Sunday, 29 March 2015

Fairway Group Holdings

I’ve been following Fairway (FWM) since their IPO in 2013 and boy has it been a wild ride. The company, founded by the Glickberg family, is a retailer of natural and organic groceries in the greater NY area and has been in existence since the 1930s. In 2007 a PE fund by the name of Sterling Partners acquired 80% of the company for $150m and in 2013 took it public.

The company IPOd with much fanfare and expectations at $13/share, reaching highs of $28, then falling all the way down to the $2s towards the end of last year. The reason for that: seriously high growth expectations that turned out to be too ambitious. When filing the S-1 the company had 11 stores (currently 15) and the plans of growing the store count by 3-4 annually. The stores were a mix between urban and suburban, naturally with a different set of economics. The urban stores are around 40,000 sq. ft. (gross), while the suburbans are 60,000 sq. ft. (gross). Growth plans (backed by consultants) saw the possibility of growing to 90 stores in the Northeast states and 300 nationwide.

These expectations were taken down to 2-3 stores annually, then to 1-2 and then they stopped giving guidance, all in the space of a year. In addition, the C-level suite was a bit of a revolving door with the board having gone through two CEOs until they hired the current CEO, Jack Murphy. In short, as far as the IPO itself is concerned it was a very successful one (for the original shareholders / backers) less so for the poor souls who bought in the following months.

Below is a snapshot of FWM vs some its competitors.
Source: Fairway Group

The new CEO has an impressive background in building grocery businesses, such as Earth Fare or Fresh Fields, amongst other businesses within a PE platform. He came out of retirement to take on the challenge of turning Fairway around. He is going back to basics – “Supermarket 101” (increasing SSS, better merchandising, inventory management etc) on the operations side and slowing down store expansion. The bleeding seems to have stopped but the turnaround will take some time for sure. I’d urge you to read the transcripts or listen to the conference calls pre and post his appointment. The tone is markedly different (for the better that is).

In terms of numbers, in the last full year (ended March 2014) the company generated $776m of sales and EBITDA of -$7m, and in the TTM sales of $800m and $3m EBITDA. While over the last five years (through 2014) sales have almost doubled, SSS was practically negative across all years and it hasn’t been better since 2014 either. This massive expansion in sales came from an almost 3x growth in sq. footage but at a cost of lower sales per square foot. Gross margins have bobbed around the 33% mark over the last five years, generally in line with comps. It’s also worth noting that given the losses over the last few years the company generated NOLs of $150m (per the last 10-K), with a 20 year life so they’ll not be paying taxes for a while.

If you dig through the financials, you’ll find that the company likes to report adjusted EBITDA, basically adding back every item they can think of as “one off”. Adj. EBITDA for the last full year was $49m, so as you can see there is quite bit of tweaking that goes on here (store opening and advertising costs, equity compensation etc). Some of it is fair, but for instance equity comp shouldn’t be adjusted for. For the last twelve months adj. EBITDA is around $40m with a 5% margin.

Looking at valuation, FWM’s current market cap is $260m and with net debt of $220m, you get to EV of $480m. There isn’t a long enough historical multiple trading range yet for FWM so triangulating valuation by using various comps is fair. On the high end you’ve the likes of Whole Foods or The Fresh Market with multiples of 10-14x (EBITDA margins of 8-9%) and on the lower end companies such as Safeway or Kroger with lower margins (4-5%) that traded historically at 6-8x. 

Based on an 8x multiple, the market is currently pricing $60m EBITDA for FWM (most likely adjusted basis), so one could argue that the shares are fair to overvalued based on near term results. FWM could be generating $70m EBITDA (on my estimates) in the near to mid-term due to improving margins (expanding private label sales, cost cutting, improving productivity etc), which is of course subject to the effectiveness of the turnaround. If this is the case multiple expansion is likely to follow. Using the $70m EBITDA and a multiple of 8-10x (high end of the low margin comps and low end of the high margin comps) you get to share price between $8-11 vs the current $6.

I’ve seen other research on FWM, which assume more generous earnings. You could argue that the new CEO has a great track record and has done these sorts of things before so my numbers could be on the conservative side. I’m OK with that, there are many things can go wrong and normally turnarounds turn slower than expected. I’d throw in here that (while I’m less familiar with the geography where FWM operates) it could be an interesting opportunity for Whole Foods to consider M&A with Fairway. It could be worth more to them considering that they could take out a large part of the costs.

There are considerations around corporate governance that's also worth flagging. FWM is a controlled company with a dual share class and the PE fund holds 92% of the super voting class B, while Howard Glickberg holds the remaining. Furthermore, the fund owns 28% of the class A shares as well. All in, they control 80% of the votes. Additionally, there are related party transactions that I don’t like such as FWM leasing properties from companies where Howard Glickberg has an interest. He is also the director of development and reports solely to the board of directors.

One word on the share price. Since the lows of October the price is up almost 3x so the shares had very good momentum behind them so far. Any pullback from here would be welcomed though.