Special Delivery 2011

ELLIOT ZWIEBACH

United Natural Foods Inc. is putting all the pieces together.

After years of broadening its scope through a series of acquisitions, the wholesaler is focusing on integrating its distribution operations onto a national platform, expanding the customer base for its specialty offerings and doubling its Canadian business.

Steve Spinner

It's also looking for more acquisitions to spur further growth.

“We're coming together as one company instead of operating as a group of separate divisions,” Steven L. Spinner, president and chief executive officer, told SN.

Historically, UNFI operated on a regional basis. However, since expanding into specialty wholesale at the end of 2007, “we've put together a national office so we can call on the largest conventional players because of the growth we anticipated we would get from that segment,” he explained.

The goal is not to centralize the buying process, he pointed out, but to run the business on a national basis.

“We used to go to market differently in each division, but now we're trying to operate with a common set of standards, including running each distribution center the same way and allowing everyone to share in the same benefits.”

UNFI is working on several fronts at once:

• It's installing single-platform voice-pick technology across its distribution network and simultaneously implementing newly developed engineered labor standards — designed to drive efficiency, accuracy and service-level improvements — “and that platform and those standards will be integrated, one facility at a time, over the next two or three years,” Spinner said.

• As part of its new national approach, UNFI is working to enable suppliers to call on the wholesaler at a single contact point. “Suppliers are thrilled because it makes their job easier and more effective,” Spinner said, “and it allows for more transparency from us than we had three years ago.”

• Having entered the Canadian market a year ago through an acquisition, it anticipates doubling its sales there through new customer growth and further acquisitions.

• As the company works to increase sales to larger chains through its specialty division, several observers expect Safeway to join its roster of conventional customers later this year.

• It has an eye out for potential acquisitions of specialty distributors to boost its intellectual capacities. “We're very careful about the acquisitions we make,” Spinner said. “We want them to be accretive, and they need to be strategic. So we're always on the lookout.”

Crossover Customers

Observers said possible areas of opportunity for acquisitions include a specialty cheese distributor or importer; a regional specialty distributor; a small Canadian specialty supplier; or a regional produce supplier. (The company said earlier this month it is divesting the nonfood assortment from its specialty offerings so it can concentrate on distributing food products only.)

Based in Providence, R.I., UNFI is a distributor of natural and organic foods, as well as specialty foods encompassing ethnic, kosher, gourmet and international offerings.

It anticipates total sales of $4.4 billion to $4.5 billion for the year ending July 30 — up 16% to 18% from the $3.8 billion it reported in fiscal 2010.

Spinner said he sees considerable opportunities for additional volume, given that the company's sales account for less than 10% of the $81 billion organic wholesale market and less than 4% of the $63 billion specialty wholesale market. “This is still a very fragmented industry, and there's plenty of room for growth,” he pointed out.

UNFI's growth at the retail level is being driven primarily by an increasing number of crossover consumers — those who shop for both organic and conventional products — Spinner said. “We believe consumers who are drawn to organics will convert more and more of their purchases over time to the categories we distribute,” he said.

This 590,000-square-foot prototype warehouse opened in late 2010 in Lancaster, Texas.

UNFI operates 13 distribution centers in the U.S. (seven in the East, six in the West), encompassing facilities in New Hampshire, Connecticut and Pennsylvania in the Northeast; Georgia and Florida in the Southeast; Indiana and Iowa in the Midwest; Colorado in the Southwest; and California (two) and Washington (two) in the West — plus a prototype warehouse that opened in late 2010 in Lancaster, Texas.

That 590,000-square-foot leased facility — located approximately 15 miles south of Dallas — is servicing customers in Texas, Oklahoma, New Mexico, Arkansas and Louisiana, easing the capacity at UNFI's warehouse in Aurora, Colo.

The Lancaster warehouse is the first UNFI facility to install the combination of new technology and engineered labor standards. Spinner said the company's warehouse in Ridgefield, Wash., is next on the list for implementation.

As additional facilities are upgraded, the company hopes to resolve what observers see as its biggest challenge — keeping margins up.

Since the addition of specialty lines in late 2007, a key focus for UNFI has been “getting costs out of the system at a pace that exceeds the decline in gross margins,” Spinner said.

Although the economics of conventional distribution are typically less expensive than those of organic distribution, gross margins for conventional products are lower than for the natural and organic products that have fueled much of UNFI's growth, so the more UNFI sells to conventional chains, the more its gross margin is challenged, he explained.

The company has set a goal of boosting operating margins an average of nine to 12 points by July 2013 — a goal observers are not sure it can meet.

“UNFI is experiencing a lot of growth in many forms, but most of it is from lower-margin customers,” Meredith Adler, managing director for Barclays Capital New York, told SN.

“It has all the necessary growth elements in place, but in order to maintain profitability, the company will need to do certain things to lower its cost structure, and UNFI is certainly doing the right things.

“However, it fell a little behind schedule in Texas because of problems getting the warehouse operating properly, and it spent a lot of money working around those problems to get product shipped out. As a result, the company wants to take its time implementing the new systems at the rest of its distribution centers, and the benefits may not come fast enough to fully offset the margin pressure that results from growing revenues with low-margin customers,” Adler added.

“At this point, it's somewhat doubtful UNFI can achieve its operating margin targets by July 2013, so profit growth will probably continue to lag the company's strong top-line growth.”

Karen Short, an analyst with BMO Capital, New York, said the lower-margin volume from Whole Foods Market, Austin, Texas, and conventional supermarket categories could dampen gross margins, “[thereby] offsetting some of the near-term supply chain efficiencies.”

According to Andrew Wolf, managing director for BB&T Capital Markets, Richmond, Va., “Gross margin is systemically under pressure the more conventional business UNFI does. So to maintain its operating margins, UNFI must become increasingly efficient, which is why it's putting in the new warehouse systems.”

The biggest near-term obstacle is getting the systems installed and the efficiencies delivered, Wolf told SN. “The issue for UNFI is not productivity, because it's very productive, with the most modern distribution infrastructure and the best capacity in the industry. The issue is taking the increased sales volume it's getting and handling it up and down the supply chain.”

Through the end of April, 37% of UNFI's sales came from independents operating natural and organic stores, 36% from Whole Foods, 22% from conventional supermarkets and 5% from foodservice.

UNFI has been Whole Foods' primary wholesaler since 1999, supplying most of the chain's Center Store merchandise, along with some refrigerated categories, and some of the chain's “365” private-label items, but no perishables. It also distributes general merchandise and HBC, but recently reached an agreement to sell that piece of its business.

According to Adler, UNFI isn't making much money from its relationship with Whole Foods.

“It's willing to take lower margins from Whole Foods because Whole Foods is a national operator, which means UNFI carries those products in all its distribution centers, and that helps cover its fixed costs. And because the fixed costs are covered, UNFI can be more aggressive with other retailers,” she explained.

“People get excited about the benefits for UNFI from the growth of Whole Foods, but that's a little bit misguided because it's not that profitable a business.

“However, while no company should be as dependent as UNFI is on one customer, Whole Foods is a good company to be dependent on because it's a growth company with little prospect of going to self-distribution.”

Asked whether UNFI sees a risk in allowing more than a third of its sales to come from a single customer, Spinner told SN, “Whole Foods is a great partner. Our goal is to grow our non-Whole Foods business, but we truly enjoy the relationship we have with them.”

Last year UNFI assumed operations of the last two distribution centers Whole Foods was operating — non-perishable warehouses in Boulder, Colo., and Austin; it also extended its supply agreement with the chain through 2020.

Short said she sees opportunities for UNFI to expand its relationship with Whole Foods even further — for example, by servicing the chain's stores in western Canada (it already supplies the stores in eastern Canada) or adding some specialty products when Whole Foods' contract with another organics wholesaler expires in two years.

Beyond its business with Whole Foods, UNFI is focused on adding more volume from conventional chains and independents, Spinner said — operators who usually don't have the warehouse capacity to go direct or the desire to handle slower-moving natural and organic foods, Wolf pointed out.

According to Spinner, “Our primary competition is not a specific competitor. It's the organic products that flow directly from the manufacturer to the retailer.”

Speaking with analysts during a conference call earlier this month, Spinner said UNFI is extremely focused on the independent retail segment.

“Independents rely heavily on us, and we rely heavily on them,” he explained. “And over the last [third] quarter, we've done a couple of things to help them. First, we've completed the rollout of specialty for independents to all regions, so now we have a full offering around the country that independents can sell in their stores. We never had that before, and that is certainly helping our growth.

“Second, we've introduced our Wowzaville website, which is specifically designed to assist independents merchandise their stores. It's an extremely sophisticated Web-based tool that allows an independent to design a planogram for any category of products based on data that is specific by geography.”

Noting that sales to independents rose 8% during the third quarter, Adler said the strength of UNFI's independent customers “is especially meaningful because it is by far the wholesaler's highest-margin business segment.”

Wolf said UNFI is particularly attractive to independent retailers “because it has the most purchasing power and the broadest selection of any natural food distributor, which means it can offer more items and win on its assortments.”

One of UNFI's strengths, Wolf told SN, is that it provides more marketing support than most other distributors, which has helped it to grow its business among conventional operators. The addition of specialty lines has made UNFI even more attractive, he added.

“Typically, large conventional chains have a single buyer for natural and specialty foods, and they prefer to buy from a single distributor,” Wolf explained. “When UNFI offered only natural and organic options, the large chains were less likely to do business with it. But now that it offers both, discussions with the large chains are more viable.”

Among conventional chains, UNFI has picked up supply contracts from several large operators since adding its specialty operation, including two Ahold divisions (Giant Foods, Landover, Md., and Martin's Food Markets, Richmond, Va.), plus ShopRite, Keasbey, N.J.; Kings Super Markets, Parsippany, N.J.; Lunds/Byerly's, Edina, Minn.; and, earlier this year, Giant Eagle, Pittsburgh.

The company also supplies select natural and organic lines to Kroger Co , Cincinnati; Hannaford Bros., Scarborough, Maine; Wegmans Food Markets, Rochester, N.Y.; and Target Corp., Minneapolis, though Spinner declined to pinpoint how much product it provides each one.

There is considerable industry speculation UNFI is likely to add Safeway, Pleasanton, Calif., to its customer roster this summer — an account estimated to be worth $250 million to $300 million annually — when the chain's existing contracts with two other suppliers expire. Spinner and Safeway officials declined comment.

“UNFI has been able to pick up a large number of regional chains, but Safeway would be its first multi-regional win,” Wolf pointed out.

Besides its 13 U.S. warehouses, UNFI operates five distribution centers in Canada following its acquisition last June of SunOpta Distribution Group, Concord, Ontario.

UNFI's Canadian operations account for sales of about $200 million. “The key there is the ‘one-tenth’ rule,” Spinner said — “Canada has one-tenth the U.S. population and one-tenth the economy, so if we do $4 billion in the U.S., we should do about one-tenth of our sales in Canada, or about $400 million.”

With Canadian sales at $200 million, “we see plenty of room for growth there,” Spinner explained. “We expect to grow our Canadian business by taking on new customers and also through future mergers and acquisitions, which are still very high on our radar. We've got a very strong balance sheet, so we certainly have the capacity to make an acquisition.”

UNFI also operates several other divisions:

• Albert's Organics, Bridgeport, N.J., which distributes organic produce and other perishables out of nine U.S. facilities.

• Woodstock Farms, Edison, N.J., which manufactures and packages organic nuts, trail mix and dried fruit.

• Blue Marble Brands, Providence, which manufactures private-label products.

“Although we have about 20 core brands, we plan to focus the majority of our energies on just five of them,” Spinner said: Tumaro's tortillas and wraps; Rising Moon organic ravioli, pizza and salsa and pesto sauces; Field Day canned goods and household products; Woodstock natural and organic dairy and frozen products; and Mt. Vikos Greek cheeses and spreads.

• Twelve natural and organic retail stores called Earth Origins Markets — 11 in the U.S. (eight in Florida, two in Maryland, one in Massachusetts) and one in Canada — that range from 5,000 to 18,000 square feet. The stores began phasing in the Earth Origins banner at the end of 2010, replacing previous banners that included Mother Earth's, Railway Market and Cape Cod Natural Foods.

“We've had those stores, including one we closed this year in Key West, Fla., for years and years. They came to us in a variety of ways, but we have no specific plans to expand them,” Spinner noted.

He said he does not expect inflation to be a problem for UNFI for the foreseeable future. “Through the second quarter, inflation was below 2%, and we think over the next 18 months, it will probably trend toward 3%,” he said.

“Inflation of 2% to 4% is good for distributors because we can pass it through. North of 4%, we'd worry how it would affect consumer demand.”