Grupo Comercial Chedraui (CHDRAUIB.MX,$2.08 USD). Smart & Final Acquisition may Offer Potential to Accelerate the EBITDA run Rate Towards $1 billion USD per Annum, Heading into 2023.

Grupo Chedraui, the newest owner of the Smart & Final grocery/cash & carry chain (primarily serving California, Arizona and Nevada) has announced the corporate intention to grow its overall store footprint in 2022, mostly in Mexico, by a total of 33 new locations.

Grupo Chedraui is neither well known to US investors nor widely covered by equity analysts. It IS the third largest grocery store chain in Mexico, considerably smaller than Walmart and marginally smaller in Mexican sales than Grupo Soriana. While Mexican growth opportunities abound, Chedraui prefers to sustain operating margins rather than engage in profit destroying slugfests against behemoths. Controlling shareholders have opted on a strategy to patiently move north, as opportunities present themselves. The company had rolled up several regional grocery stores, well known to Hispanic Americans, in California, Arizona, Nevada, New Mexico and Texas since 2018. Chedraui was best known in the US for their operation of two smallish regional banners, “Fiesta Mart” and “El Super”, located in a five state cluster.

Fiesta Mart was purchased in 2018 for $300 million USD. With that acquisition now fully digested, Chedraui just added the Smart and Final chain, comprising 254 locations, in Q3, 2021. Purchased from Apollo Global Management at a cost of $620 million USD, this is the largest asset buy in corporate history and with it comes the attendant worries about potentially acquiring a bag of magic beans, marketed to them under the guise of a good deal. Thus far, no major warts have been identified; management intends to open at least two new locations under the US banner in 2022. Some stores might change signage: El Super could use more locations in California and Fiesta Mart, tightly clustered in the Houston and Dallas TX region, is ripe for wider expansion throughout Texas. Fiesta has a toehold in Austin, TX. and the metropolitan area is booming.

To aid Chedraui’s growth push in the U.S. Southwest, management rolled the dice, on a business concept, in a multi-year year rut.

Management has indicated that Smart & Final was producing annual revenues in the range of $4.1 billion US and EBITDA of $167 million USD was reported prior to the acquisition. Chedraui offered up a proforma indication for the consolidated business pointing to annualized revenues of $11.45 billion USD and EBITDA of $.872 billion USD. If the pro-forma indications offered up by Grupo Chedraui management are to be relied upon, 2022 annualized revenues may push towards $12 billion USD.

My issue with the proforma lies in the fact that Smart & Final has historically generated highly inconsistent revenue growth and with it, less than predictable levels of EBITDA and profit. Over the past 13 years, the overall Smart & Final store count grew by 38% (184 stores in 2007 to 254 stores at planned close in 2021) but had fallen by 6 stores in the last two years. During the period of 2016-2019, the net revenue growth was less than 1%. It remains to be seen whether the reported 2020 growth rate of 11% is worth the paper it was printed on.

Historic variability in results from the new purchase suggests that one cannot do anything more than model an extremely broad range of forward guidance, to the point that even ranges might fall under the dubious category of a “guesstimate”. For 2022, real estate rental EBITDA may surpass $35-$39 million USD. Mexican retail EBITDA may range from $350 million USD to $390 million for 2022 and US retail EBTITDA margins may range from $350 million to $470 million. On a consolidated basis, this could represent total EBITDA of $735 million to $899 million.

Guidance ranges this wide are more typical with a deep cyclical than a consumer defensive investment; clearly the entire Smart & Final purchase represents a wild card. Added variability in the forecasts is based upon Forex, cost inflation and the ability to source product, in a supply chain constrained environment. Exiting Q4, 2022, absent negative revisions from management, annualized EBITDA could be on track to surpass $1 billion USD in 2023.

2022 capex is forecast to be in the area of $250 million USD. This seems a bit light given the overall number of stores. It seems that the Chedraui family requires more time to assess the prospects for Smart & Final prior to embarking upon a comprehensive investment program. The bulk of forecast 2022 free cash flow is being earmarked for rapid deleveraging of the $620 million cost associated with the Smart and Final purchase. By the end of 2022, Chedraui hopes to reduce total bank indebtedness in half, perhaps more.

Two US acquisitions within the past 3 years, with total costs exceeding $920 million US have transformed a formerly Mexican based retailer into a US centric regional player.

By the end of 2022, the overall geographic revenue mix for Grupo Chedraui could be roughly 59% US retail, 41% Mexican retail and about 1% in real estate rental revenues.

There are 964 million shares outstanding and at $2.08 USD, this is a market cap of just over $2 billion USD. Add in total labilities-short term assets of $3.4 billion and an enterprise value of $5.42 billion is the result. Assuming that my EBITDA range isn’t utter hogwash, Chedraui presently sells for roughly 6X to 7.4X my 2022 forecast EV/EBITDA.

Traditionally, when one identifies valuations at this level, it tends to be every bit as indicative of a problem as a potential opportunity.

Is Chedraui a value, or a value trap? What am I missing? Is the accounting dodgy? Are earnings set to decline? Are there jurisdictional issues?

Three key pushbacks come to mind.

1. 51.9% of the total shares outstanding (495.3 million shares) are held by the Chedraui family. With family controlled corporations, there always exists the possibility of a going-private transaction designed to squeeze out minority shareholders at a less than optimal price. This sometimes occurs just as a business verges upon a sustained increase in profitability.

2. Grupo Chedraui’ market cap is too small to be of keen interest to institutional accounts at this time. $2 billion of total market cap, less the Chedraui family shares, means that institutions need to assemble a position with the assumption that they CANNOT exit; they must decide, up-front, that the family intention is to grow the business publicly until it reaches large cap status.

3. The purchase of Smart & Final COULD turn out to be a legitimate dud. The seller, Apollo, is a well known private equity company, but that belies an LBO component of the business model. Generally, after Apollo takes a business private, they strip away certain key assets, withhold expansion capital and hold the line on maintenance expenditures. Sustained underinvestment in retail generally leaves the business in a less competitive position. It is fairly well understood that when one buys an asset from an LBO seller, the business is invariably never as profitable as advertised. The store count declined modestly and that sometimes indicates that a business is in need of a turnaround. Apollo didn’t own Smart & Final long enough to completely destroy a storied retailer, probably.

Grupo Chedraui has a very active real estate management division in Mexico.

For a company with such a modest market cap, the size of the wholly owned real estate division, comprising shopping centers and plazas, anchored by their grocery stores, is a surprise. Chedraui reports over 4.2 million square feet of third party leasable space is owned and is roughly 92% occupied. 2022 capital plans indicate further growth in this division as opportunities arise. Square footage available for lease has generally grown about 3% per annum.

As a retail investment, Grupo Chedraui, with a disciplined capital plan centering upon bolt-on purchases of discount grocers, in a defined number of US states, might be interesting in an inflationary cycle.

The CEO has indicated an intention to continue growth via organic increases in the store count as well as via acquisitions in the years to come. Organic expansion plans indicate new store potential growth, before closures and/or relocations, of about 4.5%. in 2022. Near term challenges will be to integrate the Smart & Final footprint and capitalize upon the enlarged store base in the five state region of the US, without dramatically increasing advertising expenses.

Those who know of Smart & Final consider it to be a sort of mini-Costco without membership fees. Roughly 30% of sales are to small business with the remainder to households and almost 40% of sales are fresh produce and perishables. Those who don’t currently shop at the chain tend to just drive on by, perhaps thinking it to be just another down-at-heel, close-out retailer, akin to a “Big Lots”. A meaningful opportunity exists to invigorate Smart & Final, but greater capex will inevitably need to be spent on stores. Should that succeed, the newest purchase will look exceedingly inexpensive; should it fail, management hasn’t invested enough to break the bank, but money not earning a productive return is still time wasted.

Just under $1 billion of store locations have been added, through acquisitions, in the past 48 months. This will double forecast 2022 revenues over 2018 and more than doubles the banner store count, primarily to be paid for with internally generated cash flow. $1 billion is a rounding error on the typical large cap business that piques my interest but represents a healthy “at-risk” sum for a smaller company.

Grupo Chedraui has historically earned better returns from organic growth initiatives have been reported on their external acquisitions.

The 2018 purchase of Fiesta Mart thus far, has proven reasonably profitable but not without challenges, it remains the lowest EBITDA division within the overall corporation. Equity owners should certainly take the corporate proforma with a grain of salt; consider it as more aspirational. Should Smart & Final merely match Fiesta Mart in terms of EBITDA, that would certainly be a win at the price paid. The newest acquisition represents a “show-me” purchase and the current market price of the parent company reflects skepticism of the merits.

The Chedraui family has been able to stay in their wheelhouse; they operate interesting retailers within a geographic area of the US well acquainted with their retail offerings and management keeps a tight lid on advertising expenses. Should Grupo Chedraui earn just 1/2 the initially indicated EBITDA on the Smart & Final buy, internally generated capital will be available to further build out the asset base.

During highly inflationary periods, even well-heeled shoppers generally are willing to seek out novel grocers in order to hold the line on costs. An opportunity exists at the 3 regional US banners of Chedraui to increase their customer base beyond normal, historic, growth rates. Ethnically themed grocer banners are highly fragmented, typically quite small and generally lacking in economies of scale. A determined rollup of good locations and a rollout of marketable banners, under the watchful eye of a fiscally responsible operator, could prove fortuitous over time.

Grupo Chedraui has flown under the radar of most US investors for many years; I suspect that will persist for a while longer.

Any investment decision to own Grupo Chedraui should be made with both eyes open; liquidity will be poor and while an underlying secular trend does exist (the expansion of a grocer catering to a Hispanic population in a region where demographic trends are favorable to the product offerings), this isn’t a strong enough wave, in its own right, to justify a conviction stock purchase.

On the other hand, after having surfed the Covid-19 tidal wave for about two years, my arms, legs and back are a bit tired, my brain even more so. A less challenging sector pick may offer its own measure of satisfaction, provided the numbers aren’t bogus. If/as/when consolidated EBITDA firmly tracks above a $1 billion annualized rate, I suspect that investor interest will pick up. The current valuation seems intriguing and the Q3 2021 report, albeit just the first to include a partial contribution from Smart & Final, did not contain any negative surprises. That said, should the Q4 report even the slightest hint of a negative revision, the shares could take a 50% hit, within an extremely short period of time.

There is a risk/reward scenario that should be modeled into ones’ thinking on this company; does the risk of a bad acquisition justify an uncertain potential reward? Longer term upside, should the Chedraui family succeed in doing what two prior owners could not do at Smart & Final; that being to produce persistent revenue growth, might be enticing enough to accept a bunch of risks, maybe. Fiesta Mart, which I find to be a really fun place to shop when in Texas, may also be verging upon more durable and lasting improvement in financial results. These are big ifs, but maybe, just maybe, I might be onto something, at this time and at this valuation. Or, maybe not. A retailer, to compete and win, needs to do something better than others and not just a bit better, but a whole lot better. If that formula is found, a business can have a very long runway; but fads always look like trends at the outset and fads always fade.

In order to offer the potential for Grupo Chedraui to potentially ascend into smallish “large-cap” status, annualized revenues need to move well beyond $20 billion US and an EBITDA run rate of about 8% on that revenues needs to be achieved, all else being equal.

The purchase of Smart & Final should propel consolidated annual revenue to almost 60% of that hurdle; much more needs to be accomplished to generate an additional $8 billion annually in sales. Sustainable EBITDA margins need to increase as well. Prior to the purchase of Smart & Final, there was no path towards large cap status.

Today, a tentative, extremely tricky, very narrow path towards that large-capitalization status, might be be observed, some distance from here, through the fog. Hundreds of new stores need to be added in Mexico and at least 100 more locations will need to be built in the United States to close in on the $20 billion sales threshold. Debt requires efficient and steady paydown, the US division needs considerably more positive brand recognition. Finally, at least one or two more regional acquisitions of some size, in the next 5 years, that may be paid off from internally generated cash flow, will likely need to be announced. Competitors won’t sit idly by in this scenario; every grocer has their own designs on market share, all are looking for profitable regions to service and many competitors, some public, some private, have equally strong balance sheets to support expansion.

How ridiculous“: one may readily reply. “How does a small cap grocery retailer ultimately command a value as a large cap grocer, in the next five years, considering the competitive landscape?

A minimum of $5 billion of cumulative EBITDA will need to be generated, in the coming five years. Interest bearing debts are quite tolerable, easily serviceable with forecast free cash flow. Once the Smart & Final purchase is completely paid off (within two fiscal years) a healthy sum will then be available for investment in new stores and to revamp older locations. The first year that annualized EBITDA surpasses $1 billion USD, forward thinking analysts can begin their own modeling process to confirm my vision.

Grupo Chedraui, to me, in the context of a well structured account, represents a calculated new addition and one that seems deserving of some capital within my investment portfolio.

While interesting, this grocer isn’t an everyday investment suitable for everybody, despite Chedraui’s categorization as a consumer defensive. Being a grocer, the sector classification that Chedraui falls under is known as “consumer defensive“; this seems a bit of a misnomer as it only refers to how consumers allocate spending; and does not suggest that a consumer will spend enough money at any one store to make a difference to the top and bottom lines.

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