I originally wrote about Fairway last August, and I still feel strongly that better days lie ahead for this iconic food retailer. Fairway has struggled since going public in April 2013 at $13/share. In a very comforting move, however, the company hired Jack Murphy as Chief Executive Officer in September 2014 to lead its operating turnaround. Jack has a very rich background in starting and building natural and organic food grocers. He was co-founder and Chief Operating Officer of Fresh Fields from 1990 to 1997 (before selling to Whole Foods) and, most recently, served as Chief Executive Officer of Earth Fare, an organics and natural food chain headquartered in North Carolina. In addition, while employed at private equity firm McCown Deleeuw, he helped grow the 24 Hour Fitness chain.
To recap some of my commentary from August, in April 2013 Fairway went public to much fanfare. Its stores generate some of the highest sales per square foot in all of retailing (in excess of $1,500/square foot) and, initially, management forecasted growth of three to four new stores per year. In hindsight, that growth plan was unrealistic and irresponsible, as early investors who were expecting rapid growth were disappointed when management lowered growth expectations throughout early 2014. Fairway’s original shareholder base was largely comprised of momentum-oriented investors in search of quick profits and rapid growth. When this didn’t materialize, portions of that shareholder base predictably exited.
Layered on top of this was a level of uncertainty around leadership. Fairway appointed an interim CEO in January 2014, and the company then took nine months before hiring Jack Murphy. While I’m thrilled with the outcome, this was much longer than most shareholders were willing to wait.
Over the next several quarters, Fairway Market’s focus will be on improving existing stores through a combination of “Supermarket 101” type initiatives including increasing same-store-sales, and improving shrink from better inventory management and merchandising. In addition, management intends to reduce the number of products the stores carry (SKUs) and implement various price optimization initiatives. I expect these initiatives will improve EBITDA margins by several hundred basis points in the coming years.
Senior management recently presented at the 17th Annual ICR XChange Conference. At the presentation, management laid out a clear vision for 2015, which includes establishing a strong foundation for growth. They will spend much of 2015 driving operational improvement in the business and reenergizing the brand. From this base, new store growth will resume in 2016. What excites me about this opportunity is its ability to create value today and well into the future from a combination of margin improvement, same-store and new store growth.
The market tends to take an “all or nothing” mentality with “broken” growth and high growth companies. Fairway’s volatile ride since going public in April 2013 proves this out. It went public at $13/share, and then quickly went to $28/share on expectations of rapid growth. When this growth didn’t materialize right away, then the market put it in the “penalty box”. Fairway is cheap at roughly 8x EV/EBITDA, especially considering that EBITDA should grow materially from current depressed levels. LTM EBITDA margins were 5.4%, which are much lower than what Fairway earned several years ago, and what competitors earn (9%-11%). Management clearly recognizes that this is an under-earning franchise, and has dedicated their resources on enhancing profitability over the next fiscal year. Once completed, it will then have a strong foundation for adding new stores with sharper analytics around site selection. Specifically, Fairway is developing ways to improve the return on invested capital (ROIC) by choosing new locations more efficiently.
If I’m right about management’s ability to enhance near-term profitability, then the stock is conservatively worth $8-$10/share. My assumptions for this are fairly modest – no near-term store growth, EBITDA margin improve 150 bps (to 7%), and the market values them at the low-end of the EV/EBITDA range of its competitors. With that said, I believe a much larger opportunity exists beyond the next fiscal year if management can pull off the trifecta (margin improvement, same-store and new store growth). When these three variables come together, then the market typically rewards these businesses with multiple expansion (“from the doghouse to penthouse”). It’s these conditions that create what Charlie Munger refers to as a “Lollapalooza Effect”, and allow 50% returns to become 500% returns if you are patient enough to own for several years.