Description

The Chefs’ Warehouse (NasdaqGS:CHEF) (herein “CHEF” or the “Company”), in our opinion, is one of the most attractive situations we have come across in recent years.  Given the overall appreciation in the broader market, we were frankly thrilled when the stock declined due to short-term earnings concerns.  CHEF had been on our wish list of businesses we wanted to own if the price ever got to the right place.  There are several key reasons why we think CHEF is both a solid business and will substantially appreciate in value.  These are as follows:

·        Company has the necessary scale in key markets

o   CHEF is the largest specialty distributor in US – coverage of all major US cities

o   If you are smaller producer of ingredients, CHEF is a must-have relationship

o   26,000 customer locations served and top 10 customers make up only 12% of sales

·        Organic growth has momentum

o   CHEF has reported strong customer growth (this is net of attrition)

o   CHEF has also reported solid case growth metrics

·        Acquisition opportunities are robust

o   There are over 15,000 smaller distributors in the US—robust opportunity to execute highly profitable ‘tuck in’ acquisitions

o   CHEF has an active M&A pipeline to either penetrate deeper into existing markets or expand presence into new markets

·        Industry trends are favorable

o   Over the past decade, there had been increasing pressure from chain operators (not a target customer group for CHEF) which impacted independent restaurant operators – this trend is now reversing as chain growth has slowed remarkably

o   Consumers are showing an interest in eating away from home and many restaurant operators have noted an increase in this trend since the end of the election

o   Food deflation had been a headwind for the past 18 months and this trend seems to be slowing--some categories have shown signs of inflation

·        Valuation is attractive

o   We value CHEF at $25 per share (before adjusting for tax rate – CHEF has highest tax rate in our portfolio at 41%)

o   We estimate CHEF will generate $220mm in unlevered FCF over the next four years

o   A key to the valuation story is adjusted EBITDA margins increasing from 5.4% to 7.0% over our five year forecast period

Why are we getting the opportunity to buy the stock?  CHEF missed earnings in each of the last three quarters which led to a significant decline in the Company’s share price. For reference, after the 1Q16 earnings miss, the stock dropped 17% vs. the sector index over the subsequent 30 day period. It then dropped 29% vs. the sector index over the subsequent 30 days following the 2Q16 earnings miss.  By the time CHEF missed guidance for the third quarter of 2016; the stock had already bottomed and has since moved higher.  The key reasons that management provided for the missed earnings estimates are as follows: (1) recent acquisitions have encountered integration challenges, and (2) the significant investments in distribution centers in New York, Chicago, Las Vegas and San Francisco have deleveraged the cost structure.  The integration challenges were exacerbated by the need to substantially upgrade the IT operating systems from QuickBooks to JD Edwards, which were both time consuming and led to system user issues following conversion.  The upside to these issues are that the IT systems have all been corrected and the investments in distribution centers have positioned CHEF for the next leg of very profitable growth.

“On a long-term basis, our targets are as follows: we expect to achieve 26% gross margins; operating expenses, excluding D&A, as a percentage of net sales to be down around 19% of revenue; and an EBITDA margin of approximately 7% on a long-term basis. Also, capex, which has been a significant drain for us over the last year or 2 as we've opened new facilities, we expect that normalized maintenance capex to be between $8 million and $10 million.” John Austin – CHEF – CFO – 5/03/16

Regarding its business model in more detail, CHEF is a distributor of specialty food products to chefs mainly at menu-driven independent restaurants in both the United States and Canada.  CHEF serves 26,000 customer locations in 15 key markets.  The Company distributes a broad portfolio of products totaling 34,000 SKUs from 1,700 suppliers.  The 15 key markets are served from 25 distribution centers which provide service six days per week.

CHEF sales by category is as follows:

·        Center-of-the-plate (protein) - 49%

·        Dry goods – 17%

·        Pastry – 13%

·        Cheese – 8%

·        Oils and vinegar – 6%

·        Dairy – 5%

·        Kitchen supplies – 2%

CHEF came public in the middle of 2011 at $15 per share.  In 2011, CHEF generated $401mm of total revenue.  Since 2011, through strong organic growth and a number of acquisitions, CHEF now generates $1.2B in revenue on an annual basis.  The Company was started by two brothers in their parents’ garage in Connecticut in 1985.  They actually mortgaged their parents’ house to provide the financing to start the business.  The two brothers: Chris and John Pappas are key members of the management team today.  They both believe that there is a large opportunity to continue growing the business to become a multi-billion dollar specialty foods distributor.  The brothers are also large shareholders and together collectively own 25% of the outstanding stock.

The foodservice distribution industry (dollar volume of food and supplies purchased by operators annually) was estimated to be a $262B market in 2015 with restaurants making up 59% of this total.  Independent restaurants comprise 54% of the total market for restaurants and chain operators are the balance of the market, or 46%.  Within the Independent restaurant segment, CHEF focuses on the top 35% of this market (we’d define this as ‘fine dining’ with some casual and midscale – think check size of $50 and above), which equates to a market size of their target market at $25B to $30B. This implies a CHEF market share of about 4%.  During our research process, we hired one of the top foodservices industry consultants to help us go back and analyze industry trends since 2005.  What we found in the data actually surprised us.  The independent segment of the market is very resilient and suffered its worst year ever just after the great financial crisis in 2010 with only a 4.2% decline in annual foodservice purchases.  Regarding the growth outlook, we also commissioned a market forecast to 2021 – the CAGR is projected to be 4.7%.

To further highlight the attractiveness of the independent restaurant sub-segment, US Foods commented on the differences they were seeing in their customers during the third quarter in a transcript from November 8, 2016:

Zachary Fadem – Wells Fargo Analyst:

“Can you talk a little bit about the just overall environment for independent customers? It looks like you guys are continuing to take share here. But given the choppiness in the overall restaurant environment, do you think independents are still well positioned to outgrow the national chains? And second, are you seeing any instances of heightened competition for these customers relative to the first half of the year.”

Pietro Satriano – US Foods CEO:

“So we would say the outlook is stable. We rely -- so there's a number of industry sources, as I said. We rely a lot on Technomic because they tend to break out independent from chain customers. As I believe I mentioned in my comments, the growth rate expected from independents is in the 2x range of chains. There's been a lot of press around declining traffic with respect to chains, and so those trends that we hear about are consistent with what we see in the marketplace. The independent restaurant is, I would say, alive and well and faring well, and that's part of the reason, in addition to the fit with our strategy, why we are so focused on the independent restaurant.”

The comments by US Foods are consistent with their recently reported results.  In a Form 8-K, for fiscal 2016, US Foods reported total case volume growth of 2.9%, but that actually masks the true underlying strength as their case growth for independent restaurants was 6.4%, or more than double the Company’s headline rate.

Additionally, Performance Food Group also commented on the differences they were seeing in their customers during the third quarter in a transcript from November 8, 2016:

Vincent Sinisi– Morgan Stanley Analyst:

“And just a quick follow up, if I may. Your two main competitors of course have reported this week as well. And I think there is maybe just a little bit of confusion on some, what you’re seeing, either in results and/or commentaries by some of the managements, in terms of, just kind of the, overall health of the restaurant in particular industry. So if you guys could just give us your take, and by customer segment whether or not, that would be great?”

George Holm – Performance Food Group CEO:

“If you look at our Performance Foodservice business, we were, in the month of August, we’re right at 9% [growth], the same independent growth that we had run the previous quarter. As soon as we hit the political conventions, we saw a little softening. We were like mid-sevens for case growth in the month of August, a little softening during the Olympics as well.

As we've got into September, we put back up again a little under eight. And then in the last weeks, we've been actually better again. So whatever that means, I'm not sure. I think it means that the independent restaurant continues to do well, and we’re doing well in that area. In Performance Foodservice, our national account business [chains] did weaken throughout the quarter, and that's continued into October.”

CHEF releases several statistics on case and customer growth (net for attrition) to allow investors to monitor the underlying momentum of the business.  These metrics have trended very positively over the last three years as noted below:

To put the CHEF metrics in comparison, in the third quarter of 2016, the competitors announced the following case growth: Sysco (local cases) +1.8%, US Foods (independent restaurant cases) +3.5% and Performance Food Group (independent restaurant cases) +8%. 

The foodservice distribution industry is very fragmented, but there are several large players.  It is our understanding that there are over 15,000 firms in total.  The two largest national broadline firms are Sysco and US Foods.  Broadline is a term describing the fact that these distributors carry a “broad line” of products designed to offer everything a restaurant might need, but in many cases the product line is not deep and has limited choices for each product category.  The saying a “mile wide and an inch deep” comes to mind.  The number three player in the market, Performance Food Group, is more of a regional player as compared with Sysco and US Foods.

The following data summarizes the industry according to US Foods Form S-1 filed on January 20, 2017:

               Top 10 Broadline Distributors

1.      Sysco (NYSE:SYY) – Sales $36B

2.      US Foods (NYSE:USFD) – Sales $23B

3.      Performance Food Group (NYSE: PFGC) – Sales $11B

4.      Gordon Food Service (Private) – Sales $6B

5.      Reinhart Food Service (Private) – Sales $5B

6.      Ben E. Keith Foods (Private) – Sales $3B

7.      Shamrock Foods Co. (Private) – Sales $3B

8.      Food Services of America (Private) – Sales $2B

9.      Cheney Bros. (Private) – Sales $1B

10.   Labatt Food Service (Private) – Sales $1B

One point that is important to mention is that most restaurants get deliveries from several distributors.  So it is not uncommon for a CHEF customer to also be a customer of a broadliner as well.  The key here is that CHEF is very deep in some SKUs that are very important to chefs.  To drive this point home further, CHEF carries more than 200 varieties of olive oil where the large broadline foodservice distributors carry 5-10 types of olive oil.  CHEF fills orders at a rate of about 99% and offers deliveries to customers in a 2 – 3 hour window six days per week.  Another key area of differentiation is order cut-off times.  The Company’s cut-off times extend to midnight where many of the larger broadliners have mid-afternoon order cut-offs and offer customers wide delivery windows which are often not desirable for smaller independent restaurant operators.

The following chart summarizes data we compiled on the publicly traded foodservice distributors from SEC filings and interviews:

As the chart shows, private equity has been very interested in this industry for a long time.  And with good reason, the industry is highly attractive and is very fragmented.  We believe that CHEF could be purchased by one of the larger public peers or taken private by a private equity operator.  One industry expert we spoke to commented that the big guys are absolutely “carnivorous” in their hunger for buying smaller firms and especially firms like CHEF that have higher margins than the industry heavyweights and large exposure to the fast-growing independent restaurant category.    To put this margin differential into perspective, we believe that foodservice distributors achieve EBITDA margins from independent restaurants (“street business”) that are 5x higher than chain restaurant margins.

One industry expert we talked to noted the following:

“The ‘street’ business has always been the P&L swing factor for the industry. However, the ‘big three’ (Sysco, US Foods, & PFG) have been so focused on driving efficiencies in their business that the percent of ‘street’ business has dropped big. This leaves room for companies like CHEF to continue to gain share with the ‘Mom & Pop’ restaurants.”

The table below highlights CHEF’s growth by market over time.  The rapid expansion from 2013 to 2016 has corresponded with deteriorating adjusted EBITDA margins as CHEF has struggled with the integration of certain acquired assets along with the continued investments it has made in order to substantially expand certain distribution centers (e.g. New York, Chicago, Las Vegas and San Francisco).

CHEF has expanded into many of these markets through M&A.  We’ve estimated the following data on the M&A that was completed since the beginning of 2011 ($ in millions):

After completing M.T. Food Service deal in August 2016, CHEF has been focused on organic growth and rationalizing their business units to produce the 7% adjusted EBITDA margins that they have been promising investors.  On August 2, 2016 second quarter earnings call transcript, CHEF management noted the following:

“M.T. was a must. It was a very strategic fold-in into our facility. We haven't pulled them in yet, so we have a lot of focus on that. So we're really in no rush to do any more acquisitions at this time. We have a very frothy pipeline. But right now, really, it's just getting back to where we should be in our strategy, and that's really where the management team is focused.” – Christopher Pappas – CHEF – CEO & Chairman

There has been speculation that CHEF’s entry into protein has permanently reduced margins moving forward.  We think this is an inaccurate notion.  First, the largest of the protein purchases had EBITDA margins that were above CHEF’s margins.  Secondly, thinking through the dynamics within protein, the gross margins are often lower than specialty items, but the SG&A costs per $1 of sales are much lower given the deliveries are of such high value as compared with specialty items.  Here are the financials for the Del Monte Meat Company that CHEF recently purchased. Of note, this purchase represents over half of the acquisition value paid over the last five years:

We are assuming nothing heroic in terms of valuation.  We estimate the revenues for CHEF will expand at a rate of 6.5% over the next four years ending at $1.5B in 2020.  As we noted above, our industry forecast is for 4.7% growth and we continue to expect CHEF to take share in key markets such as Chicago, San Francisco, and Los Angeles.  Over the forecast period, we estimate that adjusted EBITDA margins will rise from 5% in 2016 to 7% by 2020.  We did not adjust the tax rate and left CHEF’s rate at 41% for our forecast.  Our terminal multiple is 12.0x which is a slight discount to our distribution peer group which supports a median TEV/EBITDA multiple of 13.0x.  The peer group contains the following companies: SYY, USFD, PFGC, UNFI, SPTN, CORE, HDS, WCC, MRC, DXPE, FAST, GWW, MSM, WSO, BECN, BMCH, GMS, AIT, SITE, POOL, GPC.

The bottom line on valuation suggests CHEF shares are currently worth $25 per share.  As we noted above, given the high level of acquisition-related non-cash amortization flowing through the income statement, there is a large disconnect between earnings and cash flow.  The unlevered free cash flow between now and the end of 2020 should equate to $220mm vs. a TEV of $717mm today.

The capital structure of CHEF is leveraged due to the recent acquisitions, but the debt is covenant-lite and there is $67mm of capacity available under the ABL facility.  The sr. secured facility matures in 2022 and the ABL facility matures in 2021.  While the net debt to EBITDA is currently around 5.1x, we project through the Company’s anticipated free cash flow generation that this ratio is at its peak and will be reduced to 1.8x net debt to EBITDA by the end of 2020 (assumes no further acquisitions).  Management has stated an intent to get net debt to EBITDA into the 2x to 4x range which we think would be achieved on the current path by 2018.

While we like companies where the insiders own large stakes, that dynamic also gives us pause if the stakes are so large that the insiders feel they don’t have to listen to shareholders.  Interestingly, that does not appear to be the case here at CHEF.  The insiders collectively own 27% which is nearly the same amount held by the two largest institutional shareholders Kayne Andersen and Wasatch who own 13.9% and 13.6%, respectively.  Further, an activist shareholder Legion Partners just filed an initial 13D filing indicating 5.9% holdings.  The top 10 institutional holders control 60% of the stock and should be able to apply pressure at the board level if needed, especially now that an activist is on the scene and engaged.

Catalyst

• Strong organic growth trends
• Improving EBITDA margins to 7%
• Solid FCF of $220mm over next four years
• Activist Legion Partners files - together with top 10 passive holders control 60% of stock
• Larger industry players are well backed by institutional investors and highly acqusitive