Hello!
The is the third stock valuation I’ve done here on my substack. If you missed the other two, I also valued Smith and Wesson Brands Inc (SWBI) and RV manufacturer Thor Industries (THO).
As always, my goal is to clarify my thinking, document my valuation, and open my thesis and process up to constructive criticism. If you disagree or have any questions about anything in my analysis, please let me know so I can see other perspectives!
IMKTA
Today, we’ll go through the valuation of Ingles Markets Inc (IMKTA). Currently at $88.26 a share.
Ingles is a grocer with 198 supermarkets in six southeastern states. Headquartered in Asheville, North Carolina. Exactly the type of boring consumer-defensive stock that gets me all excited as a value investor. A fun fact - IMKTA was a stock that Michael Burry bought back in early 2021.
Preliminary Check
Just to go through the valuation process, as a first step I like to see how the outstanding shares are changing and some of the key ratios.
PE: 6.51
P/FCF: 8.97
ROE: 27.7%
ROIC: 15.4%
Current Ratio: 2.10
Ratios look pretty good - especially for a grocery store - and shares have been decreasing. So far so good.
Research
Before we get into the actual valuation, let make sure we understand Ingles as a business and the industry that it operates in.
Risks
A good place to start is to look at the risks in the 10K - you can find the latest 10k for Ingles here. I think the big risk to Ingles was highlighted in this section.
The supermarket industry is highly competitive and continues to be characterized by intense price competition, increasing fragmentation of retail formats, entry of non-traditional competitors (both physical and online) and market consolidation. Furthermore, some of the Company’s competitors have greater financial resources and could use these financial resources to take measures, such as altering product mix, reducing prices, home/in-store fulfillment, or online ordering which could adversely affect the Company’s competitive position. [emphasis added]
Companies like Amazon are entering the grocery market. There are new online offerings - and have you seen Kroger’s insane automated warehouse for deliveries? You have to see a video of it in action.
This is a risk that will definitely have to be carefully considered when thinking about the long-term prospects of this business.
Industry Outlook
If you haven’t been following the grocery industry, Pre-pandemic, the outlook for smaller supermarkets was “bleak” as a McKinsey report noted:
The outlook for subscale supermarkets without a differentiated value proposition versus larger mass players or national supermarkets was bleak: in the absence of a defendable value proposition, they were left to compete on price, racing to the bottom with discounters without seeing returns in traffic.
Essentially, supermarkets were losing market share to discounters and online options.
But the pandemic was a reversal of fortunes in the industry. Not only did grocery stores see a boost as restaurants were shut down - but the pandemic jolted supermarkets into offering online options and pickup/delivery services. Supermarkets not only saw gains in absolute terms - but outcompeted their rivals. From McKinsey again:
In an industry that has traditionally seen growth of 1 to 2 percent a year, North American grocery grew by approximately 12 percent in 2020, offsetting significant reductions in food away from home…several supermarket chains rose to the e-commerce challenge by quickly bolting on click-and-collect or delivery services through third-party providers…Prominent supermarkets reported sales growth of anywhere from 12 to 16 percent in 2020, beating out several club and discount players alike. With consumers indicating that selected pandemic-induced behaviors will remain sticky, the landscape might continue to evolve.
And indeed, the impact on the pandemic for Ingles was dramatic. The pandemic did prompt them to offer online grocery shopping with curbside pickup or delivery. And crucially, even as concern over the pandemic has subsided, the changes in consumer behavior - and Ingles’ strong net income - have remained very sticky into 2022.
Inflation
We also have to talk about inflation. The latest CPI number was the highest in 40 years - and food prices in particular have been spiking. Plus, all this inflation is happening before the energy shock has really had an impact on prices. If oil prices remain at their current levels, I’ve seen estimates that gasoline alone could add about 1% to CPI over the next few months - so we could easily be approaching 9-10% inflation rates.
What impact will inflation have on the industry? The thought seems to be that consumers will move to discount chains and reduce their overall spending.
In the past, customers have responded to higher prices or tougher economic conditions by buying fewer prepared meals and deserts, stocking up at the beginning of the month and shopping more at discount chains, said KK Davey, IRI’s president of strategic analytics.
Leaders at discount grocers such as Walmart (WMT), Dollar General (DG), Dollar Tree (DLTR), Grocery Outlet (GO), Costco (COST) and BJ’s Wholesale Club (BJ) have said in recent weeks that customers are noticing the higher prices and changing their shopping behavior. These companies say they are positioned well to attract price-sensitive customers looking to stretch their budgets.
So far though, inflation has not impacted grocery store profits. In fact, they seem to have been able to pass on the inflation extremely well.
I wanted to get a better sense of the potential impact of inflation on grocery stores, and on Ingles in particular, so I went back and looked at the profit margins for Ingles and Kroger back to 1985 (if anyone can find pre-1985 financial statements I would love to see them).
As you can see, profit margins for both companies have been low (in the 0-2% range) up until 2020 when Ingles margins shot up.
Looking at Ingles specifically, a linear regression shows only a very weak (and actually positive) correlation between inflation and Ingles’ profit margin.
And we see a similar, basically non-existent / slightly positive correlation with inflation and the growth rate of Ingle’s Gross Profit.
Given that Ingles has done very well in the last few months of spiking inflation, and that inflation’s impact has been negligible in the past, my takeaway is that the demand is sufficiently inelastic that they can pass on the inflation to the consumers. Possibly higher-end supermarkets like Whole Foods might struggle more with inflation, but Ingles’s seems relatively well-positioned.
Valuation
We’ll value the company with a DCF based on Aswath Damodaran’s DCF model using Tracktak.com. I’ll include a link to my DCF at the end, but first let’s go through the assumptions:
Growth - CGAR
First, the growth rate. I like to look at it from a few ways a get a conservative estimate.
Looking at the graph of revenues, I think a fair range to estimate past historical growth would be from 2008 to 2019 which excludes the big 2020 jump.
The growth rate was actually remarkably linear during this period (R^2 = .94). Using the compound annual growth rate formula between these years we calculate a growth rate of 2.2%.
There are other ways of estimating future growth besides looking at the historical data. Aswath Damodaran covers some of them here. I like the estimate that is based on the reinvestment rate of a company and its return on investment.
With this methodology, using the average of the data from 2015 to today, I calculated a CGAR of 4.40%. Using the trailing 12-month numbers (TTM), I calculated a CGAR of 8.43%.
I’m going to be conservative and assume that the growth rate will return to its previous 2.2% rate. However, the company has used the 2020 windfall to pay off debts increasing the capital available for reinvestment, and consumers grocery shopping behaviors do not seem to be quickly reverting to pre-pandemic trends. Therefore, I’m not going to assume that revenues reverse themselves and fall back to pre-2020 levels. Also, given how strong the last 12 months reinvestment rate and ROIC look, I’m going to assume that growth will fall back down to the 2.2% over the course of 3 years. So, year one 5%; year two 4%; year three 3%; and then 2.2% for the rest of the decade.
Operating Margin
Ingles’ operating margin is currently ~7.02%. But like revenue, margins have increased dramatically since 2020.
Looking at the same range that we did for revenues - 2008 to 2019 - the average operating margin was 3.39%. Similar to our assumptions about revenue, I think the conservative assumption is that they will return to their previous range. There is also an excellent case that margins will take a bit of time to drop back down. Not only because we’re projecting revenues will remain elevated above somewhat fixed costs, but because Ingles used the 2020 windfall to pay off debt which will increase efficiency. Moreover, consumer trends like rarer but larger shopping trips seem to be fairly sticky.
I’m going to assume that the operating margin will fall back down to 3.39% over the course of 3 years. So, year one 6.2%; year two 5%; year three 4%; and then 3.39% for the rest of the decade.
Sales to Capital Ratio
Ingle’s Sales/Capital Ratio has been in a very tight band from 2.8 - 3.0 for the last decade. With, of course, the exception of 2020 and 2021.
I think Ingle’s sales/capital ratio should stay slightly elevated given the debt reduction, so I have taken an average of the entire decade including 2020 and 2021 to get an estimate of 2.95 for our Sales/Capital Ratio.
DCF
With these assumptions we can now run a DCF to get a valuation for IMTKA
I’ve uploaded (an unfortunately static copy) of the DCF to Google Sheets so you can see the calculations for yourself. With these assumptions we arrive at a Valuation of $118.33 which would make IMKTA ~27% undervalued.
Monte Carlo Simulation
To get a better margin of safety with the company, we can run a simulation of all of these interconnected variables of operating margin, growth rate, sales to capital ratio -and how they interact with each other in a monte carlo simulation.
Our Inputs:
The CAGR Standard Deviation 2.00%
Operating Margin Min/Max between 1% and 5%
Sales to Capital Ratio Min/Max between 2.00 and 3.5
That spits out these percentiles of forecasted values.
I like to get some extra margin of safety, so I’m going to look the lower end of the percentiles - I will go will 20% and make the valuation $102.43 making the company ~16% undervalued.
Risks From Heightened Competition
But keep in mind that we haven’t factored in the risk from future heighted competition/automation in the industry. I have given a lot of thought about on how to adjust the valuation to factor in the risk of heightened competition. I don’t know how Ingles will prevail against the longer trends of consolidation and high-tech automation in the industry. I think the short to medium term trends are in Ingles’ favor. But long-term, I don’t know. Maybe ten years from now everyone will be ordering their groceries in the Metaverse from Amzon to be delivered by drone.
Honestly, all of the ways I could think of to tweak the valuation felt arbitrary. I could increase the discount rate - but by how much? I could reduce the operating margin in the terminal value. Again, by how much? I just don’t have a good sense of what the probability is that Ingles will be impacted by future competition/automation. And I have no real way of estimating the magnitude of the impact on Ingle’s finances should it occur.
I’m tempted to simply, As Warren Buffet and Charlie Munger would say, put this stock in the too hard pile.
On the other hand, I feel like with all of the inflation concerns, recession concerns, geopolitical instability, ongoing pandemic - did you hear that giant spiders are expected to start falling from the sky soon? Anyway, Being in a potentially undervalued consumer defensive stock right now seems like an ok move to me.
One last thing to consider, is that the balance sheet of the company is excellent and they own a substantial amount of real estate. If we assumed that there was a 70% chance that the company fails - but we get 100% of the book value, our valuation would be $79.37.
I would love to hear your opinion of the analysis! Poke holes in it - what did I get wrong?? And please subscribe for future valuations :)
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