With United Natural Foods (NASDAQ:UNFI) reporting earnings earlier this week, the final chapter of what was definitely a forgettable earnings season came to an end for the organic/natural food industry.
While the broader market is up over 5% so far this year, the same can't be said for this industry, which is led by the likes of United Natural Foods and its top customer, Whole Foods Market (NASDAQ:WFM).
Part of this slump has to do with sky-high valuations leading into 2014 -- but some of it has to do with real problems within the sector. Read on to see if United Foods' slumping stock should be avoided, or if it represents a good buying opportunity.
A tiny niche no more
One would think that being the first mover in what started as a tiny niche -- but is now a major burgeoning industry -- would be viewed as a huge advantage. But that simply hasn't been the case for the country's organic leaders.
Whole Foods Market turned in earnings last month that disappointed investors. While some of that disappointment was due to lower-than-expected same-store sales -- which, incidentally, Whole Foods deserves a lot of credit for not blaming on the awful winter weather -- a bigger part of it has to do with larger players entering the organic space.
As these players enter, the thinking goes, the prices for organic goods will come down, and the margins enjoyed by the likes of Whole Foods will eventually contract as well. That line of thinking -- more than anything else -- is what led Whole Foods from being a company that traded for 44 times earnings in November to one that trades for 28 times earnings today.
The same relative dynamics are playing a role in United Natural Foods' stock decline so far this year. In January, it traded for 33 times earnings, whereas now, it trades for 26 times earnings -- a 20% contraction. Whole Foods, it's worth mentioning, is United Natural's single largest customer -- accounting for a whopping 36% of all revenues.
What does it mean for investors?
Though the company continues to post impressive revenue and earnings growth -- roughly 14% each -- investors are starting to worry about the competition such success can bring on. If Whole Foods is in trouble, then that naturally filters down to United Natural.
The biggest disappointment Wall Street likely had with the latest report was a narrowing of guidance to expected revenue and earnings growth of 13.5% and 14%, respectively. Simply put, sometimes, it's hard to satisfy Wall Street's expectations.
But what we are left with is a growing company that is building out its distribution network for a growing industry. The biggest players in this industry -- especially Sysco, which recently announced a proposed merger with US Foods -- get the overwhelming bulk of revenue from restaurants. But restaurants aren't showing anywhere near the kind of sustained strength that organic grocers are.
Of course, this could mean that Sysco would try to take some of United Natural's market share, but that's unlikely given the company's desire to achieve synergies in the restaurant business through its merger with US Foods.
As it stands now, one-third of United Natural's business comes from small, independent, natural/organic grocers like this one located just down the street from where I live in small-town Wisconsin -- outside of which I routinely see United Natural's trucks.
These are the entrepreneurs that are pushing this food movement forward and will either grow to be stalwarts within their communities or get bought out by bigger players.
By aligning itself early on with such companies, United Natural is positioning itself for long-term relevance within the industry -- no matter which grocer ends up being the dominant player. With the stock trading now at just 23 times expected earnings, that's enough to convince me it's worth making an outperform call on the company for my CAPS profile.
John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Brian Stoffel owns shares of Whole Foods Market. The Motley Fool recommends Sysco and Whole Foods Market. The Motley Fool owns shares of Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.