BMO's Kelly Bania Explains Why She Downgraded United Natural Foods

In a report issued Monday, BMO analysts Kelly Bania and Lucy Hong downgraded shares of United Natural Foods, Inc. UNFI to Market Perform and trimmed their price target to $52.00. However, the stock remains among the firm’s Top 15 U.S. Small Cap Stock Selections.

United Natural Foods disclosed last week that its contract with Albertsons (including Safeway Inc. SWY ) will terminate on September 20, 2015, ahead of the end date stipulated in the contract (July 31, 2016).

The analysts have already estimated the impact of losing this client; earnings will decrease by less than 5 percent. However, the firm’s EPS estimate for fiscal 2016 was cut by approximately 5 percent (or $0.17) to $2.98. The new estimate implies 3.3 percent top-line growth (from 9 percent), “reflecting the customer loss and a more conservative core growth rate of 8% (from 9%).”

On the day of the announcement, the stock fell about 17 percent and has continued to tumble. While some think the move may look like an overcorrection, Bania and Hong believe the announcement suggests increased risk to the company’s outlook.

The analysts continued, “With a modest industry sales slowdown in recent quarters – albeit not, in our view, from an increase in products shifting directly but rather in-part from large, direct-sourcing customers (such as COST and KR) gaining market share – the risk of further increased competition from KeHE (the distributor that won the new Albertsons' contract) as well as regional suppliers remains a potential threat. Additionally, further industry supermarket consolidation (Ahold-Delhaize merger expected to close mid-2016) could result in ongoing volatility for natural and organic distributors.”

BMO continues to believe that United Natural Foods’ prospects could improve as:

1) Temporary problems fade.

2) The company’s presence in faster-growing perimeter categories (through Tony’s and M&A activity) continues to increase.

3) Management increase its focus on the ethnic/gourmet channel.

4) New customer wins could increasingly come from other channels that have not yet shifted toward N&O (i.e., drug stores, dollar stores, etc.).