United Natural Foods (UNFI) is the largest domestic distributor of natural and organic foods.The stock has been beaten down from the mid-$80s last summer to $36.00 today, we think there is 55% upside to a fair value of $55.
It might be helpful to start with why the stock has been so horrific over the past 9 months:
Organic growth has decelerated from 11-12% to around 7% as their main customers, particularly Whole Foods, ceded share to conventional supermarkets
Last July the company announced that their second largest customer, Albertsons, was switching to the #2 player in distribution, KeHe
Multiple compression across the natural organic universe
Despite the above at today’s price we like UNFI as a long for the following reasons:
Distribution is a business of scale and UNFI is the largest player by a factor of 2.5x in the natural/organic food space, an industry that is growing double digits currently and should grow above GDP for the foreseeable future
The Albertsons contract loss seems to represent more of a one off situation than a trend for the market to be worried about, in fact, UNFI has re-signed about 50% of their book of business to multiyear deals within the past six months
UNFI has a relatively clean balance sheet, just over 1x levered on TTM EBITDA, they will use dry powder and internally generated FCF to fund accretive M&A
Organic growth is running +7% right now, UNFI is trading at 12x forward earnings, other distributors such as SYY/PFGC struggle to grow in stagnant end markets and trade at 19-20x, CORE trucks around cigarettes and candy around and it gets 30x, you get the point….
UNFI itself could be an M&A target, SYY wouldn’t be surprising after the US Foods deal went through
There are a handful of decent slide decks on their website for background, but here are the most important aspects of the business to understand:
40% Independents and Others ( think SFM, NGVC, etc)
KeHe is the only other national scale player, but they are 40% of UNFI’s size, the distant #3 is BPI
They serve 44k retail locations from 33 distribution centers in US/Canada
Historically their strong suit was slow moving center of the store SKUs, they have shifted their mix via acquisition of Tony’s and Trudeau Foods to include perishables and meats/cheeses
The Alberstons loss
Albertsons/SWY was their second largest customer at roughly 4% (besides WFM nobody else is this big)
They announced in July they had lost the contract to KeHe in a bidding process, it was the first notable customer they had lost since 2007 (that customer actually came back less than a year later…)
Albertsons was likely trying to cut costs to the extent they could before their (failed) IPO process in late 2015 and we were told by a few different people that KeHe is barely breaking even on the deal and had to write a check to win
This is our take of the event:
Having a competitor willing to underwrite business at basically breakeven is a negative
BUT, this isn’t sustainable for KeHe over the long term, we’re told their top line is approximately $3B, when UNFI was a $3B business it’s SG&A was close to 16% of sales, right now its Gross Margin is closer to 15%, there is no way KeHe will be able to compete purely on price over the long term
We are told they are close to capacity constraints at this point
Albertsons was low margin business to begin with, this capacity can now be filled with (hopefully) higher margin customers
A secular share loser??
A big bear argument is that UNFI is exposed to the wrong customer set as the legacy natural and organic retailers lose share to conventional grocers entering the space
While we would agree that conventional guys will continue to take share, at this valuation level for UNFI its important to remember the following
25% of their revenues are tied to the conventional channel, they are working to expand this
Even with this pressure in 2015 UNFI’s core customers still grew revenues double digits (WFM/SFM/NGVC/etc) and it looks like that number will only slow moderately in 2016 given mid-high single digit unit growth on average
Let’s face it, the customer that shops at WFM isn’t switching to a SuperValu that was last renovated in 2004
Thinking longer term, about 2% of US farmland is USDA organic certified, as a result organic crops trade at premiums of roughly 100-450% over conventional, the majority of current needs are actually imported.The point here is really that this category is going to have a hard time becoming a “race to the bottom” because the commodity costs won’t let COST/KR do it.This also creates an inflation situation that will be helpful to UNFI and other distributors
Given the growth profile of the business, the multiple it’s peers trade at, and it’s own historical multiple of 22-25x EPS we think 17.5x our 2017 estimate is reasonable, this yields a target price of $55
UNITED NATURAL FOODS
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.
Continued data on customer sales health, particularly WFM (we’ve heard comps appear to be stabilizing intra-qtr)
Simply the passage of time as revenue and sales continue to grow, this is going to be a much bigger company three years from now….