Friday, November 2, 2012

Is United Natural Foods Good Value?

Sometimes evaluations don’t matter in investing. Now before you start penning hate messages for the comments section, be aware that I don’t believe that opening statement either! You won’t find me buying ‘story stocks’ whose evaluations are divorced from any reasonable risk/reward calculation. I confess I feel that way about the organic and specialty food sector right now. However, I don’t make the market and if it wants to chase this investment theme higher than good luck to it. That said, it’s time to look at what is happening and why in the sector.

United Natural Foods

This stock is a good example of what I am talking about. United Natural Foods (NASDAQ: UNFI) has a strong story to tell. It is the largest organic and specialty food retailer in the US with its closest competitor holding around half its market share. The rest of the market is fragmented into independents servicing specialty local markets. And size matters in this industry.

As organic/specialty sales rise in response to increasing health awareness, supermarkets seem to favor having one reliable supplier to meet their customer demands. This is probably the main reason why Safeway took its contract away from two incumbents and awarded it to United. This contract now makes up 24% of United's revenues. Safeway is locked in a battle with the likes of Kroger for market share in grocery and this sort of initiative makes sense to stop losing footfall to Whole Foods Market (NASDAQ: WFM)

Similarly, its biggest contract (36% of revenues) with the fast growing Whole Foods has been extended over the years and now has at least another eight years to run. Incidentally, small independents make up the bulk of the rest (35%) of revenue.

With these kinds of contracts and overall strong industry trends behind them, United has been able to generate low-teens compound over the last 10 years. And this rate is even higher than the industry due to its focus on the higher growth segments within it.

Putting all these things together leads to a very powerful ‘pitch’.  So powerful in fact, that the market is willing to pay 34x earnings and an EV/EBITDA multiple of 15.2x making United hardly the value stock of the month.

The Theory of Relativity

Analysts love the relative evaluation argument. It works like this. Stock X is on 50x earnings so stock Y is cheap because it is on 45x. With this flawed logic story stocks can get constantly bid up in a race to over evaluation. In United’s case it is easy to point to fellow specialty food distributor Hain Celestial Group (NASDAQ: HAIN) and its EV/EBITDA multiple of 20x or its market cap of 40x earnings and conclude that United is the ‘cheaper’ stock.

Another company which United can be compared with is GNC Holdings (NYSE: GNC) which is a retailer of health and wellness products such as vitamins and minerals. It trades on 20x earnings which, in turn, looks cheap compared to United but investors need to bear in mind that it is a small retailer whose prospects can be seriously affected by a large retailer like Wal-Mart, CVS or Walgreens muscling in on market share.

United’s Evaluation?

The truth is that none of these stocks are cheap and nor are they devoid of risk. The market didn’t like the fall in gross margins in the last United earnings report. Moreover, the company has to spend more on capital expenditures in order to service new contracts and growth. Its cash flow generation remains slight.

In other words investors are faced with margin narrowing -albeit fast growing- business that is having to invest and give good working capital terms to its customers in order to keep growth going. I’m not sure this is the best business model out there but it doesn’t matter, the story is good.

And as long as the story stays that way then the market might be willing to forget about evaluations. That’s just the way it is folks.