By Brian Sozzi
Private equity is sniffing around the retail sector, trying in earnest to dig up a mispriced gem. The latter stages of 2010 brought a flurry of deal activity, including J Crew (JCG) and Jo-Ann Stores (JAS). More recently, management teams have decided to test the waters, announcing publicly a willingness to do a deal (BJ's Wholesale (BJ), Build a Bear) or to refute what seems all too obvious (Big Lots (BIG) has not confirmed that it's pursuing "strategic alternatives"). Sprinkle in the high profiled companies seemingly forever in the takeover rumor mill, headlined by American Eagle Outfitters (AEO) and Aeropostale (ARO), and it's truly an exciting time to be a sector analyst that happens to cover retail.
As no small wonder, my phone continues to ring off the hook as clients are eager to get positioned in the next possible private equity-backed retail transaction. Sure seems akin to 2007 once again, when money was flowing easily and deal premiums were juicy.
This all got me to wondering: Can we rule out a retailer making a play for another retailer if the price is right and the addition of a new company makes strategic rationale? My advice to investors is to not rule out the probability of it happening. Now, I do not anticipate Macy's (M) binging for Aeropostale (ARO), as that combination would be missing the key qualifier of strategic rationale. What I am thinking is a form of marriage within the drug store retail sector, as the main players there are hungry to dominate the U.S. landscape and have the balance sheets to execute a transaction. Remember, Walgreen (WAG) opened its wallet to the tune of $1.1 billion to purchase Duane Reade in 2010.
The target I have identified is Fred's (FRED), a retailer that many may have never heard of before, and one I have covered for clients for five years. I have long compared the company to dollar stores Family Dollar (FDO) and Dollar Tree (DLTR) when constructing peer comparables, knowing full well the business model of Fred's was slightly different. At this point in time, I think Fred's is better served being valued on a relative perspective to Walgreen and CVS Caremark (CVS), seeing as 46% of its store base operates pharmacies (a competitive advantage to dollar stores) and an increasing amount of merchandise is priced nowhere near a dollar.
Fred's conducts business in 15 states, predominantly in the Southwest, with the largest cluster of stores in Georgia (about 110) and Mississippi (about 108). Since the appointment of Bruce Efird as CEO in 2009, Fred's has been executing upon its "Core 5" program, which aims to increase shopper frequency by having diversified products relative to competitors in the categories of home, celebration, pet, pharmacy, and paper and chemical. By the end of 2010, Fred's had roughly 30% of its store base in the Core 5 layout, which boasts improved space allocation, product placement, signage, and adjacencies. Fred's also has a successful private label brand known as "Fred's Brand," constituting 19.2% of total sales, and a high margin opportunity for the company.
The Rundown on Fred's
- 83% of the store base is located in cities with populations less than 15,000.
- Has been acquiring independent pharmacy customer lists to grow its pharmacy business.
- Has worked diligently the last two years to close underperforming stores and remodel existing stores, as well as to improve processes and technology systems.
- Competitive advantages include pharmacy operations and the sale of tobacco.
The Suitors and Why
As I mentioned, there needs to be serious strategic rationale if a retailer were to purchase another retailer. I am calling out Walgreen and CVS Caremark as potential suitors for Fred's. Strategic rationale is as follows:
Valuation: Fred's shares presently trade at a 35% discount to its nine-year P/E multiple mean and a 32% discount on an EV/EBITDA mean basis using the same measurement period. With returns on assets and equity continuing to head north, driven by positive comps and operating expense leverage, I think Fred's shares are undervalued. Applying a reasonable 15.0x P/E multiple to a reasonable EPS outcome of $1.00 for calendar 2012, yields a fair valuation on Fred's of $15.00, or 15% above the current share price. A case can indeed be made for more aggressive P/E multiple and EPS assumptions on the grounds of a greater number of stores having the Core 5 layout which will help to increase guest frequency and bring about stronger expense leverage, coupled with continued benefits from process improvement. On a forward EV/EBITDA basis, Fred's shares trade on a discount to both Walgreen and CVS Caremark.
Leverage: Fred's purchases 13% of its merchandise from Proctor and Gamble (PG), and without question greater economies of scale will be had under a Walgreen or CVS Caremark banner. Interestingly, CVS may have an appetite for Fred's as a result of its Caremark PBM business, which over time would aid in reducing script costs during a spike in baby boomer visits (note Fred's currently receives script supply from AmerisourceBergen).
Strategic Positioning: In spite of their heft, CVS Caremark and Walgreen are underrepresented in two of Fred's stronger markets of Mississippi and Arkansas. Going back to the most recent 10-Ks, the store counts (using main markets for Fred's only) look like this:
In my view, Fred's does not generate the amount of cash flow that attracts private equity. However, by no means does that equate to Fred's being off the table as a purchase by a competitor that is seeking a solid operation at a currently discounted valuation relative to future growth rates. Fred's would be a nice addition to Walgreen or CVS Caremark, giving each a bolt on acquisition and instant exposure to underrepresented markets and the potential to extract cost savings through economies of scale.