Organics feed a food industry hungry for growth

November 9th, 2012 by

Natural and organic foods are going mainstream, creating new investment opportunities as a crop of companies appear poised to generate healthy earnings growth in the coming years.

Like tie-dyed shirts and bell-bottomed jeans, natural and organic foods were once considered the province of the counterculture of the 1960s and 1970s. But like former hippies, natural and organic foods have moved into the social mainstream; they are being purchased in increasing numbers, often at premium prices.

Natural and organic foods appeal especially to affluent consumers looking for a differentiated shopping experience. At the same time they are gaining more shelf space at traditional supermarkets, which are also marketing their own natural product lines in response to mass-consumer demand for more value-conscious options.

As organic and natural foods appear on more consumer shopping lists, we think companies that manufacture and sell these products should enjoy healthy earnings growth in the years to come. These companies include Annie’s (BNNY.N), Hain Celestial Group (HAIN.O), Natural Grocers by Vitamin Cottage (NGVC.N), The Fresh Market (TFM.O), Whole Foods Market (WFM.O), and United Natural Foods (UNFI.O)

It’s important to make a distinction between organic and natural foods. To be deemed organic, food must meet certification standards of the Department of Agriculture, affirming that genetic engineering, synthetic fertilizers, sewage, and irradiation aren’t involved in production. On the other hand, natural foods aren’t bound by the same requirements as organic foods are – only the meat and poultry requirements are the same – so the term “natural foods” is a bit hazy and subjective. At any rate, natural foods are often produced and sold by the same companies and are lumped together with organic foods in industry statistics, so we’ll be combining them in our analysis.

Sales in the U.S. organic-food industry have grown steadily from a mere $3.5 billion in 1996 to $31.5 billion in 2011. Most recently, from 2010 to 2011 the industry grew at a 9.5% rate, compared with about a 5% growth rate from 2005 to 2009.

Why do shoppers increasingly want natural and organic foods? We think the reasons have to do at least in part with changing demographics and changing attitudes toward food.

For one, baby boomers – those reliable engines of domestic economic growth and consumer spending – are more discerning than ever when it comes to food because they’re older, more affluent, and more selective. In much the same way that they drove the physical-fitness trend in the 1980s, boomers are trying to eat healthier as they approach their senior years, consuming more “functional foods” – foods with a potentially positive effect on health.

Near the other end of the lifespan spectrum are millennials (those born after 1980), who are as much, if not more, health conscious than previous generations. Millennials are beginning to enter their peak earning years, and affluent millennials are much more likely to buy natural and organic products than their predecessors were. They’re also much more likely to have a brand preference for those purchases, according to a survey by research firms Jeffries and Alix Partners.

Together, baby boomers and millennials have popularized a new way of looking at food. Shoppers are considering more than price when making their food choices: they are taking into account environmental concerns, fair labor practices, and food safety as well. For many consumers, it’s a lifestyle choice that says as much about them as the clothes they wear and the car they drive.

Indeed, the trend toward healthier or more conspicuous styles of eating is considered a full-fledged movement that, among other things, has inspired the word “foodies,” coined to describe those who really do live to eat and aspire to a higher state of eating, so to speak. Books dealing with a preoccupation about food, like The Omnivore’s Dilemma by Michael Pollan and Eat Pray Love by Elizabeth Gilbert, have become bestsellers. Even First Lady Michelle Obama has chosen childhood obesity – a priority for health-conscious moms – as a prime domestic problem to address.

This trend has contributed to strong growth for the natural and organic-food market, with the outlook remaining bright, in our view. The U.S. organic food industry should generate a growth rate of more than 12% over the next two years, according to research firm RNCOS Institute. The Organic Trade Association says that 78% of U.S. families are choosing organic foods. And with organic foods now accounting for just 4.2% of all U.S. food purchases, we think they have the potential to grow much further.

As consumers’ appetite for natural and organic foods has gotten bigger, the shops that specialize in them have evolved. Natural and organic-food specialty shops were once mainly nondescript hovels tucked into the corners of strip malls, stocked with dusty boxes of flax seed and bottles of tea-tree oil. But that’s no longer the case. Now they’re polished, well-appointed stores complete with bakeries, deli counters, and exotic-foods sections showcasing premium items.

As for the affluent consumers those stores cater to, brand cachet is all important – the equivalent of Apple stores in consumer electronics. Today’s natural-foods stores are purposefully smaller than traditional grocery stores, enveloping the customer in a cocoon of locally sourced produce, sustainably raised meats, and other rarified offerings.

Leading the pack in providing such products and a refined shopping experience is Austin, Texas-based Whole Foods Market which focuses on health and wellness, selling higher quality meat and produce and selling its own line of food and nutritional products. Recently company management has tried to combat the perception that Whole Foods’ products are expensive (which may have led to its pejorative nickname of “Whole Paycheck”) by introducing more specials and not passing on all food-inflation costs to consumers.

In the last four years Whole Foods has reduced its average store size to cut costs. In 2008 the average square footage of its stores was about 50,000 square feet – a size that added to rents and opening costs. CEO John Mackey renegotiated leases on existing stores and opted for smaller new stores, reducing the average store size to a more efficient 30,000 square feet, in keeping with the company’s goal of a more personal shopping experience.

A competitor, Greensboro, NC-based The Fresh Market, sells natural and organic foods, its own branded products, and traditional products. The Fresh Market can offer lower prices than its elder brother Whole Foods by keeping the cost of operations down; it does so by choosing smaller and more economical locations for stores. The company’s labor costs are also lower, because it has fewer full-time employees, with 63% of staff working full time, compared with 75% at Whole Foods.

A third competitor, Colorado-based Natural Grocers by Vitamin Cottage is a health-food chain operating 57 retail locations in 12 states. Natural Grocers positions itself as an ardent advocate of nutrition, eschewing some of the more indulgent and effete offerings of competitors. It touts its stores as food “farmacies” and has earned customer loyalty with its “What We Won’t Sell and Why” manifesto, which lists the items the company won’t sell even though they’re approved by the federal government.

Specialty retailers like Whole Foods, The Fresh Market, and Natural Grocers aren’t the only ones driving the natural and organic-food market. Traditional supermarkets have also played a big role, bringing these products to the masses. In fact, conventional retailers are the largest sellers of natural and organic foods; in 2011 they were responsible for 54% of organic-food sales, compared with 39% for specialty retailers, according to the Organic Trade Association.

Supermarkets offer more affordable options than those typically available at specialty retailers – a critical advantage. After all, the number-one reason consumers cite for not purchasing natural or organic foods is higher prices, according to a survey by research firm Piper Jaffray. Many supermarkets offer their own branded product lines and locally grown produce.

Most of the shelf space for natural and organic foods in traditional stores is filled by either smaller brands which focus exclusively on organics, or by larger food companies that include organics in their stable of mass-market food products. In response to a growing market, the larger food companies have been scooping up niche manufacturers of natural and organic foods to broaden their product lines. Here are three companies, smaller in size, that we think stand apart in an increasingly competitive organic and natural-food market:

* Hain Celestial Group, based in Melville, NY, owns six natural-beverage brands, 31 natural-food brands, and 10 personal-care product lines based on natural and organic ingredients. In its fiscal first quarter ended September 30, the company reported revenue of $360 million, with its U.S. net sales rising 8% and its international net sales increasing 17% year over year. The company provides many of the products available at Whole Foods and The Fresh Market and should benefit from the continuing growth of those stores, in our judgment.

* United Natural Foods of Providence, RI, was formed by the 1996 merger between regional natural-food distributors Mountain People’s Warehouse and Cornucopia Natural Foods. The company’s organic and natural-foods products can be found in specialty and grocery stores alike, including Whole Foods and Safeway. The company’s net sales for fiscal year 2012 increased 15.6% year over year, to $5.2 billion.

* Annie’s, based in Berkeley, CA, makes organic snacks and its signature bunny-shaped pasta. It derives its name from cofounder Annie Withey, who helped start the company in 1989. Described by The Hartford Courant as “a laid-back woman with a radiant smile and a peaceful manner,” Annie Withey remains involved in the company, with the official title of “inspirational president:” she writes the personal letters printed on the back of the company’s product packages and responds to letters from consumers. The company’s products have long been a staple at specialty stores. Since Annie’s went public in March, its products have gained shelf space at major retailers such as Target, Safeway, and Kroger. Eighty percent of the company’s sales last year came from its certified organic products, most of which are pastas and children’s snacks free of artificial colors or preservatives.

Disclosure: As of October 31, 2012, Turner held shares of Annie’s, Hain Celestial Group, The Fresh Market, United Natural Foods, and Whole Foods Market in client accounts.