By Mark Bern, CPA CFA
If you are new to the series and would like to start at the beginning, just follow this link to "The Dividend Investors' Guide to Successful Investing." In the initial article, I provide a description of my selection process and explanations of all the metrics I use. I am currently in the process of providing annual updates to the original industry articles.
I would like to reiterate some of the simple rules that I use as filters to find prospects companies for my master list. Companies must pay a dividend and increase it regularly. I prefer dividend yield above 2.5% but will consider slightly lower yields if yields are growing much faster than the average rate for the industry. Companies that have cut the dividend within recent years or have a history that includes multiple cuts will not make the list. I require a positive cash flow that includes the ability to pay long-term debt coming due within the next five years. This is to provide certainty of viability in case the credit markets freeze up again as happened in 2008 and 2009. Companies that post losses in earnings from ongoing operations will not be considered. I also do not like stocks of companies that tend to fall further than the broad market index, S&P 500.
The purpose of these rules, as well as the other metrics that I use, is to identify companies that are well positioned to weather recessions without worry of bankruptcy. I like to hold for the long term and collect an ever-increasing stream of dividend income. Market corrections give us opportunities to add good companies to our portfolios at bargain prices. I also do not follow companies that experience significant volatility in earnings. I do remove non-cash accounting entries and one-time gains so that I am analyzing operations. But when companies have too many one-time adjustments, especially when the adjustments result in losses, it often means that management has made bad capital allocation decisions. Those companies do not make my list either.
The retail and wholesale food industry is generally considered a defensive investing area since no matter how bad the economy gets, people still need to eat. Thus, many of these stocks are somewhat resistant to recessionary pressures as revenues do not usually fall as much. However, the margins are very narrow and that does not leave much room for error. So, selectivity becomes very important for long-term investors.
The companies in this industry, with very few exceptions are not likely to provide enough consistent appreciation to excite growth investors. These are stocks that we buy for the steadily increasing income and greater price stability. I do not expect to find high double digit total returns when reviewing this industry. There are no surprises in my expectations for future returns this year. However, there were some very healthy surprises on my three picks from this industry that I introduced to readers June 27, 2012 in this article. I do not expect a repeat of 2013 gains in this industry again for some time.
In that previous article I listed my three favorite companies from the retail and wholesale food industry: Safeway (NYSE:SWY), Sysco (NYSE:SYY) and Kroger (NYSE:KR). I would like to provide an update of these three companies here with my new projections for each.
Last June, shares of SWY stood at $17.31 and today (at the market close on Thursday April 3, 2014) these shares are at $38.11. I wish I could say that I predicted that much appreciation over such a short span, but I did not. What I did project was for SWY to provide an average total return in the mid-teens through 2017. Sometimes it is better to be lucky than smart! Including dividends, SWY has given us an unrealized gain of $20.80 plus dividends collected ($1.30 so far) for a total return of 127.7 percent!
The outlook is rather simple on this company. SWY has agreed to merge with AB Acquisitions (parent of Albertson's and several other regional chains) for about $40 per share. The deal should be completed by the fourth quarter of 2014. What SWY shareholders can expect to receive will come from three sources. The first is a cash payment of $32.50 per share. Shareholders will also receive a portion of the net proceeds from the sale of some assets and can expect another $3.65 per share in total when those sales are concluded. The third piece will come in the form of shares of Blackhawk (a gift-card subsidiary) as the company distributes the remaining shares to shareholders. This piece should be worth about $3.75 per share. This amount could be more or less depending upon the price of the new shares and how many shares of SWY one will need to own to receive one share of HAWKB (the new symbol proposed for the subsidiary and class of stock). So, that totals up to $39.90 per share. Owners of SWY shares should also continue to receive dividends through September of $0.40 (two quarterly dividends of $0.20 each). So, you can expect about $40.30 per share if you hold through the merger completion. That is $2.19 above the current price, or about 5.75 percent for holding the shares another eight or nine months.
The new shares of Blackhawk may hold some appreciation potential, but no dividends, so I am not interested. Everyone needs to make their own decision but I am getting ready to sell my shares of SWY the next time the price gets much above $39.
The next company on my list is SYY, the largest wholesale distributor of food and equipment to the food service industry. This is another tricky one since the company is in the midst of acquiring a large, privately held competitor, US Foods. The size of the acquisition has polarized investors since many believe in the potential savings and synergies that can be derived while others fear that the risks inherent in such large acquisitions is too great. For an opinion from another author who disagrees with my position on SYY, please follow this link. The author makes some good points and I always believe it is important to look at your investments from all perspectives. One of his best points is made in this quote from the article:
"As a rule of thumb, it's advisable to avoid a company making an acquisition that is more than 25% of its own size. I forget where I picked it up, but it makes a lot of sense.
Sysco's TTM sales are $45 billion. The combined entity is expected to have sales of $65 billion. Doing the math, US Foods is over 40% the size of Sysco."
Of course, I have taken a look at the financials and come up with a somewhat different view. I may end up being wrong in the end, but I will base my decision on future results rather than a rule of thumb. I have held SYY shares through many acquisitions and know that expected cost savings often elude management but I continue to be pleased with the long-term results.
The first potential problem that got my attention is that the company will be assuming $4.7 billion in debt as part of the deal. But we need to put that into perspective. First, the company will be much larger and I estimate that the total shareholder equity will grow to about $8.1 billion post-merger while the debt would increase to $7.8 billion. That would raise the debt-to-capital ratio to about 49 percent. That is higher than the average for this industry and would need to be paid down. However, there are two aspects of this situation that we need to assess.
First, the merging of these two industry leaders will cause scrutiny by the Federal Trade Commission's anti-trust group. SYY already knows it will need to sell off some assets (probably some from each company) within a specified time frame to gain approval. I do not know how much the proceeds from those assets sales will be but I am willing to assume that most, if not all, will be used to pay down debt. I believe that this could potentially bring the ratio down by several points to around 45 or 46 percent. Suddenly, this appears much more manageable.
The second point we need to consider is that management has stated that it would refinance the current structure of the debt portfolio. This is common in a large merger or acquisition where significant debt is assumed in the transaction. It is necessary to review the maturities of debt and replace some with longer or shorter maturities to ensure that the debt coming due during any year is manageable for the newly combined company. There may also be an opportunity to reduce interest expenses by lowering the overall average rate on the debt portfolio. In the end, I do not consider this acquisition likely to cause significant strain on cash flow or to negatively impact future dividend increases.
The next concern that needs to be considered is whether or not this transaction will dilute existing shareholders. I estimate that the sellers (consortium including Cerberus and others) will end up with about 87 million shares which will expand the total number of shares outstanding to approximately 673 million from 586 million. The consortium will end up owning about 13 percent of the new company. Now, what will the company look like after the transaction? Sales will increase by about 44 percent over current levels (less those sales attributable to assets that are sold). Presumably, total earnings will increase by less than 40 percent but most likely by significantly more than 13 percent. Interest expenses will rise for the combined organization, but not by enough to offset the accretive impact of new earnings. Remember, this is not a straight stock deal; most of the price is in the form of debt and another $500 million of cash.
And finally there is the issue of whether or not SYY will be able to capture all the cost savings (estimated at $600 million per year). That is indeed debatable. I suspect the company may fall short of the $600 million target, but that it will be able to capture a majority of that figure within a reasonable period over two to three years.
In the end, I do not expect SYY to suddenly become a growth stock but I do expect that it will continue to pay a rising dividend for many years to come. In June 2012, I recommended SYY at $28.75 and the stock price is now $35.86 for a gain of $7.11, or 27.7 percent. If we include the dividends collected over that holding period ($1.95) the total return jumps to 31.5 percent. That is getting ahead of what I had projected in 2012, but my new five-year price target is $52 per share which, if attained, would produce an average annual compound total return of just over 12 percent (assuming dividends are reinvested). I think I will hold onto these shares for now.
The final entry from this industry is KR. Again, nothing boring about this one either as Harris Teeter is now part of the company; it is also opening new stores and expanding into a new market (yet to be named publicly).
At the time of the previous article, KR shares were trading at $22.54 and now stand at $44.96. Including the dividends collected during the holding period ($0.88) the total return has been 103.4 percent. Once again this is far better than I had projected during this relatively short span. About half of that gain has come since the announced acquisition, though.
While I think that management is excellent and continues to make the right moves I also believe that this stock has gotten slightly ahead of itself in valuation. I may be too conservative on this but my new five-year price target is just $54 with the average annual compounded total return of 5.3 percent. Of course, I stand prepared to adjust my expectations once I have been able to dig into future results of the combined entity later in the year.
That concludes my update review of the Retail/Wholesale Food Industry. I hope this article was helpful in some way to readers. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.
Disclosure: I am long SYY, SWY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.