I recently added shares of Natural Grocers by Vitamin Cottage (NGVC -0.37%) to my portfolio. Natural Grocers, valued in the ballpark of $940 million, represents a quickly expanding health store concept. With sales of organic products projected to increase 14% annually through 2018, Natural Grocers is a prime growth opportunity as health conscious consumers become the norm rather than the exception.
A family operated health business
Natural Grocers by Vitamin Cottage is no Whole Foods Market (WFM) replica. In fact, Margaret and Philip Isely founded Natural Grocers in 1955, years before the first Whole Foods was opened in 1980. Natural Grocers was founded upon five core principles -- Nutrition Education, Quality, Every Day Low Pricing, Community, Employees -- that the company follows to this day.
Nearly 60 years after its founding, Natural Grocers serves as a specialty retailer that only offers organic and natural products on its shelves. This includes produce, meat, vitamins and supplements, body care, and pet care products. Nutrition counselors are on staff at each store to assist customers, and the retailer also offers free classes and activities related to cooking, health, and nutrition.
Natural Grocers is still in the hands of the Isely family, who make up half of the company's board of directors. This generation of Iselys, which took the helm in 1998, began the expansion of Natural Grocers beyond a simple mom-and-pop concept. The company has expanded from 27 stores in three states in 2008 to 72 stores in 13 states today. Kemper Isely, who serves as Chairman and Co-President with his brother Zephyr, joined the company as an employee at the age of 14 in 1977.
The four Iselys on the board own a combined 37.6% of Natural Grocers, and all insiders own a combined 60% of shares outstanding. This level of insider ownership, coupled with ambitious plans for growth already under way, gives me confidence that this management team is focused on the long-term success of the business.
Promising growth and extensive future potential
A vision is one thing, but we want to see a focused vision correlate with successful financial results. In 2013, Natural Grocers' total sales increased 28% to $430.7 million and same-store sales increased 11.1%, while adjusted net income increased 35% to $10.9 million. Between fiscal years 2012 and 2013, the company's profit margin also increased from 2% to 2.45%.
The average Natural Grocers store comes in at 12,300 square feet, roughly a third of the size of a typical Whole Foods store and substantially smaller than average Sprouts Fresh Market and The Fresh Market locations. A smaller store size allows Natural Grocers to expand into markets that may not be feasible for its competitors who have larger stores.
Management has outlined its belief that the U.S. market can support 1,100 Natural Grocers stores. This represents more than a 15-fold increase from current store levels. The company plans on expanding its base of stores by 20% per year for the foreseeable future.
While Natural Grocers continues to expand quickly -- which includes plans to open 15 new locations in 2014 -- the company is still yet to set foot in California, Washington, or Pennsylvania, the top three states in terms of organic sales. The company's financial success thus far has been the result of careful expansion out of Natural Grocers' home turf in Colorado.
What to watch going forward
I have two primary concerns with Natural Grocers; the first being the production of free cash flow (or lack thereof). In fiscal 2013 the company produced negative $13.99 million in free cash flow, leading to the burden of an additional $14 million of debt on the balance sheet. Until the company produces positive free cash flow, Natural Grocers will be primarily dependent on accumulating more debt to finance capital expenditures and future growth.
With that said, on the company's fourth quarter conference call in November, Kemper Isely explained that management anticipates "cash on hand and cash generated from operations will be sufficient to support our capital requirements" in fiscal 2014. In other words, based on Isely's projections, the company should be able to finance its growth in 2014 without adding to its debt burden. This is the pattern we want to see in these early stages of the concept's national expansion. Keep in mind that Whole Foods was not free cash flow positive until 1996, when the company operated 68 stores.
Another concern is Natural Grocers' measly employee review rating on Glassdoor of 2.8/5. While Natural Grocers receives high reviews from customers on websites such as Yelp (often 4/5 and above), there appears to be a disconnect with the employee experience. This is especially concerning because employees are one of the five core principles of Natural Grocers.
Thankfully, in 2014 Natural Grocers is rolling out a new human resource system. It is one thing to talk about a good employee culture; it is an entirely different challenge to actually implement and maintain a rewarding culture for employees. Investors should watch this closely in the coming quarters. If the Iselys cannot lead by example in developing a thriving and sustainable employee culture, I will have doubts about the long-term viability of Natural Grocers.
Foolish bottom line
Shares of Natural Grocers more than doubled in 2013, and the stock does not exactly look cheap sitting at a P/E ratio just below 90. However, given that the company has hardly scratched its expansion potential, I am comfortable opening a starter position at today's levels. Shares are undoubtedly priced at a premium, and the company will need to meet or exceed its high expectations for this to be a market-beating investment over the next several years. Investors without a stomach for volatility should sit on the sidelines for now.
Investors who see the potential for National Grocers to become a national concept should keep a close eye on the company, and might want to consider starting a position today.
