Investors often look to food stocks for their safety and perceived resistance to tough times; even though consumers are pinching pennies, companies like McDonald's (NYSE:MCD), Sysco (NYSE:SYY) and Whole Foods Market (NYSE:WFM) are still selling food. So, when you find a company that offers a growth kicker to what is often a staid industry, it's no surprise that investors take notice. Still, so much is already expected from United Natural Foods (Nasdaq:UNFI) that it seems hard to imagine how the stock will deliver above-average gains, to long-term investors.
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Business is Still Good
As UNFI's fiscal first quarter results show the company is still delivering good growth. Revenue rose almost 16% on reported basis, with organic growth of just a little under 14%. Food inflation was below 4%; an interesting result, given the numbers reported by Sysco about a month ago, and granting that they operate quite different businesses.
Growth was strongest in the supermarket category, up more than 17%, with adjusted sales growth of nearly 12% from Whole Foods, and about 10% growth from independent retail customers.
Profitability continues to be a struggle. Gross margin slid about 40 basis points from last year and 75 bps from the fiscal fourth quarter, due both to mix shifts and higher freight costs. Operating income was up about 11%, on an adjusted basis, and though the company saw some improvement in distribution center productivity, it hasn't been enough to boost margins. (In this article, we will introduce the components and analysis of operating margins. For more, see Analyzing Operating Margins.)
The Margin and Customer Dilemma
United Natural recently added Safeway (NYSE:SWY) as a national customer and that clearly helped to boost sales. It also boosted costs, though, and that's an important trade-off. UNFI is the largest natural foods distributor in the country, and only one of two with national reach, but it is still small enough that the addition of a major customer, sends shock waves through the operation and impacts margins.
So, there's a good news/bad news story at play here. There are only a limited number of companies left to add as potential customers, including Kroger (NYSE:KR), Publix and Supervalu (NYSE:SVU), and those aren't likely to come soon, so United Natural will have time to improve its margin structure.
Speaking of margins, the company has been getting more of its revenue from lower-margin customers, lately. This sets up an interesting strategic dilemma: is it better to focus operations on generating more revenue from existing high-margin customers or get better margins out of potentially higher sales volume customers?
Beware the Downshift
Investors in UNFI should be attuned to one particular risk that could really alter their returns. Right now this stock enjoys a premium valuation on the basis of its growth profile. As that growth slows, that valuation multiple is going to contract, likely more than some investors will expect. It happened with Medtronic (NYSE:MDT) and many other growth names, and the adjustment process is often painful and frustrating, as the stock moves from overvalued on optimistic cash flow projections to undervalued, by those same models.
The timing of this transition is uncertain, but it almost certainly is a "when, not if" question. Once the future sales growth rate slips in the mid-to-high single digits, that could be the turning point.
The Bottom Line
Certainly there is much to like about United Natural Foods. It's a more lucrative business than Nash Finch (Nasdaq:NAFC) and a faster-growing business than Sysco (which, again, is not a strict comparable). There's also plenty of room for natural foods to grab shelf space from decidedly unnatural packaged foods.
All of that said, the stock already has those expectations fully built into the price. It is hard to see how the company could really exceed what's already presumed by the valuation and that makes this a risky stock to own. There's likely to be many more quarters of good growth here, but getting out ahead of that valuation reset, will be critical to preserving capital gains in this name. (Find out how your profits are taxed and what to consider when making investment decisions. For more, see What You Need To Know About Capital Gains And Taxes.)
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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.