Description

CHEF was last written up by BJG in July of 2014 at the $17.27 level, and I will point you there for background rather than re-hashing what is a relatively simple business.  Since the write up the company has made a large acquisition, made progress toward rationalizing their foot print, and continued to deal with inflation, which should be peaking and reversing soon.  The stock has moved as low as $15ish and as high as $24ish, but has given up much of the gains and is currently trading at a level where it is once again attractive.

Importantly, through most of 2014 CHEF was the victim of irrational non-economic selling pressure by the growth crowd that had bid CHEF up to a high teens EBITDA multiple on hopes that future growth would come with zero bumps in the road.  Not surprisingly, when some temporary setbacks arrived in the form of gross margins squeezed by record food inflation and operating margins squeezed by newly acquired businesses whose footprints had not yet been rationalized/optimized, the growth crowd headed for the door, just in time for all the other momentum types to exchange their shares for tax losses.

The panic selling abated into year-end 2014, but the stock is still somewhat of an orphan as the growth crowd has headed for the exits,  the stock is not optically cheap enough for the value crowd, and the extreme volatility in recent months has kept many of the quant types away.  This creates an entry point for patient buyers who are willing to let the company continue to work through their recent growing pains with an eye toward the future.

Why The Opportunity Exists

I believe the root cause of the previously mentioned non-economic selling is margin compression, as 2011 gross, EBIT and EBITDA margins were 26.4%, 6.9%, and 7.4% respectively, versus 2014 which saw 24.6%, 3.9%, and 4.9%.  The bears suggest that this compression is due to increasing competition and almost zero barriers to entry in the food distribution business. Further criticism comes because the company appears to have stretched on their most recent acquisition taking themselves to the upper range of their stated leverage zone (2-4x EBITDA) which will hinder growth by acquisition in the immediate future, and that FY 2015 guidance looks aggressive.

In the view of the bears, these factors have combined to make this an excellent short as evidenced by the fact that the short interest is currently 30 days to cover.

In my view, each of the above is either shortsighted or ill-informed as I will discuss below.

Bear Criticism: No Barriers to Entry in Food Distribution Means No Competitive Advantages

Rebuttal:

The bears are correct when they say the barriers to entry in this industry are virtually non-existent, which means that success is largely tied to price (which is largely a function of scale), and perhaps more importantly, quality service. It is in these 2 areas that CHEF is able to distinguish itself, and the company thus has an under-appreciated moat.

Scale is important to both suppliers and customers in the food distribution industry. From a supplier’s standpoint, a partner with broad distribution capabilities is necessary in order to maximize volume across a broad network of end-users. CHEF’s status as the leading specialty food distributor in North America likely makes them a preferred partner for artisanal suppliers of fine food goods throughout North America as well as Europe and Asia. From a chef-customer’s point of view, a distributor with access to multiple suppliers is important in order to provide a broad offering while minimizing the operational challenges that come from dealing with multiple vendors. The Company meets the needs of both its suppliers and customers by claiming more than 22,600 kitchens as customers, and offering almost 32,000 SKUs from more than 1,600 suppliers. This SKU count is notable as the Company estimates that most specialty distributors offer less than 2,000 SKUs. The business thus benefits from network effects as the larger the supplier and customer network becomes, the more attractive the Company becomes to potential suppliers and customers.

It may seem odd to talk about The Chef’s Warehouse as being a scale player when one considers the dominance of market leader Sysco. However, in our differentiated view, given the increasing importance of “the farm to table movement” and CHEF’s focus on higher end restaurants, there is a limit to the benefits of scale. In other words, restaurants increasingly pride themselves on sourcing fresh ingredients locally. We believe that CHEF is able to occupy the sweet spot whereby their small size in relation to industry heavyweight Sysco allows them to nimbly interact with the smaller scale suppliers that are typically found in close proximity to major cities, yet their large size next to other specialty players allows them to benefit from the previously mentioned network effects and economies of scale. Sysco on the other hand is designed to interact with industrial scale farming operations in order to meet the needs of its massive institutional client base.

  Importantly, as the Chef’s Warehouse network grows, the company is able to buy its products in greater volume and enjoy economies of scale which contribute to wider margins, giving the company the ability to both effectively compete on price vs. other specialty players and invest in their own logistical capabilities, which can further widen margins. For example, CHEF’s trucks are equipped with the latest in GPS mapping software, and their warehouses have voice fulfillment technology, both of which help to streamline logistics, and thus contribute to margins. The result is a virtuous cycle that is difficult for smaller specialty players to replicate, which gives CHEF a cost advantage.

While pricing certainly plays an important role in winning business in the food distribution industry, the importance of relationships and customer service cannot be overstated. For The Chef’s Warehouse, the high level of customer service starts with the fact that more than half of the company’s sales people have advanced culinary training, indicating not only a high level of product familiarity, but a genuine passion for food. In fact, according to the company, many sales people are people who are formally trained as chefs, but have left their restaurant careers behind due to quality of life issues (i.e. not wanting to work nights and weekends anymore). Given that the company generally sells directly to independent chefs (rather than wholesale buyers as would likely be the case with a larger chain restaurant) we view this as an important advantage. For example, when designing a new menu or planning for an evening’s specials, a customer-chef can call their Chef’s Warehouse sales representative and exchange menu ideas based on what items are freshest, seasonally appropriate, or presently available at an attractive price. CEO John Pappas has also commented in the past that after the first year, turnover in the sales force is very low, which contributes to forming and maintaining longer term relationships. Pappas further remarked,

 [working in sales for Chef’s Warehouse] is probably the highest earning job in foodservice. We have many salespeople that make really good amounts of money. The typical foodservice salesperson probably makes $50,000 - $70,000. Ours is way into the six figures, mainly because they are able to get a higher margin and they are able to sell more expensive food products.

 ~John Pappas, 2013 Canaccord Genuity Growth Conference

                 It thus seems likely that The Chef’s Warehouse is the preferred employer of people with the relationships and knowledge needed to be a successful sales person in the food distribution world. However, rather than just relying on a well-paid sales force, the company proactively seeks to build relationships with new chefs and thus new restaurants. For example, for the last seven years CHEF has catered to the Culinary Institute of America and the French Culinary Institute in order to build relationships with tomorrow’s leading chefs today. Additionally, CHEF is currently completing work on a “test kitchen” that is part of a new $13 million, 80,000 square foot facility in Las Vegas that will act as the company’s distribution center in the region. In our view, this test kitchen has the potential to become a valuable tool in recruiting new customers. The time and money that the company spends on developing relationships with customer-chefs pays dividends in the form of referrals. According to the company, most of their new customers are introduced to them through referral, most often by a chef who is striking out on his own after working for another CHEF customer.

                This focus on building relationships with chefs is important, but in our view it is all for naught if the Company cannot provide its products as ordered on time. Notably, the company’s fulfillment rate of in-stock items that are ordered and then delivered on time is greater than 97%. This is especially impressive given that Chef’s Warehouse typically takes orders up until midnight (vs. Sysco or U.S. Foods which typically cut off orders in the mid-afternoon), with promises to deliver before lunch (and in some cases before 7 AM) the next day. This “just in time” capability is important given that CHEF caters to restaurants that are typically in expensive cities, where real estate is at a premium, and thus in-restaurant storage facilities are often limited. In response to a question on the competitive threat from Sysco, CEO Pappas responded,

 It is really again the relationship that our salesforce has, the just-in-time delivery. It is almost impossible for them to really penetrate our customer base. They are just not set up for it. So a typical salesperson from Sysco -- you go to work for Sysco, US, you get a territory. You might get three or four blocks in a major city. So you have to sell prisons and hospitals and delis, and you're not going to make the money that you are going to make on your big institutional accounts, servicing a restaurant that is buying $1,000 to $2,000 a week. So they are not going to get priority on the truck. The salespeople -- it is a different type of salesperson. It is someone who is selling garbage bags and linens and 32,000 different items and has to be able to go from a prison to a fine restaurant. It is a completely different culture. The people that come to work for us, they are very passionate about food, and all they are calling on are chefs. So they become really -- they're the experts in the industry. So I think we are pretty insulated.

 ~John Pappas, 2012 Jefferies Group Global Consumer Conference

Bear Criticism: Gross Margin Decline is Evidence of No Competitive Advantage

Rebuttal:

            Over longer periods of time, food distribution is essentially a pass-through business.  However, over shorter periods of time such as the last year or so, high inflation can make it difficult for distributors to pass on the pain to their chef-customers.  This has especially been the case with CHEF and their high end restaurant customers who purchase steak.  While I consider fiverocks19 to be the resident expert on animal husbandry following his commentary on sheep breeding on the 2013 DECK thread as well as his work on PPC, I’ll take a stab at explaining the beef cycle, record beef inflation, and why it will reverse in the coming year or two.

A calf is typically fed on grass pasture for the first 12-16 months of its life (known as the stocker phase) before it reaches a feedlot entry weight of 650 – 700 lbs. When a heifer/steer reaches a feedlot, it will spend 4-6 months eating a diet heavy on corn, grains, and legumes until it reaches slaughter weight of 1,200 -1,400 lbs. While the US cattle herd has been declining for decades, starting around 2011 cattle ranchers and feedlot operators faced a perfect storm of drought and high feed costs which has led to unprecedented beef inflation. The droughts throughout much of the US forced ranchers to up their cull rate as their pasture land was browned out and thus couldn’t sustain as many animals as would be typical. Essentially, a below average amount of heifers were held back for breeding, which of course has compounding effects for future herd size.

Ordinarily this increased supply of cattle coming to market would lead to lower prices, but with feed lots facing dramatically higher corn and soy prices through 2011 and 2012 (feed costs are typically 20% of cash costs for beef production), the benefits of this supply dump were not passed on to the consumer.  Grain prices provided some relief through 2013, but then the abnormally cold winter of 2013 required more feed to fatten the animals, which prevented any pricing benefit from lower corn and soy prices from being passed on to consumers.  The result has been an unprecedented increase in beef prices, with slaughter cattle prices up more than 100% from 2010 through 2014, and 22% in 2014 alone.

Importantly however, there are signs that the most recent aggressive move higher is tied not to drought or feed costs, but rather to supply constraint, as ranchers have taken steps to hold back animals in order to rebuild the herd, and in fact, slaughter rates through the end of 2014 were at the lowest levels since 2006.  The recent explosive move in beef prices is thus indicative of a blow-off top, and price relief should be on the horizon.  A cow’s gestation period is nine months long, and a calf takes 20-22 months to reach slaughter weight, meaning that the effects from ranchers’ 2012 decision to start holding back heifers from slaughter are just starting to enter the supply chain now. Importantly, a heifer reaches preferred breeding age at 12-15 months, meaning that the eventual compounding effects of a rebuilding herd are just beginning as well. Importantly, corn and soy prices have been trending favorably, which should provide further price relief.  Still more relief should come from the strong US dollar, as ~13% of US beef is exported. In fact, recent year over year data shows exports are down 10%. Further, just last week management from RUTH indicated they are seeing relief from beef inflation.

While bears and the sell side have been critical of CHEF management’s inability to hold gross margins in recent years, Baron Rothschild would likely be complimentary.  The streets have been bloody, and CHEF has made an aggressive move into “center of plate” by buying 3 large protein/beef businesses in the last 2.5 years. This has of course been a drag on near term profitability as their mix has shifted dramatically toward beef where inflation has led to margin compression, but in my view when an owner-operator is willing to sacrifice the short term for the long term, that is a good thing for investors that can look past quarterly results. It is only a matter of time before the full effects of a normalization in beef prices benefits the company.

Chart: Changing Mix and Gross Margins

It is also worth mentioning that the company has been dealing with substantial inflation on the dairy and cheese side largely tied to whole milk prices.  In the interest of brevity, I suggest you read PwnageVIC’s excellent writeup on DF which goes into many of the issues that have effected dairy over the last 2 years, as well as why they are reversing. The short version however is that weather in New Zealand and Australia hurt the dairy supply chain, Chinese buyers want imported milk, and global prices for milk, and thus cheese have accelerated in recent years due to supply constraints.

Bear Criticism: Operating Margin Decline Indicates Failure to Execute

Rebuttal:

Over the last 2-3 years CHEF has embarked on a series of spending initiatives to broaden their presence in North America, and the initial investments are not yet being utilized to the extent that operating leverage is flowing through to free cash flow. In fact, prior to their most recent acquisition, the Company estimated that they had the operating structure in place to support up to $1.5 billion in sales, but 2014 sales came in at ~$837 million. This gap between capacity and utilization will close in the coming quarters as the company continues to grow organically in several markets, and as excess PP&E from recent acquisitions is rationalized. Specifically:

·         Chicago: The Company first entered the Chicago market through the May 2013 purchase of Florida based Qzina Specialty Foods, a pastry purveyor with a presence in Chicago, for $33 million. This was followed by the December 2013 purchase of Chicago based fine meat cutter Allen Brothers for $33 million. Following these acquisitions, the Company was operating 4 facilities in the Chicago area. In May of 2014 the Company leased 108,000 square feet of warehouse space in order to consolidate their existing Chicago businesses, and put the infrastructure in place to green field the Chicago specialty market. The presently under-utilized facility was a -$3 million drag on 2014 EBITDA. The Company expects to open this facility by the first quarter of 2015, and they are in the process of selling 2 Company owned Allen Brothers buildings that have been made unnecessary by the new facility. Chicago has been building out its sales team and management for several months, but is just now starting to compete for specialty business. Given that they already have relationships in place on the center of plate side through Allen Brothers, I expect this business to ramp quickly.

·         Las Vegas: The Company has had a presence in Las Vegas since 2005, but began a $13 million expansion project in August 2014 that will more than double the Company’s local warehouse footprint. Additionally, the facility will be equipped with a “test kitchen” where customer-chefs can come and experiment with different products. We view this as a competitive advantage in a “celebrity chef” world and think it will enhance the Company’s ability to build and maintain relationships with top chefs. The facility is expected to be operational by Q3 2015.Of note, occupancy in Vegas has been trending up, while gambling has been trending down, suggesting that there should be more net dollars available for spending on restaurants/food.

·         New York: In early 2012 the Company announced they signed a 35 year lease on 234,000 square feet of warehouse space (up from 175,000 square feet) in Bronx, NY, which they believe will allow them to eventually double revenue in New York (2014 sales were 37% of total at ~$310 million in “New York” which is defined as Boston to Atlantic City). The Company had previously been one of many tenants in this space, and has invested $20 million in order to renovate and build cold storage capabilities. Unfortunately, a series of bureaucratic hurdles and difficulties removing other tenants prevented the Company from meeting their initial goal of a June 2014 move-in date. However, as of the most recent quarter, this space is operational. Importantly, completing the move will coincide with the cessation of duplicate rent costs which have been a $400,000 quarterly drag for more than 2 years now. More importantly, the company has indicated that the real benefit is not necessarily the extra square footage – rather the company has been bottle-necked in NY because the old facility had a limited number of loading docks. The new facility has more loading docks, which should allow the company to easily access demand that is already in place. The Company will also cease to use a Qzina facility in Northern New Jersey when the new facility is fully operational.

·         San Francisco: The Company had been in the midst of consolidating and expanding its San Francisco operations from two locations which total 49,000 square feet to one 117,000 square foot location when they developed custom cut center of plate capability in the Bay Area via their January 2015 purchase of Del Monte Meat Company. Although no plans have been announced, further real estate rationalization is possible. More importantly than the real estate however is the fact that historically having a presence in center of plate has increased specialty sales by 2-3x as most customer-chefs focus on main courses first, and other items second. The Del Monte sales force now has access to thousands of specialty SKUs, and I expect sales to ramp quickly.

In addition to the above mentioned foot print expansion projects, in recent quarters the company has incurred costs tied to implementing a fully integrated ERP system and fully integrated warehouse management system. These new systems will facilitate web-based purchasing and provide increased visibility to management in regards to forecasting inventory needs and tracking margin on a per SKU basis. I view these expenditures as wise investments for the future that will contribute to margins, and allow for a more seamless integration of future acquisitions. In sum, the company is set to benefit from easily realizable operating leverage in several geographies throughout 2015.

Bear Criticism: 2015 Guidance is Aggressive and Valuation is Full

Rebuttal:

The company expects 2015 sales between $1 and $1.1 Billion, adjusted EBITDA between $68.3 and $72 milion and net income /share between .57 and .66 with adjusted net income / share between .70 and .80.  If one is focused on the earnings, shares do not scream cheap by any measure, even though other food distributors and non-food distributors regularly trade at a 20-25 P/E.  Despite the well-known problems with EBITDA multiples, I would argue that in the case of a fast growing business where normalized cap-ex is miniscule, EBITDA is the more appropriate metric, and the company currently trades between 11-12x EBITDA.  Again, this doesn’t scream cheap, but distribution companies with slower growth than CHEF often trade in the 10-14x range, so current levels are reasonable.

The criticism seems to focus on margin expansion as 2014 adjusted EBITDA margin was 5.2%, and current guidance suggests something around the 6.7% level, which does not jive with the prevailing wisdom that food distribution is structurally pressured, and margin declines are permanent rather than cyclical.  As I tried to illustrate above, that is not the case on the gross margin level although timing of normalization is hard to predict. It should also be noted however that ~35% of COGS is procured from European vendors, which should benefit from the strong dollar, which should help in 2015, even if beef disinflation is slow to develop.

On the operating side, the company is approaching several milestones which will lead to relief of pressure on the operating margin line. As recently as 2011 before the company started their expansion binge in earnest and before food inflation was rampant adjusted EBITDA margins came in at 7.4%, which suggests that 6.7% is not crazy. Perhaps more importantly, revenue guidance appears to be conservative on a pro forma basis.  In 2014 the company did $837 million in sales, and the recent acquisition of Del Monte Meat is expected to add $200-$225 million in annualized sales, implying $1.037 B at the low end for system wide sales.  Versus the top end of guidance, this implies ~6% organic growth, a number that has been surpassed in recent years.  The low hanging fruit tied to increased capacity in New York and Vegas, greenfield specialty sales in Chicago that are attached to an established protein business, and increased opportunity for specialty sales in San Fran due to attachment to an established protein business suggest that 6% is conservative, even if one were to factor in some disinflation. Further optimism comes from commentary out of MasterCard that restaurant spending is accelerating, news that recently Americans began spending more money on restaurants than on groceries for the first time, and news that corporate restaurant spending (which should be highly correlated to CHEF’s focus on high end restaurants) rose 5.6% in 2014 and is likely to continue to rise.

 Importantly, a large amount of this growth will drop to the bottom line as it costs the same to maintain a warehouse if it is half full (as several of them have been recently) or if they are overflowing. The same economy of scale benefits can be applied to the company’s delivery trucks as well – it costs the same to run the trucks if they are half full or full.

In summary, while I admit management can be a bit more promotional than I like (they like to talk about growth, and they rarely mention all the costs they can take out, and the operating leverage they will enjoy), on a normalized pro forma basis guidance is quite conservative in my view. Given that the Del Monte acquisition wasn’t completed until April of 2015 and thus 3 months of sales weren’t captured the guidance may prove to be aggressive, but we are looking forwards here.

Bear Criticism: They Overpaid for Del Monte, and They Don’t Have the Balance Sheet to Continue Making Acquisitions

Rebuttal:

The company has indicated that they typically pay 4-8x EBITDA for acquisitions, but they are willing to exceed the high end for really great purchases. With $200M of sales expected from Del Monte at the low end, and normalized EBITDA margin goals of 7%, and a purchase price of $191.2M (pre earn out), that implies a 13.7x multiple, which I agree, creates the impression that they drastically overpaid.

The company hasn’t revealed the multiple they actually paid or Del Monte’s actual EBITDA margin. When pressed, the company simply stated, “it is an exceptionally well run business,” and industry contacts confirmed that margins are likely above industry norms. More importantly however is the fact that CHEF is a strategic buyer, and thus can afford to pay up for the right acquisitions. History has shown the company that sales of their specialty items typically go up 2-3x in a geography when they sell center of the plate. This makes sense – a chef-customer is most concerned with his main course meals – if he is already dealing with a supplier of high-end beef etc, why not also get your specialty items from the same supplier, assuming the price and service are good?  The company does not break out revenue by geography (except for NY) so it is hard to say what the opportunity is here, but given that the company is controlled by a presumably self-interested owner operator, I am willing to temper my criticism of the optically high price paid for this acquisition, and assume that the company will be able to realize value from the purchase price.

As for the balance sheet, at ~3.9x EBITDA guidance, the company’s debt profile is currently full, although they retain ~$50M in revolver availability, which they say could be used for bolt-ons if the fit was right. Bolt-ons are highly accretive as essentially you are buying a customer list and eliminating all corporate expenses. However even absent bolt-ons, it is not hard to model scenarios where the company’s organic growth and likely increasing margins lead to debt equating to 3x EBITDA by YE16 and 2.5x EBITDA by YE2017, at which point the company could reload, and resume rapid M&A.

Future Growth

It is worth noting that M&A is often cause for skepticism. However, in a low tech, simple business like food distribution where M&A is really just about customer lists, there is limited room for culture clash. Further, the different geographies are essentially stand-alone businesses w/ shared back office and procurement capabilities, so integration risk should not be a problem. At this point in the company’s history the focus is on organic growth as they lever the facilities they have previously established. However, the company eventually plans to be in “every NFL city except switch L.A. for Greenbay.”

Notably, the company has commented that what often happens is that they will speak with several prospective sellers as they are considering establishing a beachhead in a new city. Once they make a purchase and throw capital into building best in class facilities, they have found that they are often approached by other distributors in the city who figure it is better to sell to CHEF than it is to be out-competed by them. Additionally, contacts in the industry confirm that there are many willing sellers.  This is not a reflection of any negativity, but rather due to the fact that food distribution is essentially blue collar work, and as successful operators approach retirement age, their children are less inclined to take over the family business than they are to pursue white collar careers. As such, the runway for CHEF remains long.

It is premature to spend much time thinking about it, but it is also worth mentioning that there may be some brand value here.  The company has indicated that they frequently receive incoming calls from home chefs seeking to purchase Chef's Warehouse goods. The Chicago based Allen Brothers meat business has a direct to consumer business (think Omaha steaks, but higher end) and the company has branded products that they currently only sell to restaurants, but could be put through the consumer distribution channel in the future.  Seeing Chef's Warehouse branded olive oils etc in a super market at some point in the future is also not out of the question.

Valuation

CHEF is a fast growing, capital light business with a long runway to reinvest in their own growth, and it is thus difficult to put a hard number on what its “worth.” However, for arguments sake I would say it is not hard to model a path to $1.3B in sales in 2017, and given the above mentioned pending abatement in food inflation and realization in operating leverage/efficiency, it is not hard to imagine EBITDA margins in the 7-7.2% range (2011 saw 7.4x, and the company has stated they think 7% is attainable on $1B in sales in a normalized environment)*.  Distribution businesses regularly trade at 10-14x EBITDA, so I consider 12x to be a reasonable multiple, which implies a 2017 share price of ~$30, or an 18.5% IRR. It should be worth noting however that given the potential for future growth, 12x may prove conservative, especially in 2017 when leverage will be reduced to the level where the company could increase its borrowings and re-ignite rapid growth through acquisition.  History has shown that at times people will put crazy multiples on this business, which perhaps isn't surprising considering SYY's multi-decade growth history.

*Its impossible to compare CHEF and SYY on gross margins b/c SYY includes delivery in COGS while CHEF considers it an operating expense. Considering that CHEF caters to cities with high population density and SYY caters to middle america, on a unit level I would expect CHEF to have a more efficient delivery mechanism in place.

Catalyst

normalization of beef/dairy/cheese inflation

rationalization/optimization of operating structure following recent growth