The grocery store business used to be quite stable. There were small grocers and large grocers, but customers gradually flocked to the larger chains due to lower prices and absolutely enormous selections. This led to great consolidation in the industry, to where there are now mainly three major players, Kroger (KR), Supervalu (SVU) and Safeway (SWY). Combined, the titans sell over $150 billion of groceries annually.
However, over the past several years, new competition in the form of low-priced competitors like Wal-Mart (WMT) and Target (TGT) has eroded market share and stolen away price-conscious consumers. On the other hand, Whole Foods (WFM) and smaller players like Trader Joe's have rapidly expanded throughout the United States to cater to the health-conscious, largely price-insensitive consumer, hurting the traditional grocers on the other end.
Roundy's Is a Little of All Three…
Roundy's (RNDY) roots can be traced back to 1872, but the modern iteration began when it was taken private by Willis-Stein, a Chicago private equity firm, in 2002. Since then, the company has sold its distribution business and is now focusing on improving its grocery operations. Roundy's is comprised of several different grocery stores in Minneapolis, Wisconsin, and recently, the Chicago area. Roundy's sells groceries under the names Pick 'n Save, Mariano's, Copps, Rainbow, and Metro Market. Pick 'n Save, Copps and Rainbow are run of the mill, average grocery stores, like Albertson's, Jewel, Safeway, Dominick's, Shaw's, or Cub Foods. Metro Market and Mariano's cater to a slightly higher-end clientele (think the nicer Safeways/Dominick's and Whole Foods). We are considering Roundy's for the watch list in the portfolio of our market-beating Best Ideas Newsletter.
According to the company's S-1, the firm has 44% market share in Wisconsin, and 12% market share in Minneapolis/St. Paul. While its market share is impressive, the firm tends to compete well amongst the traditional grocers (though Wisconsin is specifically lacking competition from Safeway, Kroger, or Supervalu), but cannot compete as well with Wal-Mart in other areas, namely Appleton and Green Bay (it also faces competition from smaller, employee-owned companies).
For the past several years, Roundy's business has been stagnant, but predictable. Revenues have been relatively flat, with income floundering since 2008. However, same-store sales have held up fairly well, only falling by 0.8% in fiscal year 2010, while the measures at Safeway and Supervalu were down 2% and 5%, respectively. We attribute its resilient sales to a dominant market position and a Wisconsin economy that has held up better than the rest of the nation in terms of employment.
Roundy's Has Been Dead But Is Ready to Grow
While their private equity partners have focused on selling businesses to pay down debt and take enormous management fees, sales and profits haven't really gone anywhere. We think such performance is a result of the company having too much leverage, restricting its ability to invest in maintaining and updating its stores. Yet, with the company now public, its debt refinanced, and potentially free of Willis-Stein in the near future, a turnaround could be in the making.
We think it all starts with reinvesting in existing locations. A few years ago Chicago-based Dominick's remodeled most of their locations, and we think Roundy's could follow suit. We note that stores with higher capital expenditures per square foot, like Whole Foods or even Macy's (M), tend to drive higher sales per square foot. Roundy's could pressure Wal-Mart super-centers by making the shopping experience much more pleasurable.
Another factor that we think could drive positive results is the entrance into the Chicago market. If you're unfamiliar with the Chicago area, there are mainly two stores, Jewel and Dominick's, but several other competitors, including Wal-Mart, Target, Trader Joe's, Whole Food's, Treasure Island, Woodman's, Costco (COST) and neighborhood grocers. This market is highly competitive. However, we think Roundy's experience (all former Dominick's executives) will serve them well as they attempt to steal market share. The company has had success before when it stole the market crown from Jewel in the 1990's, and we think the firm can do it again.
Mariano's stores are much more updated than Dominick's or Jewel, offering coffee bars, sushi, fresh chocolates, a reasonably priced deli, and cooked meals. It provides shoppers with the more "lifestyle" experience offered at Whole Foods, while the prices for private label goods tend to be cheaper than its larger competitors. Brand name products are pretty comparable, but Mariano's sets itself apart with a craft beer selection, endless aisles of wines, and a few aisles of bulk "warehouse" items to compete with Sam's Club and Costco.
This is no slight to Mariano's, but the competition is faltering. Dominick's stores tend to have higher prices than most, and Jewel stores, while offering some bargains, are in need of significant maintenance investment. Supervalu's cap-ex per square foot, for example, has fallen by more than half over the past three years. The most difficult part for Mariano's might be convincing customers that prices are the same or lower, even though the store may look much better.
Unfortunately, Not Everything Is Perfect
Theoretically, Roundy's looks like it's shaping up to be a great turnaround story. The path looks clear, and its growth plan has been executed successfully thus far. But, there have already been some bumps along the road. Its IPO actually priced below its range of $10 to $12 per share, leaving the company short over $20 million earmarked for debt restructuring. It isn't hard to tell why either. In its S-1, the company asserted that they intend to pay a $0.23/quarter dividend. That leaves the company with a totally unsustainable payout ratio in excess of 75%, in our opinion.
It has been recently reported that Willis-Stein is once again shopping its stake in Roundy's. We don't see a deal being made for much more than the current market-price, as Willis-Stein has tried to sell Roundy's for years with no success. We think it's more likely the firm unwinds its position over the next few years, creating a lot of selling pressure on the share price, but giving the firm independent and more prudent corporate governance.
Without much operating history available, we value the company's shares at about $20 per share, a potential double. We make oujr DCF valuation model template available for the individual investor here. However, we wouldn't consider buying shares of the company until the dividend situation is clarified. We are unsure whether the company can reinvest the cap-ex dollars necessary to improve same-store sales if management is beholden to an unrealistic dividend payout. We're leaving it on our watch list for now.