May 18 2020 - United Natural Foods: More Gains Ahead

Since my last article 7 months ago UNFI share price tripled, but we are far from done.

COVID-19 provides a durable tailwind in several ways.

Reported earnings significantly understate the true cash flow generation.

Shares should at least double from here and potentially reach 0 within a couple of years.

Last week United Natural Foods, Inc. (UNFI) preannounced Q3FY20 results, whereby within that one quarter they exceeded the adjusted EPS for the entire year and achieved their annual target of debt reduction in only one quarter, all without selling assets. The shares reacted and sell-side analysts belatedly raised their target prices. Ironically, Kelly Bania from BMO raised her price target from to , after the shares spiked to over and since retreated. As I detail below, UNFI is worth at least a share and potentially as much as 0.

When I wrote my previous article about UNFI, it traded at and sell-side analysts had a very grim view on it. As a sampling, at the time of the FY19 earnings release, Pivotal Research analysts lowered the share price target to . In my previous article, you can read more about my rationale for claiming, at that time, that the price of -70 per share was warranted in a couple of years.

I am now increasing my price target range to -100 for two reasons: COVID-19 and more clarity on company's financials. But first, a little history.

SUPERVALU Acquisition

UNFI specialized primarily in organic and natural grocery delivery with Whole Foods/Amazon being a large customer. They acquired SUPERVALU to expand into conventional grocery, increase scale, realize synergies and, likely, diversify away from reliance on Whole Foods. However, rarely, if ever, mergers of this scale work exactly as planned.

For a while it seemed that SUPERVALU acquisition could have been an expensive mistake. There have been delays, extra expenses and customer service issues. Margins were lower on SUPERVALU side, there were "dark" leases inherited from SUPERVALU, as well as grocery store chains that UNFI needed to get rid of but was having trouble with.

Nonetheless, the company realized almost twice of their m expected synergies for FY19.

For the full year, we overperformed relative to our synergy target and realized an estimated million in cost savings.

Source: UNFI Conference Call

It appeared the process of optimizing the combined company, selling surplus real estate, divestiture of retail banners and slowly repaying debt would take years.

Prior FY20 Guidance

Seven months ago, the company guided to FY20 adjusted EPS of .22-1.76. This even included income of Cub grocery chain that at the time was likely to have been divested during the year and did not include expenses related to disposition.

Source: UNFI Form 8-K

But note that the "adjusted" EPS was based on expected GAAP EPS with expenses of restructuring, acquisition and integration added back in. This is important, even though the guidance for the year was suspended due to COVID-19, and we will go into this detail later.

Furthermore, while at the time, some analysts got hung up on inclusion of income from Cubs into FY20 guidance, if we look at the contribution thereof into GAAP EPS, it was not large. The exact number was difficult to estimate at the time, but one thing to note was stranded costs of discontinued operations include operating lease rent expense that was almost half of GAAP income of discontinued operations: .2MM for the year vs. .8MM income. And in the Q3FY20 preannouncement, as a footnote, we finally got the amount of those stranded costs. It was MM for the quarter, or MM annualized. Pretty close to MM I estimated last year.

COVID-19

Due to COVID-19, starting in late February and ongoing, the demand for groceries, cleaning supplies and the like increased. People are and will be eating less in restaurants and cafeterias (work or school) and more at home. In addition, recession will likely last for a while, also contributing to people eating more at home.

After initial spike due to stocking up on essentials, cleaning supplies and loading up the pantries, the steady-state demand is up. For example, grocery spending was up 27% YoY in the week ended May 3rd. Meanwhile, online grocery sales growth is projected at 40% YoY.

UNFI has a foothold in both. Specifically, Whole Foods, Amazon Fresh and Amazon Pantry. I now get virtually all my groceries from a combination of Whole Foods and Amazon Fresh. The spike in demand benefits UNFI, as evidenced in their Q3 preannouncement.

Benefits are a result of greater revenues and therefore greater gross profit, combined with fixed costs of CapEx/depreciation and debt service. Even with additional costs of COVID-19, such as greater expenses for extra disinfection, salary increases, etc., the positive impact to the bottom line is profound.

Let us also not forget about lower fuel costs and higher food inflation, which increased 2.6% in one month, or 4.1% for 12 months so far, for "food at home" category. More benefits to UNFI.

Even When Reopen, Restaurant Traffic is Low

In states where restaurants reopened (for now) the restaurant traffic is very low. Take a look at the image below:

Source: Mishtalk, data from OpenTable

You can also see from the image above that restaurant traffic really declined in those states in the second half of March, meaning in those states UNFI didn't benefit from extra grocery consumption for the first half of the Q3.

Benefits of Not Divesting Retail

While UNFI planned to divest remaining retail banners, both Shoppers and Cub divestitures are now stalled and it is good news since, with grocery demand spiking, they contribute more to the bottom line now.

CARES Act

UNFI will benefit from the CARES act via increased deductibility of interest expenses, potential for tax loss carrybacks to prior years (at a higher, 35% tax rate) and faster depreciation of improvements. The exact amount is hard to estimate, but it will be just icing on the cake. The cake is described below.

Q3 Preannouncement

There were 4 items I was looking for in the preannouncement:

1. The benefit of increased demand to the net earnings for both continued and discontinued (retail) operations
2. Stranded costs of discontinued operations in continued operations
3. Total adjusted EBITDA
4. Debt repayment

All three were very positive. Let me elaborate.

Source: Form 8-K

While sales went up 12%, GAAP EPS spiked 43% to .60. This is a little misleading since there was an implied benefit of the CARES act that needed to be accounted for in the quarter it was passed. But adjusted EPS, which includes one-time items, exploded 130% to .40.

Stranded costs were MM per quarter, or MM annualized, which is even greater than MM I assumed in my previous article. This means continued operations are more profitable than what is implied by the numbers.

Source: Form 8-K

Adjusted EBITDA increased nicely, in both continued and discontinued operations. Remember that MM needs to be moved from discontinued to continued operations due to stranded cost accounting:

Source: Form 8-K

Another item to note was a 0MM debt repayment in Q3, matching the target for the entire year, and achieved without selling property, but rather from working capital adjustments. As a reminder, debt reduction decreases interest expense.

Net Income and EPS

The adjusted .40 EPS in Q3 included only a partial benefit of COVID-19-elevated demand since the quarter started in February and the spike in demand came at least a month later. On the other hand, it also included only a partial expense increase due to higher wages, etc. Including some benefit for additional merger synergies, benefits of lower fuel cost and higher food inflation we can assume another .20 a quarter, for .60 adjusted quarterly EPS. Let's add just .20 a year for interest expense reduction due to repayment of debt. We get adjusted annual EPS of .60 or 3MM in adjusted net profit.

The GAAP profit would be .88 less due to restructuring and integration-related expenses, as we saw from the prior FY20 guidance, or .72. GAAP net income would be 6MM. But it gets better.

Cash Flows

While the expected GAAP EPS and net income are already impressive, it is actual free cash flow that matters most. It is especially true for UNFI, since they need to reduce debt and move from around 5x leverage to the target they have of under 3x. The free cash flow, or FCF, is significantly greater than net income for the following reasons.

The company made a 338g tax election, which allows it to depreciate acquired SUPERVALU assets accounting them at a high tax base, resulting in high depreciation non-cash charges, much greater than ongoing CapEx. Depreciation appears to be running MM less than CapEx per quarter, or 0MM annualized.

Source: Form 10-Q

At MM per quarter or 0MM a year, the difference between D&A and CapEx contributes another .24 per share in free cash flow. The end result is 6MM in annual adjusted FCF or .96 per share. Assuming the cash flow goes to debt reduction, the annual interest expense gets reduced by MM a year, improving net profit by MM and increasing EPS by .37.

Bear Case

What if there is a vaccine available in a couple of months? Not only that, what if the recession ends in a V-shaped recovery? Everyone goes back to work and starts eating at restaurants just as before. In this case, we still get at least .50 in GAAP EPS for FY21 (if we take FY20 guidance, reduce restructuring costs in comparison to FY20 and add interest expense reduction of .20-0.25 from the recent debt repayment to it). Adding .24 per share in extra FCF from the difference between D&A and CapEx we get FCF of .74 per share in FY21.

Then, in FY22, assuming restructuring charges go away and additional synergies of MM completely materialize as guided, plus interest expense reduction of .20 per share from the debt paydown in FY21, we get the EPS of and FCF of .24 per share.

In this scenario it is also likely that both Shoppers and Cub as well as surplus property are divested for 0-300MM. While the income of discontinued operation then goes away, it really was .8MM minus MM of lease expenses reported in continued operations, or only MM. Which isn't much more than interest expense savings on debt paydown from the proceeds.

Conclusion

When 7 months ago UNFI was at and I wrote that it should reach -70 in a couple years, I was told that markets cannot be wrong by 4x-10x. I still maintain that markets can be wrong by 2x-5x from the current prices.

If we value UNFI based on its EPS, if its adjusted forward EPS is .60, even at a very low P/E of 6x we get a share price of . If we instead assume a target FCF yield of 8%, which is pretty high in this low-rate environment, we get a target price of 0. Either way, the current price implies a forward P/E of 3x and FCF yield of 43%. While the current price is more in line with reality than seven months ago, it still makes no sense. I expect the markets to become more efficient vis-à-vis UNFI once the guidance for FY21 is released or perhaps sooner.

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.