Description

Smart and Final Inc.
Ticker: SMF Price: $12.50 mkt cap: $ 375M


We are LONG Smart and Final Inc. (“SMF”), which sells food, foodservice products and culinary equipment through warehouse stores and wholesale stores primarily in California. Smart and Final is an unusual concept somewhat similar to Costco but offers smaller, more convenient locations and doesn’t require customers to pay an annual membership fee. SMF runs about 230 stores with typical store being about 17,000 sq. feet. When we first discovered SMF, it was trading at less than 7x our projected 2004 earnings. The stock had been depressed due to underperforming businesses masking a better business. Over the last few years SMF had attempted to expand its retail concept out of California into Florida and add foodservice direct delivery business to its California offerings. Both of these concepts failed and resulted in a debt-laden balance sheet, debt covenant violations and weak financial results.

In the third fiscal quarter, SMF sold its Florida portfolio as well as the food service direct delivery business. The company used the proceeds to pay down debt and then renegotiated new covenants with their lenders. The balance sheet now has $45M in cash and $155M of debt for net debt of $110M, which is about 1X 2004 EBITDA. In late September, the company also announced that Etienne Snollaerts had joined them as their new President and COO. Snollaerts came to SMF from Groupe Casino which owns 60% of SMF. We view this positively for a few reasons. Snollaerts will be the next CEO in a few years and may help push Groupe Casino to acquire the other 40% of SMF. In the near term though, he will help SMF’s relationship with their parent allowing the company to take advantage of some group purchasing opportunities never before utilized by SMF. SMF entered the fourth quarter clean and revitalized. Investors now see a chain of stores that has consistently shown 3-6% same-store sales growth for the last four years. In 2004, SMF plans to return to the street with their story and we believe it will now be well received and understood.

The largest concern in today’s retail world is the Walmart effect. Like Walmart, SMF also uses non-unionized workers. In fact, the two companies have very similar SG&A margins. Management has commented they don’t view Walmart as their primary competition. They believe Walmart helps them. When Walmart moves into a nearby location, they drive more traffic to the area and these people discover SMF. Clubs model such as Costco, which are SMF’s primary competition, have been beneficial to SMF because they help educate and train more people for the SMF model. When a Costco type store opens in the vicinity of an SMF store it usually depresses sales for about 6 months and then sales rebound to an even higher level. Those of us not on the west coast may have a hard time understanding this model but this is a concept that has been around in different formats for over a hundred years. SMF has plenty of availability to expand their concept on the west coast and their business plan assumes 10 net store openings per year.

The now three-month long grocery strike/lockout currently taking place in Southern California provides the final piece to the puzzle. The three largest chains in California have had a grocery strike/ lockout since the middle of October. SMF stores do not have unions. Management estimates that up to 400,000 new customers have come into a SMF store during the fourth quarter. SMF will obviously show strong numbers when it reports fourth quarter results, but the real opportunity will be to keep some of these new faces in SMF stores even after the strike ends. As the strike continues, people adjust their daily routine to SMF stores and will remain customers even after the strike concludes. We believe SMF management is working hard to keep these customers in their stores. Management estimates the vast majority of new shoppers have signed up for loyalty cards. These cards allow management to track shopping preferences and patterns. New shoppers were rewarded with various coupons and offers during the holiday season and management was very pleased with the response. Layering these additional customers on top of 3-5% organic growth, 2004 should be a good year for SMF.

Our 04’ EPS estimate of $1.10 assumes the strike does not continue any longer and management is only able to retain around 5% of their new customers. With the stock currently at $12.50, it is trading at about 11.4x our 2004 EPS estimates. On an EBITDA basis, SMF trades at about 4.5x our 2004 EBITDA estimate of $105M. SMF’s free cash flow number should be very similar to its net income as D&A of $37M basically offsets Capex of $40M. In 2005, SMF should earn close to $1.30 and $115M of EBITDA. Costco, in contrast, trades at 21x 2004 earnings and 10x 2004 EBITDA. While we don’t believe that SMF deserves the same multiple as Costco, we do feel SMF is undervalued and as the company reports clean numbers without the money losing stores, the market should accord SMF a valuation that is significantly higher than today’s $12.50 stock price.

Catalyst

Blow out 4th quarter number from strike.
Year over year comparisons will look very good for at least the next four quarters due to the added traffic from the strike
Management more aggressive telling their story based on simple clean story.