Apploquin
It’s been a while since I’ve updated my thoughts on Vitamin Cottage Natural Grocers (New York Stock Exchange: NGVC) (“Natural Grocers”). I wasn’t excited about the potential return in August of 2022 and the shares traded lower than their value Price then for more than a year before stronger corporate performance and margin in late 2023 woke up stocks.
After this latest round, I’m still very neutral on the stock. I have some modest concerns about consumer spending over the next 12 months, but Natural Grocers has a very loyal customer base and I think the company’s focus on affordability (at least relative to its natural/organic food competitors) will serve it well. The bigger question on my mind is whether management wants to become more aggressive and pursue a faster pace of growth.
I think that’s a pretty decent ‘what is It’s a company and stock today, but given where the valuation is now, I think I’d rather wait for a pullback to initiate the position.
Stick to it, and keep doing it
I will give credit to Natural Grocers’ management for understanding and executing their model well – the company has really focused on its customer loyalty program, in-store assortment, and value proposition to customers, and it has continued to serve the company well.
Relative to my expectations when I last wrote about the company, same-store sales were stronger, with a 10 basis point outperformance in 2022 (same-store growth of 2.6% versus my estimate of 2.5%) and an 85 basis point outperformance in 2023, and even stronger Outstanding performance so far this year.
This internal growth helped offset the slower pace of new store openings than I had anticipated, and most importantly, did not come at the expense of margin. Natural grocery businesses have outperformed gross margin in an inflationary environment, with gross margin exceeding 90 basis points in fiscal 2022 and 2023, although higher operating costs have eroded that benefit at the operating profit line (+2 basis points and +14 basis points versus my expectations) and EBITDA performance was within 2% of my previous expectations.
Same-store growth continues to be driven by the company’s diverse in-store assortment, including its strict commitment to natural/organic ingredients, growth in its private label business, and an attractive rewards program ({N}power) that continues to see double-digit membership growth (up 16 % in the second fiscal quarter of 2024) nearly a decade after its introduction.
I’d also like to note that the company has performed well on a relative basis recently. For the most recent quarter, natural grocery comps’ growth of 7.5% compares favorably with growth of 4% in Sprouts (SFM) and growth of 1.9% at New market (Owned by Sincosud), although both Sprouts and Fresh Market have significantly higher margins (EBITDA margin of 11.4% at Fresh Market and more than 10% at Sprouts versus just over 6% at Natural Grocers).
Considering these factors further, Natural Grocers has maintained strict adherence to its organic and natural product policies at a time when its competitors have relaxed their standards in order to control costs. At the same time, though, the company has continued to pay close attention to pricing — which has consequences for margins, and Natural Grocers’ gross margins are about 10 points lower than those of Sprouts — and that has helped maintain customer loyalty.
The company also continued to expand its private label offerings. Private label now represents about 4% of the company’s SKUs, but about 8.5% of sales. With gross margins on these products rising by about a third (using industry data on margin differences between branded and private label products), continued growth in this category (up from 8.1% a year ago and 6% a few years ago) gives the company an opportunity to not only To win business with different offers, it even gives management some additional flexibility in pricing.
Given private label penetration of 30%+ at Fresh Market and private label penetration of 20%+ at Sprouts, this should be a meaningful and sustainable growth driver for Natural Grocers for some time to come.
Management doesn’t seem keen on accelerating the store’s sluggish (slow?) pace of growth.
One interesting part of the Natural Grocers story is that management seems fairly content with the modest pace of new store growth. In fact, the company has opened fewer stores than I expected since my last update (2 net new stores in 2022 and 1 net new store in 2023 versus my estimate of 3 and 5, respectively), and the company still has more than 40% of its stores in Colorado and Texas (None in California or east of the Mississippi.)
This slow pace of expansion limits growth, but it also reduces the company’s capital needs (the company announced a special dividend of $1 per share in late 2023) and reduces operational risk. Investors who have been in the market for a while will likely remember more than one example of a good retail concept that ultimately failed because management overreached and expanded at a pace it couldn’t support, let alone sustain. Since Natural Grocers hasn’t reached double digits for net new openings since 2017, this doesn’t seem like much of a risk here.
The future pace of store expansion is one of the biggest unknowns I face when it comes to the design of this company. Relative to buds (more than 400 sites) and Amazon(AMZN) more than 500 All foods Natural Grocers is a very small player, and in some ways a mirror image of the eastern-focused Fresh Market.
I think the company could easily operate/support a larger space, but geographic expansion isn’t as simple as finding a construction site and writing some checks; Supply lines are important and I expect Natural Grocers to be methodical about any westward expansion to ensure it can obtain the SKUs it needs (or equivalent) in any markets it enters, not to mention not overburdening capital or management structures.
Expectations
The slow but steady pace of growth is both a blessing and a curse when it comes to evaluating this business from an investment perspective. The reality is that the Street likes growth and Natural Grocers is still a small business – the $1.2 billion in revenue I expect this year is less than one-sixth of the revenue the Street expects from Sprouts and food retail is a business that rewards high volume. In the same vein, Natural Grocers has been virtually exposed by sell-side analysts.
I believe Natural Grocers can achieve long-term annual revenue growth in excess of 6%, with steady store count growth and continued same-store growth aided by efforts such as increased private label sales. I think it will be difficult to maintain a gross margin of 30% or more, although Sprouts at least indicates what might be possible in this market. I expect operating margins to range between 3% and 4% and EBITDA margins to improve to about 7% over time, with free cash flow margins improving toward 2%.
If management accelerates the pace of store openings, cash flow will certainly decline in the short term (and likely operating margins as well, as it takes time for new stores to mature), but that will hopefully come with improved revenue growth and longer-term prospects. Term margin leverage from the enhanced range.
Between discounted cash flow and the margin/yield based EV/EBITDA approach (with a 7.5x forward multiple), I think fair value lies in the low-to-mid $20s today.
Bottom line
I don’t really have any issues with the basic business plan at Natural Grocers. The company has shown that it knows its core customer base and what they want, and management has also demonstrated its ability to manage prices and margins effectively. I think the next 12 months may be more challenging for the economy, but customer focus and competitive pricing should help offset some of the risks facing natural grocers.
Given where stocks are trading now and the challenges posed by tougher upcoming corporate annuals, I’m more inclined to wait for stocks to pull back. Maybe I’m missing some upside from here, but I feel more comfortable with a more defensive mindset ahead of those tougher comps and this is a name I would reconsider at a better price if given the opportunity.
