Regular readers probably know I am a big fan of organic food companies, and I regularly use Whole Foods Market (NASDAQ: WFM ) as a proxy for organic retailing. According to the Organic Trade Association industry survey for 2011, organic food sales grew about 13.4% annually from 2002 to 2010, while conventional food sales remained largely flat. That kind of growth is about in line with that of Whole Foods, which has been at the center of it all.
But beyond Whole Foods, there's United Natural Foods (NASDAQ: UNFI ) , the industry's chief distributor of organic food products. In fact, a third of the company's sales come from Whole Foods, so the two companies' fates are tightly interwoven. United Natural released third-quarter earnings Tuesday and raised its full-year guidance, and there was a bit of good news and a bit of bad news to go around.
First, the good news
Net sales were up 13%, with net income up 9%, and the company raised full-year sales guidance to a range of $6.03 billion to $6.06 billion, from an earlier range of $5.88 billion to $5.98 billion. At the high end, that would represent close to a 16% increase over 2012 sales.
That seems unrealistic. To reach that level of growth, United Natural would have to grow sales by more than 20% in the fourth quarter, with higher sales than this current quarter, which is traditionally the strongest of the year. Even Whole Foods is estimating just 11% growth for its full year.
Still, even a crushing fourth-quarter miss would give United Natural some growth for the year. That's more than can be said for the company's conventional counterparts. Safeway (NYSE: SWY ) is estimating essentially flat sales growth, and analysts estimate that Sysco (NYSE: SYY ) , the world's largest food distributor, will see an actual drop in sales this year.
Now the bad news
In the press release, United Natural's CEO mentioned that the team had focused on "driving further operational excellence through the execution of our initiatives to increase leverage of UNFI's cost structure." Management should be applauded for cutting operating expenses as a percentage of net sales by 76 basis points, but unfortunately, it wasn't enough to offset an 83-basis-point decline in gross margin over last year.
Even after certain adjustments for one-time expenses, total profit margin fell by 7 basis points, which may sound insignificant, but when your profit margin is 1.81%, every little bit counts. While organic and natural food companies tend to command a higher margin over conventional competitors, United Natural's is actually slightly lower than Sysco's. You can chalk that up to Sysco being so much larger and more able to take advantage of economies of scale, but the same could be said of Whole Foods versus Safeway – and Whole Foods has a profit margin four times higher than Safeway's.
Management blamed the gross profit decline on increased freight costs and a customer shift toward conventional supermarkets. The freight costs aren't United Natural's fault, but are related to suppliers being out of stock of certain products. In these situations, United Natural often elects to move products around the country at its own expense to ensure high levels of service, and this quarter happened to be a blip with higher out-of-stocks.
The shift in customer mix is, well, a mixed bag. On one hand, conventional supermarkets represent a much larger market segment than natural and organic food stores; on the other hand, because conventional grocery stores tend to have a lower margin, serving as their distributor is also less profitable.
The Foolish bottom line
United Natural is one of a handful of companies that have been riding a growth wave for several years now, one which is likely to continue as consumers get more serious about being healthy.
That said, the company has high expectations for its fourth quarter, which seem somewhat unrealistic. Additionally, management expects its already razor-thin profit margin to be further compressed as it goes after bigger fish to fry. If sales growth can stay ahead of that curve, investors will still be rewarded, but at a price-to-earnings ratio of 27, a lot of that growth is already priced into the stock. This is definitely one to keep on your watchlist, but maybe not to add to your portfolio just yet.
More food for thought
It's hard to believe that a grocery store could book investors more than 30 times their initial investment, but that's just what Whole Foods has done for those who saw the organic trend coming some 20 years ago. However, it may not be too late to participate in the long-term growth of this organic foods powerhouse. In this premium report on the company, we walk through the key must-know items for every Whole Foods investor, including the main opportunities and threats facing the company. So make sure to claim your copy today by clicking here.