Opinion: BUY

Chef’s Warehouse (CHEF) is a high-end food distributor that is currently embarking on a roll-up strategy to expand into new markets and increase penetration in existing markets through higher mkt penetration as well as higher revenues from existing customers.  The company is rapidly expanding footprint through greenfield and acquisitive efforts, while acquiring more strategic assets to increases sales to existing customers and increase penetration to new customers in existing markets.  Shares touched all-time highs of $29  in December 2013, valuing the company at $725MM on a mkt cap basis and $850MM for the enterprise.  Following back-to-back reported weak quarters in Q4 and Q1, shares have sold off and now fetch around $18 putting the company’s mkt cap and TEV at $450MM and $570MM respectively.  Shares still trade at a seemingly lofty 29x the company’s most recent 2014 unadjusted EPS guidance midpoint ($.57 - $.67).  However, adjusting revenues and expenses for footprint and capacity expansion, adding back Customer Relationship and Trademark amortization charges (about $3.5mm per year), and assuming the “weather” that affected Q4 and Q1 revenues is anomalous, then CHEF equity shares are trading at 14x to 15x earnings for a capital-lite, recurring revenue business that is growing organically in the mid- to high-single digits.

Following a guidance raise in October 2013, the company’s results have suffered with top-line meeting guidance but expenses coming in higher than expected and weather reportedly impacting top-line for Q4 and YE results 2013.  Since then, the company has also lowered 2014 guidance just 2 months after establishing initial guidance, due again to higher expense expectations.

Business Overview:

CHEFs operates at the upper end of the market, offering 30,000 SKUs to independent top-tier restaurants, country clubs, hotels, bakeries, and culinary schools.  The company’s customers are highly menu-oriented with cooks and chefs that are highly knowledgeable and particular about ingredients.  Regular menu turnover of certain items is a key part of such restaurants.  CHEFs often boasts that broadliners like Sysco and PFG offer 5-10 Olive Oils while they offer >160.  Furthermore, Sysco has stated on several occasions intentions to reduce SKUs.  While they could certainly paint the truck black or rebrand a portion of their deliveries, your typical top teir steakhouse is better served by not having a Sysco truck show up behind it to deliver product.  The company targets deliveries within 2-3 hour time windows and order fulfillment times of 12-24 hours, 6 days a week.

The predecessor company was founded in 1985 in NY as Dairyland by brothers John (age 50) and Chris Pappas (54), and NY is currently the largest market at 42% of 2013 revenues.  Customer bills today often still say Dairyland and purchases by the company from suppliers show as the same.  The company IPO-ed in July 2011 and began trading at around $17 with about 21mm shares outstanding.  Since its IPO, the company has spent $160MM on acquisitions that seem to be executed at 0.4x to 0.7x revenues.  Sources of funds for acquisitions have been new debt, shares issuance, and cash from operations.

Since then, they have accelerated their strategy which is essentially a roll-up with a 3-pronged approach to growing business value 1) tuck-in local/regional acquisitions within existing markets, 2) local/regional acquisitions within new markets to expand footprint, and 3) what they call “strategic platform” acquisitions that are proprietary food makers that serve to expand their dinner plate market share and also acting as a hook/anchor for customer relationships. 

The company cites its addressable market as $900MM of the estimated distributor annual N.A. sales of $235B (source: IDFA).  According to mgmt., natural attrition of its customer base has been and continues to be ~7% (typical customers are not your strip mall style Italian restaurant).  The company has been operating in more than half of its markets for fewer than 5 years.

Chefs’ Warehouse 2013 10-K

June 2014 Investor Presentation, p. 20

The market is highly competitive, restaurants have the ability to switch orders daily from one supplier to another, and often use multiple suppliers.  Even in CHEF’s oldest market, NY area, the company has about $70,000 revenue/customer location versus likely NY-area purchases per location of at least $250,000 (consider COGS run at 25% of revenues for typical restaurants, and few if any “nice” restaurants can survive in the northeast with fewer than $1mm in annual sales and probably need much higher figure, especially for NYC.  It’s not rare for a NYC restaurant to exceed $5mm and some have more than $15mm in revenues, implying much higher inventory purchases and much smaller pct of total customer purchases that CHEFs itself represents).

June 2014 Investor Presentation, p. 17

Growth strategy 

Organic Growth.  The last 2 quarters notwithstanding, CHEF has been growing in the high single digits organically.

In its home NY Market – defined by them as Boston to Atlantic City – CHEF has been growing top-line at  >7%.  CHEF’s reports annually the percentage of revenues from its NY Market, the only market where topline is disclosed separately.  Even backing out the company’s NY area acquisitions we can see CHEFs is growing at >5% in its largest, oldest, and most penetrated market: 1) Harry Wils & Co – by annualizing the $5.4mm rev contribution reported in Q3 ’11, and FL-based pastry/dessert maker Qzina – by assuming of its 7 key markets that NY represents 1/5^th of total revenues (company said revenue for Qzina fall between $60mm and $65mm) and adjusting for the fact that Qzina transaction closed on May 1, 2011

• Q2 2013 CC, John Austin CFO: “Organic growth amounted to approximately $9.8 million of our net sales growth, or 8.5% growth.”
• Q3 2013 CC, John Austin CFO: “Strong organic growth amounted to approximately $10.2 million of our net sales growth, or 8.2% growth.
• Q4 2013 CC, John Austin CFO: “In addition, our number of unique customers and placements also grew in the mid- to high-single digits year over year, approximately 7%, respectively, after adjusting for the estimated impact of acquisitions.”
• Q1 2014 CC, John Austin CFO: “Weather is obviously out of our control, but we do want to point out that results outside of the Northeast and Mid-Atlantic regions continued to be very strong during the first quarter while the regions is impacted by weather were relatively flat year-over-year. While we started to see glimpses of spring, April volume trends were comparable to what we saw in the first quarter. However, we did see continued inflation, primarily in the dairy category.”

Acquisitive Growth.  Since the IPO, CHEF has accelerated its strategy which is essentially a roll-up with a 3-pronged approach to growing business value 1) tuck-in local/regional acquisitions within existing markets, 2) local/regional acquisitions within new markets to expand footprint, and 3) what they call “strategic platform” acquisitions that are proprietary food makers that serve to expand their dinner plate market share and also acting as a hook/anchor for customer relationships.  The company has grown SKUs from 11,000 in 2010 to more than 30,000 as of YE 2013.  Tuck-in acquisitions quickly have a larger product selection to offer their existing customers.  Strategic acquisitions brings certain proprietary products to CHEF’s product list that drives more frequent orders and larger customer tickets, related to the proprietary product but also follow-on orders.  It’s more indicative of the typical distributor roll-up story.

CHEF’s acquisitions are transacting at 0.5x to 0.7x revenues. 

Currently, a number of factors are depressing gaap earnings and cash flow, obfuscating the business’s economics:

1)       Weather. We have spoken with 5 customer restaurants of CHEFs, a anecdotal and statistically insignificant sample no doubt, and one that is geographically concentrated in the company’s NY market.  Still, all customers suggest two things.  First, while inclement weather did not impact customer volumes on most days, snow storm days did result in “missed” days of revenues.  Second, this sample indicated they were ordering the same or more from CHEF and that they were happy with service levels and SKU options.  (The space is highly competitive though, all customers had several choices and often procure from more than one supplier, with the ability to switch something as simple as milk or crab meat from one supplier to another in a given week.)  It’s not unreasonable to assume a return to normalcy across a slightly larger footprint versus the most recent “normal quarter” which would be Q3 2014.

Margins of the business in 2011 serve as a decent proxy given prior to footprint expansions and larger acquisitions.

2)       Expansion strategy is resulting in high CapEx outlays.  The company is expanding its Bronx, NY distribution center and its Las Vegas Nevada center, building a new Chicago distribution facility and implementing JD Edwards (oracle) software.  CapEx for 2013 were $15mm and the company expects 2014 CapEx to come in at $32mm, compared with $7.5mm of total capex cumulative for the 2009 through 2012 periods.  107,000 sq ft of space signed April 30 in Chicago, to compliment the Qzina and Allen Bros facilities it acquired in the Chicago area.  In The Bronx, duplicate rent charges are being incurred while the company cannot occupy the facility it is renovating/expanding ($25mm total investment into that distribution center and should be completely moved in by early 2015.

3)       Expansion strategy results in higher OpEx running ahead of revenue optimal revenue generation.  This is evidenced through much lower revenues per unit:

4)       Amortization of acquired Intangibles, particularly Customer Relationships, results in material charges to earnings over foreseeable future.   The company discloses projections of about $6MM/yr for amortization expense of intangibles.  Customer relationships represent about half of that, about $2.7MM/yr on a straightline basis of Gross Carrying Amount at YE 2013, and Trademarks another $0.9mm/yr.  Neither Customer Relationships nor Trademarks have finite lives or deplete in the economic sense, particularly if the business is working to grow its existing customer relationships as part of its strategy, but are deductible for IRS taxes.  These charges can be added back to after-tax income for estimating EPS for the business in a steady-state. 

5)       WC investment has been largely attributable to shift in business mix given two large strategic platform investments.    Allen Bros. is a meat purveyor where wet and dry curing times for various meats, sausages, etc often exceed 30 days.  Moreover, Allen Bros meat suppliers are smaller operations who require shorter pay cycles.

Mgmt Aligned as Owners

The Pappas brothers today are the largest shareholders, owning 20% of shares outstanding.  Both John and Chris have been net sellers of the stock since the IPO, possibly contributing to part of the overhang of late, reducing their collective ownership from 46% to 21%.  According to CHEF Proxy statements, mgmt.’s variable comp is tied to total revenues and EPS targets.

Trading Valuations of steady state business

CHEF shares trade at 13.5x to 15x earnings and 15x FCF of the steady-state business.  To compensate for recently expanded footprint with below-optimal revenues, apply 2011 Gross and Opex margins of 26.4% and 19% respectively to the assumption of higher revenues per customer location ($47,000/location which is a tad lower than 2011’s figure) and per Sales Professional ($2.9mm in-line with 2011).  This yields $870mm to $940mm in revenues and $63.5mm to $69mm in EBITDA.  No margin benefit is being given for national scale as CHEF’s is already the only way for some suppliers to reach US markets and the footprint is more indicative of a collection of regional business rather than a national business (although Qzina and Allen Bros argue more for the nat’l perspective).  Interest is $9.25mm on debt and D&A is $10mm.  Taxing pre-tax earnings at 40% and then adding back $3.6mm specific to Customer Relationships and Trademarks amortization (still deductible for tax purposes) and using 25m diluted shares provides $1.21 to 1.33 in EPS (under the revenue range assumption) and $28mm to $30mm in FCF (no major assumption for WC as bad debt provision is immaterial and expensed while inventory obsolescence is also included in OpEx).

• Company reports Q2 after market close on Thursday July 31, potential commentary and/or results indicating return to more positive revenue, margins, and profit trends vs those in Q4 '13 and Q1 '14.
• Sales ramp up of new markets over next few years.
• return on investment from big CapEx spending in 2013 and 2014.
• Integration of larger acquisitions with revenue synergies across nat'l footprint.