ablokhin
It’s been a while since I’ve updated my thoughts on Natural Grocers by Vitamin Cottage (NYSE:NGVC) (“Natural Grocers”). I wasn’t excited about the return potential back in August of 2022 and the shares traded down from their price then for more than a year before stronger comps and margin performance in late 2023 led to a reawakening of the shares.
After this recent run, I’m still pretty neutral on the shares. I have some modest concerns about consumer spending over the next 12 months, but Natural Grocers has a pretty loyal customer base and I think the company’s focus on affordability (at least relative to natural/organic food rivals) will serve it well. The biggest question I have is whether management wants to get more aggressive and pursue a faster pace of growth.
I think this is a pretty decent “is what it is” company and stock today, but given where valuation is now, I think I’d rather wait for a pullback to start a position.
Sticking To Its Knitting, And Continuing To Execute
I will credit Natural Grocers’ management for understanding its model and executing pretty well on it – the company has really been focusing on its customer loyalty program, in-store assortment, and value proposition to customers, and it has continued to serve the company pretty well.
Relative to my expectations when I last wrote on the company, same-store sales have been stronger, with a 10bp outperformance in 2022 (2.6% same-store growth versus my estimate of 2.5%) and 85bp of outperformance in 2023, and even stronger outperformance so far this year.
That internal growth has helped offset a slower pace of new store openings than I’d expected, and importantly has not come at the cost of margin. Natural Grocers has outperformed on gross margin in an inflationary environment, with 90bp gross margin beats in FY’22 and FY’23, though higher operating costs have eroded that benefit at the operating profit line (+2bp and +14bp versus my expectations) and EBITDA performance has been within 2% of my prior expectations.
Same-store growth continues to be driven by the company’s differentiated in-store assortment, including its strict commitment to natural/organic ingredients, a growing private label business, and an appealing rewards program ({N}power) that continues to see double-digit membership growth (up 16% in FQ2’24) almost a decade after its introduction.
I’d also note that the company has done pretty well on a relative basis recently. For the last quarter, Natural Grocers’ 7.5% comp growth compares favorably to the 4% growth at Sprouts (SFM) and 1.9% growth at Fresh Market (owned by Cencosud), though both Sprouts and Fresh Market have meaningfully higher margins (EBITDA margin of 11.4% at Fresh Market and over 10% at Sprouts versus a little over 6% at Natural Grocers).
Looking at these drivers further, Natural Grocers has maintained a strict commitment to its policies regarding organic and natural products at a time when mean have its rivals have loosened up their standards in order to control costs. At the same time, though, the company has continued to be very attentive to pricing – that has consequences for margins and Natural Grocers’ gross margins are around 10 points lower than those of Sprouts – and that has helped maintain customer loyalty.
The company has also continued to expand its private label offerings. Private label now represents about 4% of the company’s SKUs, but around 8.5% of sales. With gross margins possibly around one-third higher on these products (using industry data on the margin differences between branded and private label products), the ongoing growth in this category (up from 8.1% a year ago and 6% a few years ago) gives the company a chance to not only win business with differentiated offerings, but gives management some additional flexibility on pricing.
Given the 30%+ penetration of private label at Fresh Market and the 20%+ penetration of private label at Sprouts, this should be a meaningful and sustainable growth driver for Natural Grocers for some time to come.
Management Doesn’t Seem Eager To Accelerate A Slow (Sluggish?) Pace Of Store Growth
One of the interesting parts of the Natural Grocers story is that management seems fairly content with a modest pace of new store growth. Indeed, the company opened fewer stores than I’d expected since my last update (2 net new stores in 2022 and 1 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 (and none in California or east of the Mississippi).
This slower pace of expansion does cap growth, but it also reduces the company’s capital needs (the company declared a special dividend of $1/share in late 2023) and it reduces operating risk. Investors who’ve been in the market a while can likely recall more than one example of a good retail concept that ultimately failed because management overextended itself and expanded at a pace that it couldn’t support, let alone sustain. With Natural Grocers not having hit double-digits for net new openings since 2017, that doesn’t seem like a big risk here.
The future pace of store expansions is one of the biggest unknowns I have when it comes to modeling this company. Relative to Sprouts (over 400 locations) and Amazon’s (AMZN) over 500 Whole Foods locations, Natural Grocers is a pretty small player, and it is in some ways the mirror image of eastern-focused Fresh Market.
I think the company could easily operate/support a larger footprint, but geographic expansion isn’t as simple as finding a building site and writing some checks; supply lines matter and I expect that Natural Grocers will be methodical about any westward expansion so as to ensure that it can get the SKUs it needs (or their equivalent) in whatever markets they enter, to say nothing of not overtaxing the capital or management structures.
The Outlook
A slow and steady growth pace is a mixed blessing when it comes to evaluating this business from an investment perspective. The reality is that the Street loves growth and Natural Grocers is still a small company – the $1.2 billion in revenue I expect this year is less than a sixth of the revenue the Street expects from Sprouts and food retailing is a business that rewards scale. Along similar lines, Natural Grocers is practically uncovered by sell-side analysts.
I believe Natural Grocers can generate annualized long-term revenue growth of more than 6%, with steady storecount growth and ongoing same-store growth helped by efforts like increased private label sales. I do think it will be hard to sustain gross margins of 30% or more, though Sprouts does at least point to what can be possible in this market. I’m expecting operating margins in the 3%-4% range and EBITDA margins improving to around 7% over time, with free cash flow margins improving toward the 2%’s.
Were management to accelerate the store opening pace, FCF would certainly go down in the short term (and likely operating margins as well, as it takes time for new stores to mature), but that would hopefully come with improved revenue growth and potential long-term margin leverage from enhanced scale.
Between discounted cash flow and a margin/return-based EV/EBITDA approach (with a 7.5x forward multiple), I believe fair value is in the low-to-mid-$20’s today.
The 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 likewise shown it can effectively manage pricing and margins. I do think the next 12 months could be a little more challenging for the economy, but that focus on customers and competitive pricing should help offset some of the risk to Natural Grocers.
Given where the shares trade now and the challenges of tougher upcoming annual comps, I’m more inclined to wait for a pullback in the shares. I may well miss out on some upside from here, but I’m more comfortable with a more defensive mindset ahead of those tougher comps and this is a name I’d like to reconsider at a better price if I get the chance.
