Natural Grocers: Executing On Margins, But Decelerating Growth

My last write-up on Natural Grocers (NYSE:NGVC) was generally positive, as I expected to see the company’s efforts to boost the in-store assortment (especially supplements) and its loyalty program pay off in higher sales, not to mention the company’s very competitive price position versus rivals like Sprouts (SFM) and Whole Foods (owned by Amazon (AMZN)). Since then, the shares are up more than 30% – not a bad return and a little better than that of Sprouts.

I’m not quite as bullish at this point, though. Traffic has started decelerating at the stores, comps are getting more challenging for the supplements business, and I’m concerned about more challenges to margins given those traffic trends. I still see Natural Grocers as capable of high single-digit revenue growth over the long term with improving margins, but with fair value in the high teens, I don’t see quite the same upside at this point.

Deceleration In Fiscal Q3

Talking about the performance of Natural Grocers relative to expectations isn’t all that helpful, as the stock is almost unfollowed on the Street. Nevertheless, I can say that the company is tracking slightly lower than I expected on sales (about 1% to 2%) and EBITDA (about 6%-7%) on a year-to-date basis than I’d initially expected, with more deceleration in the last couple of quarters than I had expected.

Revenue rose 3% in the fiscal third quarter (reported earlier this month), as same-store sales growth slowed from +4.3% in the prior quarter to 2.5% (the year-ago quarter was down 3.6%). The two-year stack was still solidly positive (up 14.1%) with less deceleration relative to recent quarters. Within the same-store sales figure, traffic went negative (-0.2%) after four straight positive quarters, while average ticket increased by 2.7%.

Gross margin declined slightly, falling 10bp to 27.6% on increased costs like shipping/distribution, but I have to say that Natural Grocers has continued to exceed my expectations when it comes to margins – a byproduct, I believe, of the improvements made to the assortment and loyalty programs that have helped support store traffic.

EBITDA fell 11% in the quarter, with margin declining 80bp to 4.9%. Operating income fell 19%, with margin down 60bp to 2.1%. Higher store expenses took a modestly higher bite out of profitability, as the company is facing the same wage and cost pressures as other retailers.

Turning The Corner On Year-Ago Improvements

In my last update, I laid out some strategies management was putting into place that I thought could drive improved financial performance, including an expanded in-store product assortment that included more private-label products and a new line of private-label supplements. Given the cost of supplements and the brand equity Natural Grocers has built with its customers over the years (the name of the business is technically Natural Grocers by Vitamin Cottage), I thought this effort in particular could be a positive for sales and margins.

And indeed, it looks as though the supplement refresh/expansion did help sales. Sales of supplements were running quite a bit higher than the overall same-store sales growth rates, and with better margins. Here in the last quarter, though, the company started encountering tougher comps (supplement comps up over 6% in the year-ago quarter), and growth has slowed to a pace more in line with the rest of the business.

On a similar note, sales of private label products continue to climb – from around 6% a couple of years ago and close to 7% a year ago to 7.7% in the last quarter. While I don’t believe that management has ever discussed the profitability of their private label offerings, various third-party studies over the years have suggested that private label gross margins could be around a third higher than national branded gross margins. If that’s the case, and NGVC’s private-label gross margins are somewhere in the mid-30%’s, it’s not hard to see how and why an expansion of this business line is well worth management’s time and effort.

Bolstering the {N}power loyalty/rewards program has also paid off. The company saw a 19% increase in members in the last quarter, with loyalty program members now making up around 75% of total sales (versus 71%). Not only do loyalty program members spend more on average (a roughly 50% average basket size) and shop more often, the loyalty program is a way for the company to use targeted discounts to offset food cost inflation and lower customer’s total bill at checkout.

The Outlook

I am concerned about the recent deceleration in the business, particularly as the company doesn’t appear ready to re-accelerate new store openings at quite the pace I’d previously expected. I have no issue with a measured “slow and steady” store expansion plan, but it does put more onus on same-store sales growth to drive the business, and I think surpassing 3% same-store growth on a sustained basis could be more challenging in the near term.

Looking at what I might call the “intermediate term”, I still see more room to expand the in-store private-label assortment in both groceries and supplements, and I see this as a low-risk, high-reward opportunity to support margins. Given the smaller store format there will be some practical limits on just how far the company can take this, but I do still see room for more growth here.

With a slower store expansion plan seeming like the more likely call now, my revenue assumptions go down modestly, though I’m still looking for long-term revenue growth in the very high single-digits. My margin assumptions are higher now, helped in part by what I believe is a boost to gross margins from private label and supplements, but that’s partly offset by some changes to my working capital, depreciation, and capex assumptions. All told, my free cash flow margin assumptions aren’t too different, with only a 10bp change to my long-term average estimate.

The Bottom Line

Between discounted cash flow and a margin/return-driven EV/EBITDA approach, I believe fair value for Natural Grocers is currently in the high-teens. Reacceleration of the top-line and even better margin performance would of course support a higher fair value estimate, while slower same-store sales growth and margin erosion would threaten that outlook. I still like the business, and I still see attractive long-term growth opportunities, but the share price today offers a more balanced risk/reward trade-off than what I saw a year ago.