Premium Foods Not Driving Premium Cash Flow For United Natural

For most of the last three years, shares of United Natural Foods (Nasdaq:UNFI) have pretty consistently flummoxed value-oriented investors. While the margins aren't great for this organic food distributor (nor for food distribution in general), revenue and profit growth has continued to support a pretty healthy valuation and a rising stock price. The market may eventually realize that it's not "different this time" and that the fundamentals of United Natural's business cannot support this valuation, but that's been a money-losing thesis for skeptics so far.

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Solid Performance in Fiscal Third Quarter
Although conventional food companies like Kellogg (NYSE:K) and General Mills (NYSE:GIS) are having their challenges growing in the current environment, stores and products appealing to higher-income consumers seem to be doing pretty well. In particular, there has been solid same-store growth at chains like The Fresh Market (Nasdaq:TFM) and Whole Foods Market (Nasdaq:WFM), and shoppers continue to buy natural and organic foods in larger amounts.

With that tailwind, United Natural Foods saw better than 15% growth in revenue for its fiscal third quarter. So-called core growth, which excludes the impact of a multi-year deal with Safeway (NYSE:SWY), was also a robust 12%.

Margins were mixed, but profits were strong overall. Gross margin did decline about a half-point, due in part to a larger percentage of sales going to Whole Foods and supermarkets. United Natural made up for it with good SG&A control, though, and operating income rose 25%.

SEE: Understanding The Income Statement

Can UNFI Change the Rules of the Game?
As a value-oriented investor, my biggest concern about United Natural is the fundamental profitability and cash flow generation potential of a distribution business. Whether you look within food at companies like Sysco (NYSE:SYY) or Nash Finch (Nasdaq:NAFC) or outside of food at IT distributors like Ingram Micro (NYSE:IM), distribution is an inherently low-margin business and it's difficult to post good free cash flow margins.

SEE: 5 Must-Have Metrics For Value Investors

This doesn't preclude a successful company or stock. Sysco has a smaller share of the market (distributing food to restaurants and food service operations) than United Natural, but has managed to generate solid returns on capital (and good long-term share returns) by leveraging the heck out of its distribution system.

I think it's going to be hard for United Natural to match that. For starters, United Natural derives a large percentage of its sales (more than one-third) from Whole Foods, and it seems likely that the natural foods retail market is going to consolidate further--whether it's through supermarkets like Wal-Mart (NYSE:WMT) and Kroger (NYSE:KR) taking a bigger piece, or another chain like Whole Foods emerging.

That means that currently over 60% of sales go to customers that fight back hard on price, and that the percentage is likely to increase. What's more, I'm not sure the scale of the business at UNFI will approach that of Sysco and allow similar scale-based efficiencies.

SEE: Earning Forecasts: A Primer

The Bottom Line
I understand that UNFI is a rare play on the growing natural/organic food market, and the combination of that scarcity and the reported sales and profit growth makes it an appealing growth stock. Nevertheless, I just don't see how the company can produce the sort of margins and free cash flow that it needs to grow into its current valuation.

Even 40% compound growth in free cash flow for the next decade isn't enough to drive a compelling price target on UNFI shares. I realize that there is more than one valid way to evaluate a stock, and that UNFI is delivering the goods today in terms of growth. I just don't see how the company can grow enough to make this more than a shorter-term momentum trade.

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