Natural Food: Still A Growth Story

lucy
10 May, 2004
New York City

As more people are ready to pay for food that is free of pesticides, hormones and antibiotics, growth at retailers like Whole Foods seems guaranteed. In the meantime, the market debates if the company is overvalued.

To an outsider it all may seem a bit crazy. Americans are readily paying a hefty premium on the price for the most basic commodity in the world - food, when it is labeled “natural” or “organic.” But wasn’t all food by definition organic? And if not, what are we actually eating when buying regular, non-organic food?

It is hardly a surprise that in the US efficiency-crazy environment, legislature permits food to be genetically modified and agricultural production to be enhanced through antibiotics, growth hormones, toxic chemical pesticides and fertilizers, and all the achievements of modern science. The focus on profitability and cost-effectiveness has turned “naturalness” into a rare and an expensive commodity.

Whole Foods ((WFMI)), Wild Oats ((OATS)), and their suppliers like United Natural Foods ((UNFI)) have been able to capitalize on the health-consciousness of the more affluent and educated consumers by selling as an exclusive high-end commodity what in most parts of the world is… just food.

The natural and organic food retailers enjoy higher profit margins than the traditional grocery stores, greater loyalty from their customers, and are less threatened by the competition of low-cost and massive-scale retailers like Wal-Mart ((WMT)) and Costco ((COST)). These specialty retailers have tapped into a lucrative and growing market. The organic food business in the U.S. is estimated to total $13 billion in 2003, up nearly 20% from $11 billion in 2002.

Retail consultant {{Retail Forward}} estimates that the organic-food business is growing at about 10% a year compared to 2.5% growth rate for traditional supermarkets. More than 10% of Americans are eating organic foods, while more than 50% of the population has at least tried them.

Recently, the U.S. Department of Agriculture created a National Organic Program to create a national standard for 'organic' certification, a move that shows that organic eating is not just a fad but is here to stay.

The Leader of the Health-Minded Pack

The natural food retail sector has a very clear leader. Whole Foods Market not only pioneered and established the supermarket concept in health foods retailing, but also bought most of the existing competition and hasn’t stopped growing. Different from traditional supermarkets, the company enjoys profit margins of about 3%, twice the 1.4% net profit in the grocery industry.

It all began in 1978, when current chief executive, John Mackey, opened Safer Way Natural Foods in Austin, Texas. He merged with another store in 1980 to create Whole Foods Market. The company accelerated its expansion in the late 1990s and currently operates 154 stores in 26 states.

Although health and natural foods stores have long existed as a niche market, they typically offer a limited range of health foods and related products, such as nutrition supplements. Building supermarkets stocked with organic bread, meat, poultry and fish, and even coffee and wine, has been a rather innovative concept.

Expansion Through Acquisitions

Whole Foods has largely been built by acquisitions, which the management considers a key part of the growth strategy. Instead of taking the risk of building supermarkets in unproven markets, the company usually buys successful ventures and then brings in its know-how and infrastructure. The company also has worldwide ambitions – it recently made its first overseas step by acquiring U.K.’s Fresh & Wild for roughly $38 million in stock.

Growth vs. Valuation

The greatest concern of investors regarding Whole Foods’ stock is that it is rather richly valued. But there are good reasons for the high valuation. In the past 10 years Whole Foods has managed to increase same-store sales by an average 8.5% annually. Total sales have consistently grown by 17%-23% each year.

The company sports gross margin of 34%, unusually high for food retailing, and operating margin of 6%. By the end of the decade, Whole Foods forecasts $10 billion in annual revenues and 300 stores. Analysts expect that revenues and earnings could rise around 20% annually.

In April, Moody's Investors Service upgraded all ratings of Whole Foods because of the company’s pattern of internally funding the store development program, the strong sales performance at new and existing locations, and continued improvement in fixed charge coverage.

And while the valuation may prompt for cautiousness at the current levels, any dips in the stock price without a substantial change in fundamentals should make this stock a must-have investment.

The Runner-Up Wild Oats

Although Wild Oats is the 3-rd biggest natural foods supermarket chain in the US in terms of sales after Whole Foods and privately-held Trader Joe's, its outlook is quite different from that of the leader. So far the company has been unable to ride the wave of healthy eating as it is struggling to solve operational issues.

In 2002, in an effort to cut costs, the company changed its primary distributor from United Natural to Tree of Life. Later, Wild Oats outlined major supply chain problems, such as products being out of stock or difficulties with stock-keeping unit designations. Now it is back with United Natural Foods, but gross margins are falling.

More importantly, current same-store sales growth is disappointing at 2.4%. In 2003, full-year revenue rose 5.4% to just above $969 million, but mainly due a 6.6% increase in square footage.

The most positive sign in the latest report of Wild Oats is the ability of the company to generate free cash flow. The year ended with an improvement in the cash position and a decrease in the debt levels.

Currently Wild Oats runs about 100 stores in 24 states and Canada. The stores provide natural, organic, and traditional grocery items, as well as environmentally-friendly household products. The company also offers bakeries, coffee, juice bars, and massage therapists in its stores.

Beyond Retail

The focus on natural and organic food is making a number of companies other than the supermarkets worth considering. United Natural Foods, a natural foods distributor, and a supplier to both Whole Foods and Wild Oats, is also gaining from the increased popularity of healthy eating.

For the latest quarter, the company reported a 31.8% jump in net earnings on a 16.2% gain in sales. Operating margins increased to 3.5%, up from 3.2% last year, and the company sees 3.8% as a reasonable level for the future.

More importantly, the company regained its second-largest customer, Wild Oats, once lost to a competitor. United Natural improved its sales outlook for fiscal 2004 to reflect the five-year deal with Wild Oats. Now revenues are expected in the $1.60 billion to $1.62 billion range, compared to previous expectation of $1.55 billion to $1.57 billion.

The return of Wild Oats will also alleviate the burden of depending too much on one customer. Currently, Whole Foods Market is the largest UNFI customer, representing 24% of the company’s net sales in fiscal 2003.

Another healthy alternative to supermarkets may come from an unexpected place. A former basement company, Lifeway Foods ((LWAY)) produces and makes popular kefir, an everyday yogurt drink from Russia. The company was founded in 1986 by Michael Smolyansky, an immigrant from Ukraine, and is now run by his daughter. By adapting the healthy kefir to the tastes of Americans, Lifeway has managed to achieve continuous growth in the past 10 years, mainly due to the increased demand for natural foods.

The company is still relatively small but this is changing fast. It sells its products through various retail outlets, including neighborhood health food stores and major chain supermarkets, such as Whole Foods and Safeway’s Dominick’s. Lifeway has grown its earnings at an average annual rate of about 20% over the past five years.

The problem with Lifeway Foods is that the stock no longer flies below Wall Street’s radar. Favorable publications in the media fueled investors’ interest towards the robust demand for the company's health-oriented products. In the past year, the stock skyrocketed from $3.50 to about $20.

Nevertheless, the stock is worth following and included in an investing diet provided a drop in the price due to volatility.

Nothing is Completely Safe

Being a successful pioneer, like Whole Foods, creates strong positions but also attracts competitors. The most serious competition may actually come not from direct rivals, but from struggling conventional food producers and retailers who try to expand their organic and natural food offerings.

Although at this point there is no significant presence of the organic food category in mainstream grocery chains, there are some indications of growing interest from traditional retailers.

If organic and natural food gradually becomes a more widespread and less expensive commodity, Whole Foods will probably have a serious problem with its business model. But the significant mind share, the strong relationships with suppliers and the experience should provide a place under the sun for the company.

Moreover, deep changes and massive shifts from engineered to natural food take long time, most probably decades. In the meantime, investors may enjoy organic growth with some of the healthiest companies in the world.