Saturday, 2 July 2016

Empire Co. Ltd. Value Trap or Opportunity?

I haven't had time to write much over the last little while.  Work has been exceptionally busy, and there's been a dearth of beat up companies to analyze as the market hovers near all time, lifetime highs.

I've been looking closely at Empire Co. as it got demolished this past month.  Here's a monthly chart going back to 2000.  Notice that price has moved all the way down to what appears to be pretty significant trend-line support.  Now, strong caveat, just because I've arbitrarily drawn a trend-line doesn't mean it's going to hold (stockcharts doesn't have data prior to 2000, and I note that trading history has been longer than 20 years, which means any long term trend-line using earlier data points could be lower than the trend-line I've drawn).  What appears to be obvious support may prove to be the exact opposite.

In order to properly evaluate Empire, I have to understand why it's under-performed, what's wrong with the story, possible catalysts, and I have to attempt to do some sort of valuation (or a range of valuations).

What's wrong with the story (leading to under-performance):

In no particular order, here are my thoughts.  Empire is paying the price for a huge deal that seems to have flopped, and if it hasn't flopped, it has severely under-delivered vs. preliminary expectations.  

They bought Safeway in Western Canada, and in retrospect, not only did they seem to overpay, but Western Canada has been soft economically.  Their poor post-deal performance has only been compounded by the unfortunate circumstances of operating in a low margin, highly competitive business.  Empire seems to be losing ground where Metro and Loblaws are succeeding.  Empire was supposed to have fully integrated Safeway by now, but they haven’t, and they continue to spend on integration.  At the time, $5.8B was almost equivalent to Empire's capitalization, so what was supposed to be transformative has been anything but.  

I recall reading Bruce Greenwald's comments concerning generating incremental returns on capital invested. The best businesses are able to earn a higher incremental returns on each dollar of capital invested in excess of their cost of capital.  Any incremental dollars spent earning less than cost of capital result in destruction of value.

I certainly think this has been the case with the Safeway integration. For starters, there's little pricing power in grocery, so the deal economics (at the time) must have been evaluated on recognition of synergies as opposed to Empire being able to pass higher prices through to consumers.  I'm also hazarding a guess that no one within Empire at the time foresaw the oil crash in Western Canada (surprise, surprise), so part of the deal economics must also have been evaluated based on sustainable growth in Western Canada.  Ok, this all old news.

The major loss in the most recent year ended April 30, 2016 was mostly non-cash: they wrote down $2.8B of goodwill attributable to the Safeway deal, which works out to almost ½ of the purchase price for Safeway!  Put simply, they bought Safeway for $5.8B, and they wrote close to $3B off this year.

The drivers of the poor year over year results seem to be continued integration costs, unrealized or non-existent synergies, & continued softness in margins due to competition.


The pipe dream catalyst here in order for Empire to right the ship would be to divest of Safeway at a loss, stop the integration game and use the net proceeds to pay down debt, but given they are now almost two years post acquisition, and having spent significant sums on integration, this really is a pipe dream.  

Maybe, they could implement a program to convert more of their Sobeys or Safeway stores into discount stores, a la Metro or Loblaws?  After all, this seems to be a winning strategy for the competition, and Sobeys is already heavily discounting its goods in order to compete.

Another possible catalyst could be a full divestiture of Empire's 41% Crombie REIT stake, which at current market prices could bring in close to $800M, and with the proceeds pay down debt, or engage in additional sale leaseback transactions with Crombie REIT in order to monetize portfolio holdings and use the proceeds to pay down debt. 

Beyond these scenarios, I can't think of anything else that would really entice investors to buy the stock (or stop investors from selling the stock), but this doesn't mean that something completely unforeseen couldn't take place, i.e., privatization, merger/acquisition, sale of gas-bars or other assets, etc. (I'll offer that the dual share structure may limit the likelihood of a merger/acquisition taking place as voting control resides with the Sobey family).

This really boils down to a valuation analysis, i.e., is Empire cheap enough to merit consideration.  I find it fascinating that investors have no problem chasing Metro or Loblaws at 20x earnings for what appear to be similar businesses in terms of overall margins, overall pricing power, and competitive environment (at least on the surface), while shunning Empire the cheaper it gets.  See below, courtesy of morningstar:

What seems to separate Metro from Empire are differences in capital allocation and execution, i.e., Metro via Super C & Food Basics has executed well, while Empire via Safeway has not, and this has made all the difference in the multiple investors award each stock.  While Metro has been able to earn positive incremental returns on invested capital, Empire hasn't.


I approached valuation from two perspectives, 1) Sum of the Parts, and 2) Capitalized free cash flow.

Sum of the Parts

My rough sum of the parts analysis is as follows, going back to 2007:

My assumptions are as follows:

  • I valued Sobeys (food operations) separately and distinct from Safeway.  Safeway was added in fiscal 2014, so prior to 2014, I valued Sobeys at implied valuation on privatization in 2007 of $2.8B (Empire bought out the remaining publicly traded stake in Sobeys at $1B and owned just under 2/3rd's of Sobeys prior, so $1B / .36 = $2.8b)
  • I assumed Sobeys grew at the rate of net earnings from continuing operations each year between 2007 and 2014.  This would put Sobeys alone at a theoretical 5.5B by 2014 just prior to the Safeway deal
  • I determined 42% of Crombie's mkt cap each year between 2007 and 2016
  • Finally, I used the Safeway acquisition price starting in 2014 and reduced it in 2016 for the impairment charge of $2.8B in 2016
  • I determined estimated value per share attributable to Sobeys, CRR, Safeway, and deducted total debt per share to arrive at an estimated sum of the parts valuation.  I ignored other real estate investments (Genstar) and the previously disposed of Empire theatres in my analysis.
  • I then compared avg price per share in the market vs. my sum of the parts analysis in order to assess whether Empire on a sum of the parts basis has traded at a theoretical premium or discount to price per share over time.


  • It's interesting to compare my theoretical SOTP vs. avg stock price.  The two metrics have tracked pretty closely since 2007, per below.  As the business grew and generated positive returns on invested capital, the spread between theoretical sum of the parts vs. avg stock price remained positive.
  • As integration and negative return on capital issues with Safeway have become problematic, the spread between the two measures has inverted.  By my measures, PPS at just under $20 is lower than theoretical SOTP by close to $6 (this doesn't mean that this spread can't get wider)
  • The discount of theoretical SOTP to PPS at .71 is the lowest discount over the last 10 years.

What if I just ascribe a value of $0 to Safeway?

Here, I get a theoretical SOTP of $16 per share, ex-Safeway.  We're only about $3 or 17% away...

Free Cash Flow to the Firm

In this case, I used free cash flow as reported in each annual report going back to 2007, and I normalized the 2014 free cash flow downward by $640M in order to remove the non-recurring sale of manufacturing facilities.  I then added back after tax interest expense each year to get a better approximation of free cash flow to the firm, and I discounted the resulting free cash flows by 8% perpetually each year (no growth), and compared the results to EV.

For my purposes, I approached free two ways, 1) using as reported free cash flows in 2016, and 2) taking the average of reported free cash flows between 2012 and 2015.  Arguably, 2014, 2015 & 2016 include non-recurring Safeway integration and system related costs, so it's possible that normalized, sustainable free cash flows once the Safeway integration is done (or undone), should be higher than reported.

My results are as follows:

In this case, I get capitalized free cash flows of between $6.2B and $8.8B, vs. current EV of say, $7.3B.  If normalized sustainable free cash flows are closer to $630M, I'd argue that Empire looks about 17% undervalued here, but until the Safeway issues are fully resolved, I'd hazard a guess that the stock will continue to languish.

Concluding Thoughts

I believe the shares will continue to under-perform until there's better visibility regarding Safeway. While compelling on the basis of sum of the parts or capitalized free cash flows, these two theoretical measures alone don't guarantee that the stock won't continue to get cheaper.  I do note that at $16, it seems that you're getting Safeway at $0 on a SOTP basis.

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