Description

Short UNFI. UNFI was previously written up as a long by ril1212 on 1/26/2016. We believe the Amazon (“AMZN”) acquisition of Whole Foods (“WFM”), which accounts for ~33% of UNFI’s revenues, and reports of WFM “conventionalizing” certain aspects of WFM’s product assortment coupled with Amazon’s aptitude for supply chain management, substantially changes the risk reward to the downside. Our price target is $34/share.

Background: United Natural Foods, Inc. (“UNFI”) primarily distributes “natural” shelf-stable foods to grocery stores. Its largest customer is Whole Foods (33% revenue) with a contract in place that extends through 2025. The balance of revenue is from independent natural grocers (30% revenue), and conventional super-market chains and other (37% revenue). UNFI has benefited over the past two decades as natural food demand has exploded and UNFI became the dominant distributor. Natural food distribution historically presented a challenge for conventional grocery wholesalers that were optimized to distribute a low mix and high volume of CPG SKUs. Natural foods stores historically have had a higher mix and lower volume, making it difficult for conventional wholesalers to service them. UNFI capitalized on this and built a supply chain optimized for delivering a high mix and low volume of SKUs.

Quick Industry Background: Most conventional grocers either use a large wholesaler such as C&S, or handle distribution internally --  through a combination of direct deliveries from suppliers/CPGs and/or their own warehouses and trucks. These distribution methods tend to be optimized for higher volume items and add, based on our checks, ~4% to the wholesale cost. UNFI and other specialty distributors like Kehe, traditionally have found a niche supplying slower-turning items, and due to additional handling/repacking, charge 10%-30% markup to the wholesale cost (depending on the type of other value-added services included). Kehe is UNFI’s largest competitor and similarly targets “natural” slow-turning items—it’s private and we estimate half the size of UNFI.

As the “natural” grocery segment has become mainstream, there has been substantial consolidation, most notably with Hain Celestial. Hain, in some cases, distributes directly and through conventional distributors. Annie’s is another example of a natural brand that has become mainstream and is now owned and distributed by General Mills.

Thesis (SHORT): As natural food becomes mainstream it removes UNFI’s competitive advantage in distributing slow-turning SKUs and will force UNFI to compete more head-to-head with lower cost conventional grocery distributors in the natural foods category, pressuring margins and volume.

Natural Becoming Mainstream: As the natural food industry grows its beginning to mirror the conventional food distribution industry. Many natural foods are sold in large volumes by consolidated players to conventional stores (e.g., Hain Celestial, Annie’s, Chobani). As natural foods continue to go mainstream and are sold in higher volumes in conventional stores, it makes a higher proportion of natural foods suitable for conventional distribution. UNFI, based on our understanding, charges a fixed mark-up on SKUs delivered regardless of how fast an item turns or the volume of the SKU that’s delivered.  In the recent past, we believe UNFI has likely benefited from this shift. More sophisticated retailers like Walmart (Kehe customer) and Kroger (UNFI customer), have shifted to direct/conventional distribution for faster turning SKUs. However, most grocery stores have been slower to adapt and in those cases UNFI has likely picked up margin as it delivers higher volumes of certain SKUs at the same high mark-up (4% conventional vs. UNFI of 10%-30%). We believe UNFI will continue to do well in the slow-turn niche, but as grocers begin to adapt their supply chain and move faster turning items to conventional distribution methods, it will leave UNFI with lower volumes and/or margins.

WFM Contract at Risk: We also believe the WFM contract is at risk for the same reasons. Since AMZN acquired WFM, there have been reports of WFM trimming SKUs to focus on higher volume items and introducing more conventional items (e.g., Vitamin Water). Before the AMZN acquisition, when WFM was pressured by conventional competitors on price for popular natural SKUs, it would respond by removing the SKUs and replacing them with multiple more niche brands, which largely benefits UNFI. We believe WFM will continue to trim SKUs in favor of higher turning items to favor “conventional natural”. Given AMZN’s existing distribution footprint for Prime Pantry (strong overlap with UNFI DCs), AMZN’s grocery ambitions, and aptitude for supply chain, we believe that AMZN will opt to insource distribution for the bulk of what UNFI currently provides by 2025 when the UNFI contract expires.

WFM has also announced that its centralizing purchasing and demanding 3%-5% discounts from vendors that sell more than $300k through WFM per year. This, in the shorter term, will likely have a direct impact on UNFI’s topline, though the exact contract mechanics are unclear given the heavily redacted distribution agreement between UNFI and WFM.

https://www.wsj.com/articles/amazon-puts-whole-foods-on-fast-track-to-conventional-supermarket-1505986380

https://www.washingtonpost.com/business/economy/whole-foods-places-new-limits-on-suppliers-upsetting-some-small-vendors/2018/01/05/7f58b466-f0a1-11e7-b390-a36dc3fa2842_story.html?utm_term=.1339c12fb82b

What’s Different: Some have argued that these headwinds detailed above, with the exception of the AMZN acquisition of WFM, have existed before and haven’t impacted UNFI. What we believe is different is grocers are coming under increased competitive pressure from new entrants (Lidl, Aldi) and investments in price led by WMT and with KR following. The competition forces grocers to reevaluate supply chains and moving faster turning items from UNFI to more conventional distributors can allow for a multi-point pickup that can be invested in price.

Valuation framework:

We used a DCF framework given these changes may take up to 2025 to fully play out. We used a 7.5% WACC and generally used consensus until the expiration of the Whole Foods contract. In practice, based on our checks, Whole Foods could get out of this contract before then if they really want to.

Base Case: $34/share – 11% premium to estimated replacement cost, or a cash flow valuation based on the company continuing to grow 4.5% - 7%, consistent with consensus, through the expiration of WFM contract at which time 80% of purchasing is shifted to conventional/internal distribution. At conventional grocers we estimate UNFI/Kehe account for <2%  of COGS.

Upside Case: $25/share – 12% premium to TBV, or a similar case to base case but with 3% growth before losing WFM contract and incremental margin compression.

Downside Case: $65/share – Company can continue to grow at 4.5% - 6%, consistent with sell-side, expand ROIC, and get an EBIT multiple rerate from 10.5x to 14.0x, similar to better positioned specialty distributors in adjacent markets, such as US Foods.

Key Risks:

(1) Merger with large competitor Kehe; (2) Buyout; (3) WFM showing interest in longer term UNFI relationship.

Catalyst

Further changes at WFM/AMZN and price/volume pressure in conventional and natural channels.