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A cautionary tale of `cap ex.'.

With the capital expenditure process, the more you spend, the more you make - as long as you're spending intelligently.

Recently I attended the debut investor presentation by the top management of the new - and much improved - Grand Union. The chain's saga, entailing a "double dip" through two bankruptcy filings, illustrates how not to - and now how to - manage the crucial capital expenditure, or "cap ex," process.

Because cap ex does not flow through a P&L statement except indirectly through depreciation, it may seem surprising to find it of interest to short-term-oriented Wall Street. However, informed investors recognize it as a key success factor in food retailing. The Grand Union re-debut was a hit among investors in part because it outlines a happy-medium "Goldilocks" cap ex strategy. That is, the company is expending not too much and not too little.

The company will be spending about 2.5% of sales on cap ex, or $290 million over five years. Much of it will go toward high-return and low-risk projects rather than new stores. Initiatives include easy catch-up on MIS (e.g., implementing labor scheduling and time and attendance systems), remodeling well-located but tired stores, and selectively reformatting smaller units to make a more compelling shopper proposition (e.g., low-price limited assortment, or perishables-only stores).

What's so promising about this cap ex plan? For one thing, the 2.5% level is midrange: enough to avoid "mortgaging the future" through the short-sighted cap ex limits imposed by the first LBO structure, yet not profligate and ultimately yielding low return as was the "Masters" store renewal program developed by the second LBO management team. A 3.0% to 3.25% level might be more ideal to build the company's competitive position, but the program could evolve in this direction should the initial operating outperformance continue.

Furthermore, the Grand Union cap ex focuses on tried-and-true measures to generate robust returns on the capital that remains precious under the new LBO structure. It certainly avoids the chanciest use of capital - building new stores in new market areas.

For example, in the early 1990s, Smith's Food & Drug invested at unprecedented levels to enter Phoenix, Ariz., and Southern California with large numbers of beautiful but overly elaborate 90,000-square-foot super combo stores. The 7%- to 8%-of-sales cap ex program, double the most aggressive ever seen in the industry, wowed Wall Street. This compounded the challenge by elevating Smith's stock to unprecedented valuation levels (at peak, almost 30 times the next year's earnings), which provided cheap capital for Smith's to throw at its expansion.

The market entries never worked, and the company and the stock imploded. Subsequently, the stock was somewhat rejuvenated but in more modest form, and only to be bought out at a modest valuation level. The moral of this story is not to overdo it on cap ex.

A less extreme, but also cautionary, case is Hannaford's aggressive entry into the Southeast, which has proved a disappointment. That Hannaford is an exceptionally well-managed company underlines the inherent perils of overheated cap ex.

A further example is Food Lion's ill-fated entry into Texas and Oklahoma. The entry proved problematic early on, but became a lost cause following the sensational negative sanitation publicity, which killed shopper trial in the new Food Lion territories.

Underinvesting in cap ex yields equally bad results, and is actually more common than overinvesting. It is easy to allow inertia or myopic cost cutting to rule the day, especially in a capital-constrained LBO context. While our industry lends itself to LBOs, thanks to the cash-flow stability, a sharp dichotomy of cap ex stance and consequent company performance divides the "enlightened" vs. "benighted" LBOs.

The former, typified by the LBOs of KKR (Kohlberg, Kravis & Roberts), build in ample cap ex flexibility to the LBO financial plan. Rather than diminish, this fostered the long-term competitive positions and consumer franchises of Safeway, Stop & Shop, Fred Meyer and Vons in their LBO years.

In contrast, less-progressive leveraged financial sponsors and structures virtually snuffed the once-vibrant life out of such companies as Kash n' Karry (pre-acquisition by Food Lion), Homeland (pre-Chapter 11 reorganization), Eagle and Pathmark. American Stores also suffered the consequences of its minuscule 1% of sales cap ex level from 1988 to 1994. The culprit was not a bad LBO per se, but the accumulation of heavy debt through acquisitions (the company bought Lucky in 1988) and historically low operating profitability, which arose in part from the very scarcity of cap ex that low profits perpetuated until new management hiked cap ex beginning in 1994.

Finally, there is clearly a management challenge to divining a golden mean of cap ex. One of the first steps taken by Steve Burd at Safeway was to slash cap ex by more than 50%. The projects were yielding poor returns due to execution problems and the lack of a compelling operating strategy. Then Burd turbocharged Safeway through a panoply of changes, including halving the cost to develop a new store and focusing on the typically higher-return remodeling rather than new store process. Only after a few turnaround years did he increase cap ex to the presently aggressive, though not excessive, level of about 4% of sales.

The lesson from Safeway, then, is: Cap ex is vital but must be adroitly directed before elevating business results; the more you spend, the more you make - as long as you're spending intelligently.

Gary M. Giblen is managing director of Rudman Partners, L.P., a New York-based money management firm.
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Title Annotation:capital expenditure of grocery companies
Author:Giblen, Gary M.
Publication:Grocery Headquarters
Article Type:Column
Geographic Code:1USA
Date:Feb 1, 1999
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