United Natural Foods' Best Growth Is Behind It

Summary

• UNFI is a serial acquirer in the food distribution industry in the US and Canada and from 1999-2015 the share price compounded at 23%, crushing the market returns of 4.3%.
• UNFI has virtually no moat.
• The company’s best growth is behind it, and longer term the acquisition runway is not very long.
• The entire industry has low returns on capital, and the 2.9 billion dollar acquisition of Supervalu hasn’t improved these returns.

Smederevac/iStock via Getty Images

United Natural Foods Inc. (NYSE:UNFI) is an American food distributor for both wholesale and retail. The parent company was founded in 1976, and UNFI IPOd in late 1996. They are the primary distributor for Whole Foods Market. This industry saw a boost in stock up buying during the beginning of the pandemic, but currently is going through rocky times in other respects like labor and supply shortages. This is a capital intensive sector that always had low margins and low returns on capital. Creating real value through acquisitions is one way to mitigate the crappy unit economics of the industry, and this has always been UNFI's key strategy.

The strategy did work well for a while, and a well-timed trade paid off handsomely. Below is the period of best returns for the stock.

Taking a longer term view and measuring the CAGR of share price since the IPO tells a different story though.

https://www.dividendchannel.com/drip-returns-calculator/

In my view there can be too much focus on EPS in general, especially without looking at changes in share count. Over ten years, EPS grew at a rate of 2.92% with the share count growing at a rate of 2%.

FCF is now in a very healthy range. Along the way the company could never stay FCF positive for more than a few years though, and this is problematic. I'm not worried about the company losing money in 2019 and 2020. This was mostly due to SVLU acquisition in 2017. They did remain FCF positive throughout, and those two years were the only times they reported a negative net income since the year 2000. However, the volatility of FCF and FCF margins over the long run makes future cash flows harder to predict for this business. (charts from gurufocus)

The Moat

Its closest competitors aren't exactly clones, their specialties aren't all the same. One distinction is that UNFI deals almost exclusively in organic and natural foods. This is a long term trend that isn't going away, compared to companies that distribute mostly or only non-organic foods. While organic food products themselves are always sold at a premium to non-organic items, this doesn't translate to much of a premium for distributors. Food distribution is traditionally an industry with low margins and low returns on capital regardless of the price of the goods.

The returns on capital are still the metric which proves whether a moat exists and what the size is, below we look at UNFI compared to its closest competitors.

Company	UNFI	PFGC	CHEF
10-year average ROE	9.6%	7.7%	7.4%
10-year average ROIC	7.6%	3.3%	3.9%
10-year average WACC	6.88%	7.44%(6yr)	8.7%
10-year CAGR of Assets	19.8%	17%	28%
10 CAGR of Revenue	21.88%	18.4%	12.9%

Click to enlarge

UNFI has barely earned returns above the cost of capital, and most of the industry fails to do so as well. This doesn't mean UNFI is an exception in terms of value creation.

While there is no actual moat, one intangible advantage could be the specific knowledge of the food distribution business acquired over the years in combination with the relationships built with suppliers and customers that can't be replicated by a newcomer. Nevertheless these things are not easily quantified and thus the company lacks meaningful barriers to entry with low switching costs.

I would stay away from this industry in general unless you find a true outlier or a deeply valued company. The business model inherently sets limits on the kinds of returns that the company can earn on capital, even though lots of capital is required for growth. Buffet actually defined this type of business in his 2007 annual letter, "Now let's move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money." To be fair, a company in this industry will only grow rapidly from acquisitions or organically only from a tiny base. Nevertheless, this is simply not a high return industry and UNFI has virtually no moat.

Reinvestment

Acquisitions have always been the main driver of top line growth. With such razor thin margins, growing by acquisition is the clear way to increase volumes, but the runway is increasingly shorter for future growth.

UNFI acquired SuperValu for 2.9 billion in 2018, which doubled revenue once completed. Margins have failed to expand since this takeover and debt levels have risen dramatically. The debt/equity ratio has risen from 0.3 in 2018 to 3.0 currently.

Gross margins did stabilize after the SVLU acquisition, but operating margins have yet to recover, dropping from 2.4% in 2018 to 1.3% currently. Synergies don't bear fruit immediately, but to see this decline in margins after three years shows there was an overestimation of actual value creation via combining these organization.

There is an upper limit placed on the growth by acquisition strategy. SYY was prevented from acquiring OTC:USDF for 8.2 billion in 2015 due to antitrust concerns. So even though in the longer term there has been some consolidation in the industry, the acquisition runway is not very long, larger acquisitions that are big enough to move the needle won't be as possible in light of the SYY and USDF failed acquisition. Smaller takeovers will be possible. Also, rival PFGC recently acquired CORE Mark, which takes away a potential target for UNFI in the future.

Valuation

Covid didn't bring the share price down very much since it was already in collapse from its 2017 peak. The recent spike in share price is not an accurate pricing of the business, it definitely goes into overvalued territory for me.

Below is a basic and conservative DCF, but my core thesis doesn't fully rely on it.

Next we will look at multiples of UNFI and its closest competitors

Company	UNFI	PFGC	CHEF
P/E	17.5	160.9	-19.7
P/S	0.1	0.2	1.0
P/B	2.1	3.1	3.9
EV/EBITDA	7.4	16.3	-36.9
EV/S	0.2	0.3	1.2

Click to enlarge

The multiples approach doesn't work very well in this situation. The p/s ratio is extremely low, but this is actually a good example of why this ratio means very little. It ignores all debt and gives a better indication of overvaluation than undervaluation. I don't rank UNFI high qualitatively, which means only a deep undervaluation would give the stock consideration.

Conclusion

UNFI is an average business within a very tough industry. The growth by acquisition strategy worked for shareholders for a roughly fifteen year period in the past, but those days are gone and future growth is limited. The FTC already prevented SYY's attempted acquisition of USDF and this sets up bounds on industry consolidation. The bigger acquisitions that UNFI would need in order to move the needle just won't be as doable. At this point most acquisitions would merely boost the top line while likely lowering the already razor thin margins.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.