United Natural Foods: Extreme Scenario Has Come Through

About: United Natural Foods, Inc. (UNFI)
by: The Value Investor

When UNFI announced the purchase of SuperValu half a year ago, I noted that the upside and downside scenario have become much more likely.

Unfortunately the downside scenario has materialised driven by leverage concerns and early disappointments.

I would like to be constructive but am too cautious on the deal and see no green shoots for now.

United Natural Foods (UNFI) has been a stock which has been on my radar, as I was quite shocked to see the strange and large deal being announced late July.

I have long been a fan of the company as UNFI operated as a wholesale distributor of natural and organic foods in North America, being clear growth markets. This positioning and bolt-on dealmaking long made it a favourite of the investment community. Shares peaked at $80 in 2015 and ever since have seen pressure amidst narrowing margins, slower growth, and the fact that the bolt-on dealmaking strategy is not delivering on the same results as they did in the past. These factors and the uncertainty following the purchase of Whole Foods by Amazon continued to cause nerves among investors.

The Deal

In July, UNFI announced the purchase of SuperValu in a move to reduce reliance on Whole Foods/Amazon, gain scale, and move into other areas as well such as faster moving units. The $2.9 billion deal was based on the ¨Build out the Store¨ strategy as greater sale and cross-selling opportunities should result in real synergies, pegged at $175 million some three years from now.

I was very cautious however as SuperValu was expected to report adjusted EBITDA of just $375-$400 million this year on $15.6 billion in sales. With depreciation charges pretty much coming in around $200 million, all the adjusted EBIT would be eaten by interest charges on the near $3 billion deal.

The very modest margins stand in contract to UNFI which generated $340 million in EBITDA on $10.1 billion in sales. Even better, depreciation charges total just $90 million, for an operating profit number around $250 million.

Alongside the deal I calculated that net debt would come in around $3.3 billion, quite lot with combined EBITDA seen at $730 million (at high end of the range), for a 4.5 times leverage ratio. I noted that a sale of the retail operations of SuperValu could bring some relief regarding leverage.

What Now?

The pro-forma operations should report adjusted EBITDA of $730 million on $25 billion in sales. Including $290 million in D&A as well as 5% interest costs on debt ($165 million), I saw earnings before taxes at around $275 million. After applying a 20% tax rate, that would work out to little over $4 per share, creating potential appeal after shares fell from the low forties to $30 in response to the deal announcement.

I noted that this looked appealing, but wondered about the deal as well as it would leverage up the balance sheet quite a lot, integration risks are real, the industry is moving rapidly, and the loss of big customer accounts during the process is a real risk as well. Furthermore, the retail operations still need to be sold, in what could be a difficult process.

For these reasons I concluded that shares looked cheap, certainly if synergies would be delivered upon, creating a potential road map for earnings per share of $7 in a few years time, yet at the same time risks increased a lot as well. For that I consider long term upside calls and puts as attractive, yet these are unfortunately not availability in the case of UNFI.

Challenging Times

Since the announcement of the deal, shares fell to levels in the low thirties and traded at around $25 per share in October, when the deal with SuperValu closed. A month later the company already sold 8 Hornbacher´s stores which were part of the retail operations of SuperValu which were acquired a month before.

First quarter results were extremely disappointing as shares lost another quarter of their value and trade at just $15 per share. The SuperValu deal closed just days before the end of the quarter and thus had a modest impact on the numbers which therefore are not that meaningful.

The pain therefore is mostly in the outlook. Sales are seen at $21.5-$22 billion, which essentially includes three quarters of contribution by SuperValu. The issue is that adjusted EBITDA is seen at just $650-$665 million. With pro-forma adjusted EBITDA seen at $700-730 million, including a roughly $400 million contribution from SuperValu each year, that is actually quite in line with the guidance provided when the deal was announced.

Problematic is that adjusted earnings are seen at just $1.69-$1.89 per share, as earnings power is very limited while net debt stands at $4 billion if we include modest pension liabilities as well. That increases leverage ratios even more as earnings power currently is very limited, and hence potential to deleverage the balance sheet as well.

What Now?

The extreme move, with shares down another 50% in just half a year, has come sooner than anticipated. For now my natural interest would be to have a position on the long side, yet I simply see too much leverage and too little earnings power to provide for an easy and quick solution.

The only potential trigger should be a sale of the retail business of SuperValu at a decent price, but the market clearly knows UNFI is in a bad spot to negotiate, not great news as well.

Free cash flow is very limited for now and is nowhere near enough to really reduce leverage. After all, using the adjusted earnings number of $1.79 per share at a midpoint of the provided guidance, this only works down to $90 million, as this kindly excludes costs which might involve real cash outflows.

Hence high leverage ratios for years to come, a challenging integration task, a weak start to the current year, and potentially more challenging operating conditions and debt markets, create real causes for concern. Hence it is still very early to see a real path for a recovery, as there are no real clear signs on such a turnaround.

Hence I am constructive on the situation, but simply see no real reason to regard the shares as a potential interesting investment at this point from a risk-return perspective.

Disclosure: I/we 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.