Description

Spartan Stores (SPTN)

Summary

Spartan Stores (SPTN) is the nation's 11^th largest grocery distributor with warehouse facilities in Grand Rapids, MI.  The company distributes more than 40,000 private label and national brand products to approximately 375 independent grocery stores in Michigan, Indiana, and Ohio.  Spartan also owns and operates 96 retail supermarkets in Michigan, including Family Fare Supermarkets, Glen's Markets, D&W Fresh Markets, Felpausch Food Centers, and VG's Food and Pharmacy.  SPTN's strategy is to be the strongest "traditional" supermarket player in each market that it competes in and to differentiate itself from low-cost supercenter players.  SPTN is the largest food distributor in Michigan and has a #1 or #2 retail market share in its two core market areas.  The company has a unique hybrid retail-distribution strategy which has consistently produced strong financial results.  On an LTM basis, retail segment revenues and EBITDA were $1.4b and $47m, respectively, and distribution segment revenues and EBITDA were $1.1b and $55m, respectively (see Quarterly Segment Results below).

We have invested in and followed SPTN for several years since Craig Sturken joined as CEO in 2003.  We believe SPTN has one of the best management teams in the industry which has pursued a long-time strategy of contiguous growth in both its retail and distribution segments around Michigan.  Despite a brutal economic downturn in Michigan and aggressive entry by superstore competitors over the past few years, SPTN is achieving near-record levels of EBITDA and cash from operations, even before a meaningful recovery has taken hold.  Over the past four years, SPTN has invested close to $200m in selectively acquiring three well-established Michigan-based retail chains and, in addition, over $150m in capital expenditures to strengthen its operations and further tighten its relationships with both retail and distribution customers.  This nearly $350m in capital investment represents close to 70% of SPTN's current EV.  Our thesis is that eventually the Michigan economy is going to recover and we think the company's results could snap back quite dramatically as SPTN finally gets a payoff on these capital investments.   

SPTN has an enterprise value (EV) of about $500m and trades at less than 5x LTM EBITDA (approx $103m), about 5x LTM cash from operations (approx $100m), and under 6x LTM FCF (defined as CFO less cap-ex) (approx $65m).  SPTN has an attractive equity free cash flow yield of about 17% and sports one of the lowest leverage ratios in the industry at 1.5x net debt to EBITDA.  This is despite the major capital expenditure and acquisition programs over the past four years.  SPTN's free cash flow yield on EV is about 12%.

Further, we believe SPTN's competition will moderate over the next few years as superstore openings decline signiifcantly.  We believe Meijers and WalMart, the two primary superstore competitors in SPTN's markets, have earned disappointing returns on their recent store openings in SPTN's market area.   Michigan is one of the most highly penetrated superstore markets in the country.  (Michigan also has one of the highest unemployment rates in the country).  As a result, a reduced number of supercenter openings are expected over the next two years, with only one new supercenter expected in the current FY12. 

There is also some evidence of food inflation based on recent comments from food retailers and others and this is generally a good thing for food retailers.  On its most recent conference call, SPTN mgmt stated that is was confident that higher commodity prices could be passed on to retail customers.

Business Description

SPTN has two segments: retail and distribution. 

SPTN's distribution segment has a dominant position in Michigan and a growing presence in Northern Indiana.  It is the only full-service distributor with a facility in Michigan.  It has a loyal customer base and one of industry's lowest attrition rates, with 8 of 10 largest customer relationships extending beyond 40 years. Key strengths of SPTN's distribution segment are value-added services, attractive private brands, and strong relationships built through close communication.  In FY10, two distribution centers were consolidated into one in Grand Rapids, Michigan to improve operating efficiencies and reduce costs.  Distribution strategy is to continue to add new accounts and improve penetration with existing accounts as well as look for acquisition opportunities in contiguous states.  Distribution customers include customers with one store and customers with up to 20 stores.  SPTN's five largest distribution customers, excluding corporate stores, accounted for about 18% of FY10 distribution sales.  SPTN believes Indiana and Ohio represent large potential opportunities for expansion of their distribution customer base.

SPTN's retail segment strategy has been to offer a differentiated alternative to supercenters and other low-cost competitors.  Retail growth has come primarily through acquisitions supplemented by organic growth resulting from major remodel and relocation projects.  Since FY07, three retail acquisitions have been completed, representing 53 total stores.  All three acquisitions were either existing or former distribution customers and this provides SPTN strong insights about their markets and operations.  In addition, distribution customers know that SPTN is a potential exit strategy for them.  SPTN currently has 97 retail supermarkets with average size of 42k square feet and average sales of $14m per year.  SPTN's supermarket store count has increased 80% since end of FY04.

Key retail initiatives have been increasing private brand penetration, introducing a loyalty card, as well as increasing the number of pharmacies and fuel stations.  Growth in retail will continue to be primarily through acquisitions in contiguous markets which company understands best and by providing a "high quality, unique, and more intimate shopping experience" that is hard to big box retailers to replicate.

Quarterly segment results for the distribution and retail segments are shown below. 

Market Shares

SPTN has strong competitive positions in it two core Michigan markets.  First, in its Northwestern, Michigan (population 616k) market, SPTN had a 38% market share, WalMart was 23%, Meijer was 13%, and Nash Finch was 10%.  Second, in its Southwestern, Michigan (pop 2,012k) market, Meijer had a 32% share, SPTN was 30%, WalMart was 17%, and Sam's Club was 5%.  In its secondary Michigan markets, SPTN has market shares of 7% (Lansing, MI), 11% (Southeastern, MI), and 12% (Flint-Saginaw-Bay City, MI).  These shares are for SPTN owned stores as well as SPTN supplied stores.

Acquisitions / Capital Expenditures

SPTN has used its strong cash flow from operations to fund most of its recent $350m investment in acquisitions and capital expenditures.  In fact, the company's net debt has not increased much over the past four years (from $134m to $150m) and net debt to EBITDA has declined.

In December 2008, the company acquired VG's Food Centers, which operated 17 retail grocery stores in Eastern Michigan for $85m plus $17m for inventories and cash acquired.  VG's increased consolidated sales by $140m on an annualized basis.  VG's was a customer of the Company's distribution segment.  In June 2007, the company acquired 20 retail grocery stores and other assets located in Western and Central Michigan from G&R Felpausch for $38m and $13m for inventories.  Felpausch increased consolidated sales by $100m on an annualized basis.  Felpausch was a customer of company's distribution segment.  In March 2006, D&W Fresh Markets was acquired and increased the company's annualized sales by $200m on an annualized basis.

We believe SPTN's distribution segment gives it an excellent relationships with and insight and knowledge of distribution customers who may be attractive acquisition candidates for SPTN's retail segment.  In fact, this is the pattern all of SPTN's major retail acquisitions have followed in recent years.  We believe these acquisitions and capital expenditures have enabled SPTN to build a very strong market position in Michigan and northern Indiana with increasingly strong customer relationships that are differentiated from low-cost supercenter players.

We expect capital expenditures to moderate over the next few years as the current store base and distribution operations are in good shape, resulting in improved free cash flow generation.  Capital expenditures are estimated at $35m for FYE 3/31/11 as compared to $57m in the prior two FY's.

Strategic Plan

The chart below clearly shows SPTN's strategic plan in action.  The company has added fuel stations, pharmacies, and private label items to more tightly connect with customers.  The result has been a steady improvement in gross margins, adjusted EBITDA margins, and cash from operations.  Further, this has been accomplished during an extremely difficult economic environment and while maintaining a stable investment in working capital, thereby driving improved ROIC results.

The problem for SPTN has been retail comp store sales, which have declined for seven consecutive quarters due to superstore competition and high unemployment in the Michigan area.  (See Quarterly Results below).  Comp store sales in recent years have trended as follows:  FY07 +1.4%; FY08 +3.4%; FY09 +3.5%; and FY10 -4.9%.  Recent quarterly comp store sales have started to improve (see Quarterly Consolidated Results below).  We believe SPTN's comp store sales are likely to continue to gradually improve over the next year or two and this will ameliorate a major headwind for financial results.

Recent Results

SPTN mgmt has indicated recently that they were hopeful the Michigan economy has bottomed based primarily on two key factors.  First, auto sales have moved up to 11m to 12m annualized -- mgmt is hopeful they can eventually return to 14m to 15m annualized or 30% higher than current levels (but still below 2007 levels).  Second, much of SPTN's retail segment operations (35 to 40 stores) are located in the Grand Rapids market, which is much more diversified and tech-oriented than the Detroit market, and has the potential to recover faster.  One more point of optimism is the change-over in leadership in Michigan with Republican governor and legislature which will hopefully be more business-friendly.

Comp store sales declined 4.4% in Q3 as compared to 4.7% in Q2 and management said they expected a sequential improvement in Q4 "at a significantly greater rate".   However, they also warned of the potential impact on sales of recent severe weather on Q4 comp store sales.  Therefore, we believe the overall comp store sales trend should gradually improve but are cautious about quarter to quarter movements.  Mgmt has indicated that SPTN comp store sales are closely correlated with the Michigan unemployment rate which is currently "officially" at 12% to 13%.

Comparables

We have compared SPTN to some other food retailer and distributors although any direct comparison is not perfect due to SPTN's unique hybrid business model and the differing sizes, geographies, and business models of these companies.  The comparables show that: 1) SPTN has a higher ROIC than these similar companies, 2) SPTN is less leveraged that these companies, and 3) SPTN trades at a lower multiple to cash from operations (CFFO) compared to these companies.  It is this strong CFFO and its effective use by mgmt that we believe will ultimately drive significant shareholder value creation for SPTN.

Strong Balance Sheet and Downside Protection

SPTN has an extremely strong balance sheet with net debt of about $150 m as of 1/2/11 or about 1.5x EBITDA, which compares very favorably to its more highly-leveraged peer group.  Its net debt position has been steadily declining in recent quarters, particularly as major capital expenditure programs are completed and current capital expenditures are much lower, while cash from operations has increased to record levels.  We expect these trends to continue.

Strong Cash Flow Generation

SPTN consistently generates strong cash flow from operations, with over $350m generated in the past five fiscal years or about 70% of the EV.  SPTN has achieved this is an extremely difficult business environment, in a state with very high unemployment rates.  Further, SPTN has achieved this during a period of aggressive superstore expansion into one of the most highly penetrated superstore markets in the country.  We believe SPTN can continue to generate strong cash flows from operations, even if the improvement in comp store sales which we expect takes longer than we planned.  We believe management is very focused and careful about how it deploys these cash flows and this intelligent capital allocation, plus the strong cash generation, both combine to limit our downside in this investment.  SPTN's food retailing and distribution business is fairly stable with well-established customer patterns and SPTN has built a very strong market position in the Michigan market. 

Conclusion and Target Price

We believe SPTN can sustainably generate $55m to $65m of free cash flow per year going forward, or $2.50 to $3.00 of free cash flow per share, representing about 6x the current share price.  This assumes SPTN is able to maintain cash from operations near the $90m to $100m range achieved in FY10 and expected for FY11, less $35m of maintenance capital expenditures (equal to D&A expense).  We would not be surprised to see SPTN trade at 10x FCF per share in a better economic environment, or $25 to $30 per share. 

Based on $50m of FCF per year, SPTN would have basically zero net debt in three years.  We believe adjusted EBITDA could easily grow to $115m or more over the next three years and, based on 5.5x adjusted EBITDA, SPTN would trade for $28 per share (assuming net debt equal zero).   We believe SPTN's well-established market position and strong cash-generating ability, combined with a management team that allocates capital very prudently, provides substantial downside protection, particularly at current price levels.   SPTN provides an attractive investment opportunity with asymmetrical risk-reward characteristics.

Summary Financial Information

Catalysts

• 1. Strong free cash flow generation and effective capital allocation should drive long-term shareholder value.
• 2. Reduced store openings and pricing pressure from superstore competitors like WalMart and Meijer.
• 3. Gradual improvement in comp store sales.
• 4. Modest valuation of 5x LTM EBITDA and 5x LTM cash from operations.
• 5. $55m to $65m of free cash flow per year results in a conservatively leveraged free cash flow yield of 17% and unleveraged free cash flow yield of 12%.
• 6. Low-risk balance sheet with net debt of $150m as of 1/3/11

Risks

• 1. U.S. economy turns down again.
• 2. Michigan economy does not continue its recovery. Comp store sales do not stabilize/
• 3. Supercenter operators return to an aggressive expansion mode.
• 4. SPTN is not able to pass on cost increases to end customers and its margins get squeezed.

Disclaimer

Disclaimer:  We own shares of SPTN.  We may buy or sell these shares at any time without notice.  The information in the write-up is believed to be correct as of the date written but VIC members should do their own verification of this information and analysis of this potential investment.  We undertake no obligation to update this write-up if new information arises at a future date.

Catalyst