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.

Sunday, 22 March 2015

Weekend reading

David Einhorn's speech at the Hackley School (ValueWalk)

George Soros and the theory of reflexivity (ValueWalk)

In depth profile on Fred Olsen (Fortune)

Masayoshi Son's secret plan for succession (Bloomberg)

FT profile on Sir Martin Sorrell, CEO of WPP (FT)

Now for something a bit morbid: a tool for calculating personal life expectancy (FT)

Two interviews from Charlie Rose: Tony Robbins and the Prime Minister of Bhutan

Charlie Munger: Academic Economics speech (Farnam Street)

Great post on using a CAPE strategy in investing (MinorityReport)

Brian Rose interviews Tai Lopez (LondonReal)

Sunday, 8 March 2015

Cash at a discount from the Swiss Alps

Spice Private Equity (previously APEN) is a listed private equity fund that makes secondary and co-investments in emerging market funds and is listed on the SIX Swiss exchange, trading at a significant discount to NAV. While there are plenty of examples of closed end funds trading at large discounts I believe there are catalysts that could help close the discount.

APEN started out as AIG Private Equity in the late 1990s to invest in developed market PE funds (North America and Western Europe) and Asia to a small extent. Things were quite rosy, however starting in 2006/07 the company experienced NAV declines and found itself in a tight situation liquidity-wise amidst substantial capital calls, as the expectations of a largely self-funding portfolio did not materialise. The company raised debt and equity (via preferreds) from a group of banks and AIG itself. Then the crisis came, the capital calls didn’t stop, APEN began looking for new sources of liquidity and finally found prince charming in Fortress (which of course didn’t come cheap).

In 2013 the company went through a restructuring with GP Investments and Newbury Partners (Brazilian and US PE funds) taking a controlling stake and buying out AIG, selling assets and refinancing debt. They also issued 1.4m shares at CHF21.8 (virtually equal to today’s share price) and raised about CHF31m. At the same time the company set up a new investment guideline and decided to liquidate what they call as the “legacy portfolio” (mostly developed market funds) and focus solely on EM.

This actually happened a lot faster than expected, as early this year APEN concluded a sale of the legacy assets (as well as the debt on the balance sheet) to Blackstone’s secondaries business for $192m. The net receivable amount will be around $187m or $37m over 5 instalments through 2017 (more details on the transaction here). This transaction represents a 14% discount in USD terms to the fair value as of June 2014. Following the transaction, the company is switching to a reporting currency of USD (instead of CHF, including the share price over the next few months), which is more representative of the underlying investments. In addition, it recently changed its name from APEN to Spice (which sounds more like a late night TV channel, but I get the concept). Following the divestment, the NAV essentially consists of cash and receivables, with a few investments in emerging market related funds and companies.

These steps have created a simpler story around the stock, yet the discount and share price moved exactly nowhere. Potential reasons are that Spice is (i) small: c. $120m market cap with no analyst coverage; (ii) illiquid - close to 60% of the company is held by the controlling group with a few other funds having 3-5% positions and only a few thousand shares trading daily and (iii) history - earlier association with AIG and a hodgepodge of funds probably didn’t help.

Let’s look at some simple math. The Q4’14 guided NAV is CHF37.5 ($37.7) or c. $200m. Following the transaction, this is made up mostly of cash and receivables. Current market cap is $120m, which translates to a discount of 40%. Assuming that the 14% transaction discount is representative (and some discount is fair as you’ve to take taxes into account, mgmt. fees and other opex etc) there is a 40% upside i.e. a share price of $32. I don’t think that this number is crazy as looking at historical trading patterns the stock used to trade at a slight discount to premium to NAV prior to the mess that started in 2008. One additional item to add. As part of the restructuring, Fortress received an option (valid through 2018) for about 700k shares to put back to the company at CHF21.8 and the company has a call option to purchase these shares at CHF41.8. The PV of this is treated as a liability on the balance sheet to the tune of CHF15.6m ($16m) or around $3 per share. This is already calculated in the NAV figures and GP has the first right of refusal on these shares.

There are two ways to reduce the discount: (i) deliver on what you set out and the market should eventually recognise it or (ii) destroy NAV. I do believe that with the new group of shareholders there is change on the horizon. Mgmt stated their intention to close the gap on the NAV and considering that they have a substantial stake they’d have the incentive to do so (though they do benefit in other ways as well). GP Investments, which is associated with the founders of 3G Capital, subject of the Dream Big book, receives fee of CHF5.1m ($5m) for the first five years and a performance fee of 10% on the NAV increase (after a 5% hurdle), which after year five will convert to a flat 1.5% fee. There is a bit of (what I call) fleecing of the minority shareholders, however it is hard to avoid paying fees in money management. Consider, that to earn the same $5m fee after year 5 the NAV would have to be $340m vs the $200m currently. Assuming they can deliver on the transformation I can live with this.

The restructuring of Spice has set it up for a solid path and while it looks like an attractive public investment opportunity, eventually it might make sense for GP to own the whole thing outright and build it out as their PE secondaries platform. In the meantime, if the board is serious about their commitment to shareholders they could take steps and buy back shares, while they are trading at such a large discount, to increase their ownership and eventually take it private (at a fair valuation to minorities) in the near to mid term.

Weekend reading

Forget what I said about the valuation of Belmond. The ADIA is bidding for a package of very high end hotels in London (such as the Claridges) at GBP3m (c. $4.5m) per room (sky is the limit when you've an unlimited investment timeframe). I estimated that the implied valuation for Belmond's owned hotels, which owns equally high end hotels around the world, is around $700k per room (FT)

Two posts from the great 25iq blog: (i) 12 things from the recent Berkshire letter and (ii) 12 things from David Tepper

Warren Buffett interview on IconicVoices. Related article from Bloomberg and a quote from the man himself: “I consider myself a journalist to some extent,” the 84-year-old billionaire said in a video interview premiering Thursday night as part of the “Iconic Voices” series at Arizona State University. “I say, ‘Is the Washington Post Co. worth $22 a share?’ in 1973. I say, ‘Is the BNSF railroad worth us paying $34 billion?’ I assign myself the story. It’s my working hypothesis that it is. But then I go and look for the facts.”

Mark Mobius' post on Brazil

Mark Cuban on why this tech bubble is worse than the one in 2000 (part 1 and part 2)

Great interview with Scott Fearon, the author of Dead Companies Walking (5GQ)

Leucadia's 2014 letter to shareholders

Barry Diller interviewed in the Lunch with the FT series (FT)