In less than a year, United Natural Foods (NYSE:UNFI) has run from under $10 to $27 a share, providing an exceptional return for investors. Given the stock has exhibited relatively muted increases in EBITDA over last year’s trough, some are wondering why the move has been so extreme. I covered UNFI during the Covid pandemic, which masked several issues with the business, and I exited prior to the Covid unwind. So, is UNFI still compelling at $27?

Overview

First, it’s important to understand that the SuperValu merger was a disaster. Integration from the merger was poor, and it created the largest grocery distributor with the least efficient footprint:

UNFI needs to consolidate DCs to match the efficiency of their peers. To better illustrate the opportunity, I created the following table of UNFI v. Peers:

Look who has the least-efficient use of DC space (Revenue/Sq Ft), the lowest EBITDA margins, and worst cash flow conversion. Also, consider the market capitalization opportunity for businesses that are more efficient.

C&S is the closest scaled peer of UNFI, especially given their ownership of some grocery locations, but they do not compete in the natural and organic categories. They were set to expand retail significantly by acquiring assets to help the Kroeger (KR) and Albertsons (ACI) merger go through, but that has been blocked. Associated Wholesale Grocers is large, but very focused in the middle of the US, as you can see above. Their footprint is focused on fewer, larger DCs and services a large swath of independent grocers. My expectation would be UNFI cedes market share to C&S and AWG in the conventional space over the coming years. I expect this will be welcomed particularly by C&S, as they have been shrinking due to Ahold and Target (TGT) internalizing distribution over the past few years (a ~$10B revenue hit).

SpartanNash has about 150 retail stores as well, across a variety of banners. They compete with UNFI on fresh & organic markets, and crossover with UNFI’s relationship with Amazon (AMZN), specifically their Fresh stores. With UNFI servicing the Whole Foods distribution, I view this as an attempt to keep the two distributors competing on price, rather than allowing one to become too engrained in their business. SPTN granted Amazon warrants to acquire up to 5.4m shares at $17.73/share, the majority of which remain unvested at this time due to Amazon not hitting order thresholds (portions vest every $200m of orders). Orders have been decelerating for a couple of years, and it sounds like this is expected to continue. With wholesale shrinking, SPTN appears focused on growing via retail banner acquisitions.

KeHe has a nationwide footprint and competes directly in the fresh & organic spaces where UNFI is looking to grow. They grew revenues 18.3% in the past year, but at least 10% of this appears to be from their acquisition of DPI. KeHe is 95% employee-owned now after having bought out half of Tower Brook’s stake. KeHe appears to be grabbing share from the other distributors at the fastest pace and will continue to be the competitor to monitor. With significant leverage from their recent acquisitions, KeHe will also likely be focused on deleveraging for the time being.

Turnaround

Normally, I am resistant to buying a laggard, given they are likely to continue lagging. One of the reasons exited UNFI in 2021 was watching how they failed to capitalize on the opportunity Covid afforded them. They didn’t sell their grocery stores at peak margins as initially planned, didn’t take the windfall profits to strengthen their balance sheet, and instead issued excessive stock compensation at lows and instituted a stock buyback at highs.

However, I believe the new CFO & refreshed board (with an activist presence) has the right vision for a turnaround. With tangible results beginning to show, I think they become more efficient and start growing into the earnings profiles of their peers.

Progress

On the surface, UNFI’s FY25 guidance for $100m of FCF seemed underwhelming. It is a $200m improvement Y/Y but remains extremely low relative to peers. $550m of EBITDA was also not an exciting number. After parsing through the guidance, I believed management was sandbagging the opportunity.

Q1 began to substantiate my assumption. After guiding to $200m of Y/Y improvement in FCF, UNFI delivered $169m of improvement in Q1 alone. This was increasingly impressive when you consider they reduced their use of their accounts receivable monetization facility by $45m Q/Q, versus last Q1’s $16m increase - so FCF would have been about $60m higher had they not retained so much AR. Additionally, UNFI made $56m of incentive payments in Q1 that were not present last year.

After all that, how much did their guidance change? They went from $100m of FCF, to “>$100m of FCF”. On the call, they cautioned investors not to expect the same level of improvement in subsequent quarters, but that’s okay. I wasn’t banking on $700m of FCF this year anyway...

UNFI grew revenues by about 4%, split between volume increase and product inflation despite closing & consolidating their Billings and Mismark DCs during the quarter. Compared to their flat guidance, this was again very encouraging. UNFI has been clear that they are going to intentionally cede business in their conventional segment, to focus on higher-margin and faster growing natural and organic products. This was demonstrated by their closure of the DCs, and planned closure of their Fort Wayne, IN DC during this quarter. All three are being consolidated to nearby distribution centers, and to date, customer retention has exceeded expectations. Selling these owned locations should generate over $100m of proceeds, and improving utilization over a smaller footprint will increase margins.

Targets

I think 2.5% EBITDA margins are attainable for UNFI. They maintained them for years prior to the SuperValu merger, even with the Whole Foods relationship (higher volume & lower margin than other distribution business). The retail segment also seems to be weak relative to scaled grocery peers, and a drag on margins. These parts of the business are likely the key headwinds that keep UNFI from approaching KeHe’s 4% EBITDA margin profile.

They are currently guiding to about $650m EBITDA by FY27, which combined with ~$100m a year of deleveraging would get them close to their sub-2.5x leverage target ($1.9B net debt / 650m EBITDA = 2.9x) and I think the rest will come from selling assets. But 14.5% Q1 EBITDA growth versus 9% FY25 guide at the midpoint continues to suggest sandbagged guidance.

2.5% margins on $31B in sales gets them closer to $775m EBITDA, and that just pulls margins in-line with smaller grocery distribution peers, much like $300m of annual free cash flow would get them to a similar conversion rate as their peers. I personally don’t see why the largest US operator can’t exceed those benchmarks, but I’ll take matching them at the present valuation.

SYY, USFD, and PFGC trade more than 10x EV/EBITDA, and mid-single digit FCF yield. UNFI, at $650m of EBITDA and a 8x multiple, would roughly double their current stock price. 10x $775m EBITDA would get you over a triple. 10% yield on $100m of FCF would suggest some downside to the stock, but around a double if they can earn closer to $300m per year.

Risks

With their Whole Foods concentration, UNFI will remain at risk of a negative headline if Amazon decides to modify their agreement unfavorably. Given the contract term runs through 2032, you have a lot of time before this could become an issue.

With low margins and leverage, there remains a risk that any kind of deterioration will be punished by the market. An investment here assumes that UNFI can continue their momentum towards the financial metrics of their peers.

An investment in UNFI requires trends towards healthier eating options, and I think the new administration is at least saying the right things in this regard. Whether this translates into increased revenues for UNFI remains to be seen.

Recessions are at the front of investor minds, and fortunately, grocery is a resilient industry as consumers trade down from restaurants. You can see UNFI grew revenues about 14% organically in FY08, if you’re looking for some evidence of the counter-cyclical nature of this business.

Moderate levels of inflation are good for UNFI, as they capture more “spread” between buying and selling the products from their suppliers. A more detailed discussion of this phenomenon is laid out in their 10-K. This appears to have been a driving factor in UNFI over-earning the past couple of years if you review their past earnings & revenue slide above.

UNFI previously opened a buyback prematurely and failed to sufficiently bring down leverage before their fortunes soured. I will be concerned if capital returns are prioritized before sufficient deleveraging (<2.5x).

There have been some arguments that UNFI's new Simplified Supplier Agreement (SSA) could drive hundreds of millions of EBITDA improvement on its own. I'm not confident this will be as material to their bottom line, which could lead to some investor disappointment.

Conclusion

UNFI appears to be in the early innings of a successful turnaround, with a lot of blue sky above if they can approach the earnings power of their food distribution peers. As much progress remains to be made, caution is warranted, but I believe UNFI’s management is making the right moves to address the long-standing issues from the disastrous SuperValu merger.