Village Super Market: "Passing" in May 2014
Traveling Through Time | 15 min read | What I learned from "passing" on Village in May 2014
This is part five in a ten-part series. Before reading this segment in the Traveling Through Time case study series — please read the Introduction post here.
Essentially, I simulated an investment opportunity from many years ago based on Geoff Gannon’s Singular Diligence newsletter. The write-up below is a record of my thought process and a reflection on what happened.
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Simulating the Past: Arriving to a decision
WOULD I HAVE INVESTED 20% OF MY CAPITAL INTO VILLAGE SUPERMARKET IN MAY 2014?
Village Supermarket is a chain of 29 Shop-Rite stores, with all of its supermarkets in New Jersey except for three.
Village is a member of a co-op called Wakefern Corporation. Village is family own and family run, averaging $50M per store across large stores of 57,000 square feet. It generates about $1B in sales and 2.5% in pre-tax profits.
Village is not the cheapest company available.
The company trades at an EV/S of 0.23x and over the long-term has generated 2.5% in operating profit.
Compared to its peers, it isn’t obviously undervalued. Across five peers, the median EV/S ratio is 0.3x. In this respect, Village is trading at a 25% discount. But two of those peers are trading in-line with Village at 0.25x while two other peers trading more than 0.4x.
And in terms of a total return, Village is not the highest. It trades at a 4% dividend yield. Historically, it has grown sales around 4% and profit a few percentage points faster than that. Based off historicals, Village could potentially meet a 10% hurdle.
Village is just at least as safe, potentially much safer, than the average company.
Village is an operator of supermarkets, a category that will always exist. Supermarkets are local businesses. These local customers have alternative options available, but the options aren’t limitless. And suppliers do not have an incredible amount of bargaining power either.
The company is family-owned and family-run, so past capital allocation decisions will likely persist in the future. The family does not use any financial leverage, owns ¼ of its stores, and the remaining are locked into 20-30 year leases.
Shop Rite is usually #1 or #2 in any of the towns it operates in within New Jersey. New Jersey is a state where incumbents with large sales volumes have an incredible advantage over new entrants due to the lack of land available to develop and the benefits that comes scale.
Yet, there is some uncertainty in the durability of its business model.
Small formats have entered the state and may continue to threaten the premise of the business model.
In New Jersey, supermarkets like Shop-Rite and Wegmans fundamentally believe that large store formats are the best way to serve the high population density of New Jersey (10x more people per sq mile than the US average).
This has been an extremely successful strategy historically. In a state where demand is extremely high but supply (due to land) is limited, Shop-Rite and Wegmans have been able to have very high sales per square foot, despite operating very large stores. In most states, this would not work. But Shop-Rite and Wegmans have built a model where they have much more market share per town than the top supermarket per in the typical town in the country.
However, players like The Fresh Market have recently entered the market with much smaller formats. These stores are 16-22K feet, around ⅓ of the size of Shop-Rite and Wegmans. So these players have been able to get around the barrier to entry of land.
The Fresh Market only focuses on a few categories such as groceries and perishables. I would venture to guess that this is an important category for customers and how they chose to supply themselves with food and other items throughout the week. In my mind, it is an anchor category.
But smaller stores can’t realistically steal the all of Shop-Rite’s per store sales. Shop-Rite does $50M per store. The typical customer can’t fulfill all their shopping at these category-limited stores. So there will always be room for the larger players like Village.
Yet, small decreases in sales can lead to operational deleverage. Operational deleverage works exactly opposite to operational leverage. For every $1 decrease in sales, a store would experience a larger decrease in profit.
Shop-Rite has substantial operating costs. At Village, the total costs per sq ft (excl. rent), is approx. $200. This is 4x as high as Weis Market and almost 2x as much as Kroger. The only reason why Village has better margins and returns than Kroger despite having the high operational costs is because of its high sales. So a decrease in sales will have a magnified impact in profit.
The entrance of The Fresh Market may also lead to a negative change in competitive behavior. Theoretically, competition in any local market should only damage the entire group to the extent it increases long-term supply faster than demand. If there is a new competitor enters, the most uneconomic location is the ones to close first.
In Village’s own history, they have benefitted from this. Village is the #1 or #2 store in any given location within New Jersey. When an competing but inferior Stop & Shop, Pathmark, or A&P store finally closes shop, Village has seen an increase in sales.
However, this critical premise is that new entrants look like existing incumbents. In simple terms, the new entrant had a business model that was very similar to existing players. They were competing for the same property, same customers, same minimum level of sales – all with a similar business strategy.
The Fresh Market disrupts this historical pattern because it has a completely different business model and market approach. It isn’t hard to imagine that the The Fresh Market could squeeze into existing markets and get a quick payback on their small store format, put pressure on other larger players to compete in their “fresh” category, and force larger players to engage in suboptimal actions that may not lead to justifiable profits (e.g. offer products at lower prices, offer more products, offer different products). And Shop-Rite doesn’t have the most superior brand or business model in the state; Wegman’s does. So Shop-Rite isn’t completely invulnerable to these potential impacts.
The combination of potential operational deleverage and uncertain competitive dynamics makes me put more weight towards the long-term average margin than more recent margins. From 2004 to 2013, operating margins have floated between 3-4%. Over the long-term, EBIT has been closer to 2.5%.
In conclusion, I think there is a low chance that Village actually loses their locations over the long-term. I simply believe that it will be more difficult to protect the 3-4% operating margins they have had in the past. And as an investor, I am more comfortable betting on 2.5% margins (or peer-level pre-tax ROIC) than 3-4% (or 33% pre-tax ROIC) with the information I have been given.
Village’s future doesn’t look as easy as its past.
To achieve a 10% annual return, Village would need to generate more than 6% in sales based on their current 4% dividend yield.
For the past 15 or so years, Village has grown its sales per sq ft by 2.5% per year. And they have done this by increasing their selling square ft (area where customers can actually shop) by 2.5%. Growing sales per sq ft is difficult enough, but to do a proportionally higher level of sales over a larger area is extremely impressive. That’s what made Village top of its class since its turnaround at the turn of the century.
Going forward, this doesn’t seem as easy as it has been in the past. Historically, Village’s additional square footage has been used to get existing customers to spend more on specialty foods. And this isn’t spend that Village is “stealing” from other competitors. This is very much introducing new products to existing customers and getting them to increase their spend on groceries as a percentage of total household budget. This is very unique.
Grocery as a percentage of GDP has been very consistent over the long-term. So it’s difficult to believe that management spending $1 to grow selling square footage will lead to $1 in additional sales over the next decade. That would mean that Village’s average size (assuming no growth in stores) is 73,000 sq ft. That’s very big. Its a number that starts to get into Wegmans range (80K-140K sq ft).
If we cut out that, it leaves us with the 2.5% sales growth. This seems possible. New Jersey could grow in population, despite the smaller format new entering the business. Groceries are very unlikely to grow slower than GDP. It’s extremely difficult to shrink their fixed operating costs, but even a 2.5% rate of top-line growth could produce an additional 1-2% to the bottom line. But even without considering dilution (annual 1%), Village’s total annual return would only be closer to 7-8%, short of the 10% minimum.
Village has committed to growing its dividend over the past decade. They’ve grown DPS by 30% annually over the last 10 years. And they paid out $25M in special dividends in 2012/13. But I’m not convinced that Village will just unwind their capex plans and pay out 90% in dividends as a publicly-traded company, even if the family owner-operators own most of the stock.
Village is an opportunity that may above-average certainty, but it does not hit me over the head.
I could be wrong on Village’s margins. They may defend their sales well against the changes in competitive landscape. They may find creative ways to compete and maintain the spend of their customer base. But this competitive industry isn’t the easiest to bet on.
I could also be wrong on Village’s growth prospects. They may be able to open up new stores in New Jersey, relocate to bigger properties, or grow their sales faster than GDP. And while those are generally easier growth strategies than others, Village may have a tough time doing that in its home market of New Jersey.
Overall, the evidence doesn’t clearly show that future will be just as good as the past. Village will definitely be better than cash. It may even achieve 10% returns with its cash balance (information not disclosed in the Singular Diligence Report) through special dividends. But I am not certain that Village will return 10% each year if I am investing 20% of my capital in the company.
Back to the Present: What actually happened
HOW WOULD HAVE IT PLAYED OUT IF I SOLD MY STAKE ON OCTOBER 13, 2022?
First, let’s talk about how the business has performed.
In 2013, Village had about $110M in cash and no debt. It had $389M in PP&E.
The company spent about $35M each year in capex, totalling $300M from 2014 to 2022. The total capex spend was about 60% of OCF. Over this 9 year period, the remaining operating cash flow went towards $115M in dividends (no increase in DPS, no special dividends), $15M in net buybacks, $40M in other investing activities, and $25M in their cash balance. Management made one acquisition in 2020 for $75M, which was financed with new debt.
On the income statement, this did not capex and acquisition spends did not seem to create a lot of value. In 2013, they did $1.5B in sales. By 2022, it grew to $2.0B, close to a 4% CAGR. Yet, the company’s operating profit did not benefit. In 2013, EBIT was 3% of sales. From 2014 to 2019, it floated around 2.3% (plus or minus 3%). From 2020 to 2022, it was closer to 1.7%. Net income was quite flat at best over this same period.
Now, let’s see the return investors received at the investment date.
When the Singular Diligence Report was published in May 2014, the market cap was close to $355M. Since then, their market cap has shrunk to $299M and the company paid $115M in dividends and $15M in buybacks (net of issuances). This comes out to a total shareholder loss (in dollars) of $74M, or a 2% annual TSR.
Reflecting for the Future: On getting better
HOW WOULD I HAVE CHANGED MY PROCESS, GIVEN THE RESULTS?
Given the results, I believe I made the correct decision.
The company only generated 2% returns for its shareholders annually over the 9-year period. And even if you consider the period right before COVID, the company wasn’t on track to creating meaningful value for its shareholders.
However, my approach (process) was quite wrong, even if I made the right decision (action) and had the right outcome (result).
Village compounded its revenue by 3.8% from 2013 to 2022. I only expected them to grow by 2.5-3.0%.
But they grew mostly because they acquired new stores. The company acquired nine stores: one Shop Rite in New Jersey, 5 Fairway Markets and 3 Gourmet Garages. Neither Fairway Markets or Gourmet Garages were located in New Jersey.
Honestly, I didn’t give much thought to new stores. It’s clear in my thesis.
Yet, there was a observably high likelihood that they would expand via acquisition.
I believed the company had some attractive opportunities, but knew they were limited. In my notes, I wrote “buying Shop-Rite stores from other Wakefern members at a reasonable price were ‘no-brainers’ – quite possibly the safest acquisition you could possibly do.” I also wrote “other acquisitions, especially outside the state of New Jersey, would be extremely risky. Village’s success has been built on the unique characteristics of the state and the company’s prior attempts in other states haven’t been successful.”
These points clearly slipped from my mind when writing the thesis. Because even though I wrote…
“But I’m not convinced that Village will just unwind their capex plans and pay out 90% in dividends as a publicly-traded company, even if the family owner-operators own most of the stock.”
… I had no mention of acquisitions.
There is one major flaw in my thesis here.
Because I said that it was unlikely that the company would be able to grow its selling sq footage per existing stores (because Village’s stores would then be looking more like the business model of Wegmans with their gigantic stores), which requires capex. Yet, I also said that the company wouldn’t pay its dividends. So underneath that, I had implicitly assumed that the company would have spent capex elsewhere. But I didn’t say where the money would go. And I didn’t attribute how much sales would come from capex spend.
Otherwise, I would have forecasted 4-5% growth, driven by acquisitions, and a lower operating margin of 1.5-2.0% (due to new, but subpar stores). I think this type of analysis could have been made with the information I had. Instead, I projected 2.5% growth and 2.5% margin.
These two approaches tell you the same answer: “Don’t invest at this price!” But just because the decision was right, doesn’t mean my underlying analysis was right. So to summarize:
I was wrong because I didn’t factor in the possibility of acquisitions, which was very likely.
And because I didn’t factor in any acquisitions, I visualized existing stores growing in-line with GDP at long-term margins, rather than the addition of new stores impacting the profitability of the entire portfolio of stores.
From 2014 to 2022, sales grew by ~4% but the company’s margin declined. In the prior decade, the company was generating profit of 3-4%. But in this holding period, EBIT quickly dwindled down to 1.5-2%. After a quick skim, the disclosures seem to point to a combination of drivers: reduced operating leverage from declining SSS, increased labor costs, opening costs, etc.
Regarding existing stores, I seemed to be right. Village did experience some level of operational deleveraging. But it didn’t come exactly how I pictured it.
I was extremely focused on this new entrant, The Fresh Market. I thought these competitors with small formats would be the pose a good challenge to Wegmans and Shop-Rite. But by the end of 2022, The Fresh Market only had two stores in New Jersey. According to various articles, it seems like the ones most responsible for competition and disruption in New Jersey were big discount stores like Lidl and Aldi.
The Singular Diligence Report wrote:
“Non-traditional competitors are the biggest threat to Village. In the industry, ‘non-traditional’ refers to both deep discount and high end (especially fresh and/or organic) grocery stores. In New Jersey, the high end is the area of greatest concern. The non-traditional supermarket with the store model best suited for entering New Jersey is The Fresh Market.”
I didn’t even give discount stores a second thought because I thought it would be extremely difficult for these large stores to get land. I didn’t get the impression that discount stores were already causing problems. It’s not exactly clear how Aldi and Lidl got their foot into the market without diving too deep into research, but it’s a fact that they exist in the state.
So I misjudged the barriers to entry by thinking only small format stores could cause disruption. In extremely competitive industries like grocery stores, I should be more wary of barriers to entry. Because in these “better mousetrap” markets, it’s better to assume that if there is a will, there will be a way.
Beyond the technical mistakes, the process was quite smooth.
I tried something new in this case study. By only looking at the historical financials and the stock price (so knowing nothing about the business beyond the name), I made a preliminary decision on the stock.
In my notes, I wrote:
“Village could be a safe company. I’m feeling a little unfamiliar with a non-dominant moat kind of company. So I would say no based on this stock price.”
This preliminary decision only took 25 minutes after looking and thinking about the historical financials and stock price. I then spent 9.5 hours reading the report, thinking about the opportunity, and then summarizing my thoughts in a written investment thesis.
I had happened to arrive at the same decision in both the preliminary analysis and the full length analysis.
Admittedly, the report did make me reconsider my preliminary decision at various times.
Learning about the state of New Jersey and the involvement in family ownership and operations made me rethink my decision. I entertained the possibility that this could be a company that generates cash flow from stores that would never go out of business and that management would pay out the excess free cash flow to shareholders, as it had done recently with special dividends and their rapidly growing common dividend.
However, I believe that layers of safety in a stock depend on one another. Safety starts with a good industry. A good business model, good management team, and good stock price significantly add to the level of safety. But an unfavorable industry affects the dynamics and safety of the other layers.
Management will only do unfavorable things if the industry is unfavorable. And you can only believe the company can grow so much if the industry is unfavorable, even if it had succeeded in the past.
So the final decision did not really differ from the preliminary decision because I already had a way to frame the stock before I picked up the Singular Diligence Report. I am familiar enough with groceries stores to understand the surface-level dynamics of competition and growth.
I think making preliminary decisions will be an important part of my process going forward.
Beyond that, I think I made a reasonably fast decision. I spent a total of 5.5 hours thinking and writing my investment thesis, after about 4 hours of reading the report and taking notes. I could have come to a thoughtful decision within 1 hour, but I tried to be more open-minded on this one. I tried more techniques to make sure I was thinking straight. For example, I compared it to every single company I had already analyzed in this case study series, as well as other companies I had looked at for my own personal investing. This took longer, but it really helped me work out any inconsistencies and biases that I might have had.
This was a great case study for approaching a familiar-ish stock with a frame ready-to-go and then spending every single ounce of energy making sure that frame wasn’t flawed by mental errors or personal biases.
So it’s a balance. You’ll know whether or not you like an opportunity within the first 60 minutes, especially if you have the right frame for the stock. But it’s also easy to deceive yourself unless you investigate your own thinking.
My thinking wasn’t perfect. I outlined the areas where I could improve. But I humbly believe I had a level of thoughtfulness that most others wouldn’t take with a “simple” stock like this. And thoughtfulness is the thing that matters the most when you’re making decisions. Snap decisions can be good decisions, but it depends on your frame and your ability to deconstruct that frame.
The case study took about 14.5 hours over the course of 9 days. I spent 25 minutes on the preliminary analysis, about 4 hours reading and taking notes on the Singular Diligence Report, 5.5 hours fleshing out my thesis, and 4.5 hours analyzing the outcomes, results, and process.
I recommend that anyone looking to improve their process find their own way to do case studies like these.
If you want to read write-ups similar to Geoff Gannon’s Singular Diligence newsletter, please visit focusedcompounding.com where Geoff and Andrew currently publish their content.