Competition And Momentum Reversal Hammer Natural Grocers

| About: Natural Grocers (NGVC)
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Weaker comps in the face of growing competition have helped spur a greater than 50% drop in the shares of this fast-growing natural/organic foods retailer.

Natural Grocers has penetrated only about 7% of its potential footprint and offers very competitive pricing, but has to prove it can compete with Whole Foods and Trader Joe's.

Expectations on the stock still factor in quite a lot of growth from the company and institutions may be slow to return to the natural/organic food space after multiple disappointments.

Owning a popular momentum stock can be a thrill ride, but if and when the company stumbles (and most growth companies do stumble at least once), the thrills turn to chills as investors stampede to the exit. Such is the case lately for Natural Grocers by Vitamin Cottage (NYSE:NGVC) ("Natural Grocers"), where the shares have lost more than half of their value in less than three months.

While the drop at Natural Grocers has certainly been accelerated by a disappointing same-store sales figure for the fiscal second quarter, this has been a lousy stretch lately for comps and peers within the natural/organic food space like Whole Foods (WFM), Sprouts (NASDAQ:SFM), and The Fresh Market (NASDAQ:TFM). I think it's much too early to say that Natural Grocers is done as a growth concept, but it may take a while for institutions to come back to the segment.

Sales Wilt In The Face Of Competition

Natural Grocers barely missed with its reported revenue number in the fiscal second quarter, and earnings per share were in line, but investors were quite a bit more focused on the same-store sales figure.

Overall, sales rose 22% in the fiscal second quarter, but same-store sales rose 6.9% as reported and 5.7% on a daily basis, missing expectations by close to three points and coming in at about 70% of the expected figure. Competition with new stores opened by Whole Foods, Sprouts, and Trader Joe's seems to have been a major factor, as management reported that 51% of its comp stores saw new competition in the quarter, versus just 15% in the prior year.

With that, you have the same-store sales deceleration, as daily comp growth slowed to 5.7% from 10.6% in the prior year and the prior quarter. The company also saw significant deceleration in the two-year comp, as sales growth dropped to 16.3% in the second quarter from 23.5% and 25%.

Lost in the glare of the disappointing comp performance were pretty decent margin numbers. Gross margin declined 20bp yoy and rose 40bp qoq, while operating income improved 29%. Reported operating margin improved 30bp yoy, while the store-level margin remained constant at 9.1%. That last number compares pretty favorably with the far larger and better-established Whole Foods (around 10%) and strikes me as quite good for a small, fast-growing grocery retailer.

The Pressure Isn't Going To Let Up

Operating conditions aren't going to get any easier for Natural Grocers in the coming months. Between Whole Foods, Sprouts, and Trader Joe's, there should be around 14 competitive store openings on the way in existing Natural Grocers' markets. Couple that with continued efforts at Wal-Mart (NYSE:WMT) and Target to expand their natural/organic assortments, and conditions are not going to be getting better for Natural Grocers in the near future.

The bull argument goes something like this - simple curiosity is going to lead a lot of Natural Grocers' customers to check out these new store openings just to see what these companies have to offer. That's probably particularly true in the case of Trader Joe's, which enjoys a pretty good national reputation and differentiated shopping experience relative to its size. Once shoppers see the assortment and prices, though, bulls believe that Natural Grocers' core shoppers will return. Not only is Natural Grocers cheaper than these rivals, but the stores take their commitment to healthy/ethical eating very seriously (the company recently announced it will no longer sell dairy products from "confinement dairies").

The bear argument obviously reaches a much different conclusion. The bears will argue that Natural Grocers can't compete against the selection and store brands of Whole Foods or Trader Joe's and that, combined with Wal-Mart, these rivals will pick off Natural Grocers customers that are either more price sensitive or less concerned about all-organic assortments and so on. Likewise, they will argue that Natural Grocers has really never been tested before now.

Still A Good Story To Tell, But Will Investors Listen?

I do not believe that Natural Grocers' decline is purely a company-specific issue. As I said in the open, the entire natural/organic food space has come under pressure as multiple companies have posted disappointing growth numbers. Those numbers certainly make it easier to argue that conventional retailers are starting to cut into this specialty segment with their own assortments and that when push comes to shove, many customers are more loyal to their wallets than to specialty stores.

I don't think that marks the end of the road for Natural Grocers. The company does use a different approach than its rivals, with a small-store format that targets secondary markets and emphasizes core grocery offerings over specialty counters (like delis, alcohol assortments, etc.). I also do believe that there is a segment of the customer base that does value Natural Grocers' commitment to 100% organic produce, a large supplements assortment, and on-premises nutrition professionals.

With that, I still believe that Natural Grocers can grow its top line at a long-term rate of nearly 20% and generate long-term FCF margins in the mid-single digits. With 81 stores, Natural Grocers has only penetrated about 7% of its long-term potential footprint, half that of Sprouts and about one-quarter of that of Whole Foods. Although I believe that long-term gross margin leverage will be challenging (improvements in sourcing will probably be offset by more competitive pricing), better amortization of corporate costs and store-level leverage can improve both store-level and overall operating margin.

The question is whether investors will care again for a while. A lot of institutions like to invest with themes and it seems like the natural/organic foods theme is finished for now. Even if Natural Grocers can return to high single-digit or low double-digit comps fairly quickly, the stock could still languish in the absence of institutions willing to go back into the space. It may sound implausible that professional investors would ignore growth like that, but I saw it happen plenty of times back in my analyst days.

The Bottom Line

I have slid some of my growth expectations a bit to the right in my model (particularly on the free cash flow line, as I believe Natural Grocers will accelerate the store opening schedule) and the end result is a fair value that moves down into mid-$30's despite minimal changes to my ultimate long-term growth expectations. I certainly wouldn't say that expectations are now modest or conservative, as Natural Grocers still needs to grow at a high-teens rate and not many companies manage that for a decade.

I am concerned about the near-term impact of more competition on this business. This is really the first time that the business model is getting a serious test from multiple competitors and management has to prove that their success is based upon more than just the absence of alternatives. In addition, I do think it may be hard to coax institutional money back into these shares for the foreseeable future.

All in all, this is the sort of pullback that you hope to see with growth stocks. As is usually the case, though, it is not a free pass from the market and the pullback is tied to real concerns about the company's long-term growth. These shares are much more tempting to me now, but I do have some concerns that the shares are still a falling knife and I'd likely keep initial position sizes on the smaller side until the price stabilizes.

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.