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:

• Customer mix is as follows:        

  • 35% Whole Foods

  • 25% Conventional Grocers (including KR, Wegmans, etc)

  • 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

Valuation

• 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