THE HEDGEYE EDGE
In the most recent quarter, we witnessed a complete break down of United Natural Foods (UNFI). The break down came in many places:
- The management team
- The income statement
- The balance sheet and cash flow statements
The break down from the management team came at the end of the earnings call when they were finally put to the test about the new guidance and the Q3 accounting change. The center of the controversy was a non-cash accounting change for the accrual for inventory purchases which benefited gross margin by 78bps and EPS by $0.27 in Q3.
The following is a truly remarkable exchange between a management team that was trying to hide a break down in the business from the Wall Street community:
Edward Kelly of Wells Fargo says: “your guidance went up by about $0.10 and you did not previously contemplate a $0.27 benefit from the accrual change, which basically suggests that the guidance went down by about $0.17…Is that the shortfall in Q3? And is that related to the underlying gross margin? Just some color there I think will be helpful for us.”
At this point of the call, UNFI CFO Michael Zechmeister, was asked numerous questions about an accounting change and was struggling to figure out how to get out of the mess, so he could only repeat what Ed stated: “I think what you suggested is $0.27 in Q3, is that what you're asking?”
Then Edward Kelly of Wells Fargo had to ask the question again: “Well, $20.9 million in incremental EBIT wasn't contemplated in the guidance when you gave it last quarter, right? That's about $0.27. You've raised by $0.10, so it implies about a $0.17 shortfall and I'm just kind of curious as to what's driving that?”
At this point the CFO has a complete break down when he says “Yes, I'm not sure that we see it that way. We see it more as a timing issue than it is anything else.” And then when pushed again, Mr. Zechmeister could only repeat himself: “Well, yes. I'm not sure we look at it that way. And I think that the color that we provided in our script is the color.”
At the end of this exchange, a rational person can only conclude that management was trying to cover up a massive decline in gross margins stemming from significantly higher inbound freight costs, inefficient distribution centers and higher labor costs. Did the management team of UNFI think shareholders and the broader Wall Street community were going to reward them by making a non-cash accounting change?
Getting past management trying to cover up a break down in the income statement, the cash flow and balance sheet are also showing signs of significant stress.
GROSS MARGIN IS DETERIORATING
Gross margin is where all the drama is, as stated above, management tried to slip in a positive $20.9M change in accounting for its revised calculation for its accrual for inventory purchases. UNFI took the benefit mostly from the first 9 months of FY18 and some from FY17 to positively impact a single quarter, and expects the street to run-rate gross margins at this new elevated level.
In reality, excluding this non-cash accounting adjustment, gross margins actually declined 84bps (management trying to pitch GM’s down just 6bps) versus consensus estimates expecting a decline of 35bps, this is a huge miss! If you wanted to be generous (we aren’t feeling generous this morning) you could spread the credit for the accounting adjustment across the first three quarters of the year it would be a $7M impact per quarter and would have brought gross margin in 3Q18 to 15.1%, down 32bps YoY.
UNFI is facing long-term structural headwinds to gross margin, headlined by the customer mix shift to lower margin customers, Whole Foods and Conventional. Whole Foods has grown 373bps YoY as a percent of sales from 33.7% of sales in 3Q17 to 37.4% of sales in 3Q18, and is headed north of 40% of sales over time. While sales to independent customers (higher margin customer) are down 182bps YoY as a percent of sales to 25.1% of total sales. Independents will continue to shrink and we believe this customer segment will struggle longer-term in an increasingly price competitive food retail environment.
This all bleeds down to their EPS guidance where this accounting change benefited them by $0.27, which actually implies a reduction in guidance of $0.17 not the growth in guidance of $0.10 that management is trying to sell to investors.
BALANCE SHEET IS FALLING APART LEADING TO CASH FLOW PROBLEMS
Total working capital for UNFI was up 18% YoY in Q3, compared to sales growth of just 11.8%, due primarily to a growth in inventories as UNFI deals with increasing customer demand and suppliers that can’t keep up. This increase in inventory is leading to a deterioration in free cash flow, which was -$34.2M.
This business is truly falling apart across the financial statements. UNFI is turning into a long term structural short in which margin upside will prove very difficult given the customer mix shift and pricing pressure headwinds.