Investors poised to harvest another organic foods boom

The organic and natural foods sector traditionally has been the haunting ground of strategic buyers looking for the next hot brand to snap up. Great for exit strategies. But to the frustration of some general partners, most target companies of scale have already been consumed by larger food and beverage companies.

“They’ve come in and picked the cupboard clean,” says Chip Baird, founder of North Castle Partners, which acquires companies involved in healthy living.

Now, according to Baird and others, a new generation of investment opportunities is ripening and may soon replenish the field of acquisition targets. A fresh crop of fast growing companies valued in the $3 million to $10 million range are on their way to meeting the $25 million to $50 million annual revenue benchmark that would make them viable buyout targets, Baird says.

That would be great news for the many buyout shops active in the market, such as San Francisco-based TSG Consumer Partners. The firm has bought and sold numerous natural and organic food brands, including organic corn chip maker Garden of Eatin’ and organic dry ingredient producer Arrowhead Mills.

Just a few blocks from TSG is Swander Pace Capital, which counts organic dairy products producer Liberte Brand Products Inc. among its portfolio companies. Other firms that have active investments in the sector include Charterhouse Group, Pegasus Capital Advisors and Solera Capital.

It’s easy to see the attraction of the market. Demand for foods produced without artificial pesticides, genetic modifications and other alterations is plentiful, and the market’s year-over-year double-digit growth has proven sustainable over the last decade.

U.S. sales of certified organic foods rose from about $16.1 billion in 2006 to nearly $18.9 billion in 2007, an increase of about 17%, according to data compiled by market researcher Nutrition Business Journal.

Natural foods, meanwhile, a category that includes products that are minimally processed, account for another $15 billion in sales per year, according to Glenn Gurtcheff, a managing director at mid-market investment bank Harris Williams & Co. This brings the market value for the entire U.S. organic and natural food sector to about $34 billion. By contrast, Gurtcheff says, growth in the conventional food market tends to match population growth, which according to the U.S. Census Bureau, ticked up only 1% in the 12 months ended July 1, 2007.

“As the industry starts to mature, I think there will be more opportunities once the cash flow parameters start to stabilize,” Gurtcheff says. “Then you will have an opportunity to bring more leverage into the equation and you will probably see more investment from the private equity community.”

Exit Concerns

Up to now, acquisitions of natural and organic food companies has produced hits and misses.

When North Castle Partners acquired Naked Juice in 2000, it structured the acquisition of the all-natural juice and smoothie maker with well north of 50% equity. At the time, Naked Juice was a small, regional player in the West Coast with sales in the tens of millions of dollars. The firm reinvested cash flow to upgrade Naked Juice’s manufacturing systems, widen its distribution and build new store delivery networks.

By late 2006, when North Castle Partners agreed to sell Naked Juice to PepsiCo (NYSE: PEP), the company’s revenue had shot up close to 10x to $150 million as Naked Juice products were now sold in supermarkets, club stores, health food stores and other specialty outlets nationwide. PepsiCo has taken the brand further, says Baird, building Naked Juice’s sales to more than $250 million.

On the other hand, earlier this year, business development company American Capital Strategies (Nasdaq: ACAS) sustained a $32 million loss from its investment in nSpired Natural Foods Inc., a maker of organic and natural nut butters and chocolates.

Bethesda, Md.-based American Capital Strategies acquired nSpired in 2004 for $63 million, taking part in a revolving credit facility, senior term loans, senior and junior subordinated debt and preferred and common equity. In March, Hain Celestial acquired nSpired for about $38 million in cash, including transaction costs. The sale amount translated into a negative 9% compounded annual rate of return on the investment, according to American Capital Strategies.

Indeed, an unstable economy raises questions about whether this is the right time to invest in the natural and organic food market. Products tend to be relatively expensive due to their scarcity and higher production costs.

Baird notes that most of the customers of such products tend to earn more money than the average food buyer, and that sales in the overall organic and natural market should continue along its high-growth trajectory.

“The die-hards are pretty die-hard about buying organic,” Baird says. “They have certain beliefs that organic food is healthier for you, that it’s better from an environmental stand point.”

However, consumers are facing more expensive fuel and food costs, lower home values and less available credit. As a result, consumers may not be willing to pay a 20% or 30% premium for an organic ear of corn.