTN’s markets—dedicated to Fresh and Prime Pantry.  This is a fraction of its 100 million in overall square footage in North America.  Given the complexities of building and operating food distribution centers (temperature controls, FDA regulations, logistics, etc.), Amazon would have to devote billions of dollars in capital to achieve scale.  Given higher return opportunities available, it is a doubtful Amazon would prioritize what is inherently a low margin, low ROIC business.  In fact, Amazon’s recent decision to discontinue Fresh in certain markets proves its focus is on other opportunities.

5. The mistake of the Caito acquisition has been made and is fully reflected in the stock price.  More importantly, this capital allocation blunder provides an attractive entry point for new investors, as the mistake has already been paid for.  With Caito revenues declining from $600 million pre-acquisition to $411 in 2017, consensus expectations are not assigning any growth to this acquisition going forward.  

At this point, any rebound in Caito’s core fresh-cut and produce distribution business and the ramping of Fresh Kitchen, an incremental $100M in revenue at scale,  provide free upside optionality.

More importantly, Caito has masked the true earnings power of SPTN’s legacy Food Distribution segment, which is growing EBITDA at a double-digit rate.  As Caito normalizes, the earnings power of the Food Distribution will be restored.

6. We believe SPTN’s 2018 earnings guidance of $2.20-2.32 per share (vs $2.10 per share in 2017) is intentionally conservative.  At the midpoint, guidance assumes a mere $0.16 per share in earnings growth, which approximates half the tax savings the Company will benefit from under the new, lower tax rate alone.  In other words, Management’s outlook implies flat year-over-year pre-tax earnings, despite a growing legacy Food Distribution business, new Military contracts, cleaner Retail portfolio, lapping of Hurricane related issues, losses in Caito, and a lower share count. Following two cuts in guidance in 2017, management is better off setting the bar low and beating expectations, and our view is that it will do exactly that.

Valuation

SPTN trades at 7.4x 2018 earnings and 5.3x 2018 EBITDA, a valuation far too low for a stable, highly cash generative business with growth opportunities in all business lines.  We believe the stock is worth $29 per share (at the midpoint of our valuation), representing 75% upside.

We believe this valuation is conservative given Caito and Nash Finch combined were acquired for roughly $1B with the legacy Spartan Corp business valued at $600M prior to the Nash Finch deal, which implies no value has been created since the deal closed four years ago.  Moreover, we believe an investment in SPTN at these levels maintains a comfortable margin of safety given its hard asset value (SPTN owns 7.9 million square feet of real estate), substantial cash generation (it should consistently generate $110M+ in free cash flow), low sentiment and expectations, low absolute and relative valuation, insider buying, and share repurchases.  

Risks

1. Value-destructive M&A deal/capital allocation

2. Caito loses another customer

3. Loss from Dollar General business or other distribution customers

4. Retail profitability takes another leg down

Catalyst

1. Earnings beat and raise in 2018 guid

2. Industry consolidation

3. Caito normalization