Mar 23 2020 - United Natural Foods: Proof That Markets Are Not Rational Or Efficient

Summary

As noted in a previous article, prior to the coronavirus, UNFI was already incredibly undervalued.

The coronavirus will result in a massive and sustainable increase to UNFI's bottom line.

Unfortunately, many Americans will be financially harmed, and the demand for groceries will not end anytime soon.

Despite doubling off recent all-time lows, the stock market is not even close to pricing in the full benefit to UNFI despite its confusing fascination with stocks like Blue Apron.

UNFI's historically low margins may skyrocket due to increased sales to customers that are not Whole Foods, lower gas prices, and the potential for massive food inflation.

Approximately one year ago, I highlighted the amazing opportunity that United Natural Foods presented in a very detailed article that can be found here. I highly recommend reading that article to get completely up to speed on the entire rationale for investing in United Natural Foods (UNFI) as I do not intend to re-introduce the investment now. Rather, I will focus on the remarkable opportunity that should not still exist as of this writing on Saturday, March 21st.

Over the past year, some people have wondered why I have not provided an update on this investment. The reason is simple. I am a Registered Investment Advisor, and I invest all of my clients into the exact same portfolio of stocks. Typically, these holdings are concentrated in less than ten names.

Those believing that I have not commented because the investment has, for the most part, fallen significantly over the last year are actually 100% accurate. However, not for the reason they insinuated. It is not that I was afraid to defend my position, it is that my fiduciary duty is and always will be to my clients first and foremost. I have used the last year to add to UNFI as it has fallen in price, and there is now zero chance that I will have the opportunity to add further due to the recent and most likely continued appreciation in share price.

On that note, let's dig into what may be one of the best investments in 2020 (even though you are unlikely to find it on the numerous lists published on major financial websites highlighting the top stocks to buy during the crisis).

Demand For Food

The current demand for food is extraordinary. In a recent interview on March 17th, UNFI's CEO remarked:

... the volume that we're doing, certainly over the last couple of weeks is considerably greater than the volume that we did in our busiest week last year which was the week prior to Thanksgiving.

In other words, the first week and the second week of March each had volume that "considerably" exceeded the best week in all of 2019. What does "considerable" mean? During the company's recent earnings call, the CEO stated:

In the case of COVID-19, we did not have that luxury. And so when you look at year-over-year growth, over the last two weeks, we've - our business is up double digits versus prior year. That's a big number. Whether that continues or not, I can't even begin to tell you. Are we going to see more and more people leaving the restaurants and eating at home? That's possible. Are consumers loading their pantries? That's possible. I think we're seeing the double-digit growth because customers trust the products that we sell, USDA Organic, [free from] [ph], and that's why we're seeing significant increase in demand.

The earnings call was on the morning of March 11th which means that UNFI was already experiencing increased grocery sales in February.

Furthermore, during the earnings call, UNFI told the market that guidance did not yet include any benefit from the coronavirus. The CEO further stated:

But obviously it's very early. And so we certainly are uncomfortable making any predictions as to what this does to UNFI for the rest of the year, given the fact that right now, our primary focus is safety, security of the teams, security of the customers, making sure that our distribution centers are operating in a very, very clean and careful and disciplined way and, obviously making sure we get the product out into the retailer. So that's our primary focus right now.

That night, the NBA announced the season was being suspended and Americans suddenly started to slowly come to the realization that the situation was much more serious than they had imagined. Despite the obvious benefit to UNFI, the next day on March 12th, the stock fell 20% and closed at .43.

Over that weekend, we all started to see firsthand the enormous demand that grocery stores and pharmacies would have. Weeks later, that demand has only grown. While the first stage consisted of panic buying of sanitary items and canned foods, the second stage now consists of consistent and durable demand for meat, fruits, vegetables, and literally every single grocery store category.

The Wall Street Disconnect

Ironically, Wall Street has highlighted many stay-at-home stocks from telemedicine, video games, movie streaming, technology, meal kit services, as well as actual grocery stores and several stocks that sell items in grocery stores.

I have not seen United Natural Foods highlighted in a single article which is beyond comprehension and highlights a lack of effort in the financial community.

The irony is that United Natural Foods is behind many of these stocks being recommended. UNFI can literally supply the entire needs of a grocery store. They even have a contract with pharmacies such as Rite Aid (RAD) to supply healthy, organic groceries such as their Wild Harvest brand. In the past, UNFI typically provided only healthy, organic foods and Whole Foods was the primary customer. However, with the acquisition of SuperValu, UNFI is now the largest publicly traded food distributor in America. They still supply healthy, organic foods, but they also supply paper towels, toilet paper, proteins and meats, non-organic fruits and vegetables, and nearly everything you see at a grocery store.

Blue Apron (APRN) skyrocketed from around per share to over at one point. It is still trading over per share as I write this article. Even here, perhaps the market is unaware, but Blue Apron sources almost all of its products from United Natural Foods! While Blue Apron will certainly see a temporary increase in demand, I'm not sure the market has looked ahead to stage three in food demand: Recession. Blue Apron is expensive and while the company may benefit from a temporary boost, that demand will fade fast once unemployment jumps, which brings us to the heart of this article.

The Benefit To UNFI Is Not Temporary

Unlike the multitude of stocks being recommended as investments during our confinement to our homes, the benefit to United Natural Foods will not be temporary for a variety of reasons:

1) More and more states will completely shut down, and the only place people will be guaranteed to be able to spend their money are pharmacies such as Rite Aid and grocery stores (which are supplied by UNFI). Companies like GNC (GNC) and GameStop (GME) are also likely to see a material bump in sales as consumers stock up on vitamins that support their immune system and video games to keep the kids and themselves entertained.

2) Once the shutdowns end, the coronavirus stigma will remain. Some (perhaps many or most) people will continue to be fearful of going out to restaurants and events. They will continue to eat at home. In China, over 95% of restaurants are now open; however, traffic has been very low.

3) While it may not be technical (two quarters of negative growth). We are in a recession. Even those people that may not be fearful of going out, may be fearful of spending extra money at restaurants and events as they are uncertain about the future of their jobs (or they may already be unemployed). Even the stimulus that is likely to come soon in the form of checks, will likely be saved or used at grocery stores and pharmacies.

4) UNFI margins should expand as demand increases across all customer channels instead of just at Whole Foods which is a lower-margin customer.

5) Margins increase materially when trucks are able to make larger drops at fewer stops. While panic buying of a few items (toilet paper, paper towel, sanitizer) may have caused inefficient deliveries to meet customer demands in the early weeks that is almost certainly no longer the case. UNFI is undoubtedly shipping completely full trucks of products across the country as grocery stores require products across all categories. This will result in a material increase to margins.

6) According to AAA, diesel gasoline averaged .017 last year and the current average is .685. A sustained decline in diesel fuel will result in increased margins. In the latest quarterly report it was stated, "As of August 3, 2019, the Company had no outstanding fuel supply agreements and derivative agreements. As of February 1, 2020, the fair value of the Company’s fuel supply agreements and derivatives were immaterial."

7) United Natural Foods will win new customers that will allow them to further cross-sell. With about 60 distribution centers, no one else can match UNFI's scale. It's possible that smaller competitors such as Spartanash (SPTN) will run out of product or be unable to source product in an efficient manner angering customers and permanently forcing them to UNFI.

8) The failure to sell Shoppers and Cubs grocery stores in a timely fashion has now resulted in an incredible situation where UNFI will benefit on both the distribution side as well as the retail side. Earnings from discontinued operations will skyrocket and the value of the operations of those stores may now be multiples higher than they would have been months ago since the increased demand for groceries is likely to continue for a long time.

9) The financial stability of UNFI's customers will significantly improve. A major risk to UNFI has been an erosion of its customer base due to grocery store closures. In fact, three customer bankruptcies last quarter resulted in a .1 million reduction in Adjusted EBITDA (although it's possible UNFI gets some of this back through bankruptcy courts). Without the bankruptcies, UNFI would have had Adjusted EBITDA of 4.1 million (35% above Bloomberg consensus estimates of 1.7 million).

10) Food inflation will skyrocket as highlighted next.

Food Inflation

The impact of food inflation requires a section by itself.

In my previous article, I highlighted how the most important macro trend may be that food inflation is finally starting to tick up again. At the time, food inflation was around 1% compared to historically being around 1.9%.

How does inflation help UNFI? Customer contracts are generally at cost plus a percentage mark-up. When a supplier takes a price advance, it opens up a short period of time where UNFI can perform a forward buy and purchase the product at the old price before the new price takes effect. While this temporarily increases UNFI's inventory levels, it provides a great payback with little risk since the UNFI customer is paying the cost at the marked-up level. The increased capacity acquired with the SuperValu acquisition will allow UNFI to make even more meaningful forward buys.

What impact might the coronavirus have on food inflation? Perhaps we can look to China. A March 10th WSJ article highlighted the following in regards to China:

Food prices in February surged 21.9% from a year earlier, outpacing January’s 20.6% gain and hitting the highest level since April 2008, when food prices jumped 22.1%, according to data service provider Wind.

This morning U.S. News via Reuters also highlighted the potential for inflation:

Lockdowns and panic food buying due to the coronavirus pandemic could ignite world food inflation even though there are ample supplies of staple grains and oilseeds in key exporting nations, a senior economist at FAO and agricultural analysts said.

The global benchmark Chicago wheat futures rose more than 6% this week, the biggest weekly gain in nine months, while rice prices in Thailand, the world's 2nd largest exporter of the grain, have climbed to the highest since August 2013.

"All you need is panic buying from big importers such as millers or governments to create a crisis," said Abdolreza Abbassian, chief economist at the United Nations' Food and Agriculture Organization (FAO).

"It is not a supply issue, but it is a behavioral change over food security," he told Reuters by phone from Rome, the FAO headquarters. "What if bulk buyers think they can't get wheat or rice shipments in May or June? That is what could lead to a global food supply crisis."

Amazon

A significant reason for the discount that UNFI has traded at over the last year has been constant attacks by uninformed analysts with little thought or fact to back up their conclusions. For example, as highlighted here, last December Arun Sundaram from CFRA spooked the market with a note that UNFI could permanently lose the Whole Foods contract which resulted in a 26% decline in shares.

Prior to this, analysts also warned that while Amazon (AMZN) may not end the contract, they may simply order at the minimum allowed quantities and pare the business back over time. However, since the Amazon acquisition of Whole Foods, the business has grown faster than ever. In fact, last quarter's YoY growth was 10% or 0 million. The following is from the 10-Q.

The increase in net sales to Whole Foods Market is primarily due to growth in new product categories, and increased sales to existing and new stores. Net sales within our supernatural channel do not include net sales to Amazon.com, Inc. in either the current period or the prior period, as these net sales are reported in our other channel.

Additionally, during the first 26 weeks of the current fiscal year, the "Other" category has grown from 8 million to 9 million. "Other" includes military business, international customers outside of Canada, e-commerce, food service, and sales to Amazon.com.

During the last quarter earnings call, the CEO stated,

Lastly, our other channel saw a decrease of 6.3%, which was driven predominantly by our strategic decision to exit a portion of our military business over the past 12 months. Last year, Sean spoke about rationalizing business where the economics just didn't make sense for UNFI, and this is one example where our profitability has increased as a result of consciously eliminating unprofitable volume. Partially offsetting the military sales decline was growth from several non-traditional customers and revenue streams that continue to expand.

What does Arun Sundaram believe fueled the 27% (1 million) increase in the Other category during the first 26 weeks of this fiscal year? We certainly know it wasn't the military segment that seemed to disproportionately impact Q2 vs. Q1. We don't know how much military revenue is in the Q2 Other figure. However, we do know that military was not included in Other during Q1. In Q1, the Other segment grew 7 million from 4 million to 1 million, an increase of over 56%.

Do we think that growth is coming from international customers outside of Canada, e-commerce, food service, or sales to Amazon.com?

It is clear and obvious that Amazon has significantly increased not only the Whole Foods business with UNFI, but they have also significantly increased the Amazon.com business. Does that sound like a partner that is looking to terminate the relationship?

Perhaps we can look to approximately minute 17 of the 2020 ICR Conference that occurred on January 14th:

We've had a long relationship with Whole Foods and it is one that is highly transparent. You know, if you look at where the Whole Foods stores are compared to where the UNFI DCs are... that wasn't an accident. So, we're really close to where the Whole Foods locations are. We run a highly efficient model. The other interesting thing about Whole Foods is the majority of the products are relatively slow moving. We utilize the UNFI network to get those slow moving products distributed throughout the country in a really efficient way.

The next thing is that we're about 60% larger in the Whole Foods relationship, so Whole Foods gets the benefit of the fact that we're materially larger than their ability to run their own supply chain network. So, even if they did want to be captive, they would have a much higher input cost than they do today. Very transparent. They share in the gains and all the costs that we provide them, because of our scale. Looking back over time... Since the Amazon acquisition, our business has expanded at a much greater rate than it has in the past, and that is primarily because more and more categories and more and more SKUs have come into the UNFI distribution network. That will continue. Today we sell every Amazon fulfillment center, we sell every Amazon Fresh, wherever Amazon has a need for food they rely on UNFI to some degree in order to get it there. That is for natural, organic, and conventional.

We would typically look to start renegotiating the Whole Foods contract about four to five years before the expiration which puts us into the 2020/2021 time-frame. We have every reason to believe that we will successfully negotiate either an addendum or a new contract with Whole Foods when the time is right. As far as the savings, we're at a point with Whole Foods where I don't anticipate that there will be material basis point reductions. We're now at the point in the relationship where we share in the efficiencies that get driven through the program. Which is why we renegotiate every five years. It's not a renegotiation of the price, it's a renegotiation of the changes that have taken place in the market, the logistics.

Lastly, I previously mentioned that UNFI has about 60 distribution centers. Amazon has about 75 fulfillment centers and during the last week they had to announce that they are suspending shipments of all nonessential products to its warehouses in order to prioritize medical supplies, household staples, and other high-demand products until April 5th.

United Natural Foods' gross profit in the last quarter was 12.63% with an EBITDA margin of 2.67%. Arun Sundaram believes that Amazon, who clearly would not be able to service the demand with their current fulfillment centers, is going to build-out another 40 or more distribution centers, an up-front cost of billions, in a business that would have an ROI of about 3%? This is the most absurd analysis and it makes absolutely no sense for Amazon to terminate the UNFI relationship. It is already the most efficient and cost-effective method available to Amazon.

The market should stop discounting UNFI out of fear that the Amazon contract will terminate. It's not going to terminate.

Interest

Since the acquisition of SuperValu, UNFI has consistently worked to reduce its interest expense by deleveraging its debt and locking in lower interest rates. Currently, about 72% of UNFI's debt has been fixed via derivatives. Given the current environment, it is likely that UNFI will now be able to lower their interest costs even further. The following chart shows the sequential progress they have made:

 

Q2, 2019

Q3 ,2019 Q4, 2019 Q1, 2020 Q2, 2020
Interest Charge .707M .917M .814M .518M .621M

Furthermore, UNFI anticipates 0 million from the Cub sale leaseback and the sale of the Tacoma DC within the next six months. Management expected to reduce net debt during the year by up to 10%, and I suspect that they will now be able to reduce debt significantly more than expected. As UNFI deleverages their interest payments will be reduced significantly and the market will place a higher and higher multiple on the business.

After the purchase of SuperValu, UNFI was also stuck with a lot of dark properties where they were left paying the lease on empty buildings. During the last quarter, management stated that they are approximately 95% through these leases.

Conclusion

In conclusion, the market is significantly discounting both the increase and the duration of the increase in sales that UNFI will achieve as well as the potential margin expansion and potential to delever faster than expected.

Estimates for UNFI's third quarter were around 0 million in adjusted EBITDA. Sales in Q3 of 2019 were .96 billion. At the current rate, it's very possible that UNFI is able to increase sales by 20% over the quarter to .15 billion. On one hand, although increased demand started in February, it didn't accelerate until March. On the other hand, several conversations with various local grocers in Wisconsin have indicated that daily grocery demand has increased over 50% in some cases. Furthermore, they expect daily demand to easily exceed 20% for the next several months.

From an EBITDA margin perspective, excluding the bankruptcies that impacted the second quarter, UNFI was able to increase its EBITDA margin by about 35 basis points YoY primarily due to cheaper fuel. A similar improvement this quarter, YoY, would put their EBITDA margin at 3.17%. UNFI will have increased labor costs, but those should be more than offset by trucks having to make less stops as well as a significant increase in sales to customers that are not Whole Foods. Additionally, the higher sales go, the less impact that fixed costs have. Would it be that outrageous to expect the EBITDA margin to increase to 4%? I don't think it is, especially if we consider that Cubs represents about 25% of adjusted EBITDA. Is anyone expecting to receive mailings with free coupons any time soon? Margins at Cubs should explode.

The result would be Q3 adjusted EBITDA of 6 million. Nearly 100% higher than analyst estimates.

This will allow UNFI to significantly delever the company, pay significantly less in interest, and completely reshape its Debt-to-EBITDA ratio. The market will be forced to revalue the stock at a much higher multiple on much higher earnings. With short-sellers comprising nearly 25% of the float, the potential upside in UNFI shares are extraordinary. If APRN can go from to on speculation, UNFI can certainly top on concrete data. Perhaps by June.

Disclosure: I am/we are long UNFI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: UNFI is currently the largest position in the DOMO Concentrated All Cap Value Composite. More information on the composite can be found at our website. DOMO Capital Management, LLC ("DOMO") is a Wisconsin-registered investment adviser. Justin R. Dopierala is the President and Founder, and a registered investment adviser representative, of DOMO. Additional information about DOMO is disclosed in our Form ADV, which is available upon request. All information contained herein is for general informational purposes only and does not constitute a solicitation or an offer to provide investment advisory services in any jurisdiction. The investment strategy discussed herein may not be suitable for everyone. Investors need to review an investment strategy for their own particular situation before making any investment decision. We believe the information obtained from any third-party resources to be reliable, but we do not guarantee its accuracy, timeliness or completeness. The opinions, estimates, projections, comments on financial market trends and other information contained herein constitute our judgment and are as of the date of the material, are subject to change without notice at any time in reaction to shifting market conditions and other factors and should not be construed as personalized investment advice. DOMO has no obligation to provide any updates or changes to such information.

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