Summary
- Military segment boasts of significant barriers to entry, given its economies of scale advantage and its existing distribution contracts with packaged goods manufacturers.
- Private label strategy is a key differentiating factor for SpartanNash’s grocery retail operations.
- Unique hybrid business model enhances the Company’s overall purchasing power compared with other independent, standalone grocery retailers and wholesale distributors.
- Company is on track to deliver merger-related cost synergies exceeding its original target of $52 million in three years.
- Current valuation implies limited upside, as the market has already factored in the realization of merger-related synergies above expectations and the advantages of SpartanNash’s hybrid operating model.
Elevator Pitch
I like SpartanNash (NASDAQ:SPTN) because of the barriers to entry for its military business, the private label strategy of its retail operations and the significant purchasing power of the Company as a whole. I am also positive on the fact that SpartanNash has managed its merger integration well, realizing cost synergies ahead of expectations. Unfortunately, I believe the market has priced in the positives for SpartanNash. SpartanNash has significantly outperformed the market index in the past 52 weeks, with its share price up by 31.16% in the past year versus a 11.93% rise for the S&P 500. It currently trades at 13.7 times forward P/E. Also, the estimated annualized investment return of 9.2% for an investment in SpartanNash based on my target price of $34.32 is not very attractive.
Company Background
Formed in November 2013 as a merger between Spartan Stores and Nash-Finch Company, SpartanNash is a grocery distributor and grocery retailer with its operations largely concentrated in the Midwest. SpartanNash operates under three business segments, distribution, military and retail which accounted for 42%, 29% and 29% of its 2014 revenues respectively. Spartan Nash's distribution business is the full service distributor for approximately 2,100 independent grocery stores, and it is also the supplier for Spartan Nash's retail segment comprising 165 supermarkets operating under various banners. The military segment (via SpartanNash's subsidiary MDV) is the largest food distributor to military commissaries (military supermarkets) and exchanges (military retail stores) for the U.S. government. It is the supplier to 169 commissaries in the U.S. and Europe, and also serves more than 440 Exchange locations.
Military Segment Benefits From Significant Barriers To Entry Despite Near Term Headwinds
SpartanNash's military segment has the lowest operating margin of its three businesses at 1.0%, compared with operating margins of 1.6% and 1.7% for its distribution and retail segments respectively. Notwithstanding, the relative lower profitability of SpartanNash's military food distribution business actually serves as a barrier to entry for the commissaries and exchanges food distribution market. The narrow profit margins imply that economies of scale, largely dependent on the degree of concentration of military bases in the specific local market that a distributor operates in, is critical to success in this space. SpartanNash is the market leader in the food distribution market for commissaries and exchanges with 51% market share in terms of revenue. It also claims to be "one of five distributors in the United States with annual sales to the DeCA (The Defense Commissary Agency) commissary system in excess of $100 million," in its 2014 10-K. As a result, sub-scale competitors and new entrants are unlikely to compete successfully with SpartanNash.
Another barrier to entry is the 600-odd distribution contracts that SpartanNash has entered into with its suppliers, the packaged goods companies. The packaged goods manufacturers typically appoint a distributor like SpartanNash as their official representative for a specific commissary or exchange location. More importantly, when a commissary or exchange needs to restock any particular product, it will place an order with the distributor which is contracted with the relevant manufacturer producing that particular product. While these contracts with packaged goods manufacturers either have a specified term or can be terminated upon notice, SpartanNash's relationships with its suppliers are "sticky" in my opinion. This is because SpartanNash is the first point-of-contact between DeCA and packaged goods manufacturers given its status as official representative, and it is not easy for packaged goods manufacturers to find competing military distributors for a specific commissary or exchange locations given SpartanNash's dominance of the markets that it serves.
Although the barriers to entry mentioned above will ensure that SpartanNash remains in a strong competitive position in the commissaries and exchanges food distribution market, the revenue growth for this segment has been negatively impacted by sequestration and its effect on DeCA's funding. SpartanNash's military segment grew revenues from $248.6 million in 2013 to $565.4 million in 2014, but this is an unfair comparison as 2013 only included six weeks of Nash Finch operations following the merger. In fact, CEO Dennis Edison emphasized at the Q4 2014 earnings call that "the commissary system remains challenged." However, the mid-to-long term outlook for SpartanNash's military food distribution business remains positive for two key reasons. Firstly, the commissary system is and has been one of the key benefits that military families enjoy and this is likely to remain the case in the foreseeable future. Secondly, commissaries are compelling shopping destination for military families, as they offer on average product discounts of 15% and 30% compared with supercenters and traditional supermarkets respectively. In addition, management's comments at the most recent earnings call suggest that things are improving.
Now, we don't have numbers yet for January, but our numbers are showing growth through the first eight weeks of the year which is different than what we experienced all of last year. I suspect DeCA is probably showing some growth as well. It's modest growth but it is growth.
Regional Scale And Product Mix Are Key Differentiating Factors For Retail Segment
Grocery retailing is inherently a high competitive and difficult business to run, especially since the retailers typically sell commoditized products with limited differentiation. Economies of scale remain one of the key competitive advantages in the grocery retailing business. On the surface, it seems that SpartanNash has limited advantages in this area with sales of approximately $2.28 billion for its retail segment (small relative to other grocery giants). However, this is potentially misleading since scale economies need to be considered and measured relative to a particular local geographic market. As mentioned earlier, SpartanNash is focused on the Midwest, with 91 and 31 of its 160-plus stores concentrated in Michigan and Nebraska respectively. As a result, SpartanNash enjoys scale benefits in Michigan and Nebraska, particularly in the area of advertising and logistics. For example, SpartanNash can spread its fixed costs such as advertising in local newspaper ads & television spots and distribution of goods from warehouse to stores over a larger revenue base in a local market like Michigan.
Apart from economies of scale, product mix is also a key differentiating factor in separating good grocery retailers from mediocre ones. Private label is one of SpartanNash's key strengths. As at the end of 2014, SpartanNash's private label product penetration rate at its retail stores in Michigan was approximately 26.4%, above the national average as per managementestimates. It boasts a private label product portfolio of 7,400 items, of which4,500 of them are unique to SpartanNash's retail operations and the independent grocery stores that it distributes to. Private label products help to build up customer loyalty and also carry higher gross profit margins than national brands. In 2014 alone, SpartanNash included 400 new products (of which 250 are unique) as part of its private label offerings.
Hybrid Business Model Boosts Purchasing Power Of SpartanNash's Distribution Segment And The Company As A Whole
SpartanNash is a unique company within the grocery space with its hybrid business operations, as most of its peers are pure plays, either grocery retailers or wholesale grocery companies. Instead, SpartanNash operates under three business segments, as mentioned above. As a standalone business, its distribution segment only generated $3.36 billion in revenues in 2014. However, when the total sales of SpartanNash's three businesses are combined, SpartanNash becomes the country's fifth largest food distributor after C&S Wholesale Grocers, SUPERVALU (NYSE:SVU), Wakerfern Food and Associated Wholesale Grocers based on 2014 sales figures.
As a result, SpartanNash's distribution and military businesses are able to source for products at lower prices that will have been possible if they were independent entities with a relatively smaller purchasing power. Similarly, SpartanNash's grocery retail business has essentially more than tripled its purchasing power from $2.28 billion (segmental revenues) to $7.9 billion (group revenues) with the hybrid business model that it operates on. Therefore, SpartanNash's grocery retail operations should enjoy higher gross margins resulting from a lower cost of goods sold compared with a competing grocery retailer generating the same amount of sales, assuming all other things equal. Unfortunately, I am unable to do a direct comparison between SpartanNash's retail operations and a competing grocer, as SpartanNash does not disclose gross profit on a segmental basis and its consolidated gross margins are also impacted by the lower relative profitability of the military segment.
Merger Integration On Track
In November 2013, Spartan Stores completed the merger with Nash-Finch Company to form SpartanNash. Prior to the merger, both Spartan Stores and Nash-Finch had a presence in the retail food and wholesale food segments, while Nash-Finch also owned a military food distribution business that was the market leader in its space. The merger was executed with the purpose of building the combined company's scale and geographic reach, and realizing an estimated $52 million of cost synergies in three years' time.
SpartanNash is on track with the realization of its merger synergies, having exceeded its first year target of $20 million in cost synergies. At the most recent earnings call, SpartanNash's CEO Dennis Edison added that "we remain optimistic that we will exceed our year three $52 million synergy target by the end of fiscal 2016." This was the result of the improvement in operating efficiencies associated with the consolidation of Spartan Stores' and Nash-Finch' retail, distribution, and back office operations.
Target Price
I arrive at a two-year (assuming share price reflects forward looking 2017 EPS one year in advance at the end of 2016) target price of $34.32 for SpartanNash by applying a forward P/E multiple of 15.6 times to my estimated 2017 EPS of $2.20. I have chosen the following companies, Core-Mark Holding (NASDAQ:CORE), Weis Markets (NYSE:WMK), Village Super Market (NASDAQ:VLGEA), SUPERVALU and SYSCO Corporation (NYSE:SYY), as SpartanNash's peers. I am using the median peer forward P/E of 15.6 as the basis for my valuation of SpartanNash. I assume that SpartanNash grows its revenue by a three-year CAGR of 1% and expands its core net profit margin (excluding merger-related expenses) from approximately 0.9% in 2014 to 1.1% in 2017. My target price implies an upside of 19%, or an annualized investment return of 9.2%, from SpartanNash's share price of $28.79 as of March 20, 2015.
Variant View
The health of the economy, the government funding for DeCA and the timing of the realization of synergies are SpartanNash's three biggest risks. Firstly, if the economy deteriorates and the unemployment rate rises, SpartanNash's grocery retail and food distribution segments could suffer as consumers cut back on spending. Secondly, if DeCA receives a lower amount of funding from the government, commissaries are more likely to "squeeze" distributors like SpartanNash on pricing. Thirdly, the market is currently pricing in expectations that SpartanNash will deliver cost synergies in excess of $52 million in three years' time. If SpartanNash fails to deliver, it will suffer a double whammy in terms of a lower EPS and the de-rating of its forward P/E valuation multiples.
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