Great Atlantic & Pacific Tea Co.'s Meltdown Was Overdone

The Great Atlantic & Pacific Tea Co.'s (GAP) acquisition of Pathmark last year further entrenched the company's position as the dominant grocer in the North East United States. GAP's flagship banner, "A&P", has been feeding families for over a century and is one of the most legendary grocery retailers in the New York, New Jersey and Philadelphia areas. Wall Street was expecting GAP's acquisition of Pathmark to produce positive results right out of the gate, but when 1st quarter results were released below expectations, investors ran for the exits as fast as they could, sending the shares down a whopping 33%. The sell-off was an overreaction according to Lehman Analyst Karen Howland: "the results were disappointing, but the negative reaction was overdone".

The Pathmark deal: Management is expecting to reap $150 million in annual synergies. The integration of the two companies is already ahead of schedule. Pathmark's focus is low prices, so today's tough economic environment should attract more price conscious consumers. GAP's gross profit margin dipped 66 basis points from 30.87% to 30.21% due to Pathmark's lower margin business model. SG&A costs improved from 31.36% to 29.65%, while same store sales increased a respectable 3.2%

The numbers: Revenues rose for the first quarter of fiscal 2008 by 74% from $1.7 billion to $2.92 billion while net income came in at -$0.51 versus -$1.54. Operating earnings were actually positive at $2.2 million versus a loss of $6.3 million. Analysts were expecting a loss of 41 cents on revenues of $2.93 billion. The company had strong cash flow of almost $100 million (helped by depreciation of $80 million) and ended the quarter with $28 million more in cash than it started with.

Exchange traded debt, or "QUIBs": The grocer's 9.375% senior bonds were also pulverized. The shares lost 25% of their value, dropping from $25 down to $16.60. This debt instrument, traded under the ticker symbol "GAJ", currently yields 14% based on an annual payment of $2.34. It is a more conservative alternative to investing in the common shares as these bonds are cumulative and rank equally to all other debt instruments. They have a par value of $25 and mature in the year 2039.

Ownership: German-based conglomerate, the Tengelmann Group, (one of the largest European food store operators) essentially controls the company with nearly a 50% ownership stake. It has deep pockets and the ability to provide GAP liquidity if needed. Fidelity owns 10%, while Satellite Asset Management and Prentice Capital each own about 6%.

The short position is large: There are currently 8 million shares short, or 16% of the 48 million share total. The float is small since one entity owns almost half the shares, so a short squeeze is a strong possibility and could come to the aid of frustrated longs looking for relief. The short interest ratio is 10, meaning that it would take about ten days of average daily volume before all the shares could be repurchased.

The impact of a weak economy: The CEO reiterated that a poor economy actually benefits operations as consumers tend to switch from restaurants to grocery stores. The bottom line: consumers end up buying more groceries because they eat out less often.

Capital expenditures: The company is expected to invest about $200 million for fiscal 2008. These cash outlays will be used to further advance remodeling efforts aimed at both its "price" and "fresh" formats.

Capitulation: The shares are oversold. They simply have dropped too much in too short a period of time. In fact, we could of seen a turning point or capitulation (the point where most limit sell orders finally get triggered and the remaining "on the fence" holders end up losing hope and selling their shares at the bottom). Thursday could have been one of those classic capitulation "events" as volume was more than four times average daily volume, and the shares ended the session rallying up 7% from their intraday lows, despite the overall averages closing near their lows. This kind of price action could be construed as a bullish indicator.

The shares are at least due for some sort of 'dead cat bounce' from a technical perspective. Those holding short positions, are likely to start buying to cover in order to book profits. Not far behind, the 'bargain Hunters' eventually add even more buying to the equation. Conventional wisdom says not to try and catch a falling knife, however getting back in after the trend has turned positive offers adequate validation to take a long position.

The analysts' take: All three analysts that provide research coverage, Lehman Brothers, Friedman Billings and Goldman Sachs, all have positive ratings cumulating with a mean one year price mean target price of $31. They don't expect GAP to return to profitability until 2010. Their $31 target price might be too optimistic, and I believe $25 seems more appropriate.

The future: GAP needs to get the Pathmark acquisition behind them and focus on improving margins by increasing sales and reducing costs. They should also focus on reducing their debt. Management is also fortunate enough to have a $400 million loss carryover available to them to offset future earnings enabling them to avoid paying income taxes. Don't try and pick a bottom on this one. Wait for the shares to rally above the $17 mark before sticking your toe in (you want the trend on your side). The Senior Debt (GAJ) is a more appropriate investment at this juncture.

Disclosure: Long

Comments

[Darber]

Thanks for presenting some reason to what has appeared to be a blind rush for the doors. I hold GAJ and only wish I had a few hundred thousand to grab it with now.

[User 169136]

As a consumer I do sometimes check out the sale items at Pathmark and Waldbaums (both owned by A&P.) Not very many "bargains" at either store. 90% of my shopping is at small produce markets that compete with the "giants" as these stores beat by at at least 40% the prices at big box stores. I never spend more than $8 at the Pathmark and always "cherry pick" the specials.