One of the companies that jumped out at me in my recent historical magic formula screen was Arden Group (ARDNA). Arden operates 18 Gelson’s supermarkets in Southern California. Gelson’s is a “full service” supermarket targeting customers more concerned with customer service and selection than price.
There’s a lot to like with this company. First, results are incredibly consistent- operating income has averaged $37m for the past 7 years, never dropping below $30m and topping out at just over $45m in 2007.
Second, depreciation consistently overstates capital expenditures, which means operating income could be understated and, at the very least, can be trusted to be conservative. Depreciation expense has average $6.9m per year over the past ten years, while capex has averaged just over $5.8m. However, this capex number includes 2001, when they opened two new stores. Excluding that year, capex has averaged $5.3m. So depreciation likely overstates maint. capex by $1.1-1.6m per year. Not quite the level BDMS’s depreciation overstates expense, but notable nonetheless.
Third, capital allocation is excellent. The company is a cash flow machine, and they pay a small dividend every year. As that cash balance continues to build, they wil lpay a massive special dividend every four to five years to get excess cash off their balance sheets. So, unlike many over-capitalized net-nets, there’s not much risk of the company never doing anything with a huge cash stockpile.
Finally, returns on capital are excellent. Excluding the excess cash and investments and excess depreciation expense, pre-tax return on assets is averaging 30-40% each year. Given those returns, it’s surprising the company isn’t trying to expand their store base (they haven’t built a new location since the 2001 build up).
My take
The company certainly is interesting. If I adjust for the excess depreciation expense, TTM operating income comes in at $30.1m, five year operating income has averaged about $38.5m, and ten year operating income has averaged $33.7m.
Applying a seven multiple (my target entry point, it gives you a 14%+ earnings yield) would give you a target EV of $210m-266m. The company recently repurchased $6.7m worth of shares, so adjusting their cash balance they have about $48m in excess cash and investments. With just under 3.1m shares outstanding, this would give a target buy price between $83-101.
Note that I didn’t say that this was the fair value for the company. That’s the value I think the company’s stock would be interesting as a value investment. A conservative “intrinsic” value for the company would probably be closer to 10x EV / EBIT, which would put the the fair value for shares between $112-138… pretty significant upside in even a worst case scenario.
So why haven’t I pulled the trigger yet? I’m a bit nervous about the future prospects of the business. While the past returns are impressive, I don’t really see anything special about the business that should enable it to continue to enjoy the returns that they do or gives them a competitive advantage against, say, Target, Kroger, or Whole Foods.
Also, while their balance sheet is clean, they could be exposed to significant off balance sheet risk. Their workers are unionized, and if you look at page 14 of their 10-K, ARDNA contributes to healthcare and pension plans for their employees. The funds are significantly underfunded, though the company can’t note how badly underfunded they are, and the company would be liable in the event the pensions run short.
Speaking of unions, the company’s labor contract expired, and they are still waiting for the major players to resolve their labor contracts before settling on a new one. If there’s a labor strike or the unions negotiate a really good deal, earnings could be significantly affected.
Finally, management is a bit shaky. Operationally, they seem very good, but they have a good bit of stock appreciation rights, and when the stock price tanked they adjusted the strike price for the SAR’s down. That doesn’t inspire confidence from me.
So I’m staying on the sidelines for now, but I do see a lot of potential for value. I could see myself going long the name eventually, especially if I can figure out what their competitive advantage is that allows them to enjoy such strong returns.
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Interesting write-up. I haven’t looked through the financials myself yet, but thought I would comment on the concern you raise about competitive advantage. As a Southern California native, I should be able to share some insight on Gelsons’ market positioning. Relative to the Kroger / Safeway store banners, Gelsons stores have higher quality food (in every section of the store: prepared, produce, dry goods, etc.), better customer service, much higher prices, and are pretty much exclusively located in wealthy areas. Their typical shopper is a ~40 yr. old wealthy soccer mom who drives a $60K car and carries a Louis Vuitton bag. Relative to Whole Foods, Gelsons’ price point is similar, but there is not the same focus on organic/local/natural, the store environment is less ‘cool’, and the selection of food is less eclectic. I’m not sure what the best non-SoCal comp for Gelsons would be…maybe Wegman’s back east? I’ve never actually been to a Wegmans, but the comments people have made to me about that store chain always reminded me of Gelsons. Long story short, I’d worry about competition from Whole Foods and not Kroger/Target.
Going forward, I am probably a ’7 on a scale of 10′ confident that Gelsons can sustain the competitive advantage they have today. From the positive angle, the quality of their offering and the demographics of their customer base (not price sensitive) are in their favor. What I worry about is the impact of Whole Foods moving in on their turf. I can think of at least one new Whole Foods that has opened within a few blocks of a Gelsons (Tarzana, CA) within the past year. I’m sure you can find other if you pull up google maps. Most WFs offer a better customer experience than Gelsons does and their offering is more in line with the current trends prevailing among rich 40yr old women. Without having the benefit of spending any time on their financials, I would bet that competition is one of the big reasons why Gelsons’ sales and operating margin have suffered over the past few years. The other major factor is the economy of course and the trend of ‘trading down’. To get comfortable with the investment, I would want to get comfortable with the competition issue first and foremost. Since their store base is so small, I’d probably want to research this on a store-by-store basis.
One other comment: I’m not sure I agree with your 10x EV/EBIT multiple. Kroger / Safeway have traded at that level fairly consistently. And of course WF has traded much higher (~20x now). But Gelsons does not have the quality of professional management or other benefits that come from being a national chain (e.g. procurement scale, geographic diversity, etc.) like Kroger/Safeway. And of course Gelsons’ growth prospects look nothing like Whole Foods. Since 1993, Gelsons’ average EV/EBIT has been 7 and I don’t see good reason for an upgrade from that level, especially considering its only briefly flirted with 10x in the past 20 years.
This name stuck out to me as well on that list. A thought. I’m lazy, so I try to get other people to perform due diligence on competitive advantages:
http://www.yelp.com/search?find_desc=gelsons&ns=1&find_loc=#find_loc=los+angeles,+california&show_filters=1
Haha thanks! I find i’m really bad at doing smple stuff (like using yelp) to do some “light scuttlebutt”. Way to get creative!
Nice write up on Gelson’s. Typically I’m not super jazzed about grocery stores bc of the thin margins, but you paint a pretty decent valuation picture above. As far as competitive advantage, I think your intro paragraph nails it:
“Gelson’s is a “full service” supermarket targeting customers more concerned with customer service and selection than price.”
Up until the beginning of 2011, I lived in Los Angeles/Hollywood area for about 7 years, and I can tell you that Gelson’s is synonymous with quality and would be considered an upscale brand relative to “Von’s” or “Ralph’s” (other local competitors). Gelson’s typically have excellent locations in well established mid-upper class to upper class neighborhoods. Their stores are clean and the staff is a hair more professional than what you see at a typical grocery store.
I think given the demographic they target based on their store locations, they can continue to keep prices high. The label consciousness in that region is very high. I also think in that area, the maxim “cheap things aren’t good and good things aren’t cheap” applies more heavily than in other parts of the world I have traveled or lived. Their stores are in well to do neighborhoods where folks can afford to seek out quality, and they do. I would consider Whole Foods & Trader Joe’s (private) to comparable, but with a more definite organic slant.
I hope any of that insight helps!
Definitely! My real worry (don’t think I articulated it well above) is what happens when WF, Trader Joe’s, etc. move in? Will people really shop there when, for similar prices, they can gain to the much trendier organic places?
The comment below does a nice job of going into this btw.
Interesting write-up. I haven’t looked through the financials myself yet, but thought I would comment on the concern you raise about competitive advantage. As a Southern California native, I should be able to share some insight on Gelsons’ market positioning. Relative to the Kroger / Safeway store banners, Gelsons stores have higher quality food (in every section of the store: prepared, produce, dry goods, etc.), better customer service, much higher prices, and are pretty much exclusively located in wealthy areas. Their typical shopper is a ~40 yr. old wealthy soccer mom who drives a $60K car and carries a Louis Vuitton bag. Relative to Whole Foods, Gelsons’ price point is similar, but there is not the same focus on organic/local/natural, the store environment is less ‘cool’, and the selection of food is less eclectic. I’m not sure what the best non-SoCal comp for Gelsons would be…maybe Wegman’s back east? I’ve never actually been to a Wegmans, but the comments people have made to me about that store chain always reminded me of Gelsons. Long story short, I’d worry about competition from Whole Foods and not Kroger/Target.
Going forward, I am probably a ’7 on a scale of 10′ confident that Gelsons can sustain the competitive advantage they have today. From the positive angle, the quality of their offering and the demographics of their customer base (not price sensitive) are in their favor. What I worry about is the impact of Whole Foods moving in on their turf. I can think of at least one new Whole Foods that has opened within a few blocks of a Gelsons (Tarzana, CA) within the past year. I’m sure you can find other if you pull up google maps. Most WFs offer a better customer experience than Gelsons does and their offering is more in line with the current trends prevailing among rich 40yr old women. Without having the benefit of spending any time on their financials, I would bet that competition is one of the big reasons why Gelsons’ sales and operating margin have suffered over the past few years. The other major factor is the economy of course and the trend of ‘trading down’. To get comfortable with the investment, I would want to get comfortable with the competition issue first and foremost. Since their store base is so small, I’d probably want to research this on a store-by-store basis.
One other comment: I’m not sure I agree with your 10x EV/EBIT multiple. Kroger / Safeway have traded at that level fairly consistently. And of course WF has traded much higher (~20x now). But Gelsons does not have the quality of professional management or other benefits that come from being a national chain (e.g. procurement scale, geographic diversity, etc.) like Kroger/Safeway. And of course Gelsons’ growth prospects look nothing like Whole Foods. Since 1993, Gelsons’ average EV/EBIT has been 7 and I don’t see good reason for an upgrade from that level, especially considering its only briefly flirted with 10x in the past 20 years.
Very interesting. Thanks for a really thoughtful comment!
On the competitive advantage- you pretty much hit it on the head. My main worry was… the business model seems pretty similar to Whole Foods, what happens when Whole Foods moves in? They’ll offer “hipper” products in a similar enviroment at similar price points, and Kroger/Target/ other grocery stores will have them beat on the low end. Seems like a double whammy to me, but it is interesting hearing people talking about how much customers love them…. surprised they haven’t tried to grow a little in the past ten years.
I did think about putting a comparable valuation with Kroger/Safeway/Supervalu up here, but I ended up not doing it for two reasons.
One- due to ongoing food inflation causing worries over margins, all of the grocers are trading at (in my mind unreasonably) low multiples, especially when you look at the prices that have been paid for mergers in the past. Not saying those were correct prices, but you have to wonder if the businesses are worth this low a multiple
2- those companies ROIC really aren’t comparable to ARDNA after stripping out excess cash
3- their capital allocation has historically been subpar- acquisitions at top multiples, share buybacks and dividends at the top of the cycle, etc. ARDNA really hasn’t had that problem, and whether the recession better than most. Their balance sheet is also much stronger.
Just my thoughts!
On the multiple:
What you say makes some intuitive sense to me, esp. the cash adjusted ROIC, but I’d say a few things:
I’m not up to date on transaction comps at all, but the only major one I know of off hand is Albertsons, which was a pricey deal (as I think you were alluding to). Perhaps there are some regional grocer acquisitions that would be good benchmarks though. In either case, I think its a bit optimistic to expect a buyout multiple where a control premium has been baked in to be realized in a scenario where there is no buyout.
On the capital allocation point, SVU is really the only one who messed up on this front with their bungled $16B Albertson’s acquisition. Accordingly they have tended to trade at a one plus turn discount to their peers (EV/EBIT).
On weathering the recession, I don’t think I’d really say Gelsons did better than Kroger/Safeway. Definitely not on a revenue basis, though the picture is more mixed on profit.
And on leverage, agree Arden’s BS is a lot prettier than SVU’s but I would argue that grocery retailers have a business model where at least modest leverage makes more sense than the almost non-existent amount Gelsons has historically had. Speaking of which, one way I could see value creation at Gelsons would be via a leveraged buyout/recap. I bet you could throw on $50M of debt, which would really juice ROE.
At the end of the day, my major concern would still be that Gelsons has never really been a 10x EV/EBIT company in the past, so I’d want there to be some fundamental change in their prospects to justify the upgrade (i.e. structural change to profitability or growth). I don’t see either of those on the horizon for Gelsons. As we’ve discussed with the Whole Foods threat, if anything I think their prospects look worse today than they did five or ten years ago. The related concern is also that Gelsons has always traded at a discount to Safeway/SVU/Kroger on EV/EBIT — and that’s looking back 20 years. Again, not sure why to expect a change there.
I’ve followed ARDNA for a while now. Never bought, but followed.
I think most of the article/comments are right, except for a few things.
This company is very well managed, much, much, much, much, much, much better than SVU and Albertsons. They have a clear strategy. This company is set up to be a cash cow. They have made it a policy to not open any new stores. So that means two things; First, there is a huge amount of cash flow and Second there will be ZERO long term earnings growth. If a normal corporate CEO would be running ARDNA, he/she would of surely done a stupid acquisition by now. Considering the massive amount of cash ARDNA produces, it’s capital allocation strategy (build it up, pay it out) is great. They could pay a regular dividend and get the share price up as yield chasers come in, but paying large special dividends achieves the same thing.
Second, I’ll repeat, there is NO growth, zero. They are not opening any new stores so they can’t grow. Since they are very upscale, they’re earnings will fluctuate, sometimes a lot, but the fluctuations are just journeys from cyclical peaks and troughs. Currently we are near a trough.
So… They don’t deserve the typical multiple. SVU, Albertsons, Whole Foods, and other supermarkets will open new stores over time and grow. ARDNA will not, so they’re different. Because they will never grow they should be viewed as a bond, with no maturity, and a coupon that will fluctuate based on the SoCal economy. The question then becomes, what is avr. earnings, what is the earnings yield, and is that an attractive yield?
But to the question of does ARDNA deserve a 10 EV/EBIT multiple, I would say definitely not. IMO a company with no long term growth deserves a 10 after tax multiple, maybe a little more if the quality is extra high. Whole Foods and Trader Joe’s competition is real, and ARDNA’s margins over the last 10 years are the absolute highest in the industry, so that may not return. That would be a huge concern for me if I was long. Whole Food’s (net) margins are around 2%. ARDNA’s average long term margins are around 5%. What competitive advantages does ARDNA have over a mega player like Whole Food’s? Not many, certainly not 3% worth IMO. So it’s a definite possibility that margins (or revenue if they don’t cut prices) will be a lot lower over the next 5 years than they were over the last 5 years.
One last word on management. Bernard Briskin is the CEO, he owns basically half the stock. He is 84 or 85 now I believe. If he dies, expect the family to shop the company as soon as the funeral ends. The problem is, he could live to 100, so that catalyst may not bear for another 20 years.
My thoughts,
-Hester
Oh, btw. Another nice article and idea. Didn’t want to sound ungrateful
.
Not at all… great insights into the business!
Maybe the 10 EV/EBIT multiple is too aggressive, but given the consistency of earnings, it’s really tough for me to believe 7x EV / EBIT is correct as well. The company really should be financed almost completely with debt to take advantage of the tax shields associated with it, and my argument for 10x EV / EBIT was basically based on someone as some point taking control of it and paying a huge dividend to shareholders in a debt recap.
Sorry for the quick reply- traveling for Easter
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