Founded in the mid-1950s as a door-to-door nutritional education provider in Golden, Colorado, Natural Grocers by Vitamin Cottage (NGVC) is a newly-public chain of natural, organic-focused grocery and dietary supplement stores that span the midwest, mountain, and southwest U.S. The Company went public in late July 2012 at $15/share and subsequently shares have oscillated between $17-24. Below are the key, summary-level rationale and analyses for why I believe shares of the company are attractively valued today, based on a long-term (meaning 1-2 year horizon) value creation hypothesis that centers around strong secular healthy eating trends, consumer focus on value-for-money, large market opportunity, and competent management team. If this writeup piques your interest, I suggest you peruse the recently-issued 10K for FY2012 as well as the prospectus from July 2012.
Surging Natural Foods Industry
The natural foods segment is growing rapidly and continues to take share from conventional supermarkets: the overall U.S. grocery market is ~$590 billion in size and is essentially growing at low-single digit rates, in contrast to the natural foods market which is expanding at high-single digit to low-double digit rates. Whole Foods (WFM) (~340 stores) is the largest dedicated natural foods player by a long shot and its revenues are ~$13 billion, <2.5% of the total market. Natural foods retailers other than WFM tend to be small, fragmented, and regionally-focused. Several of the larger and growing chains behind WFM include Sprouts Farmers Markets (150 stores), Fresh Market (TFM, 115 stores), and locally-rooted co-operative grocery stores (collectively <150 nationwide). While conventional supermarkets often carry a selection of natural and organic foods, dedicated natural foods stores comprise well <10% of the overall market, and are growing at far faster rates than conventional. During the past five years, the natural foods industry has successfully crossed over into the mainstream due to enhanced nutrition education, obesity awareness, and the aging population. Case in point, compare the organic (unintentional pun) growth rates of natural food companies such as The Hain Celestial Group (HAIN), United Natural Foods (UNFI), WFM, Annie's (BNNY), and NGVC to even the best-performing conventional food retailers (e.g. Publix (OTCQB:PUSH), Kroger (KR), Harris Teeter Supermarkets (HTSI)). The outperformance of dedicated natural foods stores has been and continues to be impressive.
Limited threat from conventional supermarkets
The grocery shopper population tends to be quite bifurcated between those who patronize conventional supermarkets and those who shop natural foods. While conventional supermarket shoppers might float between supermarket, warehouse club, and mass merchandiser channels, natural foods shoppers, once converted from conventional, tend to focus the bulk of their food shopping within dedicated natural foods stores, due to these stores' singular focus on organic and health-oriented foods. A good example of these shopping habits can be seen in the evolution of the WFM shopper over time; initially shoppers came to WFM primarily to shop the peripheral areas (meat, fish, bakery), but as WFM lowered prices and expanded stores, the retailer captured a larger share of wallet among these shoppers over time. An interesting but not statistically-confirmed hypothesis is that health-focused shoppers have a strong desire to shop at stores that make them feel healthy - therefore a supermarket that offers healthy options among more conventional products (e.g. Pepsi and Coke products, foods containing artificial ingredients) would not be as desirable of a shopping destination as a dedicated natural foods store in the shopper psychology.
WFM: More friend than foe
Though both WFM and NGVC carry a similar selection of products (natural and organic grocery, health & beauty, and produce), NGVC strives to adopt a lower-cost, less-frills approach to merchandising vs. WFM. While there is likely significant overlap between customer sets in certain metro areas where both are present, NGVC shoppers generally fit the profile of being more scratch cooks and more "hard core" about healthy and sustainable eating habits than the average WFM shopper. NGVC also tends to select locations in smaller markets utilizing a smaller store footprint, generally a strategy that does not fit the WFM store model (larger, splashier stores with a highlight on peripheral departments and prepared foods). Most importantly, WFM and NGVC can and do coexist happily. Some of the highest volume NGVC stores are located near WFM stores (e.g. Boulder, CO). In contrast to WFM's perception as a high-end retailer, NGVC prides itself on EDLP pricing while carrying many of the same products and brands as WFM, typically at materially lower prices. Lastly, when a WFM store comes into a new market, it generally does a great job educating the local population about the benefits of healthy food, which creates a nice halo effect to boost NGVC stores sharing the same vicinity.
Highly attractive per-unit ROIC
WFM has highly attractive per-unit ROICs as well, but those of NGVC are at least as good (and both are superior to TFM). Management recently disclosed upfront capital investment of approximately $2.3m per store, up from a historical average of $1.9m, but maintained the expectation of 35% [pre-tax] cash-on-cash returns by the fifth year following opening. Recent new store openings have been performing above historic trend.
Competent, cost and cash flow-focused management team
NGVC has maintained positive store sales growth for over 40 consecutive quarters (even WFM cannot claim this). Administrative expenses (central office) have grown around 10% on a CAGR basis from FY'09-'12, while topline sales have grown at a CAGR of 18% and store units have grown 21%. The management team (with the exception of the CFO) is entirely composed of members of the company's founding family, the Iselys. It is a notably insider-populated Board, with four of six seats held by the same family members of management. From the prospectus, it can be seen that the Isely Family Group had historically owned 96.3% of the Company, which was diluted to 64.0% following the sale of 20% of their stake and the issuance of new Company shares at the IPO.
Note that the lock-up agreement for IPO selling shareholders expires 180 days post-IPO, which dates to January 21, 2013.
Valuation attractive on a 1-2 year horizon
NGVC shares trade today at 39x forward P/E. While the multiple may seem high, consider that adjusted earnings grew 69% in FYE 9.30.12, and are projected to grow 45-50% in FYE 9.30.13, leading to a 1-yr forward P/E/G of 0.8x. Driving this rapid growth are:
- Strongly positive comp store sales trend of 11.6% in FY'12 (Q4 FY'12 was 13.0%),
- Self-funded store unit growth of 20% annually over the next 3-5 years, and
- Improving margins based on occupancy and central expense leverage.
Store count ended at 60 at end of FY'12 with the potential to grow to 180 stores in NGVC's existing markets, and a larger potential market of 1,100 stores nationally. Importantly, while the company may be aggressive about growth (store unit growth >20% per year), management is fiscally conservative and has guided to margin expansion driven by benefits from prior investments in fixed overhead and IT ("we anticipate these investments will support our long-term growth strategy with only a modest amount of additional capital"). In FY'12 alone adjusted EBITDA margin expanded 132 bps to 7.0% of sales. Importantly, NGVC can fund all future expansion using internally generated cash flows.
In short, NGVC's runway for growth is vast and taps into a strong trend among food shoppers nationwide to shift from conventional supermarkets to natural foods-focused grocery stores.
I am modeling sustained 20% store unit growth through 2017 (per management guidance) and high-single digit comps throughout this period (note natural foods stores tend to comp strongly in double digits over the first three years post-opening, and generally stabilize around 5% comps for a mature store >5 years old), driving sustained 20%+ revenue growth and 35%+ adjusted net income growth for the period from 2012-15. Notably, in FQ4 of 2012, NGVC's mature same-store sales (>5 years old) performed at 7.6% in the last reported quarter, evidencing the strong, sustained demand growth in natural foods in even the most mature markets. The combined effect of aggressive new store openings and continued strong comps for new and mature stores should elevate reported aggregate comp store sales trends on a sustained basis. Taking a target of 35x multiple to 2014E EPS (0.8x trailing P/E/G, 0.9x forward P/E/G) of $0.64 yields a price target of $22.50, upside of 21% from the share price at Monday's close price of $18.64. While the multiple used for the price target is meaningfully above that of WFM (trading at 24x equivalent 2014E EPS), NGVC is growing earnings and square footage over twice as fast as WFM during this forward period.
Given the strong cash flow characteristics and sustained compounded growth of NGVC as it builds new stores, NGVC should be viewed as a highly attractive, long-term GARP-style holding at today's valuation.