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Back to Part IX

By Mark Bern, CPA CFA

The Retail/Wholesale Food Industry is yet another group of primarily defensive stocks that should serve investors well during turbulent times. Even when the economy tanks, everybody still eats! More people stay home to eat, which helps the retail food companies but most people who eat most of their meals out will simply adjust where they eat so the wholesale food industry remains fairly well insulated, if the company services accounts all along the price spectrum of dining options. Those wholesalers that focus on the upscale restaurants are more susceptible to the effects of recessions, so we will stay away from those.

My first entry, not necessary the highest ranking but the one with the highest yield, is Safeway (SWY), a food retailer that operates about 1,700 supermarkets across much of the U.S. and western Canada. It also owns a 49 percent interest in Casa Ley, a food retailer in Mexico. In reviewing trends on the Safeway balance sheet I find one item that may disturb some investors so I want to bring it to the fore. While aggressively buying back shares is generally considered a good thing, SWY has been doing so with more than earnings. The company has been also adding debt to buy back shares. The trend can be seen in the declining trend in shareholders' equity even though the company has been profitable. Debt is generally considered a cheaper source of capital because the related interest expenses are tax deductible to the company while dividends are not. But the situation does not give me too much concern for the long term perspective since the company has recently completed its store remodeling program and is requiring less capital for store improve8ments. While I don't think that management intends to pay down debt, I also don't think that it will increase its borrowings by as much as it has over the last few years. I expect that with less money being required for store remodeling, that future share repurchases will be funded internally from earnings.

One other note on SWY is that the company has been pilot testing a digital marketing program called "Just For U" in two markets for several years with great success. It plans to introduce the program across the remaining stores by midyear and management has high expectations for sales increases to begin showing up later in the year. Let's look at the metrics.

Metric

SWY

Industry Average

Grade

Dividend Yield

4.0%

2.0%

Pass

Debt-to-Capital Ratio

55.0%

40.8%

Fail

Payout Ratio

31.0%

32.0%

Pass

5-Yr Average Annual Dividend Increase

20.6%

N/A

Pass

Free Cash Flow

$2.88

N/A

Pass

Net Profit Margin

1.4%

1.6%

Neutral

5-Yr Average Annual Growth in EPS

.06%

0.3%

Pass

Return on Total Capital

9.0%

9.5%

Neutral

5-Yr Average Annual Growth in Revenue

10.0%

3.2%

Pass

S&P Credit Rating

BBB

N/A

Pass

SWY receives one fail, two neutral ratings and seven passes. This is very similar to many of the top companies in other industries. The two neutral ratings are due to close misses in the net profit margin and return on total capital categories. One would expect that those two metrics would move in tandem to a degree, especially in a low margin industry like food retailing. The fail in the debt-to-capital ratio, as explained above, is not due to poor operational results, but from management's decision to trade an increase the use of a less expensive form of capital (debt) for a more expensive form of capital (equity). Strategically it makes sense and will reduce the future cost structure adding to profitability. Just the same I will be much more comfortable when I see the company paying down its debt in future years. In the meantime, that 4 percent dividend is very attractive to income investors. I have a 5-year price target on SWY of $31 and expect total return to be in the mid-teens.

My next master list member is Sysco Systems (SYY), a marketer and distributor of food, equipment and supplies to the foodservice industry in the U.S. and Canada. The company serves a broad range of customers from restaurants to schools, nursing homes, hospitals, hotels and motels, to churches and other charitable organizations. The reprieve in gas prices, however temporary it turns out to be, will help reduce one of SYY's major expenses on the distribution side of operations. SYY is more vulnerable to economic downturns that the food retailers, but the company has achieved a record of more than 40 consecutive years of increases in dividends and currently pays a 3.7 percent yield. Those are factors that help long-term investors ride out the storms. Now let's see how SYY did against the metrics.

Metric

SYY

Industry Average

Grade

Dividend Yield

3.7%

2.0%

Pass

Debt-to-Capital Ratio

36.0%

40.8%

Pass

Payout Ratio

52.0%

32.0%

Fail

5-Yr Average Annual Dividend Increase

9.3%

N/A

Pass

Free Cash Flow

-$0.12

N/A

Neutral

Net Profit Margin

2.9%

1.6%

Pass

5-Yr Average Annual Growth in EPS

7.6%

0.3%

Pass

Return on Total Capital

17.3%

9.5%

Pass

5-Yr Average Annual Growth in Revenue

4.7%

3.2%

Pass

S&P Credit Rating

A+

N/A

Pass

One fail, one neutral and eight passes is a very good showing. The fail in the payout ratio category tells me that the company is not likely to increase dividends as much as it increases earnings going forward. But I think that bringing the ratio back down will be a very gradual process and that management intends to keep the yield near present levels. What this means to me is that the share price should follow dividends over the long term and I still expect the company to maintain its policy of increasing dividend every year. All told, I expect that the average total return on SYY over the next five years could be in the low- to mid-teen range.

My last entry is Kroger (KR), the nation's largest grocery chain measured by sales, with about 2,450 supermarkets in the Midwest, South and West. The company also operates 784 convenience stores and 361 fine jewelry stores. The company has increased its dividend in each of the seven years since it started paying dividends. KR is expanding its offering of gasoline at more of its stores, providing strong top line improvements but slightly reducing overall margins. Overall, the strategy is paying off though as sales (sans gasoline) at existing stores is climbing year over year. Let's take a look at the report card.

Metric

KR

Industry Average

Grade

Dividend Yield

2.0%

2.0%

Pass

Debt-to-Capital Ratio

63.0%

40.8%

Fail

Payout Ratio

22.0%

32.0%

Pass

5-Yr Average Annual Dividend Increase

11.1%

N/A

Pass

Free Cash Flow

$3.66

N/A

Pass

Net Profit Margin

1.3%

1.6%

Neutral

5-Yr Average Annual Growth in EPS

5.4%

0.3%

Pass

Return on Total Capital

13.0%

9.5%

Pass

5-Yr Average Annual Growth in Revenue

11.4%

3.2%

Pass

S&P Credit Rating

BBB

N/A

Pass

Once again, one fail, one neutral and eight passes is a good report card. The debt-to-capital ratio is higher than I would like but there is less cause for concern here than meets the eye once we dig into the financial statements. The company aggressively bought back shares in 2011, to the tune of $1.4 billion worth. It used cash, earnings and a relatively small short-term borrowing to finance the purchases. This, in turn, reduced the amount of shareholder equity, which then increased the debt ratio. On the positive side of the equation, the company also paid down long-term debt and appears ready to continue to do so in the future. This is again a matter of management deciding to exchange some higher-cost capital for some lower-cost capital. In the long run I believe that this company will continue to do well. I currently project a five-year price target of $40 and total returns averaging in the low teens. However, I believe that the current price overvalues the company and would recommend waiting for a dip og ten percent or more.

There are far too many companies in this industry to mention why each was eliminated. Several, such as The Fresh Market (TFM), Green Mountain Coffee (GMCR) and The Pantry (PTRY) do not pay dividends and are not under considerations. Others, such as Harris Teeter (HTSI) and Weis Markets (WMK) have displayed the tendency to keep dividends flat for several years; I require rising dividends to make my list. Whole Foods (WFM) cut its dividend to zero for a year, brought it back for a year and then cut it by a third in the next year; not the sort of dividend activity I want. Then there are companies like Supervalue (SVU) which is losing market share and has reduced its dividend; need I say more?

And that concludes my assessment and master list entrants from the retail/wholesale food industry. If you are just finding this series of articles for the first time, you may find the original article that I used to begin the series helpful to understand the process I use in selecting companies for my master list.

Thanks for reading and, as always I enjoy your comments so keep them coming. Only through sharing our ideas, experiences and perspectives can we all learn to be better investors together. I wish you all a successful investing future!

Source: The Dividend Investors' Guide - Part X: The Delicious Retail/Wholesale Food Industry