VLGEA - Village Super Market: A Cheap Stock Suffering Through Some Valuation Misperceptions

2023-04-20 14:41:35 ET

Summary

• Though Village Super Market does not have characteristics deserving a premium to other supermarkets, it is still undervalued.
• Because VLGEA has no sell-side coverage, its valuation is largely driven by financial websites, which improperly overstate VLGEA's multiples.
• Non-recurring items should be stripped from valuation calculations. A coming anniversary may boost VLGEA's share price.
• IFRS 16, accounting for operating leases, unfairly damages VLGEA's valuation. If op leases are in the numerator, then EBITDAR should be in the denominator.
• Investments, in the form of notes receivable from Wakefern, VLGEA's buying co-op, represent both additional value available to investors, as well as an inability to effectively deploy cash.

VLGEA Is Your Basic Supermarket Business

Village Super Market (VLGEA) is a small, family-controlled, supermarket company, operating 34 supermarkets plus four specialty markets in NYC. It operates the supermarkets primarily under the Shop-Rite brand, and is the second largest member of the Wakefern buying cooperative, which owns the Shop-Rite banner.

With very few exceptions, I consider the grocery business to be essentially a commodity service, with little to distinguish one supermarket company from another in terms of valuation multiples. To my mind, VLGEA follows the mold, in that I do not see it as extraordinary, or deserving of any "moat" within the industry.

To wit, I would be reticent to assign any sort of brand, size, or technology advantage to VLGEA or any other supermarket company without having a strong rationale, backed by a history of better margins than competitors. By this measure, VLGEA does not qualify. In fact, VLGEA's cash operating margins are comparable to, but not better than, other better-known supermarket chains such as Kroger ( KR ), Ahold ( ADRNY ), Tesco ( TSCDY ), Albertsons ( ACI ), and Casey's ( CASY ). The basis of my Buy recommendation is predicated on a different, much simpler thesis, as follows:

VLGEA's Most Commonly Reported Cash Flow Valuation Multiple is Misleading

VLGEA's trailing TEV/EBITDA, my favorite valuation metric for steady cash-flow positive companies, is reported by Seeking Alpha as 7.4x (as it is on most financial websites), slightly more expensive than Kroger at 7.0x. So - why would I buy tiny little VLGEA at 7.4x, when I could instead buy market leader KR for a relative discount, especially when VLGEA has no inherent advantage versus KR? Simply stated, I would not.

But, here's the rub: I calculate VLGEA's TEV/EBITDA not as 7.4x, but as 3.3x. Alternately, by a different, but more appropriate, measure, I calculate 5.1x. More on that different measure later.

These are substantially different calculations and results. By SA's and other financial websites' method, VLGEA stock trades comparably to, or a bit higher than, one of the best supermarket companies in the business ((KR)), and so, is probably overvalued. But - by my method, the stock trades substantially below KR's multiple, and appears undervalued. Which one makes more sense?

Determining which of these vastly different results actually reflects fair valuation is critical to the fundamental determination of whether the stock is a Buy or Sell. Simply stated, if you believe that my calculations make sense, then the stock is undervalued, and is possibly a Buy. If not, then the stock is, at best, a Hold, or possibly a Sell.

My simple thesis regarding VLGEA is that, because there is no sell-side analysis of this stock, there are only two publicly available valuation calculations: mine, and that reported on various financial websites. They are radically different. I believe that mine is more fair, thoughtful and reasonable. To persuade you of that, it is critical that the differences between my calculation and those of the various financial websites be fully and properly delineated.

Denominator (EBITDA) Deltas and VLGEA's Happy Anniversary:

Let's compare EBITDA calculations, and the two differences between my calculation and that of SA and other websites:

There are two differences between my calculation of EBITDA and that of most financial websites noted above, one small and one large:

1. There is a double-count discrepancy in D&A. I take D&A from the income statement, whereas SA and other websites take D&A from the cash flow statement. The cash flow statement includes interest amortization of ~$1M on top of D&A recorded against PP&E. By doing so, those websites double count the $1M interest amortization in EBITDA, because it is counted once in operating income (or because it is interest expense added back into net income), and is added again as D&A from the cash flow statement. This double count is a small discrepancy, but I include it and describe it above, to assure you of my accounting and financial credibility, even though, directionally, it runs counter to my Buy argument for VLGEA. My point: this analysis is thorough, fair, and accurate, accounting for all discrepancies, regardless of which way they cut.

2. There is a non-recurring charge not properly stripped out of EBITDA . VLGEA, in fiscal 3Q22 (April 2022) recorded $12.3M of non-recurring pension termination fees. The company essentially offloaded a portion of its pension liability, paying a one-time fee to dispose of it. That was clearly a wise, one-time expense. That amount should be added to the $79M of EBITDA above, resulting in an adjusted EBITDA of $91M. SA does not do so. Nor do other popular financial websites.

All of those financial websites will soon properly report the VLGEA's higher EBITDA, when VLGEA reports April 2023 earnings in early June. There will, of course, also be the normal year-over-year change in quarterly EBITDA (which I expect to be positive $2M - $4M). At that point, LTM earnings and EBITDA will be stripped of the $12M charge on all financial websites, and LTM EBITDA will automatically and magically pop up 15%, with a consequent 13% decrease in calculated TEV/EBITDA (1.00/1.15 = 0.87). That secret is hiding in plain sight. Happy Anniversary!

IFRS 16 Changes the Valuation Game

As for the numerator, TEV, I have been an analyst for many decades, and still prefer the old-fashioned definition: TEV = market cap + net debt + minority interest, where net debt includes only debt and finance leases. IFRS 16, instituted a few years ago, changed accounting for operating leases longer than twelve months, replacing IAS 17, which separated leases into "finance" vs. "operating". IAS 17 required capitalization of finance leases, but not operating leases. IFRS 16 changed that, requiring capitalization of operating leases longer than 12 months as debt on the balance sheet.

As of the most recent quarter, January 2023, VLGEA had $293M of operating leases recorded on the balance sheet. Prior to fiscal 2020, SA would have recorded VLGEA's TEV the same as I do, $302M. Now, it lists it as $595M. SA's TEV/EBITDA = $595M/$80M = 7.4x. Not nearly as cheap as my $302M/$91M = 3.3x.

How Should We Reconcile These Very Different Valuations?

I will not pick a fight regarding IFRS 16. Though I prefer the older methodology, there is good rationale for including LT operating leases as debt. I will, however, argue that a different cash flow metric should be used if you choose to incorporate operating leases as part of your capital structure.

Simply put: If you include operating leases in the TEV numerator, then you ought to add rent to the EBITDA denominator. They're a match, just as EBITDA is with TEV, ex-operating leases; just as net income is with market cap. Sung to the tune, "Love and Marriage": EBITDAR (EBITDA + rent expense) and operating lease capitalization go together like a horse and carriage. If you capitalize operating leases, then you should give credit to the pre-rent-expense cash flows which service those leases, just as you give credit within EBITDA to the cash flows, pre-interest-expense, for the debt that it services.

The point of these ratios is to compare corporate capitalization with the cash flows available to service those capital constituents (equity, creditors, minority interests, etc.). One ought not subtract rental expense from available cash flows, and then compare that amount to TEV including operating leases. It's an unfair and inadequate representation of resources available to service the underlying capital structure.

The above is particularly important to VLGEA, because operating leases constitute such a large part of its capital structure (only 8 of its 34 stores are owned; 26 are leased). At $293M, those leases represent almost half of post-IFRS 16 capitalization of $595M ($293M/$595M = 49.2%). By comparison, Kroger has only $7B operating leases, or ~13% of its post-IFRS 16 ~$53B capital structure. A summary of the valuation techniques is shown below:

VLGEA is the poster child for why TEV, post-IFRS 16, ought to be matched with EBITDAR, not EBITDA. The commonly used new standard inappropriately implies that VLGEA (6.5x) trades at a multiple close to KR (7.0x). It really does not.

The comparison of TEV versus EBITDAR of 4.6x appropriately penalizes VLGEA for its significant operating leases, but still gives the company appropriate credit for the full $129M cash that it generates from supermarket operations, which is available to service creditors (including lessors), equity, and minority interests.

But Wait, There's More!

VLGEA also currently has $90M of notes receivable at its purchasing cooperative, Wakefern. These notes are in addition to $100M of VLGEA demand deposits held at Wakefern, characterized as cash on VLGEA's balance sheet. In effect, VLGEA uses Wakefern as both its bank (the $100M demand deposits), as well as its primary investment vehicle (VLGEA has three ~$30M tranches of notes receivable from Wakefern, totaling $90M, priced at Prime Rate + 50-75 bps; plus a mandatory $33M equity investment in Wakefern; plus $5M of patronage dividends receivable, but, hey, who's counting).

A note tranche typically matures every couple years, but is then reliably reinvested again at Wakefern. One could consider these notes as near-cash, or long-term investments. I am tempted to give a bit of valuation credit to these notes, subtracting some portion of them from TEV (as I would for other companies if those notes were simply long-term marketable investments), but that may be a step too far.

Note, however, that VLGEA does has enough cash on-hand (without using the above-noted Notes Receivable) to purchase all of the 5.4M public float. Did I mention that VLGEA's stock seems cheap? I cannot speculate on the intentions of the controlling Sumas family, but a privatization event certainly seems financially possible and plausible.

One of My Favorite Long-Term Historical Valuation Techniques:

I spend a lot of time reconciling income statements to cash flows, and cash flows to changes in the balance sheet and capitalization. So - one of my favorite perspectives is to look at the past few years and ask, "What have you done for me lately?". I answer by comparing TEV from years ago to now, asking whether the company has generated enough cash to shrink the capital structure; grow the business; and pay dividends. Note that, in this exercise, share buybacks are incorporated into the change in capitalization, so they need not be broken out separately.

The following looks at four-and-a-half years of VLGEA, and four years of KR (VLGEA has a July 31 calendar, so we're halfway through 2023). Note also that for this exercise, I do account for the notes receivable at Wakefern, since they could have been converted to cash. Finally, note that, because IFRS 16 had not taken effect four years ago, capitalizations for both KR and VLGEA are old-fashioned, and do not include operating leases.

I like the above technique, because companies cannot easily game the balance sheet over long periods. Changes in debt, cash, minority interests, and the number of shares are difficult to portray fraudulently. Changes in capitalization, combined with growth metrics and dividends, well describe whether cash flows have really been generated, as well as how they have been deployed.

By the above metric, KR and VLGEA have each generated comparable ~10 - 15% annual returns over the past few years. That is not to imply that VLGEA should trade at multiples comparable to KR. Only that the returns have been similar, and may continue to be.

The above is also a substantiation that VLGEA's cash flows have historically been adequate enough to pay dividends; grow the business; while maintaining the capital structure.

What Are the Risks?

The obvious risk for VLGEA is the family ownership. VLGEA will never be an acquisition target, due to both the controlling family ownership, as well as VLGEA's contractual relationship with Wakefern, which essentially blocks any outsider from taking control.

The second obvious risk is Wakefern, and the significant amount of cash and investments that VLGEA carries at Wakefern. There is significant counter-party risk, and general risk that Wakefern is properly operated and managed. A serious problem at Wakefern could be catastrophic for VLGEA.

A slightly less obvious risk is VLGEA's inability to find good uses for its excess free cash, substantiated by its large and growing note receivable position with Wakefern. The logic is clear: There is no good reason to use cash to pay creditors for debt reduction (VLGEA's balance sheet is already net cash positive); management seems reluctant to reinvest in the business by way of significant acquisitions (the $75M 2020 NYC Fairway stores acquisition notwithstanding); and share repurchases would be nonsensical without a clear intent to take the company private. To my mind, the best use of cash, other than privatization, might be to grow by way of swallowing some of Wakefern's stores, or some other Wakefern partners', but that is purely speculative.

Conclusion:

VLGEA is a cheap stock which has generated decent returns for investors by way of growth + dividends + reduction in the capital base.

Its valuation is obscured because there is no sell-side coverage, so most investors simply look at public websites for basic multiples such as TEV/EBITDA. Those valuations are too high, in part due to a non-recurring charge, soon to be stripped out. As a result, I expect a small pop in share price after the April earnings release.

A second problem with the valuation, the widespread and improper matching of capitalization, including operating leases, with cash flows after rent expense, will probably not be corrected in the short term. Analysts and financial websites are too set in their ways to change. Unfortunately, for VLGEA investors, this is the larger source of VLGEA's inappropriate valuation.

A final note: VLGEA's $90M of Wakefern notes receivable are difficult to value without understanding the controlling family's intentions. I do not include them in any standard valuations. The notes are a mixed bag, representing more than $6/share of relatively liquid, unrecorded, value to investors; but they also represent VLGEA's ongoing inability to effectively deploy excess cash.

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