While there have certainly been some pullbacks along the way, including a nearly 10% decline after fourth quarter earnings, United Natural Foods (Nasdaq:UNFI) has, by and large, basked in the love of growth stock investors. And not without some good reasons - United Natural has delivered excellent growth and market share gains, and has recently shown some solid margin improvements. I still think a key fundamental question remains, however, and that is whether investors are properly discounting what the company needs to spend on capex to maintain its growth rate into the near future.

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A Solid End to the Fiscal Year
I don't think investors were (or should have been) disappointed in the earnings that United Natural posted for the final quarter of its fiscal year. Revenue rose 16% as reported, or about 13% if the Safeway (NYSE:SWY) business is excluded. Either way, organic growth seems to be accelerating while inflation is moderating. Sales to major client Whole Foods (Nasdaq:WFM) increased more than 17%, while sales to supermarkets rose more than 24%. Sales to independents were less impressive, growing in excess of 9%.

Margins can wobble from quarter to quarter, but I'd say that the company's fundamental profitability continues to improve. Gross margin did pull back more than a point from last year and about 40 basis points from the third quarter. Operating income, on the other hand, rose more than 20% on a slight year-on-year margin improvement as the company's efficiency efforts seem to be paying off.

New Business ... Not Quite the Same As the Old
One of the longer-term concerns I have about this company is whether or not much of its growth is coming from lower-margin customers. Getting a bigger piece of the growing organic food distribution business is all well and good, but if the incremental margins don't look as good investors, ought to value that growth differently.

I don't believe that's behind the company's disappointing guidance, though. Management pointed to somewhat higher revenue in fiscal 2013 than the Street had expected, but the earnings guidance ($2.14 to $2.24) was lower than the prior average of $2.25. Here is one of the challenges of the UNFI model - although the company has been making progress on cost efficiency, it's not a straight-line path. In this case, the company is going to be consolidating some Colorado facilities and absorbing those costs accounts for much of the "miss" in guidance.

Can the Company Ever Post Impressive Free Cash Flow?
Another long-term challenge for the company is the inherent thin margins and free cash flow that goes with a distribution business. Given that the company seems to be pretty close to capacity, it seems probable that United Natural will need to build new distribution facilities over the next few years, and that's going to compress cash flow.

In the short term, this could actually be good for profit margins - the company may well have to turn away business if and when it's capacity-constrained, and I would expect that it would be the lowest-margin business that goes away first. Nevertheless, companies like Sysco (NYSE:SYY) and Nash Finch (Nasdaq:NAFC) have amply demonstrated that food wholesaling/distribution is just not a business that leads to wide free cash flow margins. This doesn't mean that this is a bad business or that the returns on capital and assets cannot be good; it does suggest, however, that investors need to be a little more aware of the sort of multiples they're paying for that growth.

The Bottom Line
United Natural Foods isn't at a point in its corporate lifecycle where investors care all that much about the free cash flow. Instead, they care more about the fact that this is a company with double-digit revenue growth, 20%+ EBITDA growth and growing share in an expanding industry. And to be fair, paying about 15 times EBTIDA when that EBTIDA is growing at 20% (similar to the PEG ratio) isn't such a bad thing for a growth stock. Discounted cash flow analysis isn't going to get you into this stock while it's still in its growth spurt. On the other hand, the company is likely looking at at least a few more years of double-digit EBTIDA growth. While I'd personally prefer to own this name at a low teens EV/EBITDA multiple (to cover some of the risk of EBITDA growth deceleration), I wouldn't be surprised if the stock continues to outperform on the basis of its strong growth in a generally low-growth industry.

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

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