Oct 2 2020 - United Natural Foods: The Mysterious Collapse

Summary

UNFI reported FQ4 results much better than expected, while providing strong FY21 guidance, but the stock collapsed.

Expected FY21 EPS of .05-3.55 and debt reduction of 0MM imply P/E ratio of under 5x and FCF of over per share for FCF yield of over 30%.

I explore the potential reasons for the UNFI stock's declines in the last few days and why the shares are significantly undervalued.

A couple of days ago, United Natural Foods, Inc. (UNFI) announced the Q4FY20 results, which were much better than consensus estimates at adjusted EPS of .06 vs .72 and provided forward guidance that also was much better than consensus. In particular, they guided to FY21 adjusted EPS of .05-3.55, debt reduction of over 0MM, adjusted EBITDA growth to 0-730MM and ending the year at 3.4x leverage ratio, down from 4x current and down from 5.4x just a year ago. The stock reacted, going down after hours and for two days straight as of the time of this writing. Is the decline warranted?

wrote about UNFI in the past and how undervalued it was. With the FY21 guidance only reinforcing that notion, let’s take a look at the potential drivers of the stock’s performance in the last couple of days to see if there is merit to them.

CEO Transition

On 9/28, prior to announcing the results, an 8-K was posted announcing that Steven Spinner, UNFI’s CEO, was going to retire within the FY21, while continuing to serve as UNFI’s Executive Chairman after his retirement. I don’t see this development as concerning. While it adds uncertainty, at least the retirement was announced on a high note and Steven will continue to serve as the Executive Chairman.

Q4FY20 Top Line Deceleration

Even adjusted for one fewer week in Q4FY20, the top line growth in the distribution business was lower than what industry, as a whole, experienced and the Supernatural channel (Whole Foods) experienced a comparable growth of only 3.6% in Q4. The overall comparable growth of 8% in Q4 was lower than 11% in Q3 and no color was provided on the conference call into the Q1FY21 to date. However, it was noted that the QTD top line growth “wasn’t materially different” from Q4.

Furthermore, the lower growth in Supernatural channel can be partly explained by consumers replacing organic/natural foods with conventional, at a lower price. How do I know this? I shop at Whole Foods and have been buying more conventional foods, partly because of lack of availability of usual organic options, and partly because pesticides concern me a little less now, with COVID and bigger issues. And in this economic climate, “the whole paycheck”, as Whole Foods is sometimes called, doesn’t go as far as it used to. Also, some of the Whole Foods locations were looted and damaged during riots, during the quarter. Some affected locations include Grove in Los Angeles, Dallas, Brooklyn, downtown Indianapolis, etc. Additionally, the company stated that some of the decline in Supernatural channel is due to sales growth that is

...partially offset by the impact of categories that have been adversely impacted by COVID such as bulk and ingredients used for prepared foods

Source: FY20 Form 10-K

Finally,

We expect our year-over-year sales to this customer [Whole Foods] to improve as we move through fiscal 2021.

Source: Chris Testa, UNFI President, Q4FY20 Conference Call

Some of the similar dynamic might be playing out within UNFI’s other channels. Consumers in some cases are likely switching to conventional from organic or buying private label, with latter reducing the sales but increasing the gross margin.

And on the declines in the "Other" channel:

The remaining decrease of million is primarily due to a 23% (or 4 million) decline in sales to foodservice customers, whose purchases slowed due to the COVID-19 pandemic based on their locations being temporarily closed. We expect sales to our foodservice customers in the first half of fiscal 2021 to decrease as compared to fiscal 2020 as a result of the COVID-19 pandemic.

Source: FY20 Form 10-K

What Happens Post-COVID

On the conference call, when asked about post-COVID, while the responses included lower interest expenses, what was not mentioned was COVID-related expenses (MM in Q4FY20) will go away. The company assumes no vaccine until at least summer of 2021 and even then, it is likely food from home will be more pronounced than food away from home. Some sell-side analysts disagree. But this isn’t new information and would not explain the latest sell-off.

If we think about what will happen once the COVID is behind us, some of the food at home will be replaced by food people eat at restaurants, at work or school, which will reduce UNFI's top line. But then there will be improvements for UNFI in the following areas:

  • Lower interest expense due to debt reduction
  • Elimination of COVID-related expenses
  • Increase in foodservice sales
  • Increase in bulk and ingredients for prepared food, e.g. in Whole Foods
  • Improvement in fill rates, reduction in costs of moving the product around to keep the service levels high
  • Increase in promotional activity
  • Increase in consumption of natural/organic vs conventional, which increases the top line

Additional Positive Developments

The original integration synergies of 5MM that were supposed to have been achieved in full a couple of years from now have already been achieved and exceeded. From the 10-K:

We exceeded our original longer term cost synergy expectations, which called for a minimum of 5 million in savings related to the Supervalu acquisition, and believe we have further cost saving opportunities that we plan to pursue in fiscal 2021 and beyond

The Depreciation and Amortization charge is lower than CapEx, even though CapEx includes expenses of automation, which has a greater than 20% rate of return (slide 77). From the 10-K:

The Ridgefield distribution center will deploy a warehouse automation solution that supports our slow-moving SKU portfolio

Below is where the CapEx went in the former years.

49793840-1601526414541493.png

Issues with Sell-Side Models

As I was reviewing sell-side models, I noticed that when modeling the share price, some of them (e.g. BMO and R5) appear to use assumptions of a specific EV/EBITDA ratio, whereby they use the projected EBITDA in FY22, but their EV does not take into account the debt reduction that will have happened between now and FY22. It makes no sense to use future EBITDA but today’s EV. That way, the per share in FCF per year is completely ignored. They should either use the FY22 EV, post debt reduction (which results in roughly 0MM greater market cap and the target share price increases by about ) or DCF methodology.

Some Sell-Side Analysts Are as Perplexed as I Am

The report from R5 Capital indicates they can’t fathom the recent price action and estimate the price target of using P/E, using EV/EBITDA (using today’s EV; I argue above this is incorrect and the actual value should be closer to , but then you can argue 6.5x multiple they used is too aggressive), and using DCF. They updated their price target to from . I agree that is the lower bound of the reasonable valuation for UNFI.

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