| 2013 | 2014 | ||||||
| Price: | 33.87 | EPS | $0.00 | $0.00 | |||
| Shares Out. (in M): | 14 | P/E | 0.0x | 0.0x | |||
| Market Cap (in $M): | 468 | P/FCF | 0.0x | 0.0x | |||
| Net Debt (in $M): | -82 | EBIT | 0 | 0 | |||
| TEV (in $M): | 386 | TEV/EBIT | 0.0x | 0.0x | |||
| Borrow Cost: | NA | ||||||
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Recommendation:
Village Super Market Inc. (VLGEA), an operator of 29 ShopRite grocery stores, is facing increasing competitive threats which I believe could result in operating profit declining by 25% or more. With profits at the risk of decreasing, I believe the trading multiple (currently at 16.5x LTM EPS) is at risk of falling as well. Therefore I am recommending VLGEA as a short.
My thesis is as follows:
Company Description:
Village Super Market, Inc. operates a chain of 29 ShopRite supermarkets, 18 of which are located in northern New Jersey, 8 in southern New Jersey, 2 in Maryland, and 1 in northeastern Pennsylvania. Village is a member of Wakefern Food Corporation, the nation’s largest retailer-owned food cooperative and the owner of the ShopRite name. As a small company with limited needs for financing, Village is a bit off the radar and has no analyst coverage.
Village is the second largest member of Wakefern and owns 13.7% of the cooperative. Wakefern and its members, including Village, operate nearly 300 ShopRite supermarkets. Members of the Wakefern cooperative must purchase at least 85% of their requirements from Wakefern (Village purchases substantially all of its merchandise from Wakefern). As part of the cooperative, Wakefern members benefit the use of the ShopRite brand name (which is owned by Wakefern), economies of scale in purchasing and distribution, and a share of any profits that Wakefern generates.
The average Village store is 57,000 square feet and aims to provide a one-stop shopping experience. Village’s ShopRite stores are fairly traditional grocery stores, although they do generate a healthy amount of sales from perishables (which typically are higher margin). The perishable/non-perishable split for Village’s stores is about 50/50; non-traditional competitors like Whole Foods are more like 65/35 perishable/non-perishable, whereas traditional grocery stores only do about 30-40% of their sales in perishables. In their last full fiscal year, Village’s product mix was as follows:
Village and its other ShopRite siblings are typically well-run stores. Village’s stores have a good track record of same stores sales growth (average same store sales growth of 3.2% annually over the last decade) and currently average over $50 million in annual sales per store. I spoke with a friend of mine who works at a competitor of ShopRite’s and he noted that ShopRite was a solid competitor: “We have to be pretty sharp on price in the markets we overlap with ShopRite….There are worse operators in New Jersey.”
Village was originally established in 1937 by brothers Nicholas and Perry Sumas and went public in 1965. The Company has a dual class structure with 9.0 million Class A shares and 4.8 million Class B shares. Class A shares are entitled to dividends 54% greater than those of Class B shares, but Class B shares get 10 votes per share and are freely convertible into Class A shares. For the purposes of this writeup, when I calculate market cap, enterprise value, and per-share figures, I’ve assumed that all of the Class B shares have been converted into Class A shares. As you might expect, the Sumas family owns most of the Class B shares giving them control of the Company. As of the last proxy, the Sumas family owned 39% of the economic interest in the Company but 64% of the voting power, and five members of the Sumas family serve as both officers and directors.
Investment Thesis:
Nontraditional competition is ramping up in Village’s core New Jersey market, and it’s likely to get worse:
Village’s New Jersey market is a lucrative one, but as a result, it’s getting more and more competitive. There are the traditional incumbents like Pathmark, A&P, Stop & Shop, Giant, Safeway and the like, but Village is also facing, or will soon face, competition from a lineup of expanding non-traditional players, including the following (in alphabetical order):
When I scan the list above, I see a lot of players that I’d hate to have as competitors. In the case of potential entrant AmazonFresh, Village would be competing against a company that doesn’t always care about generating a profit, at least not in the short term. In the case of Whole Foods, Fairway, and FreshDirect, Village is competing against companies that are trying to steal the highest margin perishables business. In the case of the warehouse clubs like BJs, Costco, and Sam’s Club, Village is competing against companies that are tough to beat on price. In the case of Wegman’s and Trader Joe’s, Village is competing against companies with cult-followings from their customers.
None of the above listed competitors are shrinking, and several of them have explicit plans to expand their New Jersey presence in the near term. As my friend in the grocery business explained to me, the groceries “in the middle” like ShopRite are getting squeezed, and that’s not going to change.
The effects of this competition have begun showing up in Village’s operating results:
Importantly, the threat of increased competition for nontraditional grocery players is not just hypothetical; it has started to show up in Village’s operating results. While Village’s top-line continues to look good (same-store sales up 3.2% in the nine months ended 4/27/13), margins have begun to suffer, and EBITDA has declined in each of the past three fiscal quarters:
Revenue SSS Adj. EBIT Adj. EBITDA YoY Change in EBITDA
QE 7/30/11 $345.0 7.7% $15.7 $20.5 +$0.2
QE 10/29/11 $342.7 8.1% $12.2 $17.0 +$5.1
QE 1/28/12 $362.6 6.2% $16.3 $21.1 +$4.6
QE 4/28/12 $347.0 3.8% $11.6 $16.6 +$1.3
QE 7/28/12 $369.9 1.8% $15.5 $20.6 +$0.1
QE 10/27/12 $358.2 2.6% $10.5 $15.4 -$1.6
QE 1/26/13 $382.2 3.4% $14.4 $19.5 -$1.6
QE 4/27/13 $359.8 3.7% $8.2 $13.2 -$3.4
What is the reason Village gives for the recent decline in profitability? The Company doesn’t hold earnings calls, but in their most recent 10-Q, they explained that “gross margins declined in several departments primarily due to investments in lower prices to combat nontraditional competitors.” This was the first filing in which they mentioned this factor in their MD&A section.
At their peak (which I’ve defined as the 12-month period ended 4/28/12), Village generated EBITDA of $75.2 million on sales of $347.0 million. For the most recent 12-month period ended 4/27/13, Village’s EBITDA has declined 9% from this peak level to $68.7 million. Directionally, I expect Village’s profitability to continue to decline. Quantifying the amount and pace of future declines is difficult, however. That said, another 25% decline over the next couple years would not surprise me. Looking at Safeway, a competitor that has already faced declining profitability, CSFB estimates that Safeway’s US EBITDA (excluding Blackhawk, real estate, and its Canadian operations) is down almost 40% over the last five years.
Looking at in another way, Village’s LTM EBITDA margin is currently 4.7%; ten years ago, that margin was 3.2%. If Village’s sales grew another 5% over the next couple years but EBITDA margins reverted to the 3.2% level of a decade ago, EBITDA would be $49.4 million, or nearly 30% lower than the current LTM level.
With the stock up over the past year and less than 15% off its all-time high, the market hasn’t properly accounted for this threat:
The competitive threats facing traditional supermarkets have not gone unnoticed by the market (hence the high short interest for Safeway and Supervalu), but Village’s stock price has been relatively unscathed by the recent negative competitive developments the Company has faced. At its current $33.87 stock price, is only down 12% from its high closing price ($38.47 on May 22nd) and is still up more than 5% over the past year after adjusting for a $1.00 special dividend declared at the end of 2012.
The Company isn’t expensive on EV metrics (it trades at 8x EBIT and 5.6x EBITDA), as unlike other traditional grocers, Village has a net cash position ($5.94 per share). But Village trades at 16.5x LTM EPS, which I think is too high given that:
The risk of Village being acquired (always a threat when shorting small-caps) is relatively low:
The grocery store industry has seen its share of acquisition activity lately. Safeway recently announced the sale of its Canadian stores, Cerberus bought stores from Supervalu, Bi-Lo bought Winn-Dixie, and Harris Teeter is the subject of buyout speculation. While Village might seem like a probable acquisition target at first glance, there are some factors that substantially mitigate this risk.
First, the Company’s relationship with Wakefern would complicate most potential deals involving Village. From Village’s 10-K: “In the event of unapproved changes in control of the Company or a sale of the Company or of individual Company stores, except to a qualified successor, the Company in such cases must pay Wakefern an amount equal to the annual profit contribution shortfall attributable to the sale of the store or change in control….A ‘qualified successor’ must be, or agree to become, a member of Wakefern, and may not own or operating any supermarkets, other than ShopRite supermarkets, in the states of New York, New Jersey, Pennsylvania, Delaware, Maryland, Virginia, Connecticut, Massachusetts, Rhode Island, Vermont, New Hampshire, Maine, or the District of Columbia, or own or operate more than twenty-five non-ShopRite supermarkets in any other locations in the United States.”
We don’t know exactly the amount of the buyout penalty most acquirers would have to pay Wakefern, but we can try to estimate it. Over the LTM period, Village purchased all of its merchandise from Wakefern, and Village’s cost of sales was $1,072 million. If we assume the “annual profit contribution shortfall” would be, say, 2% of Village’s cost of sales, then that would be a $21 million penalty, not including any costs associated with rebranding the stores to something other than the “ShopRite” name. This penalty wouldn’t be insurmountable, but even this $21 million estimate would raise the price of acquiring Village by 5%. And the penalty might be higher. Village’s investment in Wakefern ($23.4 million as of 7/28/12) is pledged to secure Village’s obligations to Wakefern, and four members of the Sumas family have personally guaranteed Village’s obligations to Wakefern.
In addition to the complications the Wakefern relationship would introduce to a potential acquirer, there is also the fact that Village isn’t being sold unless the Sumas family wants to sell it. As I mentioned earlier, the Sumas family owns 39% of the economic interest in Village but controls 64% of the voting rights. And while the Sumas family could benefit from a buyout through their ownership of Village stock, at least five members of the family would likely lose their well-paying jobs. Over the last 3 years, four members of the Sumas family have been earning an average of almost $2 million apiece in annual compensation from Village:
In addition to the four Sumas family members listed above, there is also John J. Sumas, who is 42 years old and is a VP, director, and general counsel for Village. The proxy statement doesn’t disclose his compensation, but I’m guessing it’s meaningful, and given his age, John J. Sumas could be a logical choice to eventually become CEO. A buyout of Village would likely nix such a plan.
Liquidity is a bit of an issue in implementing a position, but it’s not a crowded trade (less than 3% of float is short), and a cheap borrow is available:
The first half of 2013 has provided ample evidence of the dangers of being involved in crowded, expensive-to-borrow shorts. And several other traditional grocer equities are already heavily shorted. But these concerns are muted for Village, as less than 3% of the float is sold short, and a cheap borrow is available (although there is a 3.0% dividend yield to pay).
Risks:
Potential catalysts include:
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