It will not take you long to learn that Mr. Market is angry with UNFI because of its Animal Spirits. "This transaction accelerates UNFI's growth strategy by immediately enhancing our product range,equipping us to bring an attractive, comprehensive product portfolio to an expanded universe of customers," said Steve Spinner, UNFI's boss."The combination of UNFI and SUPERVALUE provides a substantial premium and delivers certainty of value to our stockholders, meaningful benefits to our customers and expanded opportunities to our employees.

Written by:

Noam Ganel is the Managing Director of Pen & Paper, a value-oriented stock research publication. Subscriptions are now available. He also serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Financial Analyst (CFA) credential. Click here for frequently asked questions.

Hungry for Leverage?

Why I am Bearish on United Natural Foods Stock

December 22, 2018

Benjamin Graham would be proud. Using Value Line stock screener for stocks trading at less than 5 times the trailing earnings per share, I came across a company that operates in the unglamorous business of food distribution. 

United Natural Foods, I quickly learned, is a fortune 500 company that had earned a profit in each year of the past decade. And yet it was trading at less than 5 times the trailing earnings per share. Was I dreaming?

At at a first glance, UNFI was alluring

The historical operating financials were beautiful. In 2008, earnings per share were $1.38 compared to $3.26 earnings per share as of its most recent annual filing. And this not-to-be-taken for-granted 9% compounded rate of growth was achieved with little dilution of outstanding shares. And participants in capital markets, whether speculators or investors, traded the stock of United Natural Foods as low as $13 (in 2009) and as high as $84 (in 2015).  

The income statement and balance sheet were attractive, too. After adjusting for an impairment expense, I arrived at a three-year average cash flow per share, net of capital expenditures, of about $2. More importantly, there was plenty of income to service the debt: the operating income to interest expense ratio was greater than 14 times during that period.

 And after removing goodwill from the reported assets, I arrived at book value per share of $29 in 2018 and of $26 in 2017. Put differently, priced at $22 per share, UNFI was trading at 25% discount to book value.  

Yet the price of the stock had more than halved this year. In January, common shares in UNFI were quoted at around $50. With the passing of six months, the stock declined to $32 from $42 in less than a month, a drop of 24%. And for those investors that held the stock, at the time of this writing, the stock price is $10.

 UNFI's appetite for leverage

 It will not take you long to learn that Mr. Market is angry with UNFI because of its Animal Spirits. "This transaction accelerates UNFI's growth strategy by immediately enhancing our product range,equipping us to bring an attractive, comprehensive product portfolio to an expanded universe of customers," said Steve Spinner, UNFI's boss.

"The combination of UNFI and SUPERVALUE provides a substantial premium and delivers certainty of value to our stockholders, meaningful benefits to our customers and expanded opportunities to our employees."  

And as somewhat expected from any merger and acquisition transaction by a Fortune 500 company, Spinner used the s-word. Synergy.

The expected, rosy future of the combined entity is the result of a serious gamble. The gamble being the amount of debt UNFI used to finance the transaction, where the cash used to pay out SUPERVALUE shareholders was not from retained earnings, but using the willingness of lenders. 

And in a rising interest rate environment, management decided that adding $1.2 billion in a new revolving line facility, as well as adding $2.05 billion in the form of a term loan. Not a good idea.

The dean of the world distressed debt, Howard Marks, once said that we should not predict future, but instead, focus our attention on the present and what present conditions say about the future.

 In the case of UNFI, certainly we cannot predict what the company’s income statement will look like in five years, but we can understand the significant amount of the leverage taken. Due to the acquisition, United Food increased the right side of its balance sheet by three times, from $1.2 billion as of July 2018 to over $4.3 as of today.

So, not only are current buyers of the stock taking leverage risk and risk related to how successful the merger will prevail, but also,invariably, these traders are taking on risks that the company never addressed previously. 

To name a few: the company is highly dependent on the success of Whole Foods Markets, as it accounted for about 37% of the fiscal 2018 sales. Or that the firm operates in a low margin business where profit margins are expected to decease as the industry is consolidating.

Count me out

I had other, idiosyncratic reasons to avoid UNFI stock. First, I do not shop at Whole Foods. I believe they sell overpriced items that can easily be found elsewhere at a cheaper price. 

And it is absolutely meaningless to me that in some stores you can now shop without taking your wallet from your pocket (I didn’t thought it to be of such an inconvenience).  

Second, I believe UNFI overpaid for SUPERVALUE, which to me is a sign of an overly optimistic, bullish management. In its most recent annual filing, SUPERVALUE disclosed to shareholders that the stock price range was $14 in the fourth quarter of 2018. Yet UNFI paid $32.50 for the same stock.

 UNFI's management must not believe in the Efficient Market Hypothsis.

While I did not buy any shares in UNFI, I did buy an equity interest in other businesses this year. In Make Equity Great Again I wrote why I bought shares in the company best associated with the word "Victoria’s Secret models.” 

Unrelated to the beautify business, but somewhat implicitly related to the business of being and looking healthy, in Lifeway Foods: Why I am long probioticsI wrote about my purchase of a small company that produces kefir products. 

And in August of this year, I described my Tupperware purchase, both of the physical product itself and of the company's stock. You can read more about it in Tupperware Company: A Quality Product but Shareholders Should Beware of The Debt Level.