Looking Beyond the AI Trade

While companies involved in the AI investment cycle have been leading headlines and have benefited our portfolios, we continue to search for ideas across industries that we believe are mispriced. Fitting into this was United Natural Foods Inc (NYSE: UNFI), which was initiated in our small-cap portfolio in February of this year, at an average price of $38. In our view, UNFI is a misunderstood company, and its valuation does not reflect its underlying economics.

UNFI is a leading wholesale food distributor. Approximately 50% of their revenues are from their natural segment, 45% from their conventional food distribution and the remaining revenues from their own operations of 75 grocery stores primarily in Minnesota and Maryland.

We view wholesale food distribution in the US as an attractive industry for several reasons. Firstly, organic food distribution is a consolidated industry which is dominated by UNFI and KeHE on a national scale. Secondly, organic foods are part of the healthy living trends that have risen in popularity, particularly among younger consumers. This should also benefit from increased usage of GLP-1 medications. Thirdly, food distribution is generally resistant to economic cycles, an attribute we value in our portfolios.

Shares peaked in early 2018 at around $45 and fell by nearly 85% to a low of $6 following the company’s acquisition of Supervalu in 2018. The logic behind this deal was to diversify the business away from their key customer, Whole Foods, which was acquired by Amazon in 2017 and at the time accounted for 37% of their revenues.

Over the following years, the Supervalu acquisition weighed on shares with high debt and its undesirable retail segment. Beginning in 2021 with the appointment of Sandy Douglas as CEO, the company embarked on a multiyear turnaround. By mid-2024, the turnaround began to take shape with strong cash flows and operational improvements, which led to its leverage rolling down from a peak close to 5x debt to EBITDA. When we initiated our position, we were not betting on a turnaround but instead acknowledging its success and our belief in continued execution.

The market views the Amazon relationship as risky because many large grocery stores have turned to a self-distribution model. In our view, this is unlikely to happen at Whole Foods because of the capital intensity of building out food distribution supply chains and the low likelihood of high returns on invested capital for Amazon. UNFI’s contract with Whole Foods was recently extended to 2032, and we anticipate continued extensions.

From a valuation perspective, without assuming material margin expansion, we believe shares are attractive. The company throws off $300 million of annual free cash flow against a $6 billion enterprise value. We see upside to cash flow generation should management achieve its margin expansion ambitions, while the deleveraging should eventually lead to capital being returned to shareholders via either share buybacks or dividends.

At ~$47 today, shares have rallied over 20% from our initial purchase on the back of strong earnings reports over the last two quarters. The market has begun agreeing with us, but we continue to see material upside in the shares.