Two Grocery Companies to Buy, One to Avoid

Shweta is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

World food retail market performance will grow at an estimated CAGR of 5.5% for the period of 2011-2016, a slight decline from 5.7% for the period 2007-2011. Grocery stores are facing stiff competition and price wars. Companies are battling these obstacles with strategies like expansion and store remodeling.

Three grocery stores are currently working on these strategies, which will improve their margins as well as profitability.

Strategic initiatives and improved margin

Casey's General Stores (NASDAQ: CASY) is growing through strategic initiatives. The company plans to convert 100 stores to a 24-hour format, remodel 25 stores, replace 20 stores, and add pizza delivery services to 107 stores in fiscal year 2014. The remodeled stores are also equipped with larger coffee and fountain offerings, and made-to-order sandwich programs. This plan will help increase free cash flow as the replacement of stores generates about a 50% boost in fuel, grocery, and general merchandise sales and about 80% boost in prepared-food sales. The company will generate free cash flow of $19.4 million in fiscal year 2014 and $28.2 million in fiscal year 2015 as compared to free cash outflow of $19.0 million in fiscal year 2013.

In the past two months, Casey’s exceeded its target gasoline margin of $0.15 per gallon because of a recent surge in Renewable Identification Number, or RIN, value above $1. Casey buys gasoline and ethanol separately and then blends them. After blending, Casey receives RIN that is a 38-character number assigned by the Environmental Protection Agency, or EPA, to each gallon of renewable fuel.

Under the Renewable Fuel Standard program, the EPA uses RIN to monitor the sale of fuel that should contain a minimum volume of ethanol. Casey sells this RIN to obligated parties such as refineries. Flat gasoline demand and rising ethanol consumption targets surged RIN value. Therefore, the company’s gasoline margin will be $0.19 per gallon in the first quarter of fiscal year 2014.

Benefits from new stores, remodeling, and better margins will increase Casey’s EPS to $3.90 in fiscal year 2014 from $2.86 in fiscal year 2013.

Sale of assets and mediocre free cash flow visibility

Last month Safeway (NYSE: SWY) announced the sale of its Canadian operations. It agreed to sell Canada Safeway Ltd., or CSL, to Sobeys for $5.64 billion in cash. Now it can focus more on its core operations in the U.S. CSL generated earnings of $260.71 million in fiscal year 2013. This sale will lower near-term earnings but will contribute to the growth of the core business. Safeway will invest some of these proceeds into its core business operations. Additionally, the company will likely pay down $2 billion of debt and will buy back some of its shares in order to improve shareholders’ value.

The company invested significantly in store remodeling in 2004, and additional remodeling is unnecessary for the next 10 years. Safeway spent $837 million in the U.S. in 2012, and allotted $900 million for 2013. However, reinvestment will be required to remodel its stores after such a long period. Safeway estimates spending will increase from its current level to maintain the quality of its 1,400 stores and to fight off competition due to entry of new stores and new competitive formats and technology. This will reflect in the company’s free cash flow; Safeway’s FCF will reduced to $517 million compared to $642 million last year.

Store expansion and improved margin

The Fresh Market (NASDAQ: TFM) built two new stores in the last quarter. The company is on track with its new store development program and plans to build around 20 new stores in 2013. This matches the company’s objective of 15%-17% store growth annually. Four new Houston based stores will open in this quarter and next quarter. There is significant growth opportunity for store expansion because of the adaptable store format and under-penetrated markets west of the Mississippi River. The company also reported new store productivity of about 85% in the first quarter of 2013, which is approximately the long-term average. With the long-term expansion potential for 500 stores in the U.S., The Fresh Market will reach the 250 store mark, from the 131 stores currently, in next five years. Company's revenue will increase to $1.52 billion in 2013 and $1.78 billion in 2014 as compared to $1.32 billion in 2012.

The Fresh Market reported a 34.0% gross margin in 2012, an increase of around 4% in the last five years. Its contract with Burris logistics is scale based and provides lower per case cost as the volume levels grow. Store growth will generate lower sourcing costs with the increase in volume levels. Continued improvements in the inventory management system and processes will reduce the shrink rate to around 5% in next few years, which is around 8% currently. These factors will improve gross margins to 34.4% in 2013 and 34.6% in 2014.

Unit growth and margin improvement will drive EPS growth from $1.34 in 2012 to $1.60 in 2013 and $2.00 in 2014. 

Conclusion

All three companies of these companies are using strategies like expansion, remodeling stores, or improving margins. Benefits of store remodeling and replacement along with increase in RIN value will increase Casey’s free cash flow and gasoline margin. The Fresh Market expects EPS growth because of its store development program and improving gross margin.

Therefore, I recommend buying both these stocks.

Safeway will offset spending and reduced FCF with the sale of its Canadian operations. Therefore, if you hold the stock, don't dump it.


Shweta Dubey has no position in any stocks mentioned. The Motley Fool recommends The Fresh Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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