GF540 Unit 10 Grocery Chain Research Report Example

Target $41 Against a $34 Price: A Unit 10 Investment Research Report on a Regional Grocery Chain

[Student Name]

Purdue University Global

GF540: Investment and Securities Analysis

Unit 10 Investment Research Report

[Instructor Name]

[Date]

The grocery chain, its peers and every figure are composite and illustrative; the articles and textbooks cited are real.

Summary Box

Rating: Buy. Twelve-month target: $41. Price: $34. Value range: $36 to $47.

Thesis in three lines. Store-brand products are taking a larger share of sales and lifting margins. Remodeled stores are earning back their cost faster than the market assumes. The balance sheet can fund the remodel program without new equity.

The Business

The chain operates 310 supermarkets in four Midwestern states, with revenue of about $6.2 billion and EBITDA of about $390 million, a margin near 6.3 percent. It has 80 million shares and net debt of about $900 million. Its stores are mostly suburban, and it competes with two national chains, a discount grocer and warehouse clubs. All amounts are in dollars; large figures are in millions or billions as stated.

The Industry

Supermarket sales grow roughly with population and food inflation, and margins are thin. The main pressures are discount competitors, which win on price, and online ordering, which raises labor and delivery costs. Regional chains that hold their position usually do so through convenience, fresh food and store brands that cost less to stock than national brands.

The Thesis

Store brands. Store-brand products rose from 21 to 24 percent of sales over three years. They carry gross margins about 8 to 10 points above national brands at this chain. If the share reaches 27 percent in three years, as management targets and as stronger regional peers have achieved, the mix alone adds roughly 0.3 points to EBITDA margin.

Remodels. The chain is remodeling about 40 stores a year at about $2.2 million each. A typical store sells about $20 million a year, and remodeled stores have lifted sales about 11 percent in their first full year. At an incremental margin near 25 percent on the added sales, each remodel earns about $550,000 a year, a payback of about four years. The market price appears to assume closer to six, judging by the multiple investors pay relative to peers that have finished similar programs.

Funding. Free cash flow of about $180 million a year remains after all capital spending, including about $88 million a year for remodels, so net debt can stay near 2.3 times EBITDA without issuing shares.

The Forecast

The forecast has revenue rising near 3 percent annually through year 5. EBITDA margin rises from 6.3 to about 6.9 percent by year 5 as store-brand share and remodeled stores contribute. Capital spending stays near $260 million a year, including remodels. Next year's EBITDA is about $415 million.

Store-Level Evidence

The thesis rests on results the chain already reports. In its annual filing, the 2022 remodel class of 38 stores grew sales about 11 percent in the first full year after reopening, against about 2 percent for stores not remodeled. Management has disclosed store-brand share by quarter for three years, and it has risen in eleven of twelve quarters. Neither figure depends on a forecast. What the report adds is a judgment that both will continue at roughly the recent pace, and a valuation that shows what that continuation is worth.

Management and Capital Allocation

The chief executive has run the chain for six years and set both programs in motion. Capital spending has stayed within guidance in each of those years, and the company has not made a large acquisition. Dividends have grown modestly, and the board has said it will not repurchase shares while the remodel program runs. That discipline supports the funding leg of the thesis: cash is going to the stores, not to deals.

Valuation

Cash flow model. Discounting free cash flow at a 7.9 percent weighted cost of capital, with 2 percent terminal growth, gives about $44 a share.

Peer multiple. Four regional and national grocers trade at a median of about 9.5 times forward EBITDA. Applied to $415 million, less net debt, that gives about $38 a share. The peer set excludes warehouse clubs and discounters, whose economics differ.

Blend. The two are weighted equally, giving a target of $41. Analysts' price targets carry more information when they rest on explicit forecasts and stated methods, and investors respond more to reports whose justifications are specific (Asquith et al., 2005).

The thesis does not depend on the chain growing faster than its industry; it depends on two internal changes, a higher share of store brands and faster remodel paybacks, that are already visible in the last three years of results and that the current price treats as if they were not.

Sensitivity

At 9.0 times forward EBITDA the multiple gives about $35, and at 10.5 times about $43. The cash flow value moves about $4 a share for each half point in the cost of capital. The low end of the range, $36, combines a 9.0 multiple with a cash flow value near $37; the high end, $47, combines 10.5 times with a value near $50.

Catalysts

1. Third-quarter report, early November: first quarter with the new store-brand produce line in all stores.

2. Remodel update at the March investor day: results from the 2024 remodel class after a full year.

3. Fourth-quarter report, late February: full-year margin, the first clear test of the forecast.

What Would End the Thesis

1. Remodel returns fall short. If the 2024 class lifts sales less than 7 percent in its first full year, the payback stretches toward the market's assumption and the gap closes against us.

2. A discount competitor enters the core market. An announced store opening program by a national discounter in the chain's two largest metropolitan areas would pressure prices and store-brand margins.

3. Store-brand share stalls. Two consecutive quarters without a gain in store-brand share would undermine the margin case.

Risks Beyond the Thesis

Food inflation can squeeze margins if costs rise faster than shelf prices. Labor costs are rising across the industry. The chain's debt, while manageable, leaves less room than the national competitors have if a price war begins (Damodaran, 2012).

Conclusion

The shares trade as if the chain's improvements were temporary. If store-brand share keeps rising and remodels keep paying back in about four years, the price should move toward $41 within a year. Analysts' recommendations are most useful when they tie the rating to a forecast the reader can check, and the catalysts above are where that check will happen (Bradshaw, 2004).

References

Asquith, P., Mikhail, M. B., & Au, A. S. (2005). Information content of equity analyst reports. Journal of Financial Economics, 75(2), 245-282. https://doi.org/10.1016/j.jfineco.2004.01.002

Bradshaw, M. T. (2004). How do analysts use their earnings forecasts in generating stock recommendations? The Accounting Review, 79(1), 25-50. https://doi.org/10.2308/accr.2004.79.1.25

Damodaran, A. (2012). Investment valuation: Tools and techniques for determining the value of any asset (3rd ed.). Wiley.