Great Atlantic's Silver Lining

 |  Includes: GAJ, GAP
by: Mark Krieger

GAP’s $1.4 billion acquisition of Pathmark is looking like a big mistake lately, especially when you consider the company’s entire market cap today is a mere $491 million. What happened? First we can blame it on the economy, and secondly GAP’s poor operational execution. This double whammy is certainly a bummer, but something that this 150 year old company can bounce back form. The economy is subject to cycles, and operations are fixable. The question is when?

The grocery operator announced a $400 million third quarter write down against good will and this further spooked the market, as investors hit the sell button in droves. It surely could be argued that this write down was actually a good thing, because it enables GAP to utilize this non cash expense as a write off against future income - Translation: the supermarket operator will be free of the burden of paying income tax for a long time. Third quarter results were certainly a disappointment with sales slumping 8%, gross profit margin dropping from 31.14% to 30.09% and administrative costs rising from 30.57% to 32.16%. If there were any silver linings to the quarter, they comprise of the following:(1) the dismal results , render future comparables the opportunity to look very good (2) the company was still cash flow positive, generating “EBITDA” of $36 million (3) Food deflation is transitioning into food inflation .

Yucaipa Companies to the rescue

Management finally realized that its promotional strategy was too complex and confusing, and they are enlisting the aid of one of its largest shareholders for help with its marketing initiatives (Ron Burkle’s Yucaipa Investment Group has invested over $100 million in GAP and taken an activist role). Burkle, who has made a multibillion dollar fortune managing Grocery chains, is no stranger at offering the necessary guidance to turnaround floundering operations. Another interesting development is the presence of Aletheia Research and Management. This Investment firm has had a voracious appetite for the shares the past six months, accumulating more than a 25% stake. Do they know something the rest of us don’t?

The bonds have cratered: GAP’s senior notes have lost 25% (GAJ) of their value in the last week alone - dropping from $24 to as low as $18, before a minor recovery to the $18.50 area. This drop has increased the bond’s current yield from about 10% to 13% (the bond pays $2.34 cash per annum).This could represent a buying opportunity because much of the damage was caused by a high yield letter writer’s sell signal. Once those sellers are cleared out, the bonds could quickly rebound as they are severely oversold.

Strategic value of store footprint

GAP has an extensive store footprint in the densely populated New York metropolitan region. This difficult market to penetrate gives GAP definite strategic advantages, and the company is not closed minded to monetizing those advantages by implementing asset sales, store closings or the sale of the whole company. In fact, the Grocer owns a nice little real estate portfolio consisting of 57 properties including: 36 stores, 7 shopping centers, and 14 other industrial properties ( such as corporate headquarters and distribution facilities). The company is even open to further acquisition opportunities.

Bottom line: it is kind of ironic, but the shares have now fallen to the same level they were last July, the same day Yucaipa’s strategic relationship was announced. That day, the shares rallied 12% from $7.84 to $8.79 and then ran up to nearly $13, until just last week. The stock’s recent 33% drubbing might just offer the buying opportunity contrarian value investors are seeking. After all, it’s a good thing to be on the same side as Yucaipa, because Burkle’s track record speaks for itself.

Disclosure: long gaj and gap