A Natural Phenomenon Organic foods is a flourishing industry--for consumers and investors alike.
By Stephanie D. Smith

(MONEY Magazine) – If you think organic foods are just for bourgeois bohemians--Birkenstock-wearing, tofu-eating baby boomers--well, think again. The organic foods industry has mushroomed over the past decade into an $11 billion-a-year business. It is now the fastest-growing segment of the $1 trillion U.S. food market, with annual growth rates expected to exceed 20% for the foreseeable future.

Now organic foods are entering the mainstream. Starting Oct. 21, food dubbed "organic" will have to adhere to standards set by the U.S. Department of Agriculture. New legislation requires that labels on organic products--foods that are developed, grown and processed without chemicals, pesticides or genetic engineering--must detail whether they're 100% organic or just made with some organically grown ingredients. (Organic goods have more stringent standards in terms of additives than so-called natural foods.) That's good news for consumers but perhaps even better news for the industry. "The regulations validate the industry," notes Carole Buyers of RBC Capital Markets.

The popularity of organic foods stems from a few trends. First and foremost, heightened awareness of nutrition and the health dangers of obesity among aging baby boomers. Then there are the growing concerns about food purity in the wake of scares like mad cow disease and bioterrorism. Consumers of all stripes are going organic, and sales are coming from outlets other than natural foods stores. Supermarkets now account for half the organic foods sold in the U.S., up from 35% in 1998. Still, the segment makes up just 2% of the U.S. food supply, so there's lots of room for growth.

There are just a handful of publicly traded companies offering pure plays on organic food. The stocks are small--all have market values of no more than $2.5 billion--and thus can be volatile. Yet they offer an opportunity to capitalize on a market as sure to swell as baby boomers' waistlines.

Whole Foods (WFMI) is the nation's biggest natural foods supermarket chain, with $2.6 billion in revenue and 135 outlets in affluent U.S. neighborhoods. The Austin-based company courts the dedicated organic shopper as well as the mainstream consumer interested in natural foods. Its stores average 45,000 square feet and are stocked with a bounty of organically grown produce, free-range poultry, gourmet granola, even "natural" toilet paper. These products have helped Whole Foods register sales that average nearly $700 per square foot (Kroger, in comparison, garners $382 per square foot), which translates into 2.9% net profit margins (vs. 2.5% for Kroger).

Alas, these glowing numbers don't come cheap. At a recent $43, Whole Foods stock is changing hands for 26 times estimated 2003 earnings vs. an average P/E of 14 for the food-retailing industry. But Whole Foods forecasts a 20% annual growth rate for the next five years (vs. 11% for Kroger and 12% for Albertsons), as it plans on opening another 70 stores by 2004. Analyst Himali Kothari of John Hancock, which owns Whole Foods stock, argues that the shares are attractively priced, given Whole Foods' attributes. She says, "It has a great organic growth story [no pun intended] in a tough retail environment."

With 99 stores in 23 states and sales of $913 million, Wild Oats (OATS) is Whole Foods' biggest rival. While Whole Foods is widening the appeal of organic and natural foods, Wild Oats caters to adherents of a strict organic lifestyle. Wild Oats had a couple of rocky years thanks to a big-store concept that alienated its core shopper. But in march 2001, new CEO Perry Odak, formerly CEO of Ben and Jerry's, ditched that plan and returned Wild Oats to its small-store, service-driven roots to recapture its ardent clientele.

At a recent $9.50 the stock trades at 20 times estimated 2003 earnings. In the wake of management's recent efforts to fix the company, analysts expect it to notch 92% profit growth in 2003, on top of a 164% rise in 2002. Because it is in the early stages of its turnaround, the stock is risky. And, Whole Foods is a fierce competitor.

Perhaps a smarter way to play the industry's potential is through the largest national distributor of natural and organic foods, United Natural Foods (UNFI). The $1.2 billion (sales) company garners 20% of revenue from traditional grocery stores, 20% from Whole Foods and 40% from independent natural foods stores. Wall Street expects sales will grow at a 22% clip and hit $1.4 billion in 2003.

The stock was crimped in September, after Wild Oats, which accounted for 14% of its sales, declined to renew its contract, going instead with a smaller distributor. After boosting earnings by 39% this year, United Natural is expected to show an 8% gain in 2003. The stock, at $21.63, trades at 18 times next year's earnings. "The company really knows its market and management has been great," says Marilyn Mendel Han, an analyst with David L. Babson, which has 2% of its Babson Enterprise fund in the stock. "It's worth holding for the long term."

Another organic play to consider is Horizon Organic (HCOW), leading producer of organic dairy products. Its customers include natural foods stores and mainstream grocers. It recently introduced single-serving milk and pudding snacks, products that have higher profit margins than milk sold by the gallon. Horizon logged only $170 million in sales over the past year. Its stock, at $16, trades at a pricey 38 times 2003 earnings. But Kothari, whose funds own Horizon, says the milk maker will benefit from the new labeling rules and could be an acquisition target. --STEPHANIE D. SMITH