Description

WINN is less than a 50 cent dollar.  It is a post-bankruptcy supermarket chain located in the Southeast in the midst of a multi-year turnaround.  WINN’s margins are currently 1/6 of industry average.  WINN has temporary, fixable problems with no structural impediments to the achievement of industry average operating metrics.  With a strong balance sheet, excellent management, and strategic assets with great potential, we believe WINN shares have the potential to more than double over three years, with little risk of capital loss.

 

 

*** Business Description ***

 

Winn-Dixie is a supermarket chain in the Southeast with retail operations in Florida, Alabama, Louisiana, Georgia, and Mississippi.  WINN currently operates 521 stores with over $7bn in sales. 

 

WINN was founded in 1913 by the Davis family.  Store profitability began to decline in the 1990s when the Davis family became less involved, competition from Wal-Mart and Publix intensified, and costs were cut to a level that resulted in poor customer service.  The store base peaked at 1,073 in 2003.  At the time, stores were located in more than 10 states across the Southeast, and there were a dozen stores in the Bahamas.  Management began to rationalize the store base, but continued underinvestment in capital and labor led to poor execution at the store level, increasing debt levels, and a vendor-provoked liquidity crunch that resulted in Chapter 11.  WINN emerged from Chapter 11 in November 2006 with just 520 stores.

 

The following table presents some financial highlights.  Note that these results have been restated to show continuing operations only (more or less today’s store base of 521); discontinued operations were less profitable or losing money.  We would highlight the fact that today’s store base had EBITDA margins well over 5% in the past, versus its current margin of around 1%.  Management chose to keep their best locations.

 

$  millions	Fiscal Years Ended 6/30,
	2003	2004	2005	2006	2007	2008E
Sales	$7,516	$7,305	$6,945	$7,133	$7,201	$7,373
Sales/Sq Ft	$315	$301	$285	$285	$299	$306
EBITDA	$416	$188	$35	-$25	$65	$110
EBITDA %	5.5%	2.6%	0.5%	-0.4%	0.9%	1.5%

   

 

 

*** Balance Sheet Strength and Flexibility ***

 

WINN currently has a rock solid balance sheet, with $212mm in cash, no debt (other than $24mm in capital leases), $391mm in borrowing availability, $315mm in net favorable leases, and over $600mm in NOLs.   The leases and NOLs merit further discussion below. 

 

As part of the reorganization process, WINN marked all of their leases versus fair market value market and recorded “favorable” and “unfavorable” leases on their balance sheet as an asset and liability, respectively.  The favorable lease asset is $258mm and the unfavorable lease liability is $136mm.  The favorable lease asset is understated due to the intricacies of fresh start reporting.  In brief, upon emergence from Chapter 11 shareholder equity was valued at $759mm, liabilities were valued using appropriate interest rates, and assets (which exceeded Liabilities plus Equity) were written down pro rata to force the balance sheet to foot.  The value of the favorable lease asset prior to this accounting adjustment is $450mm.  Net of the unfavorable leases implies the $315mm of value we attribute to them, or $5.50 per share.

 

The NOLs are a moving target.  WINN has $480mm in federal NOLs but this amount will increase as remaining bankruptcy claims are settled.  Approximately 8mm shares are in reserve to settle remaining claims.  The NOL will increase by the market value of the shares when they are distributed.  Assuming a $20 share price, for example, implies an additional $160mm in NOLs, for a grand total of $640mm.  We present value the NOLs to $100-150mm, or about $2.00 per share.  There are no restrictions on the use of the NOLs as long as there is no change of control before November 2008. 

 

WINN’s strong balance sheet will give management adequate time and flexibility to execute the turnaround.  It also limits downside risk in the event that the turnaround does not go as planned.  Yes, the credit facility does have minimum EBITDA covenants.  However, these covenants do not apply unless excess availability goes below $75mm.  Excess availability is currently $441mm, a sizeable cushion.

 

Finally, over time there are other opportunities to increase cash and liquidity from better vendor terms, collection of income tax and insurance claims, and reduced letters of credit for workers compensation.  We estimate that there is a “liquidity” opportunity of at least $100mm in total from these areas.

 

 

*** Excellent Management ***

 

One of the most important prerequisites of any large scale turnaround is competent management.  We believe that WINN has motivated, proven operators throughout the organization.

 

The Chairman, President and CEO, Peter Lynch, is a 30-year veteran of the industry that joined in late 2004 to help engineer a turnaround.  He was recruited out of retirement and previously served as President and COO of Albertson’s.  While there, he spearheaded the merger with American Stores and held the positions of President of ACME Senior VP for Jewel/Osco.  He began his retail career with Star Markets.  In the course of his career, Mr. Lynch has remodeled over 1,000 stores.

 

Since joining WINN, Mr. Lynch has recruited several of his former Albertson’s colleagues to join the turnaround effort, including Frank Eckstein (Operations), Dave Henry (Marketing) and Phil Pichulo (Development).  Senior management is highly incented and collectively owns well over 1mm fully-diluted shares.

 

At the store level, WINN has invested in training and development of associates and most critical store directors, the “front line” of the turnaround.  WINN replaced 100 store directors in 2005-6, replaced another 60 in 2007 and will probably replicate that in 2008, mostly with outside managers who crave a challenge.  WINN is willing to share upside via restricted stock and competitive base salaries. 

 

Management’s progress over the past couple of years has been impressive.  Geographically, WINN streamlined its store base and narrowed its footprint.  Operationally, WINN reduced costs, reduced shrink, consolidated distribution centers, and invested labor in the stores.  Financially, WINN shored up its balance sheet, realized positive same store sales growth through better merchandising and crossed from EBITDA negative to EBITDA positive.  These are reasons to be optimistic about the future.  

 

 

*** The Remodel Program ***

 

WINN recently began a major remodel program to drive traffic and increase sales.  Since emergence from bankruptcy WINN has completed 24 remodels and management is encouraged by their initial progress.  The plan is to remodel 75 stores in fiscal 2008 at a cost of $140mm and continue to remodel stores for next several years.  Half the store base is expected to be remodeled by the end of fiscal 2010.  Remodels cost an average of $1.9 million per store, with a 3-5 year payback.  Importantly, remodeled stores do not contribute incremental EBITDA until year 2 due to start-up costs and timing (not all stores are remodeled the first day of the fiscal year).  Thus the major benefits of the remodel program will not be seen in the financial results until fiscal 2009.

 

The current WINN store generates an average of $14mm in sales.  WINN is targeting a 10% sales lift in the first year of the remodel.  With a contribution margin of 20%, this implies $280k of incremental EBITDA.  However, given that remodels occur throughout the year, the average store is only remodeled for half of year 1, reducing EBITDA to $140k.  Subtract $150k in start-up costs and there is zero incremental EBITDA.  In years 2-5, there are no start-up costs and no half-years.  By year three of the remodel, we estimate that a remodeled store will contribute $500-600k in incremental EBITDA versus today.

 

We have confidence that the remodel program will be successful.  The remodels will help differentiate WINN from Wal-Mart and emulate Publix.  In the past, customers would literally drive past the Winn-Dixie store to shop at Publix.  A clean, renovated store with fresh products and friendly service will help win these customers back.   

 

We estimate that the remodeled stores, due primarily to sales lift and the resulting operating leverage, will contribute $150mm in incremental EBITDA by fiscal 2011. 

 

 

*** Margin Opportunities beyond the Remodel Program ***

 

WINN has several margin opportunities which we categorize into five areas: (1) private label, (2) perishables, (3) shrink, (4) supply chain, (5) legacy stores.  In sum, we estimate the total margin opportunity is $75-125mm (75-125bps). 

 

Private label brands (a.k.a. store or corporate brands) drive customer loyalty and increase store traffic.  Private label penetration (percent of sales) for the industry is 25%, whereas WINN is targeting 20.5% for fiscal 2008 (up from 19.1% in fiscal 2007).  Private label products have margins approximately 1,000bps higher than national brands.  Over the next three years we believe that WINN can approach industry-average private label penetration rates.  The net margin difference between private label and branded products results in $25-35mm in incremental EBITDA.

 

Perishables include floral, produce, deli, bakery, meat and seafood (why dairy is not a perishable is a mystery to us).  These departments have margins 700-900bps higher than the general merchandise.  Perishable areas were significantly cut prior to bankruptcy as WINN removed labor from its stores and tried to compete with Wal-Mart on price.  Industry perishable penetration is 35% whereas WINN is currently 30%.  We believe that WINN can close the gap, resulting in incremental EBITDA of $25-35mm.

 

Shrink is simply lost sales due to goods being stolen or going bad.  WINN has already significantly reduced shrink to 2.5% of sales, management believes there is more room to improve.  The industry is at 2.3% of sales and we believe that WINN can get to industry levels or better, resulting in $10-20mm in incremental EBITDA.

 

On the supply chain side, WINN recently consolidated 10 distribution centers into 6 and invested in new machinery and technology.  The savings, primarily labor, have only begun to show in the financial results and we believe additional productivity gains will result in $0-5mm of incremental EBITDA.

 

Legacy store merchandising simply refers to increased sales productivity at non-remodeled stores.  Management has already made significant progress in this regard, but we believe that WINN can continue to improve sales per square foot at its legacy stores, especially as the brand builds momentum.  We estimate that there will be only 175 legacy stores in fiscal 2011 that can generate $15-30mm in incremental EBITDA.

 

In sum, the margin opportunities beyond the remodeling program total $75-125mm. 

 

 

*** Competitive Landscape ***

 

WINN is number 1, 2 or 3 in nearly all of the markets it serves.  The competitive landscape includes: Wal-Mart, Publix, Delhaize (Food Lion, Sweetbay, and Kash n’Karry), and Albertson’s/ Cerberus.  WINN’s most important competition comes from Wal-Mart and Publix; Delhaize and Albertson’s/ Cerberus do not have significant scale in the region.  Wal-Mart is overdeveloped in the Southeast and the peak in new supercenter openings has passed.  This is positive for WINN.  Publix is the best grocery chain in Florida but is not invincible.  It was simply the best of what was available to consumers.  In the past, WINN tried to compete directly with Wal-Mart while Publix successfully differentiated itself by focusing on customer service.  Today WINN is investing capital and labor into the store base to enhance the customer experience to drive profitable sales. 

 

 

 

*** Valuation & Target Price ***

 

WINN currently trades at under 10% of forward sales and under 6x forward EBITDA, while comparable companies (Kroger, Safeway, Ruddick, Weis, Ingles, etc.) trade at 40% and 7x, respectively.  As a result, WINN is currently trading a depressed multiple on depressed sales and earnings.  We see this as a compelling buy opportunity.

 

By fiscal 2011 (calendar 2010), we believe WINN will have $350mm of EBITDA on a little over $8bn in sales.  The bridge to 2011 EBITDA is presented as follows:

 

$ in millions
2008E Baseline EBITDA	$110
Remodel Contribution		$150
Private Label Mix		$30
Perishable Mix		$30
Shrink		$15
Supply Chain		$5
Legacy Improvements		$20
Cost Increases		-$10
2011E EBITDA	$350
EBITDA Margin	4.3%

 

We note that the margin of 4.3% is below what the current store base earned in the past, below the average comparable margin of 6%, and under half of Publix’s 9% margin.

 

In terms of valuation, we estimate that maintenance capital expenditures are about $75mm annually.  Subtracting $75mm and hypothetical taxes of $100mm, we arrive at after-tax free cash flow of $175mm.  Assuming a conservative 14x multiple, the implied enterprise value is $2.5bn, or $2.7bn including projected net cash and NOLs.  This equates to $47 per share by calendar 2010 (3 years from now), well over 2x the current share price of $18.61. 

 

 

*** Risks ***

-          The Winn-Dixie brand fails to regain credibility, resulting in lost market share and negative same store sales.

-          It is very early in the remodel program and there is a chance that the program’s financial returns are inadequate.

-          The legacy store base is unable to improve sales productivity.

-          Wal-Mart reinitiates an aggressive expansion in the Southeast.

-          Florida’s bursting housing bubble wreaks havoc on consumer spending at grocery stores.

-          Hurricanes cause disruption and/ or damage to stores.

 

Catalyst

(1) Legacy store improvements through better merchandising.
(2) Benefits of remodels begin to show in the financial results.
(3) Potential acquisition target after November 2008 when limitations on change of control related to NOLs expire.