United Natural Foods Downgraded To Underweight At Morgan Stanley

United Natural Foods, Inc. UNFI faces top-line headwinds across its business, and its outlook is more challenged than the market appreciates, Morgan Stanley's Vincent Sinisi said while downgrading the organic retailer to Underweight from Equal Weight.

Looking Forward

"UNFI faces top line headwinds across its business that we believe are unlikely to abate," Sinisi wrote in a note to clients.

"UNFI's core natural/organic packaged food distribution business faces pressure as segment growth shifts more to 'fresh' offerings. At WholeFoods (Whole Foods Market, Inc. WFM), UNFI's largest customer (34 percent of sales), we forecast ~5 percent average sales growth in '16e–'19e, down from ~13 percent on average from '06–'15," Sinisi noted.

Related Link: United Natural Foods Announces Acquisition Of An Organic Food Producer

"For Independent Natural Retailers (32 percent of sales), competitive pressure from larger chains is unlikely to subside. For Conventional Supermarkets (26 percent of sales), a lost 5 percent customer pressures the segment outlook, and continued self-distribution risk remains," the analyst added.

The Broader Sector

Sinisi expects organic (ex-acquisition) sales growth reaching 5 percent overtime, well below double digit growth levels in recent years.

Meanwhile, Sinisi highlighted that "the sales deceleration comes right as United Natural Foods nears completion of an infrastructure investment cycle, driving a about 50bp EBIT (earnings before interest and taxes) margin decline."

Sinisi elaborated, "To management's credit, UNFI recognized the shift to 'fresh' and significantly invested in distribution capacity at new and existing DCs in order to serve this segment. As this capacity came online right as sales have slowed (including the lost 5 percent customer), margins are poised to contract ~50bps in '16 by our estimates. Absent a material pick-up in sales, which would likely take time, we do not forecast margins recovering this lost ground."

Sinisi's downgrade is also based on the share price move following the 2/29 pre-announcement, as he believes such a move is "unwarranted."

What Happened In Late February?

"On 2/29, UNFI pre-announced 2Q earnings and lowered its FY16 EPS guidance by 16 percent at the midpoint. Consensus estimates reflect ~8 percent EPS growth in '17/'18, implying 2016 setbacks are more of a blip; we see a fundamental reset and our maintained estimates reflect ~4 percent average growth over that time frame," the analyst said.

Sinisi noted that since February 29, "consensus EPS is unchanged while UNFI's P/E multiple has expanded by 20 percent. Coupling recent multiple expansion with a growth reset and the potential for further negative earnings revisions, we see downside potential supporting an UW rating." The analyst sees full-year EPS of $2.35 and $2.40 for the next year.

"We believe the +20% share price move since 2/29 is unwarranted. We continue to see topline and margin headwinds, driving our '17eEPS ~7 percent below consensus. We downgrade to UW from EW, with 8 percent downside to our $34 PT," Sinisi added.

Shares of United Natural Foods closed Friday's regular trading session at $37.02. In the pre-market hours, the stock was down 2.35 percent to $36.15.