UNFI hosted its analyst day on 1/16 with a detailed overview of the rationale and outlook for the SVU acquisition and provided its long-term guidance for sales, earnings, and leverage. The difficulty we have with the equity is that the risks are tremendous, and the outcomes are binary. In one scenario, the company could execute on its integration, divest its retail assets, recognize its synergy targets to hit the FY22 goal of $875mm to $925mm in Adj. EBITDA, and pay down its debt to 2.9x leverage, in which case we think the stock has very meaningful upside from today. In the other scenario, further execution difficulties integrating SVU’s distribution centers, the inability to divest retail assets, and the potential loss of key customers such as Whole Foods/Amazon could lead to a scenario where the equity value is not worth anything behind the heavy debt burden. While on paper the acquisition strategically made sense, the company is now very far on the risk curve, in part due to the price paid for SVU. While we view the chances of a downside scenario as more likely, we remain Peer Perform rated as the equity could have significant upside if goals are met.
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The calendar may have turned, but the challenges impacting the Food Retail and Food Producers industries remain unchanged. The groups are marred by slow sales growth, higher costs, falling returns and subpar balance sheets. We do not believe 2019 will see any deviation from these difficulties as they appear largely systemic and, as such, we continue to advise investors to underweight Food Retail and Food Producers. In our opinion, while a sharp economic slowdown would clearly hurt if it were to materialize, the Hardlines Retail industry still appears poised to see robust sales growth fueled by a strong consumer, stable margins, and higher ROIC. These companies also have solid balance sheets and a penchant to return cash to shareholders. With valuations reasonable, we continue to suggest investors overweight Hardlines Retail. Finally, the Broadlines Retail industry is seeing sales grow rapidly, in part due to the strength of the economy, but with labor expenses increasing and with the need for omnichannel investments, EBIT growth and better ROIC remain elusive for some. While this causes us to advise market weighting the Broadlines Retail industry, we do believe there are opportunities for outperformance (AMZN, DG) and underperformance (BJ) within the group.
The Kroger Co. (KR, Underperform) today (01/07/19) announced a partnership with Microsoft, using Kroger technology and Microsoft’s cloud service, Azure, to pilot two “connected stores” (in Monroe, Ohio and Redmond, Washington), and jointly market a commercial Retail-as-a-Service (RaaS) product to the broader retail industry. The goal is to combine Kroger’s EDGE (Enhanced Display for Grocery Environment) Shelf technology and Azure to help customers with a unique, guided shopping experience, use video analytics to improve employee insight and productivity, and leverage the EDGE Shelf to generate new advertising revenue from CPG manufacturers through personalized offers.
Our latest three surveys in December showed mixed results with the Chicago market continuing to deteriorate, while Philly and D.C. remain relatively calm. Overall, sequential and year-over-year pricing throughout the U.S. appears to be largely deflationary, with a couple exceptions, signaling that the tough competitive environment of flat to falling prices and rising costs for operators is unlikely to ease anytime soon. The biggest takeaway for us is whether Walmart will need to increase its price investments, or whether the company is taking profits by allowing prices to remain flat in deflationary categories such as coffee. With this note, we are removing our industry rating on Drug Retail (previously Market Weight) following the transfer of coverage of WBA to Justin Lake (see his note here). We are also separating our rating on Food Retail / Food Producers as well, though we continue to rate both industries as Market Underweight.
The strategic rationale of UNFI being interested in an asset like SVU, as we have written before, seemed logical at first blush. With Amazon’s Whole Foods as UNFI’s largest and fastest growing customer requiring UNFI to invest in facilities, the acquisition of SVU gave UNFI additional distribution capacity and diluted the customer concentration of its revenue base. However, the devil is always in the details, as SVU’s business was under its own pressure integrating its own acquisitions, facing the industry-wide cost pressures in distribution, and addressing challenges in its sub-scale retail division. UNFI has now inherited these problems, is seeing pressures in its own business, and has put on significant leverage paying a hefty premium for SVU. Like many highly levered, speculative companies, the potential range of outcomes is quite wide at this juncture. While we are somewhat biased to the downside, we wouldn’t rule out this scrappy management team turning around the business, at least to a degree, and as such we are maintaining our Peer Perform rating.
This morning (12/11/18), TreeHouse Foods held its first investor day since new CEO Steve Oakland arrived in March. The company outlined its progress on various initiatives such as TreeHouse Management Operating Structure (TMOS), THS2020 and Structure to Win, re-iterated its full year 2018 guidance, and established a preliminary 2019 outlook for net sales of $5.45bn to $5.75bn (Wolfe estimate $5.75bn; Consensus $5.74bn) and EPS of $2.35 to $2.75 (Wolfe estimate $2.63; Consensus $2.54). Beyond 2019, the company anticipates 1% to 2% organic growth and EPS growth at or above 10%, with two-thirds of the EPS growth driven by EBIT. Presenting for THS were Steve Oakland, CEO & President, Matthew Foulston, EVP & Chief Financial Officer, Shay Braun, Chief Operations Officer, and Moe Alkemade, SVP & Chief Strategy Officer.
This evening (12/6/2018), after the market closed, UNFI reported lower-than-anticipated 1Q19 earnings (Adj. EPS of $0.59 vs. Consensus of $0.73). In addition, the company outlined much lower-than-anticipated full year Adj. EPS as purchase accounting adjustments, higher-than-expected financing costs, and deteriorated performance at Supervalu eroded earnings. Guidance for FY19 moves to $1.69 to $1.89 (including Supervalu) from $3.48 to $3.58 (excluding Supervalu).
KR reported its third quarter this morning before the market opened, with ID sales (ex-fuel) and gross margin below expectations offset by a decline in OG&A dollars, leading to an EPS beat of $0.48 vs. our $0.43. The lackluster comp sales of 1.6% and gross margin decline were largely in-line with our research of a highly promotional pricing environment recently. Our top questions for management are 1) Whether investors should expect OG&A to decline y/y going forward 2) If gross margin declines are likely to continue in order to drive volume 3) Why are “alternative revenue streams” not yet benefiting gross margin 4) Whether the digital business will require more investment and continue to be a headwind next year and 5) What is the cadence of earnings growth next year and is there potential for it to be back half loaded given ongoing investments that are likely to continue into the first half of next year.
Our latest round of pricing surveys in Houston, Atlanta, and Southern California in November showed the pricing climate to have deteriorated further, led by traditional supermarket operators Kroger and Safeway/Albertsons. With price gaps to Walmart narrowing again in certain markets, the question in our mind is what will Walmart do? Walmart’s business became troubled near the beginning of this decade as a result of a need to fund its growth ambitions by milking its U.S. operations. This led to an erosion of its low-price advantage and a failure to adequately invest in its labor force. Fast forward to today and we wonder whether the financial pressure from Flipkart and the e-commerce losses prevent Walmart from lowering prices further in the U.S. to thwart resurgent competitors. Clearly, letting people back in the game would be a long-term negative for Walmart but a godsend to other retailers as well as consumables manufacturers, in our opinion.
The trends in SJM’s 2Q19 earnings on 11/28/18 were supportive of our concerns on the equity (Jammed Up) with challenges across the three major segments of its business. For Retail Coffee, while falling commodity prices for coffee has served as a tailwind to margin, we see the potential for increased private label competition and the increased need for trade spending to deteriorate margin. In Consumer Foods, while the volume growth of 4% is a positive, net price realization fell 3%, which suggests to us that SJM will need to continue its investments to grow sales through promotional and trade spending in its highly commoditized categories. In Pet Foods, we see building risk as the pure-foods trend expands to pets and as SJM’s current portfolio faces competition from fast growing on-trend products as well as larger companies. While we think that management is making the right decision to invest in its brands and reposition the company, the outcome is likely to be lower earnings and falling returns. As such, we are reiterating our Underperform rating on SJM and lowering our price target to $87.
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