Grocers Grow

The last several years have been fallow ones for the grocery store market. But this year, the sector seems ripe for a rebound. Regional chains in particular are engaging in M&A. Other healthy signs: a pair of well-known chains emerged from bankruptcy, and another has made an initial public offering.

Steeped in the supermarket sector's dealmaking activity is Andy Jhawar, senior partner and co-head of the consumer and retail industry group at Apollo Global Management LLC's private equity division. Since Jhawar joined the firm in 2000, he has been steering Apollo toward the best opportunities in the supermarket arena, including Sprouts Farmers Market, which is currently completing a merger with Sunflower Farmers Market.

The acquisition of Sunflower, which has corporate headquarters in Boulder, Colo., and Phoenix, will push the annual revenues of Sprouts, also based in Phoenix, into the $2 billion range, making it one of the major supermarket heavyweights in the Southwest region of the United States.

Sprouts' trajectory and Apollo's role in its growth embody many of the trends in supermarket dealmaking today. The Southwestern supermarket's development has been in the making for years. Apollo bought the natural and organic food retailer and merged it with its Henry's Farmers Market portfolio company in February 2011, but the evolution actually started to develop much earlier by the Boney family, who founded Sprouts and Henry's Marketplace, also based in Phoenix. The two companies operated separately for nearly 10 years before coming together under one roof.

The Boney family had a set of stores and changed the name to Henry's Marketplace in 1997. Two years later, Wild Oats Market of Boulder acquired the specialty food retailer. By 2007, Whole Foods Market Inc. stepped in and bought Wild Oats for roughly $565 million. The Whole Foods and Wild Oats deal sparked an investigation by the Federal Trade Commission, due to antitrust issues. As a result, Whole Foods agreed to divest 35 Henry's locations situated in California and Texas.

Apollo's Jhawar had his sights set on the opportunity. "That was a business that I liked quite a bit," Jhawar recalled. He described Henry's as a differentiated player in the natural and organic space with a value-priced farmer's market concept and a go-to-market strategy that was unique given its wide demographic appeal.

Jhawar then realized that Henry's back-end infrastructure came up short. The grocery store didn't have an accounting and finance department or a human resource division. He ended up pairing the asset with the Commerce, Calif.,-based Smart & Final, a warehouse store operator that Apollo had acquired from Paris-based Groupo Casino in May 2007 for $812 million. Six months after Apollo closed on the Smart & Final deal, the firm acquired Henry's from Whole Foods for a reported $166 million. "I put Henry's into Smart & Final recognizing that, for the long term, it probably wasn't the best place for the Henry's business," Jhawar says, explaining that he just needed somewhere to put it because of the infrastructure related issues.

After the Boney family sold Henry's to Wild Oats, the family started Sprouts, which was a replica of Henry's. "I always thought that putting Henry's together with Sprouts was something that made a lot of intuitive sense," says Jhawar.

The Boney Family held informal interviews with most of the major private equity firms in the industry, says Shon Boney, the CEO of Sprouts. The executive did not divulge what firms he met with but said he was looking for a supportive partner who had similar personalities, which he found in Apollo. "For us, their background in retail was definitely appealing," says Shon.

It wasn't until last year that Apollo was finally able to acquire a majority controlling stake in Sprouts and put it together with Henry's. Both Shon and Andy Jhawar wanted to keep Sprouts as a pure play, high growth, specialty retailer that can operate as a standalone business. "That was crucial to us and Andy was supportive of that," says Shon. "It took a while for both sides to realize that a combined business would have enhanced scale and size that could lead to a premium valuation for the combined company in a future IPO," explains Jhawar.

Sagent Advisors acted as the financial advisor to Sprouts on its merger with Henry's. The Boney Family still owns an undisclosed minority stake in the business, and members of the family lead the management team with Stan and Sean Boney, as the chairman and CEO of Sprouts, respectively.

Sprouts' recent acquisition, Sunflower Farmers Market, was founded by the former co-founders of Wild Oats, Randy Clapp, Libby Cook, and Mike Gilliland. With Sunflower, they created essentially another carbon copy of Henry's, as they were the ones who brought Henry's into the Wild Oats fold in the late 1990s. Once again, Jhawar thought it was an ideal match. "It fit in a seamless way and allowed access to additional markets," says Jhawar. Sprouts, which already has stores in Arizona, California, Colorado and Texas, was able to gain entry into Nevada, New Mexico, Oklahoma and Utah, through the Sunflower deal.

Apollo has had its fair share of grocery-store investments, including Ralphs Grocery Co., based in Compton, Calif., and Dominick's Supermarkets, of Pleasanton, Calif. By the late 1990s, Ralphs and Dominick's were sold to supermarket retailers The Kroger Co. and Safeway Inc., respectively. During the late 1990s, large conventional retailers were gobbling up regional players because buyers believed that scale mattered. Synergies created buying power and leverage of the overall business model. The consolidation wave continued into the early 2000s, as large players continued to open stores and standardize the store formats of the regional stores they acquired.

According to reports, more than 4,100 stores changed hands between the years of 1997 and 2000. Lead acquirers included the Cincinnati-based Kroger; Boise, Idaho-based Albertsons; Carlisle, Pa.,-based Ahold USA; and Safeway, based out of Pleasanton, Calif. When 2005 rolled around, the top 20 retailers were responsible for nearly 60 percent of grocery sales.

"What happened in the early to mid-2000s was a transformation of consumer buying patterns," Jhawar recalls. As it turns out, many shoppers didn't like the standardization that was taking place by some of the big players. The industry then started to see an emergence of differentiated, convenience-oriented specialty stores, such as the all-natural and organic grocery stores. After the Whole Foods and Wild Oats transaction which took place in 2007, M&A activity dwindled, a trend begun before the recession, but exacerbated by it.

Sprouts' latest addition is a sign of what's to come in the supermarket industry. "The cycle of strategic activity in the supermarket space is coming back in a big way," says Joshua Benn, a managing director at the financial advisory and investment banking firm, Duff & Phelps.

Industry observers aren't counting on mega transactions like the ones that took place in the 1990s. Instead, deals will be right in the center of the middle market. Some of the growth is coming from companies that struggled in the past. A few supermarkets have filed for Chapter 11 and emerged on the other side of bankruptcy. The Great Atlantic & Pacific Tea Company, which is based in Montvale, N.J. and better known to consumers as A&P, spent nearly 14 months in bankruptcy and emerged in March. Prior to coming out of bankruptcy, A&P got rid of unprofitable stores and renegotiated labor contracts. The Yucaipa Cos., Mount Kellett Capital Management and investment funds managed by Goldman Sachs Asset Management assisted the grocery-store chain with its reorganization plan, which included $490 million in debt and equity financing.

Bi-Lo LLC also went the bankruptcy route. After spending 13 months in bankruptcy, the Greenville, S.C.,-based regional supermarket came out of bankruptcy in 2010, assisted by Lone Star Funds. Bi-Lo quickly started working on a five-year plan, aimed at becoming a stronger competitor throughout the Southeast. In March, Bi-Lo closed its purchase of Winn-Dixie Stores, Inc., based out of Jacksonville, Fla., for $560 million in cash.

John Heinbockel, an analyst at the privately-held global financial services firm Guggenheim Partners, expects that future deals will look similar to the Bi-Lo and Winn-Dixie transaction, in which two regional players that are too small to compete effectively agree to combine. "When you put the two together, you have a bigger company, with more geographic diversity that now has more scale," says Heinbockel.

"There is going to be a lot more activity coming in the next two years," says Duff & Phelps' Benn, who pointed to the Southeast, Midwest, and the Northeast, as key markets that will experience consolidation. "There are also some interesting things happening out west," alerted Benn.

For Sprouts, which operates close to 100 stores throughout the Southwest, much of the growth has already occurred -- although Jhawar is not ruling out bolt-on acquisitions. "In all likelihood, we probably have done our last big acquisition of scale at Sprouts. That being said, if there is something that is very attractive and looks like it can be seamlessly done, from an integration standpoint, it is something that we would evaluate," says Jhawar.

The Southeast also appears to be fertile ground, with several grocery-store chains demonstrating potential as buyers and/or sellers, including: Ingles Market Inc., based out of Black Mountain, N.C.; Harris Teeter, Inc., which is owned by Ruddick Corp., of Charlotte, N.C.; and the Charleston, S.C.,-based family-owned grocery chain, Piggly Wiggly Carolina Co., which industry observers suggest needs modernizing.

In February, the Mount Olive, N.C.,-based Belle Foods announced that it is buying Southern Family Markets, a supermarket chain based in Birmingham, Ala. Terms of the deal were undisclosed, but Belle Foods picked up all of Southern Family Markets' 57 stores, with locations throughout Alabama, Florida, Georgia and Mississippi, from C&S Wholesale Grocers. Belle Foods has room for more acquisitions, notes an investment banker.

Albertsons may offer some opportunities, in that it still has a few stores it wasn't able to sell a few years back, say observers.

Haggen Inc., an operator of 30 supermarkets under the Haggen and Top Food & Drug banners, with locations in Washington and Oregon, is another possible dealmaker. The Bellingham, Wash., family- owned company sold a majority stake to ComVest Group, a private equity investor in West Palm Beach, Fla., in February 2011, for an unknown amount. Once ComVest cleans up the investment, it will likely look to grow Haggen through acquisitions.

Middle-market private equity firms are also going to take a ride on the consolidation wave, and there are plenty that know their way around the supermarket industry.

The Yucaipa Cos., for example, has demonstrated a solid track record with supermarket investments. The leveraged buyout firm bought stakes in A&P, the super center Fred Meyer (Portland, Ore.), Jurgensen's Grocery (Pasadena, Calif), Pathmark Stores (Montvale, N.J.), Ralphs, Supervalue (Minnesota), and Wild Oats.

Morgan Stanley Private Equity owns Tops Markets out of Williamsville, N.Y. The firm bought the chain in 2007 from the Amsterdam, Netherlands-based food retailer, Koninklijke Ahold NV, for $310 million. In 2010, Tops doubled the number of its stores when it acquired 79 stores from the Syracuse, N.Y., regional supermarket retailer Penn Traffic, bringing Tops' total to more than 150. The acquisition also enabled Tops to expand in New Hampshire, New York, Pennsylvania and Vermont. Tops sold some of the Penn Traffic stores to Giant Eagle of Pittsburgh, Pa., and to Price Chopper Supermarkets of Schenectady, N.Y., and ended up scaling down to around 130 company-owned and five franchised stores.

Other private-equity supermarket notables include: Lone Star Funds, which continues to back Bi-Lo; and Willis Stein & Partners, which had a long run with its Milwaukee retail grocery chain Roundy's Inc. before taking the investment public in February. Roundy's IPO had mixed reviews. It priced slightly below range but sold more shares than it had expected to initially and ended its first day of trading at $9, fifty cents up. It raised net proceeds of $111 million, which the company said would be used to pay down debt.

More PE-backed supermarket IPOs are on the horizon. "I think you will see other players in some of these differentiated worlds go public, especially the private equity-backed companies," says Jhawar. Possibilities include: Apollo's Smart & Final; Berkshire Partners' deep-discount supermarket Grocery Outlet, of Berkeley, Calif.; and Berkshire's 99 Cent Only Stores, of City of Commerce, Calif., which agreed to be taken private in October by Ares Management and the Canada Pension Plan Investment Board, in a deal valued at $1.6 billion. 99 Cent Only, too, "can eventually go public again because it has a new-store growth strategy behind it," says Jhawar.

Earth Fare, a Fletcher, N.C. organic and natural foods supermarket, is another likely IPO candidate. Its private equity investor, Monitor Clipper Partners, is preparing the organic and natural food supermarket chain to hit the capital markets within the next two years, says an investment banker who declined to be named. Apollo's Jhawar says that Earth Fare, which currently has 29 locations throughout the Southeast and Ohio, would have to increase its store count significantly before it can be considered a genuine IPO hopeful.

Modern IPOs are likely to be more modest than those of a decade ago. When Kroger, Safeway, and Albertsons, were consolidating regional players ten years ago, valuations were in the 8 to 10 times Ebitda range, says Jhawar. "The regional and conventional players are now trading between 4.5 to 6 times Ebitda," he says.

The dip in valuation can be blamed on competitors that are augmenting their consumable offerings and taking a bite out of the market share of conventional operators. Companies, such as the dollar-store chains, with the likes of listed Family Dollar and Dollar General, typically trade within the 9 to 10 times Ebitda range.

Club stores and mass merchants are also eating into traditional grocery stores' market share and are trading between 7.5 to 10 Ebitda. And it is hard to leave out the drug stores that are also expanding their grocery offerings and are trading at 8 times Ebitda.

The big game changers are the high-growth alternative specialty players that are trading at super multiples within the 16 to 20 times Ebitda range, says Jhawar. Take The Fresh Market. The family-owned specialty grocery retailer went public on the Nasdaq exchange in 2010 and currently has a valuation of 20 times Ebitda. Compare that performance with Roundy's, the IPO of which came in at about 4.7 times Ebitda. "Conventional middle-of-the road supermarket chains aren't getting valued above 6 times Ebitda anymore, because their customer base is getting picked away from all of these other forms of competitors," says Jhawar.

The trend bodes well for The Fresh Market, Trader Joe's Company (Monrovia, Calif.,) Whole Foods - and for Sprouts, which will have 150 stores at the end of the year after the acquisition of Sunflower.

The next step is to focus on organic growth by opening more locations throughout the U.S., with an IPO the goal in another year or two.

"Although Sprouts is likely to have significant strategic interest in the business," says Jhawar, "I think that an IPO would be a logical route for this company, given the ability to potentially have up to 1,000 stores nationally and the premium valuations being afforded to high-growth, specialty-food players."