Sunday, September 14, 2008

From the Mailbag: The Great Atlantic and Pacific Tea Co.

The Great Atlantic & Pacific Tea Company (NYSE:GAP) is a food retailer operating 447 stores in primarily north eastern U.S. states. GAP sold its Canadian operations to Metro Inc. in 2005. The stock has fallen quite a bit this past year from a high of $32.86 to the recent price of $13.64. The company has a market cap of ~$650M, is trading at a P/E of 13.6 and does not pay a dividend.

Value investors want to buy good companies at cheap prices. This can mean different things to different value investors. For the prominent value investor Charles Brandes, a value company is one that hasn't had operating losses in at least the past 5 years, is trading as less than its book value and has as much or more equity than debt on the balance sheet. Lets review the record for GAP according to Brandes' criteria (for a closer look at more of Brandes' criteria, I wrote about it here).

Upon investigation, I found that GAP has had operating losses (EBIT) in each of the past five years. This is indicative of a company with at least mid to high business risks as viewed by the substantial earnings volatility over time.

GAP has an equity value of $445M and a market cap of $650M giving a price to book value of 1.5. One potential problem with this equity value is there is over half a billion dollars of goodwill and intangibles on the balance sheet. In my opinion, the book value of goodwill and intangibles becomes increasingly dangerous to rely on when the company's earning power value is less than its asset value, which is my assessment of GAP. If you discount the goodwill and intangible assets it will have the effect of raising the price to book ratio even higher than 1.5.

The debt to capital ratio for the company is ~65% not including the impact of operating leases. Even without operating leases, the 65% debt/capital ratio implies that debt is significantly higher than equity.

Three of Brandes' value criteria have been violated with GAP. My own personal assessment is that GAP is not a (good) value play. This company has moderate to high business risk as evidenced by operating margins over time. A company with higher business risk and higher financial risk as seen by its debt leverage could mean big trouble if operating conditions do not improve. I won't try to forecast the future, but rather prefer to look at what the company has accomplished. For this reason and because I believe in protection of capital first, just as Graham taught, I would look for other safer investments for the time being.

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