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We reaffirm our Neutral recommendation on United Natural Foods, Inc. (UNFI - Analyst Report) following an appraisal of its third quarter fiscal 2013 results, wherein strong demand for organic foods was overshadowed by weak margins.

Why the Reiteration?

On May 28, United Natural delivered third quarter fiscal 2013 results with earnings growth of 8.5%, driven by top-line growth. Net sales also grew 12.8% year over year driven by continuous increase in demand for the company’s organic and natural food products and increased sales within the conventional supermarket channel. United Natural’s earnings and revenues beat the Zacks Consensus Estimate in the quarter.

United Natural managed to grow its market share as a result of its continued focus on value added services and broader selection of products, including specialty foods. In addition to organic sales growth, United Natural also benefited from the inclusion of $12.5 million in incremental sales related to the acquisition of certain assets of three distributors completed during the first quarter of fiscal 2013. Food price inflation of approximately 1.8% also contributed to sales growth in the quarter.

However, increase in freight expenses and shift in customer mix to lower-margin conventional supermarkets led to a gross margin contraction of 83 basis points in the quarter. In fact, this shift in consumer mix has been negatively impacting the company’s gross margins over the past several quarters. Operating margin also declined 6 basis points in the reported quarter due to higher operating expenses.

The continued increase in demand for natural and organic foods led the company to raise its sales guidance for fiscal 2013. The company now expects sales in the range of $6.03 billion – $6.06 billion, compared with the previous range of $5.88 billion - $5.98 billion.

However, the company expects most of the net sales growth to occur in the lower gross margin supernatural and conventional supermarket channels in fiscal 2013, which led the company to narrow the company’s adjusted earnings guidance in the range of $2.15 to $2.17 per share, compared with the previous guidance of approximately $2.15 to $2.21 per share.

Overall, we remain impressed with the company’s decision to divest the company's non-foods and general merchandise lines that has allowed it to concentrate on its core business of the distribution of natural, organic, and specialty foods. However, United Natural remains severely impacted by the continued shift in the company's customer mix to lower-margin conventional supermarkets, which has been impacting its gross margins since the last few quarters.

Other Stock to Consider

United Natural currently carries a Zacks Rank #2 (Buy). Other stocks in the food industry worth considering are Nash Finch Co. , Fairway Group Holdings Corp. (FWM - Snapshot Report) and Green Mountain Coffee Roasters, Inc (GMCR - Analyst Report). While Nash Finch holds a Zacks Rank #1 (Strong Buy), Green Mountain and Fairway hold a Zacks Rank #2.

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