Smart & Final – Return on Equity

A quick way to assess the quality of a business is to look at the return it as able to generate on tangible equity.  Companies which are able to consistently generate high returns on equity typically benefit from a form of competitive advantage.  Calculating ROE is not as formulaic as net income / average equity because accounting treatment often masks the earnings power and capitalization of the enterprise.  Let’s look at Smart & Final as a case study.

Google Finance shows returns on equity for S&F of 2.5% in 2013 and 7.5% in Q4 ’14.  These numbers indicate a weak business with limited competitive strength.  Let’s dive into the numbers to see if this is the case.  Below, I’ve adjusted the balance sheet to determine the amount of equity capital that would need to be in the business to support current operations.  I first convert all the net debt to equity, then strip out intangibles such as goodwill and trademarks.  This gives us an accurate picture of how much equity capital would be in the business today if no acquisitions or debt financings were consummated.

I then turn to the income statement to determine an accurate figure for normalized, unlevered earnings.  I start with EBITDA and add back all the one-time, non-recurring charges to get to an appropriate adjusted EBITDA figure.  Note, many adjustments presented by management are bogus and as such it’s important to be conservative in your approach.  Finally, I adjust the D&A figure to get an accurate picture of steady state earnings.  S&F is spending nearly $100 million of capex per annum, 75% of which is being directed towards growth.  Maintenance capex is a more modest $25 million, or $100k per store.  The income statement should reflect the earnings power of the enterprise based on the amount of equity capital which has been plowed into the business.  As such, $25 million is a more appropriate figure for the calculation because it reflects the ongoing capital needs required to support existing operations.

The numbers, as adjusted, depict a tier 1 enterprise.  For context, the S&P 500 as a whole earns ~12% on equity.

For FY 2014, S&F will likely generate north of $150 million of unlevered, adjusted pre-tax earnings.  This compares to an adjusted market capitalization (assuming all debt is equity) of $1.7 billion, implying a pre-tax trading multiple of ~11.3x.  Buffett has repeatedly said that 10x pre-tax is a good price to pay for a wonderful business so we’re not too far from his measuring stick.

What makes S&F intriguing is the abundant opportunity it has to deploy capital at high rates of return over the next decade.  The company currently operates 252 stores across 6 states and Mexico.  ~190 of those stores are located in California.  The company believes it can open an additional 150 stores in existing markets plus convert ~40 of its existing stores to the higher return “Extra!” format.  Per management’s figures, this will require an additional ~$450 million of capex over the coming years.  If history is a guide, the capital spend should generate 20-25% cash on cash returns.  Bigger picture, once the business starts developing a stronger brand presence, it has an opportunity to expand eastward.

I’ve developed a preliminary hypothesis that S&F is a good business trading at a reasonable price.  It appears to offer customers a great value proposition – low cost, high quality food products in a convenient format.  The company has only had one year of negative comp store sales growth in the past 25 years, including positive growth in 2009.  I still have a fair amount of work to do on the competitive strategy piece and need to go through the checklist, but this has passed through my initial filters and is worthy of further investigation.

Feedback is certainly welcome.

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