Natural Grocers Boldly Going Where Others Have Gone Before

| About: Natural Grocers (NGVC)
This article is now exclusive for PRO subscribers.

If imitation is the sincerest form of flattery, Natural Grocers (NYSE:NGVC) (also known by its full name of Natural Grocers by Vitamin Cottage) is paying some big compliments to Whole Foods (WFM), The Fresh Market (NASDAQ:TFM), Trader Joe's and Sprouts. The company is pursuing a growth strategy in the organic/natural food retailing sector that seems to be taking some of the best ideas of these larger chains and coupling them with an even tighter focus on the hard-core healthy eating community. While these shares have had a big run in 2013 and sport pretty robust valuation multiples, it may be hasty to assume that the stock is overpriced today on a long-term basis.

When Whole Foods Isn't Healthy, Or Close, Enough

It may be tempting to look at Natural Grocers and say "here's another Whole Foods wannabe," but I think that misses the point.

Natural Grocers is quite a bit more like an organic grocery co-op, and the company is intensely focused on its product standards. While Whole Foods has bowed to economic reality by selling non-organic produce, Natural Grocers sells only 100% organic produce and proteins. New products require a senior-level management review, and products are not cleared if they contain artificial colors, sweeteners or hydrogenated oils. Likewise, the company does not sell alcohol, and the company takes care that its meat products are wrapped in such a way as to not offend vegans or vegetarians with stray odors.

This may sound exceedingly fussy, and I suppose it is to those who are not committed to organic/natural foods diets. Nevertheless, there is a growing segment of the market that feels as though it has been alienated by the changes Whole Foods has made as it has morphed from a specialty orientation to more of a high-end supermarket for a wider range of customer tastes.

That's not the only differences with Whole Foods, though. Natural Grocers is pursuing a small-store format with about 20% to 33% the square footage of a typical Whole Foods store. The company is also looking to be where Whole Foods isn't - targeting secondary markets that are not well-covered by its competitors.

Will A Service-Light Model Pay Off In The End?

Another interesting difference between Natural Grocers and Whole Foods (and to a lesser extent, The Fresh Market) is the lower level of in-store service offerings. What I mean by that is that Natural Grocers does not have a deli, bakery, prepared foods, or meat and seafood counter. Like Trader Joe's, Natural Grocers sells these products, but they're not produced on-premises and they come packaged/wrapped in the case or on the shelf.

In the short term, this allows Natural Grocers to operate its stores with lower staffing levels and a sleeker, smaller "box." While the average NGVC store is quite a bit smaller than the average Whole Foods, the actual differences in store space devoted to produce and groceries is not nearly so large (as a large percentage of Whole Foods square footage goes to areas like the deli, bakery, and so on).

I do wonder, though, if this comes at a long-term cost to customer acquisition and retention. I cannot be the only shopper in the U.S. who originally started shopping at Whole Foods because of its fresh seafood/meat counters and bakery, and then started slowly adding more produce and packaged groceries to the basket until it became a regular shopping destination. So I do wonder if Natural Grocers is missing out on some potential sales and/or customers from this policy.

Vitamins Are More Than Just Supplements To Growth

While I previously compared Natural Grocers to a hybrid of Whole Foods, The Fresh Market and Trader Joe's, I probably should have added Vitamin Shoppe (NYSE: VSI) and GNC (NYSE: GNC) to that mix. About 30% of a Natural Grocers' store revenue comes from vitamins and supplements, and about 40% of store SKUs (7,000 out of 18,000) are dedicated to this area.

What that means is that every Natural Grocers operates with a vitamin and supplements offering on par with the average Vitamin Shoppe or GNC. Not surprisingly, the company's assortment is a bit different - Natural Grocers is not where you'd go to get your 42-gallon drum of Super-Mega Muscle Protein Blastorama. This is a very good business to be in, though, as supplement retailing carries very attractive margins relative to regular supermarkets and specialty grocers.

Operating Margin (by year)
2012 2011 2010
Vitamin Shoppe 10.5% 9.0% 7.9%
GNC 17.6% 13.6% 11.7%
Whole Foods 6.4% 5.4% 4.9%
The Fresh Market 7.6% 7.5% 4.2%
Kroger 2.9% 1.4% 2.7%
Natural Grocers 3.6% 2.8% 4.0%

Is The Opportunity Real?

I'm sure at least a few readers are skeptical that there's really room for another retailer selling over-priced groceries to the lululemon/Coach target market. I think there is, and I think that position overlooks several points.

First, Natural Grocers isn't as expensive as investors may think. Multiple sell-side surveys have shown its products are typically about 9% to 12% cheaper than Whole Foods, and my own single-store due diligence trip showed about an 8% difference (my trip was after Whole Foods' recent decision to "invest in lower prices").

What's more, similar surveys have shown that Whole Foods isn't nearly as expensive relative to Kroger's (NYSE: KR), Wal-Mart (NYSE: WMT) and other supermarkets as commonly believed - while the particular assortment of products makes a huge difference, Whole Foods itself is often within 5% to 10% of supermarkets on a total ticket basis. Couple that with Natural Grocers' policy to target secondary markets, and the price differential isn't bad at all.

It's also worth noting that the natural/organic food industry is somewhere in the neighborhood of $90 billion to $100 billion, and still growing at a high single-digit rate. So while some will scoff at the prices of organic produce and claim that this market is not sustainable, the post-housing bubble recession certainly didn't kill it. Moreover, I'd argue that the small size of Natural Grocers (about $400 million in trailing revenue) makes that point largely moot

It's also important to note that Natural Grocers is very early in its lifecycle. The company has just 65 stores in 13 states, with almost half of those stores in Colorado. By focusing on a 10K-square foot format (about the same size as Trader Joe's), Natural Grocers spends less than $3 million per store and earns that back in about four years. By way of comparison, there are over 330 Whole Foods around the country and nearly 400 Trader Joe's.

I think it's also important to address the issue of competition. Whole Foods is indeed the 800lb gorilla of the natural/organic food space, and many retailers are adding more natural and organic products to their stores. But this isn't The Highlander, and in the end there *can* be more than one. If Natural Grocers can connect with those shoppers who are really serious about what they buy/eat, or simply appeal to a wider set of shoppers with high-quality products, competitive prices, and a pleasant shopping experience, there is no reason Natural Grocers can't compete.

Margin Leverage Will Be Important

As that earlier table showed, Natural Grocers has work to do in getting its operating margin up to snuff. The company compares fairly well to Whole Foods and The Fresh Market on sales per square foot and gross margin, but the cost of newer stores and its lack of operating scale are weighing on the operating line. With a disciplined pace of store expansion and mature stores (five years or older) still comping at nearly 6%, I do believe those margins will get meaningfully better in the years to come.

With the company targeting 20% new store growth for several years to come, and overall comps in the low double-digits, I like the company's long-term revenue growth potential. If Natural Grocers can grow at a long-term compound rate of 18% (below Whole Foods' growth from a similar starting point) and generate similar 6% free cash flow margins, fair value is about $26.

But what if this is the next Whole Foods? What if the extreme focus on organic and natural products resonates with consumers and the supplement offerings drive strong high-margin sales? If Natural Grocers follows Whole Foods' growth trajectory, the long-term revenue CAGR jumps to 25%, the forecast revenue for 2022 jumps from $1.7 billion to $3.1 billion, and the fair value jumps to $43.50 - and that's assuming the same free cash flow margin (which I think may understate things, as this should be a more capital-efficient model for the long term).

Clearly many things can go wrong. Managing growth is incredibly challenging and the company may need to look beyond the Isely family for leadership (or may choose to sacrifice growth to maintain control). Likewise, Whole Foods, Trader Joe's, Sprouts and/or The Fresh Market could simply out-compete them. And let's not forget that things could change in time - perhaps management here will face the same challenges that Whole Foods did in terms of merchandising and eventually relax its focus on 100% organic products. Likewise, maybe margin leverage will be hard to generate - the company gets more than half of its products from United Natural Foods (NASDAQ:UNFI), and UNFI has to somehow make up for the margin it loses to Whole Foods.

The Bottom Line
I just laid out my cash flow-based valuation assumptions for Natural Grocers - a target in the mid-$20s on a "reasonable" set of assumptions, and a target of over $43 for the very bullish "next Whole Foods" case. I'm not going to argue that Natural Grocers is "cheap" or low-risk, but I would also point out that the company's EV/EBITDA ratio is 24x, while the average EBITDA growth forecast for the next two years is 39% and 28%. While "EV/EBITA to growth" is not as well-researched or used as often as the PEG ratio, I think the underlying premise is at least comparable.

All in all, then, Natural Grocers is an interesting growth stock for investors looking to play the seemingly inexorable growth in organic and natural goods. There are risks aplenty here, but I think the company has a very interesting, and very distinct, merchandising and store format philosophy and I believe that investors are at least getting solid growth prospects to go with these high valuation multiples.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.