2023-06-07 12:30:33 ET
Summary
- United Natural Foods, Inc. missed profit expectations in FQ3 and revised EBITDA guidance significantly lower for the next quarter on weak core gross margins.
- United Natural Foods was one of the biggest beneficiaries of inflation and procurement gains, but the quick reversal in these gains and poor per-case profit visibility has left management flat-footed.
- The company is investing in automation and digitalization to improve logistical capabilities and efficiencies while also pursuing a multi-point operational efficiency program.
- United Natural Foods shares do look undervalued on a long-term basis, but the stock remains risky as management acknowledges weak visibility into per-case profitability, and it is unclear if the worst is now in view.
What macro drivers can give, they can quickly and unpredictably take away. United Natural Foods, Inc. ( UNFI ) was one of the biggest beneficiaries from the pandemic and the inflation that followed shortly thereafter, but new challenges from disinflation and changing consumer habits have hit the company hard, and a lack of visibility into its own business has exposed the limits of management’s forecasting capabilities.
I had mixed feelings about UNF when I last wrote about the stock, seeing the shares as undervalued (and they’ve risen about 33% since, underperforming US Foods ( USFD ) and Performance Food Group (PFGC), but outperforming Sysco Corporation (SYY)). However, the company at risk from challenges from large customer concentration, post-pandemic normalization, and logistical inefficiencies. I still see the latter two as issues, and while I like the investment in automation and the increased attention to operating efficiency, and the valuation is not demanding, I’m tempted to wait a bit longer before going bargain-hunting.
Another Tough Quarter Undermined By Margins
Despite a significant cut to EBITDA guidance after fiscal second quarter results (a 15% cut), it wasn’t enough as management acknowledged poor visibility into the business (particularly in terms of per-case profitability) as fiscal third quarter results missed expectations and management once again significantly revised estimates.
Revenue rose 4% in the quarter, more or less meeting expectations . Inflation drove the growth in the quarter (up 8%), as volume weakness accelerated (to around a 4% decline) despite management talking about “increased business with existing customers.” Supernational continues to perform considerably better than average, with revenue up more than 12%, while chain revenue growth slowed to below 1% and growth among independents grew a little more than 2%.
Margins were quite weak, with ex-LIFO adjusted gross margin down 120bp YOY and down 20bp qoq to 13.8% - the lowest level in years. Inventory and procurement gains continue to erode quickly as inflation abate (and turns to disinflation in some product areas, like organic wholesale), and management noted some shifts in customer habits (downtrading to save money) as well as worse shrink. Gross margin missed expectations by around a quarter-point.
Adjusted EBITDA declined 19%, with margin down 60bp to 2.1% and adjusted operating income declined 43%, with margin down 70bp to 0.9%.
Another Tough Quarter Ahead
United Natural Foods’ fiscal third quarter wasn’t great, but another big cut to guidance is decimating sentiment – not only due to absolute decrease in earnings expectations, but the impact it has on investor confidence in management’s visibility into the business and their ability to adjust the business appropriately in response to those changes.
While management has basically kept revenue expectations intact, EBITDA expectations have been cut from $715M-$785M previously to $610M-$650M, suggesting a fiscal fourth quarter EBITDA number down more than 50% year-over-year and almost 40% sequentially. Management likewise cut EPS expectations significantly – from $3.05-$3.90 to $1.80-$2.30.
To be fair, these aren’t UNFI-specific problems. With inflation coming down (and reversing to disinflation in some cases), procurement gains have evaporated. This is particularly troublesome for UNFI, as the company saw well above-average gains during the peak – while U.S. Foods and Sysco saw roughly 20% improvement in gross profit per case, UNFI basically doubled that and management has struggled to accurately forecast the normalization from that peak.
Shrink has become a more material issue across the board, and not just with United Natural Foods. Addressing this is a complex challenge and it will take time to fix.
Addressing Issues Will Take Time
In the past, I’ve had issues with United Natural Foods’ logistical capabilities and efficiencies, and I believe there are still ongoing issues. Management spoke of being blindsided this quarter (and this year) due to poor visibility on per-case profitability, and I would argue that at least some of that can be tied to a lack of prior investment into systems automation and digitalization – along those lines, management pointed out the company’s history of M&A has created a complex infrastructure and supply chain that is more challenging to monitor (which, I argue, is a strong case for increased spending in digital capabilities).
I do believe that improved investment here could drive better internal management forecasting and more responsive sourcing and pricing. To their credit, there is an automation initiative underway, with UNFI partnering with Symbotic ( SYM ) to increase the level of automation in its distribution centers.
Reinvesting in automation and digitalization will take time and will consume capital, but the company is also pursuing shorter-term operational improvement initiatives. Some of these are relatively standard projects – more rigorous budgeting, contract reviews (with customers and suppliers) and SKU rationalization to identify and eliminate underperforming products. Management is looking for around $100M in benefits from these efforts, though my take on their commentary was that a lot of this will go towards offsetting ongoing challenges (including lower procurement benefits in 1H’FY24) as opposed to net improvements.
The Outlook
The challenge with United Natural Foods now as a stock is to not fall into the trap of thinking it can’t get any worse – “how much worse can it get?” are some of the most dangerous words in investing. To that end, with management acknowledging weak visibility into per-case profitability, it’s hard for me to feel confident that the worst is now in view. On top of that, I do expect weaker tailwinds from inflation, and volumes could see further pressure if consumers continue to trade down.
I’m only modeling around 2% long-term revenue growth from here, and I think that should be a number that the company can hit (if not exceed) without too much difficulty. The bigger question is on the margin line. I’ve revised my near-term expectations lower to account for recent underperformance, as well as increased capex, but there’s a lot less visibility than I’d like into what UNFI can reasonably expect as a “steady state” free cash flow margin – I do see the potential to improve free cash flow ("FCF") margins to 2%, but potential only gets you so far, and I’m modelling in far less improvement as my base-case (a long-term level around 0.6% on a weighted-average basis).
Those assumptions are enough to drive an FCF-based fair value in the high-$20’s, and likewise a forward multiple of 5.5x (below what the company’s normalized margin/return profile should be able to justify) gets me into the mid-to-high-$20’s today.
The Bottom Line
I can understand the temptation to buy a beaten-up industry leader such as United Natural Foods (in this case, national distribution of natural and organic products), particularly as the addressable market continues to grow and there are still opportunities to grow higher-margin businesses like professional services. Still, there’s clearly a lot of work left to do at the systems/logistics level, and volume weakness remains a concern.
I believe this is a name to monitor, and maybe aggressive investors with more faith in the long-term story will want to start/add to a United Natural Foods position here. However, I’d like to see more evidence of stabilization in volumes and gross margin, not to mention further progress with the cost-out and capex programs and improved management visibility, before taking the plunge into United Natural Foods, Inc. stock.
For further details see:
Macro And Execution Issues Leave United Natural Foods Investors Feeling Sick