Please see the previous VIC write up for more background on the history and business of SVU.
We believe SVU is a long because it continues to be a misunderstood post-reorg equity that trades at attractive free cash flow multiples and a discount to a sum of the parts of the three businesses. In our view, a major catalyst for the shares will be the likely exit of the low multiple conventional grocery stores in the next 12 months that will force the market to re-rate the stock to a more appropriate valuation. Our base case price target is $11 (50% ups).
Note: FY ends Feb so FY15 is essentially CY14 and FY16 is CY15
Business Segment Description & Recent Trends:
Save A Lot (31% of EBITDA) – SAL is a hard discount supermarket format which is a relatively new concept in the US that we think has a real square footage growth story that the market can get excited about. Last year management showed that SAL, when run properly, is a LSD/MSD SSS grower as we saw with the corporate owned stores (30% of total stores). In addition, last quarter (Q4 14) we saw the inflection to positive SSS for the licensee stores (70% of total stores). SAL will open at least 65 new locations in FY15 offset by 30 store closures resulting in 2.5% net sqft growth with continued acceleration from there. The right peer group for SAL is the Dollar Stores which trade at 8-9x 2014 EBITDA. The Dollar stores are expected to grow SSS at MSD and sqft at MSD/HSD, in line with our expectations for SAL starting in FY16.
Retail (33% of EBITDA) – This segment are the remaining (post 2013 Cerberus transaction) traditional supermarket banners consisting of Cub, Shop N Save, Shoppers, Farm Fresh, and Hornbachers. Retail is slowly getting to revenue stability while maintaining solid EBITDA margins. Management has made progress in reducing market share loss and improving SSS comps over the last year through price and operating expense investment. Last quarter was the first positive SSS comp since 2010. While the segment has stabilized, we believe there will be further margin investment in FY15 to get the banners to the level that management believes is necessary for them to be competitive at. For FY15 we assume 50 bps of positive SSS and EBITDA down 6% to $276 mm, followed by modest SSS and EBITDA growth in FY16. We value the Retail banners at 5.5x EBITDA in the base case. As we discuss later, we believe it is likely that retail will be sold.
Independent Distribution (35% of EBITDA) – “ID” is a stable low-growth distribution business that supplies independent supermarkets with their products. Given the stability of cash flows and low capital intensity relative to EBITDA, distribution businesses are quite leverageable and a common target of private equity. While ID has taken the longest to stabilize of the three segments, it is also the most predictable and has the most M&A optionality. FY14 revenue was down 2% (down 60 bps in Q4) because natural customer churn of LSD per year was not offset by new customer wins due to their new customer pipeline running at ~half of historical levels because of the uncertainty around the business during the strategic review. The pipeline is recovering: management expects normalization in FY15 which will stabilize revenue, and grow LSD organically thereafter. Upside from M&A could come from several different opportunities: 1) If the Retail banners are sold and ID maintains the distribution agreement there is 10% upside to revenue and EBITDA 2) ID is well positioned to distribute to any stores divested in the SWY/ABS merger 3) ID could potentially win the SWY Eastern region distribution agreement from which is worth an additional 7% increase in sales and EBITDA. While there is a lack of public market comps for ID, we value the segment at 7.75x EBITDA given the low capital intensity and leveragability of the cash flows. We also believe ID would have a lot of cost synergies to a strategic and therefore garner a high multiple in a sale; witness the SYY purchase of US Food at 10x EBITDA.
On FY15 (ending Feb 2015) we are at EPS of 69 cents, FCF of 88 cents, and maintenance FCF of $1.17/share. This is 10.7x/8.4x/6.3x EPS/FCF/Maintenance FCF respectively. We believe as Retail and ID stabilize and SAL growth accelerates that the consolidated SVU can grow revenue and EBITDA MSD. If we are correct these are attractive multiples to be buying SVU stock today. Using consolidated FY15 EBITDA of $771 mm and applying 5.5x on Retail, 7.75x on Distribution, and 8.5x on SAL results in a $11 price target.
Ultimately we believe the Retail banners will be sold as SVU looks to exit the Retail business. Management has been clear, most recently at the Barclays Retail conference in April, that they view the new SVU as a distribution and hard discount grocer and not a conventional grocer. In addition there was a detailed Dealreporter article in April suggesting that the retail banners were being shopped. We believes these banners can be sold for 5.0-5.5x EBITDA and allow SVU to keep the distribution contract for those stores, driving inorganic distribution revenue and EBITDA growth but also shifting EBITDA from a lower multiple segment to a higher multiple segment.
The Pro Forma SVU ex-Retail:
We believe the new SVU will be a stable distribution business combined with a growing hard discount grocery format that will not have an EPS drag from excess depreciation from Retail. This is important because the sell side will no longer be able to think of SVU as a conventional grocer and will be able to see the valuation discount through their preferred EPS-lens rather than a hypothetical maintenance FCF multiple or sum of the parts argument.
Assuming 1) Retail segment is exited at 5x EBITDA 2) with no tax leakage given capital loss carry forwards 3) cash proceeds are used to de-lever the balance sheet (to 2.8x from 3.7x currently), we see PF EPS in FY15/FY16 of 73/83 cents (10x/8.5x PE). The RemainCo EBITDA would be roughly half ID and half SAL, with prospective revenue and EBITDA growth of MSD. The Dollar stores trade at 16-17x EPS with a similar prospective growth profile. While there is no good distribution comp, the range is 13-18x EPS.
A blended 15x EPS multiple would yield a price target of $11 on FY15 and $12.50 on FY16 which is 50-70% upside.
Note that in the high case should ID be sold to a strategic at a SYY/USF deal multiple of 10x EBITDA that would yield incremental upside of $2.50/share (for 100% ups in this Dream Big scenario).
We could be wrong on the Retail divestiture thesis in which case SVU will continue to be an orphaned show me story. Even in that case, SVU is trading at consolidated earnings/FCF multiples that limit downside.
Sentiment around management communication has been poor as the company missed their FY14 EBITDA projections and on the latest conference call the CFO gave sloppy FY15 EBITDA guidance of “lower than FY14” which spooked people as consensus had flat EBITDA in FY15. Besides the sentiment overhang, it’s important to note that SVU is a levered equity so small EBITDA misses are magnified to the equity.
Cerberus today owns 21% of SVU but has more capital at risk in the pending SWY/Albertsons merger so some people worry that Cerberus would disadvantage SVU if it helped SWY/ABS, with one example being the current TSA agreement between SVU and ABS. Our view is that while Cerberus has a lot of money up in the SWY/ABS deal, they still care very much about their $400 mm equity investment in SVU and will look for opportunities that benefit BOTH SVU and SWY/ABS such as shifting distribution business from 3rd parties to SVU. Regarding the TSA specifically, we believe that SVU management has a significant runway to variabalize their cost structure and wind down the TSA over time with minimal EBITDA leakage.
I do not hold a position of employment, directorship, or consultancy with the issuer. I and/or others I advise hold a material investment in the issuer's securities.