Description

Cost-U-Less (CULS) was first written about on this site in February 2004. Since that time, the shares have doubled and it was obviously a great recommendation. Today, the business is much stronger than it was back then and has a longer history of positive performance. The shares are still massively undervalued and represent one of the biggest bargains that I see in the market currently.

Executive Summary
CULS operates a chain of eleven mid-sized warehouse club-style stores typically on tropical islands. CULS has two stores in Hawaii, two in Guam, one in American Samoa, one in Fiji, one in California and four in the Caribbean. The CULS stores, while averaging roughly 31,000 feet, appear nearly identical on the inside to a Costco. CULS targets niche island situations where the demographics and competitive landscape are attractive.

Key statistics of CULS are as follows:

Annual revenues (TTM) $221 million
EBITDA (TTM) $7.1 million
Net income (TTM) $3.0 million
Current share price (6/27) $7.79
Enterprise value $32.0 million
TEV to EBITDA 4.5x
P/E Ratio 10.8
Price to tangible book 1.3x
Free cash flow yield 9.2% - Normalized. See below.
Expected growth rate 5%-7%

Based on my work to date, CULS appears to be very attractive and certainly undervalued. Given the recent purchases by two institutional investors and the recent indication that one of the groups may be interested in buying the business, I don’t think it will take more than 12 to 24 months to see a substantially higher valuation. Further, as you will read below, CULS has reasonable growth prospects which should further support even higher future valuations.

CULS is currently trading at just under $8 per share. I think the stock is worth somewhere between $11 to $12 per share and, interestingly, has briefly traded up to that range in the last 18 months.

Business
CULS operates a chain of eleven mid-sized warehouse club-style stores typically on tropical islands. CULS has two stores in Hawaii, two on Guam, one in American Samoa, one in Fiji, one in California and four in the Caribbean. The CULS stores while averaging roughly 31,000 feet appear nearly identical on the inside to a Costco. Basically, the best way to think of CULS is a smaller Costco sitting on a tropical island. The product mix within a given store is typically comprised of 3,000 SKUs with a large grocery component. The stores offer mainly U.S. branded goods. The big difference between a Costco and CULS is that CULS has a smaller store footprint, very limited apparel and no books or magazines. Typically, sales are made up of roughly 65% food and 35% non-food items. Costco, as a comparison, generates about a 50%/50% split between food and non-food.

Unlike most club concepts operating in the U.S., CULS does not charge a membership fee at its stores. This is because management believes that an annual membership fee of even $25 would be difficult for many residents to afford given the per capita incomes of locations served. In a couple locations, CULS offers a loyalty program whereby frequent shoppers earn cash back. CULS has considered rolling this program out across all locations, but, given the limited competition in most locations, the management team feels there would be little, if any, benefit. Since inception, CULS has tried several store locations that ultimately failed including: (1) a chain of stores on the mainland U.S. which were subsequently closed; (2) stores located in New Zealand which were poorly received due to local brands being more well received than U.S. branded goods, (3) a location in Fiji which had to be closed due to unstable political issues. Since inception, I think CULS has opened roughly 21 stores, however, management over the last few years have streamlined the business back to the current eleven locations and are seeking to grow and expand using the currently successful model.

Given the current size of the chain, growth of even one location equates to nearly 10% growth. Management believes that they have targeted most of the really attractive easier locations. You get the sense from talking to them that the Caribbean is the area of focus for future growth. Recently, they announced that they received preliminary approvals to begin working on building a store in the Cayman Islands. Absent green-field new developments on new islands, CULS is looking to expand existing store locations. This would be accomplished either through expansion of an existing site or through relocation to a larger facility. While the stores currently average 31,000 sq. ft., several of the early locations are nearly 50% smaller in sq. ft. than the current targeted footprint of 36k to 38k sq. ft. As its leases expire in these smaller locations, CULS will be attempting to increase its footprint and thereby its sales.

This business will generate very attractive returns as it grows. This is because incremental locations are not very capital intensive. The business with eleven locations generates gross margins of roughly $12 million or roughly $1.1 million per location. The cost of opening a new leased location that is leased is probably roughly $1.5 million. Additional inventory of about $2 million per location is required, however, through accounts payable terms, approximately two-thirds of the cost of the inventory is perpetually financed by the suppliers. The incremental net assets expended to get into a new leased location are at most $3 million and, as noted above, these locations should earn $1.1 million gross profit per year. Another interesting factor is that in many markets the first couple years are the best years that a new location will experience. This is because many times the attractive prices offered by CULS on televisions and other electronics spur purchases that have effectively been pent up, due to high prices, prior to the opening of a CULS location.

The following are the current store locations:

Date Lease
Location Opened Sq. Ft. Expires
Dededo, Guam 05/01/92 38,800 05/31/17
Hilo, Hawaii 08/27/92 23,000 08/31/07
Kapaa, Kauai 03/18/93 22,000 04/22/10
St. Thomas, USVI 06/25/98 36,000 09/30/17
Sonora, CA 01/27/94 23,150 04/30/09
St. Croix, USVI 11/03/94 38,000 Owned
Tamuning, Guam 03/15/95 35,000 03/01/10
Pago Pago, Amer. Samoa 03/20/95 32,055 02/28/15
Suva, Fiji 11/12/98 30,000 11/01/08
Curacao, Neth. Antilles 03/02/99 38,711 02/01/09
St. Maarten, Neth. Ant. 06/29/00 36,000 02/25/24


Using conservative estimates of the growth prospects of CULS, I have forecast the revenue and EBITDA growth potential over the next six years (see below). For my projections, I assumed that the Hilo and Kapaa stores are expanded one year after the current leases expire. Additionally, I added 6,000 sq. ft. in 2007 for an expansion of the St. Thomas store that has already been announced. Also included in my projections, is the St. Croix expansion which has just been completed. Next, I put three new store openings in the projections over the next six years. Since there are a variety of laws governing foreign business ownership on the various islands throughout the Caribbean, I added two of these units at half size and one full size unit. This would roughly take into account having a local partner with 50% ownership. Actually, there are several reasons why this methodology understates the economic returns from a 50%/50% structure. Finally, I added a 0.5% per year increase in base sales for incremental retail concept improvements initiated in the existing stores. Management of CULS has been adding incremental sales and services to its stores over time which boosts the sales per foot in constant dollars over time. My projections are all in constant dollars to exclude the impact of inflation which, if management raises prices to offset the impact of inflation on expenses, represents a zero-sum game. In constant dollars, my projections show that the revenue and EBITDA CAGRs between 2006 and 2011 are 5.4% and 6.1% respectively. This is outstanding growth when one considers the current valuation level. Further, given the modest capital investments required to achieve this growth, the free cash flow yield should increase rather dramatically.

Sales Projections:
TTM $221 million
FY 2006 $222.7 million
FY 2007 $226.9 million
FY 2008 $245.5 million
FY 2009 $269.4 million
FY 2010 $270.5 million
FY 2011 $289.6 million

EBITDA Projections:
TTM $7.0 million
FY 2006 $7.0 million
FY 2007 $7.2 million
FY 2008 $7.9 million
FY 2009 $8.7 million
FY 2010 $8.8 million
FY 2011 $9.5 million

While these projections only project minor EBITDA margin expansion, the growth rate projected in constant dollars (this ignores inflation) represents a revenue and EBITDA CAGR of 5.4% and 6.1% respectively.

Management has announced plans to replace its existing POS system with a new version at an estimated cost of between $0.7 and $1 million.

Competition
CULS has varying degrees of competition at its locations. CULS faces direct competition from Wal-Mart at its stores in Hawaii and at its store in Sonora, CA. K-Mart competes with CULS locations in Hawaii, Guam, St. Thomas and St. Croix. Another competitor is PriceSmart, which is headquartered in San Diego. The founders of PriceSmart, the Price family, pioneered the concept of the membership warehouse with the Price Club in 1976. Price merged with Costco in 1993 and the Price family subsequently exited the management of Costco. The Price family has substantial real estate operations and a very large privately owned self storage business. Their self storage location nearest our office is a brand new facility just off the 10 freeway at Overland. Following their exit from Costco, the Price Family founded PriceSmart. You get the sense that they probably had a domestic non-compete from the Costco transaction since they targeted building their new warehouse offshore. Today, PriceSmart’s 22 locations which are all in Central America and the Caribbean are performing horribly. These locations were performing very badly until quite recently when sale growth finally resumed. The PriceSmart location in Guam lasted less than one year and was in direct competition with a CULS location. Management of CULS indicated that they basically dominate PriceSmart wherever they encounter them. Currently, there is a PriceSmart location that competes with a CULS location in St. Thomas. PriceSmart stores average about 50k sq. ft.

The following are the locations of the existing PriceSmart stores:

Country/Territory Stores Ownership
Panama 4 100.0%
Costa Rica 3 100.0%
Dominican Republic 2 100.0%
Guatemala 2 100.0%
El Salvador 2 100.0%
Honduras 2 100.0%
Trinidad 2 90.0%
Aruba 1 90.0%
Barbados 1 100.0%
U.S. Virgin Islands 1 100.0%
Jamaica 1 67.5%
Nicaragua 1 51.0%
Totals 22

The competition from Wal-Mart and K-Mart is not exactly comparable as both these competitors tend to have stores that are roughly 100k sq. ft. and carry a different assortment of goods. In addition, in every market, CULS competes with local mom and pop operators who are in the grocery business.

Typically, management does not seek to compete on pricing with Wal-Mart of K-Mart. This is especially true in the case of Wal-Mart where local store managers have free reign to change prices at the store level to compete with other offerings. In my work, I visited a CULS store that competed head-to-head with a Wal-Mart and noted that pricing at CULS was slightly higher on every item that was comparable between the two retailers. CULS management indicated that as long as they play the game in this manner Wal-Mart has not made any aggressive moves to drive them out of a location.


The following table highlights some of the income statement differences between the competitors (excluding K-Mart, including Costco for comparison purposes):

CULS Wal-Mart Costco PriceSmart
Prod. gross margin 18.49% 22.86% 10.79% 15.16%
Op. inc. as % of Sales 2.21% 6.00% 2.89% -0.87%
Net income as % of Sales 1.29% 3.61% 1.93% -0.75%

I found it rather incredible that CULS has such positive operating income and net income with its small store base. As additional units are opened over time, both operating income and net income as a percentage of sales should increase as the corporate overhead is spread over a larger store base.

During my analysis of CULS I had an hour long call with the CEO and CFO to discuss the business and go over a bunch of questions that I wanted to ask. They seemed well versed on their business and were helpful in answering questions. The CEO is particulary impressive and seems to have a very solid retail background.

Financial and Valuation
The historical quarterly financial statements for CULS can be found as Exhibit B to this document.

Given the current market price of the equity, the valuation is as follows:

Assume
TTM St. Croix
Current Refi
Current share price (6-27-06) $7.79 $7.79
Fully diluted shares out. 4,222 4,222
Equity market cap. $32,889 $32,889
(-) Cash $(4,573) $(4,573)
(-) St. Croix refi. -- $(4,200)
(+) Net Debt $3,739 $3,739
TEV $32,005 $27,855


Current Current
Measures (excluding inv. income): TTM TTM
Sales 220,867 220,867
Pre-tax profit 4,669 4,669
Net income 3,039 3,039
EBITDA 7,122 7,122
Book value 24,939 24,939
Tangible book 24,939 24,939
Levered FCF (Normalized) 3,039 3,039
Levered FCF (Actual) (1,850) (1,850)

Multiples:
Sales to TEV 0.15x 0.13x
Pre-tax profit to TEV 6.87x 5.97x
P/E 10.82x 10.82x
EBITDA to TEV 4.50x 3.91x
Share price to book 1.32x 1.32x
Share price to tangible book 1.32x 1.32x
Levered FCF Yield (Normalized) 9.24% 9.24%
Levered FCF Yield (Actual) -5.77% -6.64%

Fair value EBITDA Multiple 7.0x 7.0x
Implied share price $12.01 $13.00
Discount to current price 54% 67%

There are several items worthy of mention relating to the valuation. You will note that I have added a normalized free cash flow yield. This is because the company has been incurring substantial capex associated with the relocation and expansion of its store in St. Croix. This has been financed to date out of cash and cash flow from operations. Through September, CULS spent $5.6 million to buy the land in St. Croix and construct the store. CULS is looking to do a refinancing of this debt or to do a sale lease back on this property. As I noted earlier, CULS is not focused on owning the real estate associated with its locations. Accordingly, there will likely be a large positive cash flow back to CULS in the next six months. Since historically CULS has been paying rent in St. Croix, the difference sale-lease back should have nearly no impact on margins, unlike other situations, where a sale-lease back occurs and a company begins to incur rent expense that was previously not occurring. Accordingly, if one assumes the refinancing of the expenditures in St. Croix takes place and was to proforma a $4.2 million cash inflow (75% of $5.6 million) impact to the valuation, the implicit EBITDA multiple on a TTM basis would drop from 4.5x to 3.9x.

One big issue that many retailers face is the constant requirement to upgrade the tenant improvements and modify the look and feel of the stores. CULS operates locations which are generally cinder block construction and a cement floor. The interior of the store is fitted out with large racks, refrigeration systems and lights. These items require maintenance, but have long expected useful lives. Management estimates that normalized capex requirements for maintaining the current base of eleven locations is between $500k and $1 million. Currently, depreciation is running roughly $1.8 million per year. In my estimates of free cash flow yield on a normalized basis, I used depreciation and capex equal to each other which generated a current normalized free cash flow yield of 8.6%. If I adjusted the capex in the free cash flow calculation to $1 million (the upper-end of the maintenance range), the normalized free cash flow yield jumps to 11.2%. That implies a nice free cash flow yield to investors should the growth prospects ever run out or slow down for CULS. Further, in such a steady state environment, one could also eliminate store opening and closing expenses which, after tax effecting, would further boost free cash flow yield to about 12%.

The U.S. dollar is the functional currency in all locations except for Fiji and the Netherlands Antilles.

Key risks
The key risks to this investment include:

1. Small store base is more vulnerable to changes in its operating than a larger chain would be.
2. Competitive environment could change and new competitors could appear and make existing locations less profitable.
3. Natural disasters have been increasing in frequency in the last few years. The CULS locations could be impacted by floods, hurricanes, typhoons, tsunamis and earthquakes.
4. Declines in tourism could substantially curtail income of residents who are dependant on tourism for their livelihood.
5. A major disruption in shipping goods to stores could impact sales levels.

Ownership
The ownership structure of CULS sets up well for extracting value. Management owns less than 3% of the outstanding. Institutional holders, including the 13D/G filers, control over 50% of the stock. On October 11, 2005, Whitebox Advisors LLC, a hedge fund, filed an initial Form 13G showing that they had acquired a stake. On November 1, 2005, the Delafield group of investors filed a Form 13D showing the recent purchase of 317,916 shares. They noted in their filing that they felt the shares of CULS were undervalued and that they may have an interest in acquiring the entire business.

Subsequently, Delafield increase its ownership to 380,993 shares and filed an amended 13D filing and stated the following:

“Holders have communicated with management and members of the Company’s Board of Directors regarding their belief that the shares of the Company are undervalued. The same Holders continue to believe that the shares of the Company are undervalued and have written letters to and had conversations with management and members of the Company’s Board of Directors suggesting ways to increase shareholder value — including a sale of the Company or a leveraged recapitalization of the Company.

The Holders have also requested that the Company take steps to improve communication with its owners. Specifically, the Holders requested that the Company host a conference call following the release of each quarter’s earnings. The Holders believe that owners, the Company’s Board of Directors and management will all benefit from an open exchange of information.

The Holders are requesting that the Company’s Board of Directors eliminate all anti-takeover provisions……”

There are two potential roadblocks to one group seizing control of CULS: (1) there is a shareholder rights plan that kicks in if a group goes over 15% and, (2) there is a mention in CULS’s SEC filings about certain anti-takeover protections that exist in the State of Washington where CULS is incorporated.

Current large institutional holders are as follows:

Institution Shares %
Delafield Hambrecht 380,993 9.47
Whitebox Advisors 259,692 6.46
Advisory Research Inc 224,755 5.59
Barclays Global Investors Intl 203,844 5.07
Axa Rosenberg Investment Management 180,215 4.48
Rnd Resources Inc 166,965 4.15
Cannell Capital Management 151,000 3.75
Dimensional Fund Advisors 100,791 2.51
Wellington Management Company 82,800 2.06
Perkins Capital Management 52,000 1.29
Perritt Capital Management 41,000 1.02

Catalyst

1. Delafield a 10% shareholder is pressuring managment to sell the business or do a leveraged recap. Delafield has also indicated they would like to potentially buy CULS.

2. Significant cash should return to the balance sheet following the refinancing of the St. Croix build out. When this becomes apparent investors will see the real EBITDA multiple is less than 4x.

3. Solid business with good growth prospects. Given the small size of this chain, 11 stores, any new location represents nearly 10% growth.

4. Management will be under severe shareholder pressure to do a dividend or begin a share repurchase over the upcoming months following the refinancing of St. Croix.