Description

Roundy’s Inc. is a conventional grocer operating 119 stores in Wisconsin and 30 stores in Illinois. The company is arguably one of the worst performing grocers in the country as evidenced by flat to negative same-store sales in each of the past eight years, a track record that ranks below any other grocer I could find. To drive this point home, $1.00 of sales at Roundy’s in 2009 was only $0.92 by 2014, an 8% decline during a rebounding economic cycle; by contrast, this same dollar of sales is now $1.01 at Wal-Mart, $1.05 at Safeway, $1.08 at Ingles, $1.24 at Fresh Market, $1.33 at both Costco and Smart & Final, $1.41 at Whole Foods, and $1.43 at Sprouts.

For a retail business with high fixed costs, declining SSS sparks a death spiral where negative operating leverage leads to margin contraction, which results in declining cash flows, which crimps cash available for reinvestment in stores, which turns off customers, which leads to more SSS decline, and so on. The Great Atlantic & Pacific Tea Company (A&P / Food Emporium branded stores) fell into this death spiral several years ago and recently filed bankruptcy for the second time in five years; in the first Ch. 11, when GAP was a public company, its equity got wiped out. Roundy’s is currently caught in this death spiral.

Roundy’s problems stem from two sources. First, its “home” market, Wisconsin, is under attack by Wal-Mart and Meijer, both of which have been aggressively opening new stores and taking market share. The company highlights this dynamic in its investor presentation and management’s attitude towards the situation is to shrug their shoulders and say there’s not much they can do but roll with the punches. My contact at Meijer has indicated that Meijer has no plans of stopping this attack as store ROICs remain impressive and market share keeps coming – shoppers prefer Meijer’s brand new, shiny stores to Roundy’s dilapidated footprint.

Second, Roundy’s was a leveraged buyout by Willis Stein (4.5x acquisition multiple) and is plagued by too much debt. The interest burden on the debt, in combination with shrinking margins, drains the company’s cash flows, preventing it from refreshing stores and reinvesting in the business – which are required to compete effectively. As a telltale sign that Roundy’s has big debt problems, its 10.25% senior secured second lien notes due 2020 are currently trading at 84, for a distressed yield-to-worst of 14.5%. The company cannot afford to refinance debt at this level, and the maturity of this debt may eventually be the death nail for Roundy’s equity.

In an effort to save the business, management threw a Hail Mary, choosing to enter the adjacent Chicago market with a new concept store, Mariano’s (eponymously named after Roundy’s CEO). At first, this concept looked like a good idea, with new stores generating $1 million in weekly sales. However, as the store base has grown, cannibalization has been more severe than anticipated, driving down weekly sales to $875,000 as of Q1’15. But perhaps the bigger problem is that Roundy’s chose to enter the fiercely competitive and highly coveted third largest DMA in the country and go toe-to-toe with Whole Foods, Fresh Market, Albertson’s, Trader Joes, Aldi, Target, Wal-Mart and other deep-pocket, well-established grocers. Whole Foods has made a point of letting Roundy’s know they have been provoked by announcing aggressive expansion in Chicago, growing its footprint in that market from 19 in 2014 to 30 by the end of 2015. Whole Foods expansion has already started to have a meaningful negative impact on Mariano’s with the Mariano’s banner experiencing a whopping 7.7% SSS decline in Q1’15. This trend will likely worsen as Whole Foods’ store openings are weighted to the back half of the year.

In response to these factors, Roundy’s stock has gotten crushed. The stock is now at $2.60 but I think it has another 50% downside over the course of this year, and eventually is a donut when it comes time to refinance debt, albeit this is several years away.

Valuation

The short thesis math is simple. Roundy’s should be valued using a sum-of-the-parts analysis, delineating between the worst-in-class Wisconsin operations and the good-but-not-great Chicago business.

Wisconsin Stores

The Wisconsin store base has shrunk from 127 stores in 2010 to 119 stores currently. Per conversations with management, I estimate the store base will stabilize at 110. The average Wisconsin store did about $425,000 in weekly sales in 2014, down from about $475,000 a week in 2010. For the first quarter of 2015, weekly sales dropped further, to about $420,000. With this trend likely to continue, I assume stabilized weekly sales of $400,000. These assumptions equate to about $2.3bn in annual sales. The company’s consolidated EBITDA margin is currently about 3%; when I back solve for 4-wall EBITDA margins using corporate overhead and management’s guidance for Mariano’s (discussed below), I get a 4-wall EBITDA margin for the Wisconsin stores of 4.5%. This leads to $103mn of Wisconsin 4-wall EBITDA.

Supervalu, Inc. is the closest conventional grocer comp to Roundy’s Wisconsin stores, although SVU has meaningfully outperformed Round’s on a SSS and EBITDA margin basis and only has a 60% debt capitalization vs. Roundy’s 80%. SVU currently trades at 6.0x 2015 EBITDA. I think very valid arguments can be made that Roundy’s Wisconsin stores should trade below this, but to bake some conservatism into the analysis, I use 6.0x. This puts the contribution value of the Wisconsin stores at $618mn.

Chicago Stores – Mariano’s

Management believes the Chicago market can handle 50 Mariano’s stores and that at full maturation these stores can generate $800,000 to $900,000 weekly ARPU. This looks like an aggressive assumption given the downward trajectory of sales and the increasing competition, but I give the company credit for the bottom of this range. This equates to $2.08bn of annual Mariano’s sales. Management also thinks the mature 4-wall EBITDA margin is 5% - 6%. The existing store base is currently doing about 2.5% of 4-wall EBITDA margin. I assume 5%, but believe ultimately it will be lower. This leads to $104mn of 4-wall EBITDA.

Mariano’s is more of a fresh and organic foods concept, so its closest peers are The Fresh Market and Whole Foods (although it is certainly not the caliber of Whole Foods, nor does it have the growth potential or anywhere near the margins). Whole Foods currently trades at 10.0x 2015 EBITDA and The Fresh Market trades at 7.0x 2015. Again, to leave room for margin of error in my analysis, I give Mariano’s an 8.0x multiple. This puts the contribution value of the Chicago stores at $832mn.

Corporate

The company currently has $100mn of annual, unallocated corporate expenses. I assume that after reducing Wisconsin stores and doing some cost cutting, management can bring this down to $90mn. I apply a weighted-average segment multiple of 7.0x to corporate costs to derive $630mn of negative contribution value from corporate overhead (this mimics how the valuation would turn out if management allocated these costs to the segments).

Sum-of-the-Parts

All together this leads to an $820mn TEV. The company currently has $705mn of gross debt, including drawn L/Cs, and will require $115mn of cash investment to build the remaining Mariano’s stores (per mgt. each store costs $5.5mn), which will have to be funded with equity or debt as the company currently burns cash. I estimate the company will have about $45mn of cash at the end of 2015, but almost $35mn of this is “cage cash”, i.e. cash that is sitting in registers, in safes, etc. So excess cash will be more like $10mn. Netting these items out leaves $60mn for equity value. The company has 50mn shares outstanding, resulting in a per share value of $1.15, which is nearly 60% below last.

Other Considerations

-          Insiders are selling and don’t care at what price. Willis Stein currently owns 3.5mn shares, or 8% of the company. They owned twice this much in May 2015 before they did a secondary offering. The night the offering was priced, Roundy’s stock closed at $4.50. The offering priced at $3.50, or 22% below last. I think any private equity firm that believed in their portfolio company’s value would have pulled the offering at that price. But Willis Stein didn’t. This speaks volumes on what insiders really think of the company’s prospects; and I believe the same thing will happen with Willis Stein’s next sale.

-          While this is several years out, the company’s term loan has a springing maturity three months before the 10.25% bonds mature in December 2020. The term loan pays L + 4.25% with a 1.00%, or 5.25%. The loan currently trades around 97. The bonds trade at a 14.5% YTW. The debt markets are telling investors that Roundy’s is in distress and likely doesn’t have access to the credit market to finance the Mariano’s expansion. This means equity dilution is coming.

-          The company burned $45mn of free cash flow (cash from operations less capex) in 2014 and another $20mn in Q1’15, which wasn’t even a bond coupon quarter ($10mn semi-annual coupon payments). My model shows the company continuing to burn cash well into 2018 as it sticks with its Hail Mary plan to expand Mariano’s. This cash shortfall will be funded with the company’s $220mn ABL revolver, making credit metrics look worse and worse and shifting more value of a shrinking pie away from equity and towards debt.

-          Roundy’s still has a $150mn equity value, so there is plenty to short. Short interest stands at 8% and there is plenty of borrow at the bulge bracket prime brokers at regular rates. This idea is very actionable and has been working nicely the past few months.

Catalyst

Additional secodary offerings from PE sponsor, worsening credit metrics, acceleration of SSS decline, cash drain from making high coupon interest payments