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By Phillip Seligman
Fleming Companies (FLM ) is a $14-billion industry leader in food distribution and a growing presence in "price impact" supermarkets, currently serving around 3,000 supermarkets, 3,000 convenience stores and nearly 1,000 supercenters, discount stores, limited assortment stores, drug stores, specialty stores across the U.S.
We at Standard & Poor's believe that the stock represents a compelling investment in a generally defensive stock market environment, and believe it represents a solid addition to a diversified equity portfolio. Fleming carries S&P's highest investment ranking of 5 STARS (buy).
The company's strategic focus took a dramatic turn in 1998 with the hiring of a new CEO, Mark Hansen, formerly the head of Wal-Mart's Sam's Club operations. With Fleming's traditional supermarket customer base exhibiting stagnant growth, the company embarked on a program to diversify its customer base while significantly cutting overhead. Fleming decided to aggressively go after other non-supermarket retail channels that sell food and certain other items.
The impact of this decision can be seen in the changing breakdown of sales. In 1998, 77% of distribution sales went to conventional supermarkets, with supercenters/discount stores, convenience stores, and other channels accounting for the balance. In 2000, conventional supermarkets accounted for 63% of distribution sales.
Under Hansen, Fleming also targeted the acquisition of $500 to $600 million (net of contract attrition) in new distribution business annually, and it has exceeded this goal with at least 50% of new business growth coming from non-supermarket channels. Looking ahead, Fleming sees a sizeable growth opportunity in serving convenience stores, a $35 billion market opportunity. Fleming presently has just over $1 billion in annual sales to this channel, representing an approximate 30% increase above the 1999 level, and hopes to add $3 billion to $4 billion yearly in the foreseeable future. Exclusive of these and other major, new revenue streams, we look for total distribution revenues to grow 3%-4% annually over the coming three to five years.
In February 2001, in one of the more significant developments announced by Fleming in recent years, the company signed a 10-year exclusive distribution arrangement with Kmart, under which Fleming will distribute $4.5 billion of products annually to Kmart discount stores and supercenters. The Kmart deal is defined by Fleming as an alliance, with the two sharing in the benefits. Besides serving as Kmart's only food distributor, Fleming's BestYet brand of private label products will become Kmart's only private-label food products. Fleming previously had a $1.3 billion business with Kmart, so the additional business amounts to $3.2 billion annually.
The company will not realize all of it this year, as the logistics will not be fully in place until the second half; initial deliveries to Kmart commenced in April 2001. Still, the additional volume is expected to translate into $320 million in annual cost savings for Kmart and $180 million for Fleming by the third year of the contract. Of that, Fleming intends to reinvest $120 million into top-line growth by passing on that amount via lower prices for its goods and services to other clients. Meanwhile, talks are under way to include health and beauty products, adding another $2 billion to revenues.
The Kmart deal, as it now stands, should yield a 20%-plus return on an investment of $200 million to $150 million in working capital, primarily inventory, and $50 million in capital expenditures, to add warehouses to support Kmart. Management recently indicated that the Kmart deal should boost annual per-share profits by as much as 15% by 2003.
The retail segment, which accounted for 23% of total net sales in 2000, has been undergoing change as well. From 1998 to the second half of 2001, Fleming will have sold or closed 238 of its conventional supermarkets, converted 10 to the price impact format, and will have adopted certain elements of the price impact format at the remaining 44. All told, ongoing businesses accounted for roughly 58% of 2000 segment sales.
Here, Fleming plans to focus mainly on price impact supermarkets, which offer deep-discount, everyday low prices in a warehouse-style format and operate mostly under the Food4Less and Fresh4Less banners. Its typical price impact supermarket attracts average weekly sales of $425,000 vs. $325,000 for a conventional supermarket. Its gross margin is narrower, owing to heavy discounting, but that is more than offset by lower selling, general and administrative costs as a percentage of sales. In 2000, Fleming had 30 price impact stores, which contributed $648 million total sales; it looks to add 100 stores within three years.
Standard & Poor's believes Fleming is one of the more efficient distributors in the industry. During 2000, it completed the streamlining and consolidation of its distribution network. This helped leverage operating costs, while raising average sales volume per full-line distribution center from $389 million in 1998 to $550 million in 2000. In addition, Fleming shifted to centralized procurement. Previously, there was one buyer at each warehouse responsible for all of the ordering for that warehouse. The aggregated purchases increased Fleming's leverage with the vendors, thereby helping to lower costs for its orders.
Finally, the company created a unique, efficient warehouse system. In addition to a full-line distribution center carrying approximately 15,000 stock-keeping units (SKUs), there are specialized centers. Slower-turning general merchandise and specialty products consisting of 18,000 SKUs that turn at less than half the speed of groceries and ordinary consumables are aggregated into six facilities. Fleming also developed a warehouse devoted to the convenience store channel and its limited 8,000 SKUs, and flow-through distribution centers for products shipped and displayed in full pallet loads.
Based on projected revenues of $15.3 billion, we look for 2001 EPS of $1.90, representing a 22% gain from the $1.56 earned in 2000. Going forward, we look for share earnings to rise 32% to $2.50 in 2002 and another 32% to $3.30 in 2003. This year's slower growth is partly due to the divestiture of some conventional supermarkets, a move also masking some of the top-line growth of ongoing operations. The stock was recently trading at 15 times our 2001 estimate and only 0.1 times forward sales, less than half the valuation of its closest and most significant distribution rival, Sysco Corp. Sysco's premium may be tied to the historical consistency of its earnings growth and superior return on equity.
Nonetheless, we believe that the company's sustainable revenue and earnings growth rates warrant significant expansion of its price-to-earnings (p-e) multiple and look for the stock's valuation gap versus Sysco to narrow. Taking a conservative stance, we assume that the p-e will expand to 20 times forward projections, which would remain well below projected long-term average annual earnings growth of 30%. Based on our 2001 EPS estimate of $1.90, we have established a 12-month price target of $38, representing a potential gain of 33% over recent levels.
Seligman is an equity analyst following the retail drugstore, supermarket, food distribution and agribusiness industries for Standard & Poor's