Activist investing and special situations.

Organic Food Investing, It's Not Whole Foods

Added on by Lee Ho Fook.
whole foods.jpeg

Be sure to check out our detailed stock analysis (click here).  One of the biggest trends of late has been the move to organic foods, with the consumption of organic and natural foods having grown gangbusters over the past few years. While many investors are loading their portfolios up with Whole Foods Market  (NASDAQ: WFM), I think there might be a better way to play the organic food craze. 

United Natural Foods  (NASDAQ: UNFI) is the U.S.' leading distributor of natural and organic foods, selling more than 65,000 products to more than 23,000 customer locations. This company is one of the best ways to play the broad organic-foods market.

The demand for organic foods should continue to grow over the interim, and United's revenue is expected to grow by some 16% in fiscal 2013. Organic foods is an over-$60 billion industry globally, according to the International Federation of Organic Agriculture Movements.

What's more is that from 2002 to 2011, the industry grew 170%, or about 19% a year. The real beauty for United Natural is that the U.S. is the the largest organic food market in the world.

United also has a solid customer-base mix, with independently owned natural- product retailers making up 35% of revenue, natural-foods supermarkets making up another 35%, conventional supermarkets 25%, and all others at 5%.

The build up

United has been growing its distribution assets and partnerships for a number of years. Back in 2010, United bought up various distribution assets from Whole Foods Market. In 2011, United inked a three-year agreement with Safeway (NYSE: SWY) to supply the grocer with non-proprietary natural, organic and specialty products. Also, in 2010 United extended its agreement with Whole Foods to act as the grocer's primary distributor through 2020. 

Whole Foods is United's largest customer, accounting for over 30% of revenue, and so the new agreement is a big positive. On the other side, United's largest supplier, Hain Celestial,  only accounts for around 6% of the company's total purchases. 

United acquired the assets of three distribution companies so far this year, and in 2012 it divested its non-foods and general-merchandise lines of business, making the company a purer play on natural foods. 

United's top customer, Whole Foods, plans to continue growing via new stores. This is another positive for United. The company opened some 25 stores in 2012 and plans to open at least 33 stores in fiscal 2013 and 2014, each. 

Last quarter, Whole Foods saw profits jump over 20% year-over-year, but I have my hesitations. Whole Foods should see increased competition from the likes of various other retailers, which include retailer Target and dollar stores, i.e. Family Dollar and Dollar General, that have started offering consumables. Eventually, these companies could also start offering organics, a positive for United, but not for Whole Foods.

Whole Foods expects to see margins contract over the interim as it looks for ways to mitigate the competition from new peers. Its latest initiatives include upping its promotional activities, including one- and three-day sales. The company is also looking to cater to specific markets, such as Detroit, where it offers a higher percentage of non-organic foods to help keep prices lower.

Conventional growth

Going forward, United plans to increase its strategy for serving conventional supermarkets. Historically, this area of the market has been low margin. But United plans to change this. Its plan includes lowering operating expenses, which involves rolling out a national warehouse-management system. The new system is expected to be at all its distribution centers by the end of fiscal 2016. 

One of United's leading partners, Safeway, is re-positioning its product portfolio to better serve the U.S. market. A couple of months ago, the company announced plans to sell its Canadian store and manufacturing operations. Safeway is also making other moves to refocus its portfolio by selling 22% of its subsidiary, Blackhawk, the gift-card operator. One of the most promising aspects? Safeway plans to start a wellness initiative, which will focus on a holistic approach to providing wellness products. 

The U.S. grocery industry is still a huge market that's potentially worth over $1 trillion, according to Progressive Grocer. Supermarkets account for about 55% of this market. Natural- food stores still have plenty of room to grow, only accounting for about 4.5% of this market share. 

Bottom line

All in all, United remains one of the best pure plays in the organic-food industries. The market will continue to be one of the fastest growing in the food industry as the rise of healthy eating continues. Whole Foods is up nearly 500% over the past five years and trades over 38 times earnings, and as a result I'm holding off investing in the company. Meanwhile, Safeway still has a lot to prove with respect to the low margins of its business, so I would hold off on the grocer for now.