Description

Winn Dixie, an 80 year old fixture in the Southeast United States, was once a dominant regional grocery chain with over 1200 stores.  The company began to decline in the 1990s as the founders and largest shareholders, the Davis family, lost focus on the business and began to funnel Winn Dixie cash flows (paid out in dividends) into other ventures.  While Wal-Mart was oft-tagged as the culprit for Winn Dixie’s decline, it was a Florida chain called Publix that actually delivered the death-blow.  By 1993, Publix had already established a reputation as one of the top places to work in the country and as one of the largest employee-owned companies.  It prided itself on customer-service and the company turned heads when it found success opening stores in what were thought of as impenetrable Winn Dixie regions.  Publix is blessed by a true focus on the customer, but it’s hard to overstate the true blessing for Publix:  Operating in a region where your largest and most powerful competitor self-destructs. 

Winn Dixie filed for bankruptcy in 2005 and closed or sold about 360 of its stores.  The company now operates 522 supermarkets in the southeast, with about 70% of the locations in the state of Florida.  Winn Dixie emerged from Chapter 11 in November of 2006 with a renewed focus on Florida and a brand new management team led by Peter Lynch (no, not Peter Lynch), a veteran retailer who was CEO of Albertson’s and had great success turning around Acme Markets for American Stores Co.         

I don’t want to focus on Winn Dixie’s past and I don’t want to pile onto the company too much for mistakes that are now history.  While it’s interesting to read and write about the company’s failures, I think doing so will cost me credibility with those of you who are long the stock.  Obviously, it is you longs who I am trying to win over.  Prima-facie, Winn Dixie looks cheap.  With a TEV somewhere in the neighborhood of $700mm and sales around $7.2B, very slight operational improvements will yield very large returns on this stock.  It is my job to prove to you that these very slight operational improvements are not going to occur and that a short position in WINN stock is not completely insane.  

Okay, let’s start debunking some Winn Dixie myths.

Myth #1: If Winn Dixie gets more rational on pricing and remodels its stores like Publix, it will start to see operating margins at 2%, 3% or even better!  (Note: Operating margins are currently negative)

I think it’s important that we first understand the supermarket business.  Most important, supermarkets do not, and should not, really compete on price.  They highlight a few targeted promotions to drive traffic, but long-term, success is driven by service, quality and location.  Ask any supermarket executive and they’ll tell you the same thing a Kroger veteran told me, “We were never the cheapest.  Walmart can beat you on price 10% across the board, if you try to compete with them you die.”  This has been true longer than many realize.  Walmart did not kill Winn Dixie in the 1990s and early 2000s, poor service did. 

It’s also important to note that Publix is not successful because their stores are more “upscale”.  If you go to Florida and look at some Publixes and Winn Dixies, you’ll be struck by how plain-vanilla most Publix stores are.  With a few exceptions, they are not like HEB or even the marketplace-style Safeways and Krogers I’ve been too.  They look pretty much like most of the Winn Dixies I’ve been in (except with more customers and more employees).  Winn Dixie is embarking on a massive remodeling plan to the tune of $1.5mm to $2.0mm per store.  This will make all the Winn Dixie’s look sparkling clean and new, but while it’s good to rejuvenate an aging store base, the remodeling program is not a saviour.     

So there are some key points here:

1) Winn Dixie is already rational on prices and there is no low-hanging fruit to reap by simply raising prices (see Myth #2)

2) Publix is NOT an upscale chain.  Winn Dixie is already competing for the same customers and it’s not as simple as moving to an upscale concept.  This is not the same as Delhaize converting its Kash and Karry stores to Sweetbay.

3) Publix has newer stores, but they are not winning this battle because of store-remodels.

A focus on customer service must be ingrained in a retail company’s culture.  This is a huge issue.  Publix has built its company on customer service and Winn Dixie stores have featured poor service for 15 years.  Peter Lynch could be the best manager in the world, but this is not a quick turnaround-style fix.  A few remodels and new upscale product offerings are not going to bring Winn Dixie 2% operating margins.  Winn Dixie needs to win its customers back from Publix by matching with good customer service. 

Myth #2:  Winn Dixie will increase gross margins with more “effective” pricing and continued shrink reduction. 

Winn Dixie management has done a good job of bringing shrink down to industry levels, but the low-hanging fruit here has been reaped.  There has been a lot of talk about “effective” pricing as a lever at Winn Dixie’s disposal, but I think this is greatly overrated.  Price raises work in the short-term, but if you do not at least match your direct competition, it kills you long-term.  Winn Dixie already seems to have slightly higher pricing than Publix (source here is more anecdotal than a full survey), so I think it is wishful thinking that they can all of a sudden “compete less on price.”  As I’ve discussed above, Winn Dixie and Publix already occupy the same place in the competitive landscape and neither of them is down there irrationally competing on price with Walmart.  To increase its gross margins, Winn Dixie has to drive more sales. 

Myth #3:  In addition to growing gross margins, Winn Dixie can cut costs in its SG&A line to increase operating margins. 

The biggest cost below the gross margin line is obviously Winn Dixie’s cost of labor.  There is simply no fat to trim here.  Winn Dixie is understaffed and to compete with Publix on customer service they need to bring in new, good employees and they need to treat them well.  As with gross margins, the key here is that Winn Dixie simply needs to drive its sales.  That is the only way these guys can increase operating margins in the long term. 

Myth #4: Winn Dixie’s healthy liquidity and strong balance sheet ensures that the company has time to turn around its operations.

Winn Dixie has $133mm in cash and cash equivalents, about $80mm in insurance and tax receivables and an undrawn-on $725mm credit facility.  This seems like a nice cushion, but the company has been burning cash: about $100mm of cash used by CFO plus another $35mm in capex over the first two quarters of fiscal 2007.  The company expects to complete 15 more remodels for the year, which will cost an additional $25mm.  The true availability under the credit agreement will be somewhere closer to $200mm, as there are restrictive covenants that will prohibit them from borrowing on the full borrowing base.  (The most obvious is the minimum consolidated EBITDA covenant:  At January 9, 2008 LTM EBITDA must be $146.9MM minimum ramping up to $180mm by January 2009 if excess availability is less than $75mm).                

Going forward, the company wishes to remodel about 75 stores annually at a cost of $1.5mm to $2.0mm per store: $130mm in capex.  If they stick to this plan and cash flows from operations do not materialize, Winn Dixie will begin to brush up against covenants by the middle of 2008.  If the company continues to burn cash at its current rate, they will definitely blow through covenants next year. 

Winn Dixie will soon be a borrower and they will be on a short leash with their lenders.  Unfortunately, the nature of the turnaround requires that this be a long-term effort.  As we discussed above, supermarket customers are sticky enough that you can raise prices to benefit your store in the short-term.  But once you lose customers it takes a long time to win them back.  Winn Dixie must not only endure the long process of teaching its associates to value the customer, once this occurs (IF it occurs), the customers will not flock back overnight.  I think, in the end, if the company cannot bring shoppers back to its stores in the short-term, it files again.   

Myth #5:  By virtue of its long history in the region, Winn Dixie has the best locations.

Winn Dixie does have the benefits of legacy leases.  (The company has 271mm of favorable leases and 144mm of unfavorable leases on its books, as valued in the bankruptcy.)  But I don’t buy that Winn Dixie has a large number of top-shelf legacy locations that give it any kind of competitive edge over new openings.  Florida is a rapidly growing and changing state, and Publix been expanding aggressively into faster growing suburbs.  This is really my opinion, so perhaps it’s unfair to say that I’m refuting a myth here. 

Valuation:

Optimistic investors have bid the price of Winn Dixie’s post-bankruptcy stock up to a level where a short position in the stock finally makes sense from a risk-reward standpoint.  At $16.50, assuming final share count comes to around 54.5mm, market cap is around $900mm.  As of January 10^th, you had cash as well as short-term insurance and tax receivables that added up to over $200mm minus $150mm or so of workers comp self-insurance Letters of Credit.  So I think a TEV of $850mm is about right.

For $850mm you also get a few hundred million dollars of good leases and all the tax-loss carryforwards you can shake a stick at.  The best way to think about the stock’s upside is to make a very simple excel sheet that basically needs three inputs: sales growth, gross margin and operating cost margin.  In truth, you don’t even need the sales growth line.  But you can easily get to some huge values for this stock.  For example, say you have 3% sss growth and 1.5% operating margins. . . then you’ve got $111mm of EBIT.  Put a conservative 10x multiple on this thing (remember that they won’t be paying taxes) and youch, $21 share price. 

Based on current margins, however, Winn Dixie isn’t nearly as pretty.  The company has negative operating margins with no more easy fixes at hand.  Last Q’s EBITDA came in around $12mm, so without improvement they’ll do around $50mm annually.  With shrink at industry levels and SG&A needing a little bump up, this company is already burning cash.  The remodeling plan will have to be funded by debt. 

On paper, everything about Winn Dixie looks right.  This is an overlooked, name-fatigued post-bankruptcy stock with a highly incentivized management.  A little bit of operational improvement can make some eye-popping share-prices appear on your spreadsheet.  Additionally, it seems reasonable that with a little investment in the stores and a move to more of an “upscale” concept, Winn Dixie can approach the sort of EBIT margins that Publix garners.   

Unfortunately for Winn Dixie, I think the road to improvement is much longer than the market believes.  Sure, the company is getting better all the time, but I think the only way for the company to return to profitability is for it to grow sales and regain share from Publix and Sweetbay.  Winn Dixie guest counts were actually DOWN 1.9% in the most recent quarter.  With both Sweetbay and Publix committing to investing in growth, and with all three competitors occupying the same competitive space, Winn Dixie can’t survive by just remodeling its stores and playing defense.  The long thesis that Winn Dixie only needs to get “part of the way” just does not hold water when Publix is opening 50 new stores a year.  Winn Dixie needs to win its customers back for it to survive.  This is hard to do overnight when you have invested 15 years in letting your customer down. 

RISKS:  I believe the risk is larger that some sucker overpays for WINN than that operating margins start improving rapidly.  That will be keeping me up at night with this investment.  Still, slight operating improvements will get the market excited and could hurt badly.  Don’t bet the ranch with this one.      

Disclosure:  I recommend that you never, ever, use a Winn Dixie restroom in the town of Tampa, Florida.       

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