Description

Short Idea: United Natural Foods (UNFI) is a leading national distributor of natural and organic foods and products. Put another way, they are the Fleming (or Nash-Finch, or Spartan) for the granola crowd. By end customer, the company’s revenue breaks down by channel as follows: 45% Independents (mom and pop health food stores), 33% Supernatural (i.e. health food superstores like Wild Oats (ticker: OATS) and Whole Foods (ticker: WFMI)), 13% Mass Market, and 9% Other. UNFI has many of the hallmarks of a good short. From a fundamental perspective, valuation is stretched. The company trades at over 20x current year EPS, and has an unappealing business model. In addition, there are numerous warning signs – financial, operational, and strategic – which point to a major earnings stumble within the near future.

The bulls point to two factors that make UNFI a “buy”: 1) the healthy aggregate growth rates in the natural/organic food market, and 2) UNFI’s relative valuation discount to its primary customer, Whole Foods (WFMI). These factors are quickly dismissed. While aggregate growth rates in the natural/organic food industry are admittedly good on an absolute basis, and outstanding by overall food distribution standards, UNFI’s valuation is currently discounting what I believe is a best-case scenario. In addition, as I will describe further below, cracks in this part of the thesis have already started to develop. With respect to the company’s relative valuation versus WFMI, there are very good reasons for the disparity (most importantly, major differences in capital efficiency) that explain the spread.

Natural/organic food has been a lone bright spot in recent years for food retailers. A look at the relative valuation of broad line grocers versus natural/organic grocers (WFMI, OATS) will give you a quick sense of the market’s estimation of their relative growth potential (<10x P/E vs. >25x P/E, respectively). Broadly speaking, the natural/organic segment grows at 7-9% per annum. Whole Foods, which currently represents 24% of UNFI’s revenue, grows comps in-line with the industry and square footage at roughly 12% per annum. Despite the impressive growth, WFMI recently announced that it expects comps in the coming quarters to come in at the low-end of its previously stated guidance range of 6.5-8.5%. WFMI had a host of excuses for the softening in comps, but even if one chooses to buy these excuses the law of large numbers will ultimately bring industry comps to more subdued levels. UNFI was previously the primary distributor to the two heavyweights of the Supernatural distribution channel, Whole Foods and Wild Oats. However, in mid-2002 it lost the primary distribution contract for Wild Oats to Tree of Life, a subsidiary of a publicly traded Dutch company, Koninklijke Wessanen. The primary supply contract has now terminated, although UNIF continues to serve as a secondary supply source for Wild Oats. Wild Oats will likely represent $10-15mm of annual revenues going forward (1% of total). The loss of the Wild Oats contract highlights another fallacy in the “discount to Whole Foods” bull case thesis. In a worst-case scenario, Whole Foods walks away at the termination of its supply contract in 2004. In a more likely scenario, Whole Foods drives a hard bargain at contract renegotiation time, knowing full well that a loss of its business could be a near-mortal blow to UNFI’s profitability. Over a longer-term time frame, there is a possibility that Whole Foods chooses to move to a self-distribution model; something that the broad line grocers have been doing for years.

A move to self-distribution is also a risk in the mass-market channel. Natural/organic foods are one of the few growth areas for broad line grocers. If the segment grows large enough, any number of UNFI’s mass-market customers (Pathmark, Publix, Stop and Shop, Shaws) could choose to self-distribute, thereby cutting UNFI out of the loop and keeping the distribution margin for themselves. And of course, everybody’s favorite grocery bogeyman – Wal-Mart – is reputed to be surveying the natural/organic food segment to determine whether or not it is worth a major push. Wal-Mart’s ability to devastate its competition is well known.

In order to replace the business that was lost with the Wild Oats contract termination, UNFI purchased two cooperatives last year – Blooming Prarie and Northeast. Total consideration was roughly $44mm. UNFI’s goal is to get these businesses up to corporate-level operating margins over time, but this will be a tough task to accomplish. A look at the most recent 10Q indicates that these cooperatives were in aggregate unprofitable on a pre-tax basis prior to acquisition. Cooperatives, of course, are frequently not operated with profitability as a primary concern, so one might argue that UNFI should have an easy time of it restructuring these businesses and driving them towards profitability. However, there are several reasons to be skeptical. First, cooperatives by their very nature are frequently operated because the service being provided has limited profit potential. Member companies can be quirky and demanding, and don’t typically have the scale on a standalone basis to attract profit-seeking suppliers or service providers. UNFI has provided limited information about the cooperative’s customer base, but anecdotal evidence suggests that the customer base is fragmented and tends to order in small (i.e. unprofitable) lot sizes. Of greater concern is UNFI’s abysmal history integrating other distributor acquisitions. The acquisition of Stow Mills in the late 1990s was so woefully executed that it led to the ouster of the company’s founder and CEO, Norman Cloutier. Another late-90s distribution acquisition, Hershey, continues to drag on company results to the tune of a couple of cents/shr each quarter. Speculation at this point is that Hershey is damaged to the point that current management may seek to divest it. The acquisition track record certainly doesn’t inspire confidence.

UNFI currently reports several different same-store comps numbers. One, the as-reported number, excludes acquisitions. On this basis the company was flat year-over-year in the most recent quarter. The other, more optimistic, presentation excludes both acquisitions and the loss of the Wild Oats contract. On this basis the company grew roughly 14% in the most recent quarter. One can debate the veracity of a same-store comps number that excludes the loss of a company’s 2nd largest customer, but in any case this optimistic view of same-store sales declined sequentially from 17% to 14%, and gave some credence to the argument that Wild Oats’ recent conservative guidance was not a company-specific issue. Admittedly, 14% is an impressive growth rate, but in any case it is heading in the direction of the industry’s mean 7-9% growth (which is itself declining over time). The more interesting subtext of the company’s same-store comps number was in the breakdown by sales channel. UNIF claimed to see 14% same-store growth in its Independent channel. I find this assertion suspect. Supernatural channel growth rates suggest that the independent mom and pops are losing major share to the Supernaturals. The industry is growing at 7-9%, yet Supernaturals are increasing comps at 7-9% and square footage at 10%+ (for implied total growth of 17-19%). This incremental Supernatural growth has to be coming out of somebody’s hide, and it is unlikely to be coming from the mass market retailers, who have only just begun tapping into the natural/organic segment of the market and are growing that segment of their businesses aggressively. Given UNFI’s heavy concentration in the Independent channel, share losses will hurt the company disproportionately.

There have been a number of management changes (over the last several months) and stock sales (over the last several years) at UNFI of note. In December of last year, Michael Funk, the CEO, relinquished his CEO position and stepped upstairs to become non-executive Chairman. Michael was one of the company’s co-founders. The existing non-executive Chairman, Thomas Simone, stepped down to become Vice Chair of the board. Thomas had been brought in several years previously to provide some reassuring gray hair when the company’s other co-founder, Norm Cloutier (mentioned previously), nearly brought the company to its knees with the disastrous Stow Mills acquisition. Michael Funk has reduced his shareholdings in the company aggressively over the last several years, from 2.2mm shrs at year-end 1998 to roughly 700k shrs currently. He has sold little stock within the last 12 mos. Thomas Simone, on the other hand, has been a seller of note recently. He exercised and subsequently exited his entire options position (130k shrs) in April of this year.

In January of this year, the company’s CFO was abruptly terminated. Little explanation was given for his dismissal.

There are a final couple of yellow flags on accounting and leverage. UNFI still sticks to an aggressive approach with respect to pro forma earnings reporting. The company routinely backs out both distribution center relocation and integration costs, although these have been ongoing for the past several years (mgmt maintains that they will end soon). In addition, pro forma add-backs include interest expense related to the company’s existing swap agreements. In my opinion, the add-back of these swap expenses for pro forma reporting purposes is aggressive. The swaps were put on to mitigate the company’s exposure to floating rates on its existing credit agreements and are a full, legitimate component of interest expense. Investors can obviously choose to adjust their own numbers based on whether they believe these charges to be regular and recurring, but I think that the decision by management to break them out is indicative of broader potential issues. The real question is, if interest rates move up and swaps become a favorable adjustment to the P&L, will management continue to consider their contribution “extraordinary”. As an aside, termination of the swaps would currently cost the company roughly $7mm cash. UNFI covers its interest >5x, which is reasonable in the context of the distribution business. However, its debt structure is questionable. The company has financed its acquisitions through its revolver, which currently has >$135mm outstanding on a limit of $150mm. A longer-term debt structure would arguably be more appropriate.

UNFI hews to the typical lousy-return grocery distribution model. As compared to typical broad line grocery distributors, though, its working capital requirements are higher as a result of its highly diversified supplier base and significant SKUs (leading to high inventory requirements). The company’s net working capital runs at 11-12% of revenues, which is onerous given its 3-4% operating margins and 1.5-2% net margins. Assuming a 15% revenue growth rate, the company will need to reinvest nearly 2/3 of its net income back into working capital. So, you end up with an entity that can only begin to generate real free cash flow as the top-line growth rate slows markedly – an ugly Catch-22. I estimate that returns on unlevered capital run around 9%, and ROEs are in the low double digits. Any missteps on the operating margin line will send these already-pallid returns deep into the abyss. In addition, as the acquired co-op business replaces Wild Oats business, working capital requirements may increase even further due to a less efficient overall supply chain.

I am modeling an aggressive valuation case for the company on a 10-year DCF-basis and reaching a target value of $18.40/shr – a decline of roughly 30% from here. My assumptions behind this analysis are: 1) consensus growth for the Jul 2004 fiscal year of 15% top line (aggressive in light of recent quarterly comps of 14%, down from 17% the previous quarter), 2) top line growth scaling down to in-line industry growth of 7% over the subsequent two years, and flat-lining at 7% for another 7 years thereafter, 3) operating margins increasing to 3.8% over a 3-year period and flat-lining thereafter, 4) net working capital stays at its current level of 11% of revenues, 5) capex converges with D&A over the coming 4 years, 5) terminal growth of 5%. For reasons mentioned above, I believe that all of these assumptions are generous to UNFI. Given the inherent financial and operating leverage in the business, a slip in any of these metrics could lead to real earnings risk, major multiple compression, and downside of greater than 50%.

Catalyst

Flubbed integration of recent co-op acquisitions; continued slowing secular growth for natural/organic food industry; loss and/or scale-back of distribution contract with Wild Oats, market share losses by Independents, operational stumble in upcoming move of Northeast distribution center