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. Fundamental Analysis

    5 Must-Have Metrics For Value Investors

    Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know.
  5. Investing News

    Super Savings for Your Super Bowl Party? Bet on It

    Prices for wings, avocados and TVs are all coming down, which will make your Super Bowl 50 festivities less costly.
  6. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  7. Investing

    What Investors Need to Know About Returns in 2016

    Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016.
  8. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  9. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  10. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
RELATED FAQS
  1. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  2. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  3. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
  4. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors insight into how efficiently a company (or more specifically, its ... Read Full Answer >>
  5. How do you calculate working capital?

    Working capital represents the difference between a firm’s current assets and current liabilities. The challenge can be determining ... Read Full Answer >>
  6. What is the formula for calculating the current ratio?

    The current ratio is a financial ratio that investors and analysts use to examine the liquidity of a company and its ability ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center