ARDNA? quoteWhopper is a deep value investor and the founder of
whopperinvestments.com. He can be reached at [email protected]

One of the companies that jumped out at me in my recent historical magic formula screen was Arden Group (ARDNA). Arden operates 18 Gelson’s supermarkets in Southern California. Gelson’s is a “full service” supermarket targeting customers more concerned with customer service and selection than price.

There’s a lot to like with this company. First, results are incredibly consistent- operating income has averaged $37m for the past 7 years, never dropping below $30m and topping out at just over $45m in 2007.

Second, depreciation consistently overstates capital expenditures, which means operating income could be understated and, at the very least, can be trusted to be conservative. Depreciation expense has average $6.9m per year over the past ten years, while capex has averaged just over $5.8m. However, this capex number includes 2001, when they opened two new stores. Excluding that year, capex has averaged $5.3m. So depreciation likely overstates maint. capex by $1.1-1.6m per year. Not quite the level BDMS’s depreciation overstates expense, but notable nonetheless.

Third, capital allocation is excellent. The company is a cash flow machine, and they pay a small dividend every year. As that cash balance continues to build, they wil lpay a massive special dividend every four to five years to get excess cash off their balance sheets. So, unlike many over-capitalized net-nets, there’s not much risk of the company never doing anything with a huge cash stockpile.

Finally, returns on capital are excellent. Excluding the excess cash and investments and excess depreciation expense, pre-tax return on assets is averaging 30-40% each year. Given those returns, it’s surprising the company isn’t trying to expand their store base (they haven’t built a new location since the 2001 build up).

My take

The company certainly is interesting. If I adjust for the excess depreciation expense, TTM operating income comes in at $30.1m, five year operating income has averaged about $38.5m, and ten year operating income has averaged $33.7m.

Applying a seven multiple (my target entry point, it gives you a 14%+ earnings yield) would give you a target EV of $210m-266m. The company recently repurchased $6.7m worth of shares, so adjusting their cash balance they have about $48m in excess cash and investments. With just under 3.1m shares outstanding, this would give a target buy price between $83-101.

Note that I didn’t say that this was the fair value for the company. That’s the value I think the company’s stock would be interesting as a value investment. A conservative “intrinsic” value for the company would probably be closer to 10x EV / EBIT, which would put the the fair value for shares between $112-138… pretty significant upside in even a worst case scenario.

So why haven’t I pulled the trigger yet? I’m a bit nervous about the future prospects of the business. While the past returns are impressive, I don’t really see anything special about the business that should enable it to continue to enjoy the returns that they do or gives them a competitive advantage against, say, Target, Kroger, or Whole Foods.

Also, while their balance sheet is clean, they could be exposed to significant off balance sheet risk. Their workers are unionized, and if you look at page 14 of their 10-K, ARDNA contributes to healthcare and pension plans for their employees. The funds are significantly underfunded, though the company can’t note how badly underfunded they are, and the company would be liable in the event the pensions run short.

Speaking of unions, the company’s labor contract expired, and they are still waiting for the major players to resolve their labor contracts before settling on a new one. If there’s a labor strike or the unions negotiate a really good deal, earnings could be significantly affected.

Finally, management is a bit shaky. Operationally, they seem very good, but they have a good bit of stock appreciation rights, and when the stock price tanked they adjusted the strike price for the SAR’s down. That doesn’t inspire confidence from me.

So I’m staying on the sidelines for now, but I do see a lot of potential for value. I could see myself going long the name eventually, especially if I can figure out what their competitive advantage is that allows them to enjoy such strong returns.

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