United Natural Foods (Nasdaq:UNFI) offers an interesting test-case for two conflicting realities of Wall Street. On one hand, investors frequently pay up for above-average growth stories, and particularly those with strong market share and/or barriers to entry. On the other hand, margins are an under-appreciated driver of investment performance and investors seldom pay high multiples for weak margin stories. While these shares have underperformed in a hot market for packaged food stocks, the market continues to assign a pretty rich value to this natural foods distribution company.

Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.

Fiscal Third Quarter Earnings Show Margin Pressures
The bullish long-term thesis for United Natural Foods rests on driving operating leverage, and the company didn't do such a great job of that this time around. Even so, an in-line result suggests that the Street was already in tune with some of the margin challenges for this quarter.

Revenue rose almost 13% as reported this quarter, with about one point of that growth due to acquisitions. Whole Foods (NYSE:WFM) remains the growth driver for United Natural, with sales to this leading organic/natural chain up more than 15%. Sales to supermarkets were also quite strong, up nearly 14%. Sales to independent retailers were weaker (up 8%), but this is an older, more mature business for the company.

SEE: Analyzing An Acquisition Announcement

On margins, UNFI saw gross margin fall more than 80 basis points. The declines were due in part to a higher contribution of private label foods and lower promotional receipts due to vendor out-of-stocks, but also due to the higher percentage of sales to lower-margin customers (particularly Whole Foods). Operating income still rose better than 10%, with operating margin down only 7bp on a GAAP basis (I do not subscribe to the notion that UNFI's costs due to labor difficulties with a union should be excluded).

Getting Creative On Driving Sales And Paying For Capex
Necessity can breed creativity, and United Natural seems to be getting creative in terms of driving better customer throughput and financing new capex needs. For the former, the company created new territory manager positions; the idea being that having company reps frequently visiting and talking with retailers could help stimulate more orders (more SKUs) from those stores. As UNFI's trucks are heading to those stores anyway, it makes sense to get as much business as possible.

In terms of capex, United Natural Foods management is looking for ways to continue to add the distribution capex it needs without overly compromising its liquidity and cash flow situation. To that end, it looks like sale/leaseback transactions may become more common for the company.

Will Maximizing Revenue Challenge Margins?
One of the pillars of the bullish thesis on United Natural is that the company still has plenty of growth potential with large national retailers. Chains like Kroger (NYSE:KR) and SuperValu (NYSE:SVU) (as well as Publix, Meijer, and others) could represent substantial sources of revenue if and when United Natural can become their natural/organic food distributor of choice. And given that UNFI is the largest distributor around (and really only has one direct competitor), there's a good chance they could be.

The question I have is at what cost will that growth come? Not unlike Sysco (NYSE:SYY), the reality for UNFI is that the more recognizable the client's name, the lower the gross margins tend to be. While a larger revenue base should allow for meaningfully better operating leverage, there is a balancing act here to consider. At the same time, though, I do wonder if UNFI can ever leverage its market position. I've talked to a handful of people in the food retailing business (both national chains and independents) and they say that UNFI is generally the low-cost distributor in natural foods. That makes me wonder, then, if UNFI can eventually grow to a point where they can stand up and fight for incrementally better gross margins, though it's not something I'm building into my models.

SEE: 5 Must-Have Metrics For Value Investors

The Bottom Line
I continue to believe that the biggest problem for this stock is that investors are much too optimistic about the long-run margin and cash flow generation opportunities. Even with better than 8% long-term revenue growth, I don't see UNFI moving past the low single digits for free cash flow margins. Accordingly, I can't generate a fair value all that close to the current stock price, and I can't really see the argument for buying these shares as anything more than a play on ongoing growth and/or leverage to the growing natural/organic food industry.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Related Articles
  1. Insurance

    Investing Beyond Your Borders

    Investing abroad poses risks, but can also help you diversify. Discover ways to invest in foreign stocks.
  2. Mutual Funds & ETFs

    Introduction To Fundamentally Weighted Index Investing

    If you believe the market smiles on those who focus on value, growth or income, this vehicle may be for you.
  3. Options & Futures

    5 "New" Rules For Safe Investing

    Did the credit crisis leave a new landscape for investors? Maybe, but it's not as unfamiliar as you may have imagined.
  4. Investing

    Asset Manager Ethics: Acting With Competence and Diligence

    Managers must make investment decisions based on their personal investment process, which in turn should be based on solid research and due diligence.
  5. Forex Education

    Understanding The Income Statement

    Learn how to use revenue and expenses, among other factors, to break down and analyze a company.
  6. Stock Analysis

    Will J.C. Penney Come Back in 2016? (JCP)

    J.C. Penney is without a doubt turning itself around, but that doesn't guarantee the stock will respond immediately.
  7. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  8. Professionals

    The Best Financial Modeling Courses for Investment Bankers

    Obtain information, both general and comparative, about the best available financial modeling courses for individuals pursuing a career in investment banking.
  9. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  10. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  1. What does low working capital say about a company's financial prospects?

    When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>
  2. Do nonprofit organizations have working capital?

    Nonprofit organizations continuously face debate over how much money they bring in that is kept in reserve. These financial ... Read Full Answer >>
  3. Can a company's working capital turnover ratio be negative?

    A company's working capital turnover ratio can be negative when a company's current liabilities exceed its current assets. ... Read Full Answer >>
  4. Does working capital measure liquidity?

    Working capital is a commonly used metric, not only for a company’s liquidity but also for its operational efficiency and ... Read Full Answer >>
  5. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  6. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>

You May Also Like

Trading Center