UNFI -- Small Position Now, Larger Position Later

This week I decided to open a small position in United Natural Foods (UNFI). I wanted to share the logic behind the position, and what I expect could happen in the near term after the company reports earnings on Monday. In a previous post I said that the things I look into a pre-earnings trade are valuation, momentum and comparables. I don’t particularly love the setup on momentum or comparables, but I do love the valuation.

Valuation

If you’ve read any of my work, you’ll notice that I tend to refer to excess cash flows. This is not a popular method for fair value estimates as most investors prefer to use discounted future cash flows. However using the past performance of the company allows me to concretely determine whether the investors prior to me got a fair return on their invested capital. I start from a year ago, look at the companies market cap as of one year ago to calculate it’s cost of equity, it’s debt at the same time to calculate cost of debt. I then use the cash flows earned for 12 months after that point. This allows me to see if the company adequately met investor’s expected rates of returns for the past year.

I then take those excess cash flows to the minimum required returns and add them into the market cap at the start of the year. This gives me a fair equity value that I then use to compare to the present equity value (market cap). I try to see if the stock is trading to a premium/discount to where it did a year ago.

Understandably some may cringe and say ‘the stock market is forward looking and you look backwards.’ This is true. However in looking backwards I can see whether a company is already carrying future cash flows into it’s present values and I can then assess whether the expectations are reasonable by looking at things like TAM, Growth Rates, and the companies ability to invest in new revenue streams.

Having said that when I looked at UNFI, I found the stock trading at a discount to it’s fair equity value based on historical valuation. This would be rather surprising when you consider the run up in the stock this year (see below).

As you can see UNFI had a huge runup in May before pulling back and then climbing up into August. All total the stock is up 44% on the year. However in looking at it’s valuation it still looks relatively cheap. For the TTM UNFI has a FCF of $470M. It’s current market cap as of writing is 959.7M, it’s debt total is right at 3B. So for ease of math we’ll say it has an Enterprise Value of 4B.

Unfortunately the debt that UNFI has isn’t cheap. A look at their 10K shows that most of their debt runs near 6 to 7% interest. That is nearly double the average rate of the broader market which is currently at 3.67% before the cost of tax (Source -- Cost of Capital by the Dean of Valuation).

So assuming a cost of capital at around 7.5% you would expect that a business with an EV of 4B would return 300M in FCF. As we saw earlier, UNFI returned 470M in FCF. Nearly 50% higher than the expected fair return on capital.

That is an outstanding number. Having said that questions should loom as to whether that number is sustainable or not. While the company has sustained 36% Rev Growth on average for the past 3 years, it hasn’t been organic but rather through M&A (the company acquired Supervalu in 2018. Unfortunately since the acquisition operating margins have contracted from around 2.5% prior to .65% since. These are extremely paltry margins and of their own right are quite worrisome.

However considering the companies outstanding performance in the past year on a cash flow basis, their attractive Price/Book ratio (.83) and their extremely attractive Price/Sales ratio (.04) I find the valuation of UNFI to be extremely compelling. I believe that any improvement in margins towards prior levels would likely see the stock move substantially higher.

Momentum

When we look at the chart of movement for the stock price, we see that since mid August and into September the stock has pulled back in considerably to the August highs. As I said in my trade about THO, I prefer this to a stock running up into earnings. While it is true that this can set up negative sentiment, it also lowers the expectations. On a moderate beat or loss, which is what happens more often than not, the stock moderates on it’s reaction upwards or downwards. A quick look at the option chain showed significantly higher call buying than put buying for the Oct monthly options. So sentiment overall seems to be mixed. Again I prefer this to being hyper bullish and setting up impossible expectations going into earnings.

Comparables

Finally I like to look at the comparables between analyst expectations and the prior year to see how analysts will be grading the quarter. Analysts are expecting revenues of 6.63B. The prior year’s revenues were 6.41B. This would indicate a revenue growth of 3.6%. It would be shocking if they didn’t attain this number. Looking at the grocery earnings of two companies that have already reported (Costco and Kroger) we see that sales were up about 13-14% across the board for the groceries in the prior quarter. I would expect to see revenues for UNFI to post similar jumps.

The larger concern that I have for UNFI going into earnings is the Analysts earnings expectation. Analysts are expecting EPS to be .74 per share. This would be on the upper end of companies earnings projections. Given that the pandemic has caused increases in costs to numerous businesses and looking at the recovery in fuel prices since the numbers given here were announced, it wouldn’t surprise me for them to fall short of the Earnings projections.

Conclusion

Depending on the earnings, revenue and guidance I could see one of two likely outcomes for the stock. I could see it going down to 16.80 and testing that number if the guidance is soft or the earnings are weaker than expected. However with a beat and solid guidance (especially if they have margin expansion) I could see the stock go up and test the 50 day moving average which currently sits at $19. Of course extreme news in either direction could cause for an extreme move.

I don’t love the setup going into earnings. However I do love the valuation. I also like the companies focus on ESG. I think post-election, more attention will be paid to infrastructure investments including decentralizing the food chain, improving soil quality, lowering carbon emissions and increasing carbon drawdowns. All of these things make me like UNFI as a potential investment idea. I’ll buy a few shares into earnings, see how things go and then see if the change in valuation makes me want to buy more or keep it on the watch list.