Sector Spotlight: Organic Foods Poised For Another Harvest

The 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 swallowed by larger food and beverage companies. “They’ve come in and picked the cupboard clean,” said Chip Baird, founder of North Castle Partners, buyer of companies benefiting from trends 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 said.

That would be great news for the many buyout shops active in the market. San Francisco’s TSG Consumer Partners 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’s offices resides Swander Pace Capital, which counts organic dairy products producer Liberte Brand Products Inc. among its portfolio companies. Others firms that have active investments in the sector include Charterhouse Group, Pegasus Capital Advisors and Solera Capital (see chart for more details.)

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, which must meet standards set by the USDA’s National Organic Program, rose from about $16.1 billion in 2006 to nearly $18.9 billion in 2007, an increase of approximately 17 percent, according to data compiled by Nutrition Business Journal, a research, publishing and consulting company that covers the industry. In the past decade, year-over-year sales increased have never dipped below 15 percent, while reaching as high as 21 percent consecutively in 2000 and 2001.

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 approximately $34 billion. By contrast, Gurtcheff noted, growth in the conventional food market tends to match population growth, which according to the U.S. Census Bureau, ticked up only 1 percent 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 said. “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.”

Equity Concern

Your typical natural or organic food company is a small, entrepreneur-run player operating in a rapidly growing market.

Cash flow is often limited, either because the company has not reached a certain size and scale or because the money is being funneled back into supporting continued growth. Thus, businesses in this sector tend to be unable to shoulder payments associated with the 60 percent to 70 percent leverage favored by so many general partners. As such, the only way GPs can participate in much of the organic and natural food market is by “over-equitizing” their investments.

Naturally, the market has produced both 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 percent equity. At the time, Naked Juice was a small, regional player in the West Coast with revenues 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 10 times to $150 million and Naked Juice products were being sold in supermarkets, club stores, health food stores and other specialty outlets nationwide. PepsiCo has subsequently taken the brand even further, said Baird, building Naked Juice’s sales to more than $250 million.

In another success story, Catterton Partners last month realized a 7x return and 60 percent gross IRR on its investment in Wellness Pet Food, a provider of all-natural dog and cat food products. The Greenwich, Conn.-based firm acquired Wellness Pet Food in 2004 with a $45 million equity tranche. The company’s subsequent focus on sales force expansion and new product deployment helped more than triple revenues to $150 million and paved the way for a lucrative $400 million exit to investment management firm Berwind Group.

On the other hand, earlier this year business development company American Capital Strategies (Nasdaq:ACAS) earlier this year 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, investing up and down the company’s balance sheet, taking part in a revolving credit facility, senior term loans, senior and junior subordinated debt and preferred and common equity. This March, Hain Celestial acquired nSpired for about $38 million in cash, including transaction costs. The sale amount translated into a negative 9 percent compounded annual rate of return on the investment, according to American Capital Strategies.

Economics of Organics

The unstable economy does raise questions as to 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.

North Castle Partners’s Baird noted that most of the customers in the category 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 said. “Fundamentally they have certain beliefs that organic food is healthier for you, that it’s better from an environmental stand point.”

Nevertheless, Baird also pointed out that heavy, regular or occasional consumers of organic and natural foods make up only 10 percent to 15 percent of the U.S. population. “You’re talking about a relatively small percent of the country,” he said.

Food prices, meanwhile, are expected to rise another 4 percent to 5 percent in 2009, in addition to the projected 6 percent hike for full-year 2008.

With consumers facing more expensive fuel and food costs, lower home values, and less available credit, “Are people still willing to pay a 20 or 30 percent premium for an [organic] ear of corn, a head of lettuce, a packaged food product?” asked Harris Williams’s Gurtcheff.

Some see an answer to that question in the poor recent results posted by natural and organic foods grocer Whole Foods Market. In the three months ended July 6, 2008, the chain’s net income plummeted 31 percent, to $33.9 million from $49.1 million for the same period the year before, according to a regulatory filing. “Consumer confidence measures in June 2008 hit their lowest levels in more than a decade,” the company said. The dismal quarter spurred the company to suspend its quarterly cash dividend for the foreseeable future and to cut the number of stores expected to open in its fiscal year 2009.

Strategic Difficulties

There’s also the question of whether buyout firms will be able to compete effectively with strategics for the latest crop of organic and natural food companies.

Much of the segment’s allure stems from the lucrative exit market. If a firm can build a quality business, there will almost certainly be a major food and beverage company or a consumer products company willing to take it off its hands.

Firms have on more than one occasion tapped the likes of ConAgra Foods (NYSE:CAG), General Mills (NYSE:GIS) and The Hain Celestial Group Inc. (Nasdaq:HAIN), to monetize their investments.

The dark side of that phenomenon, of course, is that strategic buyers can come to dominate the exit market so completely that buyout shops have no room to compete. Resent strategic acquisitions include General Mills’s June acquisition of Humm Foods, makers of natural and organic nutrition bars under the Larabar and Larabar Jocalat brand names, and March’s purchase of Pilgrim’s Pride Corp.’s turkey production facility by Hain Celestial.

Said North Castle Partners Managing Director Louis Marinaccio: “Often, if I’m in conversation with an entrepreneurial owner of a business they will have had conversations with one of a handful of the largest food and beverage companies out there.”

And with the leverage constraints inherent in the business, it’s virtually impossible for a buyout firm to compete with a strategic when it comes to price. Added Marinaccio: “If an entrepreneur or a seller is really only looking for the highest possible price today, nine-plus times out of ten we can’t compete with a strategic buyer who really wants to own the business.”