What kind of stock price would you expect for a retailer with no tangible book value, no owned real estate, a history of restructurings, stores whose sales plummet every time a competitor opens nearby, an EPS expected to be somewhere around .40 in 2006 and whose earnings per share and comps in a fast growth industry over the past 10 years were:

1996    -.32      1.5%

1997    +.53     5.0%

1998    +.71     3.0%

1999    +.53     6.0%

2000    -.65      -2.6%

2001    -1.87    4.0%

2002    +.19     5.2%

2003    +.05     2.4%

2004    -1.37    1.4%

2005    +.11     3.8%

 

Oh, and did I mention that the fast growth industry is finally beginning to mature and experiencing greatly intensified competition?

 

Welcome to Wild Oats (OATS), whose stock price has usually been more related to future hopes than actual performance.  In addition to the usual hope that OATS will somehow be turned around and transform itself into a high quality company like competitor WFMI, or that some grocery chain will some day vastly overpay for OATS, there is now the hope that grocery investing veteran Ron Burkle of Yucaipa will work his magic on this company, as he has with a number of grocers in the past.  From the standpoint of the traditional value investor, this stock price is far higher than the fundamentals warrant, and it’s not necessary to review reams of numbers to figure that out.  But due to reasons just stated and relative value comparisons to WFMI, this stock has been overvalued for most of the past decade.  So why short OATS now?  What catalysts will cause this stock to trade at a value reflective of the fundamentals?  The answers are not strictly numerical, so a review of the company and its industry are in order in order to understand the answer.

 

The stock price has already dropped over 10% since I started working on this report so rather than further refine this write-up, I’m posting as is before the potential gains from shorting evaporate.

 

 

After enjoying double digit annual growth for two decades running, the natural/organic food industry has seen growth slow into the high single digits over the past few years and is transforming from a niche into the mainstream.   According to industry publication Natural Foods Merchandiser, sales in the natural/organic retail channel have gone from $1.9 billion in 1980 to $25.5 billion in 2005, and total sales of natural/organic food in 2005 were $51.4 billion when all sales channels are included (mass market, internet, multi-level marketing, etc.).  The food marketing institute claims total supermarket sales in 2005 of $478.9 billion.

 

The industry has evolved in a relatively typical fashion, with thousands of manufacturers and retailers started in the early years, and consolidation in the later years leading to several remaining companies dominating the market.  On the manufacturing/marketer side, HAIN has become the largest consolidator of brands targeted specifically at the natural/organic consumer, with revenues over $700 million projected for 2005 (though new brands continue to proliferate).  Among distributors, UNFI dominates with revenues approaching $2.5 billion for 2006, and Tree of Life a very distant second.

 

Among retailers, Whole Foods Market and (privately held) Trader Joe’s have proven to be the leaders in many respects and are likely to remain the leaders for the foreseeable future, but there is much competition.  There are many well run natural/organic independent supermarkets or small chains.  There are hundreds of food co-ops, some of which are very well run, and many have banded together to recently sign a national purchasing agreement with UNFI, enabling them to reap the benefits of purchasing leverage as a virtual chain.  And, after numerous botched, half-hearted attempts at natural/organic offerings, mainstream grocers are beginning to make major strides in this area.  Safeway has made significant investments in stores in order to attract the natural/organic customer, and appears to be enjoying significant success.  Kroger is making progress.  Wal-Mart has declared a major commitment to organic food and has begun to aggressively place Organic products in their stores.

 

 

OATS started out as a relatively small chain of successful natural/organic grocery stores in Colorado and New Mexico.  Starting in 1994, OATS embarked on a rapid string of acquisitions in a bid to keep up with bigger and more successful Whole Foods Market.  After years of inconsistent results that brought OATS close to bankruptcy in late 2000, founder and CEO Mike Gilliland was replaced by Perry Odak in March of 2001.  Perry Odak brought to OATS the credibility of a CEO who had turned around several businesses in a variety of industries, including most recently Ben & Jerry’s.  This credibility gave OATS a renewed opportunity as Odak secured financing and was given breathing room by the various stakeholders to implement a turnaround.

 

Historically, OATS has trailed WFMI, most independents, and most small chains of natural/organic grocers in almost every metric, in spite of its scale advantages over most competitors.  Sales per square foot for 2006 will be approximately $440 at OATS, as compared with $880 for WFMI (and note that WFMI has a much higher portion of younger stores than OATS) – and sales per square foot are even higher at most food co-ops.  WFMI’s comparable store sales have been in the 7% to 13% range for most of its history and food co-ops (see Cooperative Grocer) have experienced comps nearly as good, while OATS has barely kept up with inflation.

 

So what went wrong for OATS?  The simple explanation is that former CEO Gilliland was totally incapable of successfully integrating all the acquisitions and led the company to the position of having a large number of different store brands and sizes, geographically scattered across the country (CO/NM the only concentrated area) with an organization ill-equipped to manage such complexity.  While Odak has been able to successfully stop the bleeding (and it took 5 years to do that much), the decade-long distraction of having to integrate so many different brands and manage such geographically scattered stores has caused OATS to lose focus on delivering a great customer experience.

 

As a consumer of natural/organic products, someone who has worked in this industry, and someone who knows many other consumers of such products, I can say that I have never heard someone claim to like Wild Oats better than a competing store such as Whole Foods Market, Trader Joe’s, Wegman’s, New Seasons, or one of the larger food co-ops.  What I have heard about Wild Oats stores is that they have higher levels of out-of-stocks than the competition (though this has improved since switching back to UNFI as the primary distributor), they have too high prices (relying heavily on promotions), they do not have the greatest selection, and the stores do not have as nice a shopping atmosphere as competitors.  From anecdotal conversations and a recent store visit, I believe that they have a top down command structure which makes it difficult for stores to cater to local tastes – for example, the wine section at a Wild Oats store I just visited in Portland had one of the worst selections (both quantity and quality) of local Oregon wines I have ever seen, as compared with Whole Foods Market, New Seasons, Zupan, and Market of Choice which all had excellent local selections.  I will be happy to provide more details about store differences if anyone is interested.

 

Wild Oats’ inferiority to New Seasons is particularly ironic as Wild Oats bought Portland-based Nature’s in 1999, and it the stores have floundered since.  But former executives from Nature’s started New Seasons, which has become a very successful chain with 7 locations (soon to be 9) in the Portland, OR metropolitan area.  When New Seasons opened a store less than a mile away from a Wild Oats store on SE Division Street, the Wild Oats store saw its sales drop from $250,000 per week down to $125,000 per week – and then it closed.  And this story is repeated all over the nation with competition from numerous independents and small chains (and of course WFMI and Trader Joe’s) who seem far more able to cater to local preferences than Wild Oats.

 

 

Under Odak, Wild Oats had improved in several respects and is beginning to reap the benefits of these improvements.  Out-of-stocks are down to manageable levels, raising prices and expanding private label has led to positive profits, and the number of brands has been reduced to four:  Wild Oats Natural Marketplace, Henry’s Farmers Market, Sun Harvest Farms (Texas), and Capers Community Market (Canada).  And perhaps most significantly, Odak strengthened the balance sheet through stock issuance and a convertible debt offering without too much dilution thanks to great timing.

 

However, industry growth is slowing and competition is in the process of greatly intensifying, as both WFMI and OATS are admitting.  WFMI has lowered growth expectations for two quarters in a row, OATS has followed suit, and I am hearing that many independents’ same store sales growth are slowing as well.  As mentioned above, some mainstream grocers such as Safeway are finally figuring out how to attract the natural/organic customer and it is only a matter of time before most grocers begin to copy the successes of Safeway and Wal-Mart.  And having local chains such as New Seasons opening up 1-2 superior stores per year certainly doesn’t help matters.

 

Wild Oats response to competition has been relatively uncreative, as they flip back and forth between increased promotion/advertising to boost sales, then cutting back to increase profitability.  At the moment, it seems that Wild Oats is at the tail end of a run of increased profits.  But pricing at the stores is 5% to 10% higher than most of the competition.  At some point, OATS will again need to resort to increased price promotions to merely maintain sales growth at the rate of inflation.  (Those more bullish on Wild Oats would point out that they have been performing experiments on new store formats that have much higher potential – but what does that say about the existing store base and what about all the CapEx that will be needed if they end up converting most stores to a new format?).

 

Perhaps the most unrecognized increase in competitive intensity is the national contract between food co-ops and UNFI that was just signed which will lower costs for many food co-ops (representing over $700 million in annual revenues).  Most co-ops already have stronger balance sheets, higher sales per square foot, and greater customer loyalty than OATS and this development will only widen the difference for core natural/organic customers.

 

Another unrecognized issue is that inflation has been running very high this year in the natural/organic category.  I don’t have firm statistics to back this up, but I have heard anecdotally that inflation in 2006 is running around 5% or 6% compared to prior years of 3% or so.  I am guessing this is because most shipments are in less than full truck loads to stores from UNFI (and in some cases from manufacturers to UNFI), and thus more heavily impacted by rising fuel costs than traditional food (which is experiencing only 2% inflation this year).  It is possible that scarcity of organic produce is also contributing to inflation.  So this means that real comps (that is, comps adjusted for inflation) are by far the worst they’ve ever been for the industry as a whole.  If real comps continue the current trend, and inflation reverts back to 3% in 2007 now that oil prices have stabilized, then expect comps to drop industry-wide by an additional 2% to 3% in 2007 from this factor.

 

I don’t have a firm prediction for comps for 2007 as it depends on how promotional OATS gets.  I do predict that either profitability will improve while comps turn negative, or comps will be as good or better than inflation but profitability will decline from 2007 levels.  In order to stop this sputtering performance, I believe a new CEO is needed who brings a significant organizational change to empower local employees to better focus on the customer at the local level.  Given large shareholder Yucaipa’s prior mode of operation, I doubt this will happen.

 

 

Over the past two years, famous grocery investor Ron Burkle of Yucaipa has purchased a large amount of OATS’ stock and now owns 17.3% of the company (some was purchased in August at over $16/share, but most was purchased at much lower prices in 2005).  The board and the management team are gradually being replaced by Yucaipa-influenced picks and the biggest change of all was the recent resignation of Odak.

 

Yucaipa has been highly successful in the past with turning around ailing grocers and selling them so I am guessing that the biggest reason Wild Oats’ stock price is so high is investor faith that Burkle will do it again.  I don’t think he will succeed with this one, as this is not a typical grocery turnaround.

 

I worked for nearly a decade in the natural foods industry.  I saw numerous executives from mainstream grocers or food manufacturers hired into positions at natural foods companies and, with no exceptions, I saw every single one of them fail to do well in the natural foods industry.  It takes a very different type of mentality to succeed in this industry and for whatever reason mainstream grocery and/or food manufacturing executives have been unable to make the shift.  Core consumers of natural foods are highly educated and like to learn more, they care deeply about authenticity (as they perceive it), and they care a lot about their health.  Marketing messages and product selection need to be attuned to these and related consumer attitudes but mainstream grocer methodologies have a proven track record of not working for the core natural/organic consumer.

 

Yucaipa has been populating the executive ranks (or at least influencing these decisions) with executives from traditional grocers.  I have no doubt they will fail to turnaround Wild Oats.  Recruiting executives from Whole Foods Market or Trader Joe’s would probably be much better for Wild Oats, as these are large retailers who really do have culture’s that encourage high customer responsiveness at the store level.  But I doubt that will happen.

 

As for Wild Oats being bought by another company, I find it hard to imagine a buyer who would pay a premium to the current stock price.  Grocers typically seem to get bought when they are doing well, and at their peak performance tend to be valued at something between .4 x sales and .6 x sales, which (when subtracting the debt) implies a value of somewhere between $12 and $20 for Wild Oats, IF AND ONLY IF it’s profitability and ROE attained the levels typical for a well run grocery chain.  1998 was the only year OATS ever came close to achieving that kind of financial success, and that was when competition was much less intense.

 

 

Given OATS’ historically inconsistent performance, inferior store base, lack of a CEO (and a new CEO who will probably come from a traditional grocer), intensifying competition, and poor “real” comps, I don’t think it will take more than a year for the market to revalue the shares to an EV of 6 x EBITDA as some of the catalysts I identified become more obvious.  Given normalized EBITDA of somewhere between $40m to $50m/year, 30m shares, and long term debt and overdraft net of cash and investments of approximately $106m, that implies:

 

EV = 6 x EBITDA = $240m to $300m

Market Value = $134m to $194m

Stock price = 4.5 to 6.5

 

The actual floor on the stock price may be around $6 or $7 given that Yucaipa was a heavy buyer at this level in 2005.  But this floor would not exist if Yucaipa sold off its stock.  I have no idea how likely Yucaipa is to abandon its investment in OATS, but there is no indication that they will do so in the next few months.