Finding Yield in the Grocery Aisle

Editor’s Note: ACCESS YIANNIS AND ELLIOTT’S PRELIMINARY RESEARCH. Elliott contributes regularly to Seeking Alpha, a free website that features analysis of stocks, markets and economic trends. He’s started publishing some of the initial research that he and Yiannis do for Cocktail Stocks on Seeking Alpha. Readers interested in a behind-the-scenes look at Yiannis and Elliott’s process should register with Seeking Alpha, follow Elliott’s feed and share their take on their investment ideas. Your input could help determine which investment idea becomes the stock of the month. Of course, the final pick is reserved only for loyal Cocktail Stocks subscribers. Yiannis and Elliott look forward to hearing from you.

The Stock

The Trade: Roundy’s (NYSE: RNDY)–Buy < 12.50

Why Now:
This Midwest grocery store operator generates steady free cash flow, and the shares will boast an 8 percent yield once the company initiates its dividend.

The Story

With summer already in full swing in Washington, DC, Yiannis and Elliott decide to discuss the May issue of Cocktail Stocks on Yiannis’ back patio. Elliott arrives at Yiannis’ house with a bottle of Chateau de la Riviere Fronsac and a large bag of victuals from Balducci’s.

Elliott: The Grecian Sensation! I brought a few light snacks: Some thick steaks, a few ears of corn and a bottle of wine. I never know what swill you’ll try to get me to drink.

Yiannis: Swill? You’ve never had a bad glass of wine in my house. Let me show you some of my recent wine purchases.

Elliott: I’m joking, man. Take me to that new grill you’ve been bragging about. 

Yiannis: Follow me.

When Elliott and Yiannis reach the back patio, Yiannis begins to frantically press the igniter on the grill, which only produces a clicking sound.

Yiannis: The grill won’t light!  

Elliott: You do know that you need to cook with gas, right?    

Yiannis: Of course, the tank is right there.

Elliott: You need to open the valve. I guess you use charcoal in Greece, huh?  

Yiannis: Charcoal is the way to go.

Elliott: All right, let’s fire up the grill and talk about this month’s pick.

Yiannis: I’m all ears. What’s on your mind?

Elliott: I’m worried that the stock market is ripe for a pullback, which is why we decide to sell Tal International (NYSE: TAL) for a 26 percent gain. The S&P 500 has enjoyed quite a run since its October 2011 low. Although stronger US economic data and lower yields on bonds issued by the Italian and Spanish governments somewhat justify these recent rally, investors are overlooking a number of potential downside catalysts.

This isn’t the first day we’ve had summer-like weather in the DC area this year; you have to wonder how much of the improvement in economic data stems from distortions caused by the unseasonably warm winter. That would explain why employment data has softened over the past month.

Meanwhile, concerns about Spain’s fiscal health suggest that the EU sovereign-debt crisis could once again weigh on investor sentiment this summer. We’ll see if the market endures its third consecutive summer swoon this year.

Yiannis: I wouldn’t be surprised if the S&P 500 were to pull back. But investors have been too bearish about China’s growth prospects. China’s gross domestic product (GDP) grew only 8.1 percent in the most recent quarter, while analysts’ consensus estimate called the Chinese economy to expand by 8.4 percent. China’s five-year plan calls for average annual GDP growth of 7 percent; double-digit GDP growth was always unsustainable.

That being said, Beijing’s efforts to rein in inflation appear to have succeeded, with most economists calling for consumer price appreciation to average about 3.4 percent–well below the targeted 4 percent. Moderating inflation gives authorities the scope to stimulate the economy.

I also suspect that the government will relax some of the housing market restrictions put in place to curb speculation, helping to shore up the part of the economy that worries investors the most.

Your concerns about the developed world are well-founded, but China’s economy shouldn’t suffer a hard landing.

While Yiannis explains his outlook for China’s economy, Elliott seasons the steaks and puts them on the grill.

Elliott: I can taste these steaks already.

Yiannis: It’s going to be difficult for me to concentrate with those steaks on the grill.

Elliott: Back to business. Based on my outlook for the stock market, our call to sell Best Buy (NYSE: BBY) short above 24 should do well if equities pull back.

Yiannis: True. That was a great bet, my friend.

Elliott: Let’s not rest on our laurels. I’ve been working on a special report about recent initial public offerings (IPO) and came across the perfect pick for the current environment.

Yiannis: What is it?

Elliott: Roundy’s (NYSE: RNDY)!

Yiannis: Never heard of it.

Elliott: Are you kidding me? You’ve never heard of Roundy’s? You’ve never heard of the Midwest grocery retailer that started in 1872 and has grown to 158 locations in the Midwest?

Yiannis: Doesn’t ring a bell.

Elliott: Perhaps you’ve shopped at one of its five branded stores. The company owns 93 Pick ‘n Save locations, 32 Rainbow stores, 26 Copps, 3 Metro Market outlets and 4 Mariano’s Fresh Markets. More than three-quarters of the company’s stores are located in Wisconsin, and roughly half of these stores are located in Milwaukee.

Yiannis: Milwaukee? I’ve never had the pleasure of visiting Milwaukee.

Elliott: I thought you were a world traveler. You should cancel your summer sabbatical in Greece and take the family to Milwaukee. Roundy’s also operates in the Chicago metro area and Minneapolis and St. Paul, Minn. The stores range in size from 26,000 square feet to 130,000 square feet.

Yiannis: I’ll tend to the steaks while you explain why Roundy’s should be this month’s stock pick.

Elliott: Works for me. The company’s Pick ‘n Save, Copps and Rainbow stores are traditional value-focused grocery stores that sell national packaged-food brands, non-food items, the firm’s in-house brands and perishables such as meat and vegetables. Mariano’s Fresh Market features an expanded selection of perishables, a deli and a smorgasbord of prepared food. This format targets wealthier customers in the Chicago metropolitan area. Metro Market stores tend to be smaller and serve younger customers who live in apartments and condominiums in downtown Milwaukee.

Yiannis: Are these steaks from Pick ‘n Save or Mariano’s Fresh Market?

Elliott: Ha. If this pick works out, perhaps we’ll fly to the Midwest to check out the selection at Mariano’s Fresh Market. Anyway, make sure you keep an eye on those steaks.

Yiannis: I’m on it.

Elliott: Over the past four years, Roundy’s has grown its store count by only five locations. But the company plans to add nine new Mariano’s Fresh Markets and a handful of Metro Markets in coming years. Grocery retailers tend to earn higher profit margins from perishables than from packaged foods, so these new stores should boost the company’s operating margins.

This strategy also makes sense because smaller stores in urban areas usually face less competition from Wal-Mart Stores (NYSE: WMT) and other big-box retailers.

Yiannis: What’s the competitive landscape like among grocery stores?

Elliott: Price competition on packaged foods can be intense, which tightens profit margins. But demand for food remains relatively resilient, even when the economy weakens. Roundy’s managed to grow same-store revenue–sales at locations that have been open for more than one year–by 0.6 percent in 2008, while this metric declined by 1.2 percent in 2009, a challenging year for many industries. In 2011 the company’s same-store years were virtually flat, a decent result relative to its major competitors

Yiannis: You still haven’t said anything that makes a compelling case for investing in Roundy’s.

Elliott: The grocery store business is neither exciting nor growing rapily, but Roundy’s offers investors an interesting value proposition based on two factors: a dividend yield of almost 8 percent in 2012 and management’s proven ability to maintain the company’s profitability.

Yiannis: Tell me more.

Elliott: First and foremost, Roundy’s is the top grocery retailer by market share in Wisconsin, where the company has built a strong local supply chain and low-cost distribution network. This foundation has traditionally enabled Roundy’s to sell its products at a discount to many competitors without sacrificing profit margins.

Management has also gradually shifted its focus from packaged foods in favor of fresh meats and vegetables. In 2007 perishables accounted for 31.6 percent of sales, compared to one-third of sales in 2010. Although this slight uptick appears insignificant at first blush, grocery stores are a volume business; by increasing sales of higher-margin perishable goods relative to non-perishable products, Roundy’s has padded its overall profit margins.

By renovating its stores and expanding floor space dedicated to perishable and prepared foods, Roundy’s is capitalizing on the ongoing consumer trend toward a healthier lifestyle. Consumers have been shying away from packaged foods and consuming more fresh products.

In addition, store brands tend to carry superior margins to those earned on branded products because Kraft Foods (NYSE: KFT) and the other major food companies demand a bigger chunk of the profits. Roundy’s has steadily expanded its lineup of own-label foods to 5,200 items and 19.7 percent of sales in 2011 from 1,600 items and 8.4 percent of revenue in 2005.

I also like Roundy’s decision to use Mariano’s Fresh Markets to expand in the Chicago area. Over the next few years, Roundy’s should be able to grow its overall sales at an annualized pace of roughly 3 percent to 5 percent.

Yiannis: Tell me more about the dividend–a stock yielding 8 percent holds a lot of appeal in these uncertain times.

Elliott: In Roundy’s S-1 statement and its annual report, the company commits to pay out the majority, but not all, of its free cash flow to shareholders as a quarterly dividend. Management intends to initiate a quarterly dividend of $0.23 in 2012, equivalent to a yield almost 8 percent at the current stock price. However, because the company has not yet declared or paid its dividend covering the first quarter of 2012, most financial and brokerage websites incorrectly list the indicated yield as zero percent.

By comparison, Safeway (NYSE: SWY) pays a quarterly dividend of just $0.145 per share, equivalent to a yield of 2.7 percent. Even Supervalu’s (NYSE: SVU) beaten-down stock yields only 6.2 percent. Roundy’s shares also fetch roughly eight times forward earnings estimates, whereas shares of Safeway trade at 11 times forward earnings.

Yiannis: How are the company’s debt levels?

Elliott: Roundy’s debt amounts to about $750 million, net of cash–a sizeable amount when you consider that its market capitalization is less than $600 million. But elevated debt levels aren’t uncommon for supermarkets. The company’s loans consist of a term-loan expiring in 2019 and a revolving line of credit expiring in 2017, so Roundy’s has no near-term repayment issues or liquidity concerns.

Roundy’s isn’t an exciting story but has executed well in a tough economic environment. The firm’s ongoing store expansion and renovation plans are also bearing fruit. I see scope for the industry-leading dividend to increase gradually over the next few years, making Roundy’s a low-risk income play. Roundy’s rates a buy under 12.50. Look for the company’s first-ever quarter dividend to be an upside catalyst for the stock.

Updates on Open Trades

August 2010: Vale (NYSE: VALE)–Buy < 30

Iron ore demand is steadily increasing. For now, even high-cost Chinese capacity is necessary to balance the market. Expect iron ore prices to average around USD140 for the next two to three years. Vale’s long-term growth story remains intact, though iron ore prices will drive the stock in the near term.

September 2010: Teekay Tankers (NYSE: TNK)–Buy < 10

A 13.5 percent yield is Teekay Tankers’ only saving grace. We have been in this trade long enough that all the bad news has been priced into the stock–including lower day-rates on the spot market in 2012. The stock has surged almost 50 percent thus far in 2012 but has a ways to go for us to break even.

February 2011: ProShares UltraShort 20+ Year Treasury (NYSE: TBT)–Buy < 30

Betting against US Treasury notes has been a losing proposition. This position could recover some lost ground when investors rotate funds from safe havens to equities.

June 2011: iShares MSCI Italy Index (NYSE: EWI)–Buy < 15

This play on Europe’s turnaround is less risky than our Greece-related bet. The Italians are progressing well under the leadership of their technocratic government, although a broader European confidence boost would also help. The exchange-traded fund also offers a 4.6 percent dividend yield.

July 2011: TransGlobe Energy Corp (NSDQ: TGA)–Buy < 15

Shares of this small-cap oil producer have rallied 74 percent thus far in 2012 and should continue to climb. This speculative stock will outperform in bull markets and underperform in bear markets.

July 2011: Market Vectors Gulf States Index (NYSE: MES)–Buy < 23.50

This exchange-traded fund (ETF) has held its own since we featured it in July 2011. That being said, the ETF has returned only 5 percent in the new year. We’re holding out for a powerful upsurge.

August 2011: National Bank of Greece (NYSE: NBG)–Buy < USD6

This stock is our most speculative play to date and is only appropriate for aggressive investors who can stomach a bet that’s based solely on a turnaround in Greece. Any orderly resolution to Greece’s sovereign-debt crisis could send the stock price higher.

September 2011: China Cord Blood Corp (NYSE: CO)–Buy < 4

Don’t let near-term volatility shake you out of this stock. Shares of China Cord Blood Corp have gained 5 percent this year despite some volatility. Expect more upside as the industry’s fundamentals turn.

October 2011: Infosys (NSDQ: INFY)–Buy < 55

A slower mover than other technology stocks, shares of Infosys should keep pace with India’s stock market, which has been unstable as of recent. Investors should adhere to our buy target and only add to their positions when the stock is below 55.

December 2011: Symantec Corp (NSDQ: SYMC)–Buy < 18

Internet security is a major growth market, and Symantec should continue to benefit. The stock seems to have found support at current levels. Investors should adhere to our buy target and only add to their positions when the stock trades below 18.

February 2012: Greenbrier Companies (NYSE: GBX)–Buy < 27

This stock has pulled back since we profiled it in February, but the company’s underlying growth story remains intact. Shares took a hit from a second consecutive quarter of sequential backlog declines. Energy-related railcar demand may be taking a small breather after a solid run.

March 2012: Best Buy (NYSE: BBY)–Sell Short > 23

Disappointing fourth-quarter results sent shares of this electronics retailer lower. We expect further downside.

April 2012: AU Optronics (NYSE: AUO)–Buy < 5.

The company recently said that its losses are narrowing at a faster-than-expected pace. Panel prices have increased gradually raising. If demand keeps up, we may see shortages of panels by September. AU Optronics remains a turnaround play with solid upside.

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