|Shares Out. (in M):||37||P/E||0||0|
|Market Cap (in $M):||658||P/FCF||0||0|
|Net Debt (in $M):||519||EBIT||0||0|
|Borrow Cost:||General Collateral|
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INVESTMENT THESIS SUMMARY
SpartanNash Company (“SPTN” or the “Company”) is a regional grocery store chain, food distributor and military concessions operator. The Company’s grocery and distribution segments are both facing secular headwinds and both experienced transitory pandemic-driven boosts that are now reversing. This is happening just as its largest and higher margin distribution customer (17% of revenue) is in the process of transitioning its business away and its military commissary business is losing money at an accelerating rate. SPTN’s stock price does not reflect this reality and has been buoyed by the announcement of an expanded distribution deal with Amazon Fresh last month. This deal came on very unappealing terms for SPTN—negative calorie/ very low margin growth with significant equity dilution. We believe this short presents a +50% return potential as the Company’s revenue growth falters and margins come under pressure over the coming quarters. SPTN is presently GC.
SpartanNash’s retail segment (29% of revenue/ 57% of EBITDA) consists of 155 mid-tier grocery stores in the Upper Midwest (MI, OH, WI, NE, IN) primarily under the Family Fare (87 units), Martin’s (21), VG’s (9), Dan’s (5) and D&W (10) banners. These are smaller local markets, averaging 44k sq ft relative to regional competitors Meijer and Kroger which average 200k and 160k sq ft, respectively. In 2016, the Company acquired what is now its distribution segment (49% of revenue/ 42% of EBITDA). This business operates out of 18 DCs (8.2M sq ft) in the Midwest and Southeast. SPTN’s military segment (22% of revenue/ 1% of EBITDA) operates 236 commissaries on US military bases domestically and abroad.
There are several key issues the market is not fully discounting into the stock or is not aware of at all.
Amazon Contract: There were few details provided in the October 8th press release referencing the agreement but based on previous filings and research, we know the following. SpartanNash had been delivering for Amazon Fresh (does not distribute for Whole Foods) since 2015-2016 and then signed a formal commercial agreement with them in 2016. The October extension represents the 11th amendment of that agreement. Management has not provided any color regarding how much of its revenue comes from Amazon but SPTN has been doing business with AMZN for over four years and with the pandemic surge (AMZN noted its online grocery tripled Y/Y in Q2’20), are likely approaching the 10% customer/ $1B revenue mark (to be disclosed in the 2020 10-K). As part of this new cut of the deal, Amazon is immediately receiving approximately 5% of SPTN’s shares in the form of 1.1M warrants and up to 12% ownership of the Company if certain volume thresholds are met (cumulative $8B in revenue over the 7-year life of the warrants). Incremental margins on this type of service are in the 2-3% range, at best.
This arrangement presents a new conflict with the Company’s existing customers. One competitor noted that the warrant transaction with AMZN may push independents and other non-AMZN accounts to change distribution partners as they choose not to buy from someone who is also their biggest competitor.
Bottomline: In exchange for a five-year renewal, Amazon extracted a pound of flesh from SpartanNash just to maintain the relationship. The reason SPTN was willing to concede so much for somewhat limited incremental volume over the next couple of years and little to no profits is because it simply could not afford to lose its two largest customers and desperately needed to fill some of the hole being created by customer attrition.
Dollar General: DG is the Company’s largest customer (36% of segment sales, 17% of consolidated) and the source of much of its growth over the last several years. In fact, excluding DG growth, SPTN’s distribution segment has been declining since 2017. Below is the historical breakdown of sales the Company derives from DG.
On earnings calls and in other public forums, Dollar General has indicated it intends to self-distribute and fully own its supply chain. This undertaking began early last year with its self-distributed fresh and frozen program, DG Fresh. DG has ramped this program nationally, accelerating its course to owning its entire supply chain. The following is a new risk factor that appeared in SPTN’s 2019 10-K (emphasis added):
A significant portion of the Company’s sales are with a major customer and the Company’s success may be dependent on retaining this business and its customers’ ability to grow their business.
Dollar General accounted for 17% of the Company’s net sales in 2019. The Company serves as the primary distributor of various products and product categories to Dollar General under the terms of its distribution arrangements. The Company’s ability to maintain a close, mutually beneficial relationship with Dollar General is an important determinant of the Company’s continued growth.
The loss of business with Dollar General, including from increased self-distribution to its own facilities, closures of its stores, or reductions in the amount of products that Dollar General sells to its customers could materially and adversely affect the Company. Similarly, if Dollar General is not able to grow its business, or if Dollar General does not continue its relationship with the Company, the Company may be materially and adversely affected.
On Dollar General’s recent Q3’20 earnings call management indicated this transition process is accelerating:
We were self-distributing to more than 13,000 stores from 8 DG Fresh facilities at the end of Q3. We expect to capture benefits from this initiative in more than 14,000 stores from 10 facilities by the end of this year, and are well on track to complete our initial rollout across the chain in 2021…We are in the process of building, expanding or opening a number of distribution centers across our Dry and DG Fresh networks.
DG operated 16,720 stores (of which SPTN has disclosed it services 16,000) so the above shift represents over 80% of its store base. Dollar General also recently announced it is building a new DC in Nebraska that will open next year. SPTN’s third largest DC is located in that market. This transition leaves a major volume hole for SPTN to fill and will be particularly impactful on profits as fresh items bear higher distribution margins than center store dry goods and other non-perishables.
The Company’s contract with Dollar General is up for renewal next year. The writing on the wall signals it is likely that DG will either partially or fully move its business away from SPTN. We think this would equate to an annual revenue loss of $250M-$500M and an EBITDA loss of $15M-$30M EBITDA. Moreover, SPTN faces dis-synergies as its system will still need to continue deliveries to existing customers without the DG capacity to fill their trucks. Either way, the Company’s already razor thin margins will likely continue to compress regardless of the outcome.
Structural Headwinds: Prior to the pandemic, the Company’s core grocery business was demonstrating signs of secular decline with organic EBITDA and same stores sales falling every year over the past five years. Mid-tier chains like those SPTN operates in its grocery segment and primarily services in its distribution business have been getting squeezed from above and below. These independent grocers have faced secular headwinds as Aldi, Lidl and Walmart have increasingly dominated the lower end of grocery, taking share from the tier-twos that cannot compete on price nor selection. On the higher-end, Whole Foods, Trader Joe’s and regional concepts such as Wegman’s and Central Market have encroached. We estimate the core customers SPTN distributes to are declining in the mid-to-high single digit rate per annum. Importantly, these independent grocers are the most profitable for SPTN. Below details the segment trends prior to Covid.
SpartanNash’s distribution segment revenue was up 17% in Q2 yet margins were flat during one of the most favorable quarters for the industry in recent history. SPTN totally missed that opportunity, demonstrating how ineffective they are as operators.
Abating Covid Benefits: Pantry loading, larger basket sizes, lack of promotion and certain consumer shopping preferences resulted in a one-time boon for SPTN. During the lockdown phase of the pandemic people limited their shopping to smaller supermarkets in close proximity to their homes. This bolstered mid-tier local chains like the Company. Various datapoints confirm this temporary trend including a statement from the management team on its Q2 earnings call, “we continued to gain market share compared to the prior year for a second consecutive quarter as consumers have gravitated towards trusted local supermarkets.”
Consumer behavior is now normalizing and the promotion that stopped during the early pandemic has returned as the larger chains are seeking to regain the market share they conceded during the spring and summer. Meanwhile SpartanNash operates in markets saturated with larger, higher quality competitors Kroger, Aldi, Meijer, Walmart and Trader Joe’s. Industry trends such as the move to delivery and online grocery will only exacerbate these headwinds. All in, we suspect retail EBITDA for SPTN will revert to its pre COVID levels of ~$60M per annum, down from $110M for the LTM period.
Margin Headwinds: The Company as well as other grocers and distributors face well known margin pressures. Labor continues to tighten for SPTN as well as peers such as UNFI with wages continuing to increase. The fact that both companies utilize unionized labor will not grant them much flexibility. These labor and shipping pressures, coupled with lost volumes from DG will negatively impact profitability. Simply put, the party is ending and its already razor-thin margins are headed south.
Tying this all together implies SPTN will generate $150-160M in EBITDA in 2021. Applying its historical 5x multiple (arguably generous given the increasing challenges the Company faces) equates to $8-10 per share for a 45-55% return on the short. The DG runoff and contract renewal next year, competitive pressures, normalizing of volumes and various margin pressures discussed should begin to manifest themselves in the near-term and be the catalysts for this outcome.
OTHER RED FLAGS & CONSIDERATIONS
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