I first became interested in Marsh Supermarkets (MARSB) while reading Stockcoach’s Corner.  But MARSB kept dropping and dropping and dropping.  Then back in January, I noticed ABC Funds took a position as well.  But still it kept dropping and dropping and dropping.  Then a couple weeks ago the stock jumped 30% and that’s when I bought.  You might be wondering: Did Theo turn into a Momentum Investor?  Nope, not at all.  Let me explain my actions in this blog post.

Marsh Supermarkets was founded in 1931 with one store in Muncie, Indiana.  In 1953, the Company went public with 16 stores.  Today Marsh operates 119 supermarkets under the Marsh, LoBill Foods, O’Malia’s Food Markets, Arthur’s Fresh Market and Savin*$ banners, and 160 Village Pantry convenience stores in central Indiana and western Ohio. They also own and operate a food service division and a floral division.  The company’s major competitors are Kroger (KR), Wal-Mart (WMT), and Meijer.

In February 2005, their CFO, Doug Dougherty, announced his retirement plans.  John Elbin was hired as Marsh’s new CFO in July 2005.  At about the same time, Marsh’s quarterly report was released and their diluted EPS was $0.08, less than half the $0.20 last year.  The stock took an immediate dive, but then stabilized until late November.  

That’s when the next quarterly report was released.  This time Marsh suffered a serious loss of $0.43/share.  The company cited competitors and higher oil prices as reasons for their inability to improve gross margins.  They also reported that Standard & Poor’s Rating Services lowered their corporate credit rating to B- from B and Moody’s is expected to do the same.  This, of course, makes it more expensive for the company to borrow money in the future.  Lastly, the main dagger in that quarterly report:

On November 22, 2005, the Board of Directors of the Company determined to suspend the payment of future quarterly cash dividends until the Company improves its financial performance and its credit ratios are improved on a sustainable basis. As indicated elsewhere in this report, the Company continues to face market challenges, and as a result believes that its cash can be used for other business purposes.

I believe the suspension of their $0.52 dividend is what caused Marsh’s stock to drop 50% in less than two months.  Adding insult to injury, Mr. Elbin also resigned in December after just a five month-stint.  Mr. Dougherty came out of retirement to become Marsh’s CFO once again.

Despite the bad news, the line that peaked my initial interest in the November quarterly report, and which also makes the stock a special situation, was:

The Company has retained Merrill Lynch & Company to explore strategic alternatives for the enhancement of shareholder value, including a possible sale of the Company.

After disclosing that, the Board of Directors reduced future compensation obligations to executives by $28 million in January 2006.  Don E. Marsh, Chairman and Chief Executive Officer, stated, “These actions are part of the Company's announced plans to pursue strategic alternatives.”  By taking a pay cut, the executives were telling me that they are serious about selling the company.

In mid-January, Marsh announced they had secured a $25 million two-year loan.  Again Mr. Marsh stated, "The term loan enhances the Company's liquidity position and continued commitment to further progress on the previously announced process of identifying and considering strategic alternatives for the Company."

By then I was still just watching the stock and absolutely puzzled.  Why was it dropping more?  Panic, it seems, knows no boundaries.

At the beginning of February, Marsh announced a reduction in force of approximately 25 employees at the headquarters office, including four officers: David A. Marsh, President and Chief Operating Officer; Arthur Marsh, Executive Vice President -- Mergers and Acquisitions; Don Marsh, Jr., Vice President -- Specialty Procurement and Joseph Heerens, Senior Vice President -- Political Affairs.  They also reduced overhead expenses.  Collectively, those actions were expected to save more than $12 million per year.

Finally, in their February quarterly report, Marsh announced they were closing some stores to reduce costs and, to my surprise, they had their real estate appraised:

As part of the Company’s recent financings and previously announced decision to explore strategic alternatives, the Company had substantially all of its owned real estate appraised. The Company owns the real estate and buildings for 34 of its supermarkets, 44 of its convenience stores, and 5 of its other florist and catering facilities. In addition, the Company owns its corporate headquarters, certain warehouses and other land and buildings. Based on recent appraisals, management of the Company believes that the fair market value of the Company’s owned real estate and buildings exceeds the net book value of such real estate and buildings reflected on the Company’s consolidated financial statements by $100 to $150 million.

Looking at their Balance Sheet, assuming their inventory is worth 50% of book value, and using the $100 million real estate appraisal above, Marsh’s equity is $144 million.  That means their book value is $18.23/share.  Right after this announcement, and even though the stock jumped 30%, I took my initial position at $8.18.  The stock was still selling at a 55% discount to tangible book value.  Management, by then, had not only proved they were willing to make sacrifices by securing financing, cutting their own pay, and reducing staff including highly-paid executives, but the appraisal of their hidden assets was the ultimate catalyst for me.

Today MARSB closed at $8.10 and I will be adding to my position tomorrow if the stock does not have a large move.  I believe there is a significant margin of safety here.  As mentioned above, the stock is selling at a wide discount from a very conservatively-calculated book value.  Furthermore, their Price/Cash Flow ratio of 5.30 is cheap by both absolute and comparative measures – Kroger and Wal-Mart have twice that.

Speaking of which, this special situation is not without risks.  Marsh is in an extremely tough industry competing with the likes of Kroger and Wal-Mart.  Kroger has already said they were not interested in acquiring Marsh and if a buyer does not emerge soon, Marsh could suffer more losses and even cash flow problems trying to compete against those two behemoths.  As for the real estate appraisal, the risks are that it might not be accurate or events could change; in addition, some of the real estate has been used as collateral for the company’s debt.  But all-in-all, if the company is sold, or even liquidated, the stock should be worth at least 50% higher from today’s close.