Co-op Devolution Part 2

From #104, January-February 2003

Co-op Devolution Part 2:

Northeast Cooperatives to Fold,
United Natural Foods, Inc. Assuming Services After Merger Vote

B Y   D A V E   G U T K N E C H T

Part 1 of "Co-op Devolution" appeared in CG #102, September-October 2002: http://www.grocer.coop/articles/co-op-devolution-blooming-prairie-frontier-north-farm.

Member-owners of Northeast Cooperatives on December 14, 2002, voted approval of a proposed merger with United Natural Foods, Inc. (UNFI), a larger, private distributor. The co-op's board of directors, after months of exploring potential business partners, proposed the merger several days prior to a scheduled October 26 business meeting in Brattleboro, Vermont. I was invited to attend what was probably the last full meeting for Northeast Cooperatives (NEC) members, directors, and employees.

Over one hundred member and employee representatives directed questions to management and board members and heard detailed explanations of the proposal and sobering reports on the state of the co-op. The negotiated agreement will cover NEC liabilities, maintain and strengthen services to buying clubs and stores, retain most employee jobs, and mitigate the loss of equity through cash bonuses for members that transfer their patronage to UNFI. On the other hand, if members had not approved the merger, NEC was threatened with liquidation.

Background

The NEC member vote will close out a year in which the three largest food co-op distributors folded through bankruptcy, sale, or merger. North Farm declared bankruptcy in August, and the announcement by the NEC board of the proposed merger came one month after members of Blooming Prairie voted to sell that cooperative distributor to UNFI. Northeast and Blooming Prairie each conducted negotiations with UNFI during the past year and reached separate agreements to fold into UNFI.

2002 was also the end of twenty years of co-op distributor consolidation. A series of maps was shown to NEC members at the October meeting, giving the names and locations of U.S. consumer co-op distributors. In 1982 there were 28. In 1989, seven years later, there were 14. In early 2002 there were six: North Farm, Blooming Prairie, Northeast/FORC, Ozark, Tucson, and Frontier. A 2003 map shows just the latter three.

Both Northeast and Blooming Prairie grappled with a rapidly expanding natural/organic market in which fast growth and much greater economies of scale were needed for them to continue as the primary distributor for existing as well as new members and customers. The two cooperatives engaged in their own merger talks during recent years, but without completion. The 1999 NEC merger with FORC, a small co-op distributor based in Ohio, was intended to be a step toward the merger with Blooming Prairie, which attempted but was unable to realize a parallel merger with North Farm. A related move was a brief alliance formed by NEC, Blooming Prairie, and Nature's Best. The latter serves the Southwest region and soon will be the only remaining mid-sized natural/organic distributor ($100-$200 million annual sales). Limits to capital formation, a longstanding problem in co-ops, proved the undoing of NEC, along with some bad timing. Operating in an extremely competitive regional market, NEC had been losing money while growing strongly, this past year exceeding $130 million in sales to more than 1,200 buying clubs, retail co-ops, and private stores. NEC got to this level with only a few million dollars in equity--an impressive accomplishment, but one that also foretold its end. At some point a business cannot obtain or support any more debt financing, and NEC reached that point in 2002.

Capital was needed in several strategies supporting NEC growth and competitive position: mergers and alliances, private label development, and Manager on Contract, along with major expansion of facilities and inventory. These efforts were largely financed through increased debt. Member equity payments (including equity from employee owners, an added component at NEC) helped keep the cooperative afloat but steadily shrank in value. Other investors and potential partners--through structures such as a subsidiary of the cooperative, as in the case of Frontier Natural Brands--were not attracted by the future of a mid-sized food distributor. The competition, primarily Tree of Life and UNFI, is much bigger now. In 1996, mid-sized regional distributors Stowe Mills and Cornucopia merged into UNFI, and by 2002 UNFI had 10 times the sales and 80 times the equity of NEC.

Bad timing worsened the cash pinch at NEC by upsetting a planned sequence of FORC merger followed by new Vermont facility followed by stronger growth. The merger encountered procedural delays. Phase 1 of the Vermont warehouse construction was delayed by unexpected and needless environmental review. And NEC's chief competitor, UNFI, had a prolonged computer system and service breakdown that generated a big surge of business at NEC when the co-op already was experiencing 25 percent growth. Accelerating Phase 2 expansion of the Brattleboro facility helped maintain services but also maximized the debt load. The deteriorating cash situation was manifested in payment problems experienced by vendors and high out of stocks experienced by customers.

Operating in a price sensitive field, unable to obtain more capital, and facing a much stronger competing distributor, NEC leadership foresaw a vicious downward cycle of declining volume and services as business migrated to UNFI. This same pattern was predicted by the leadership at Blooming Prairie, while at Northeast the threat was already painfully present.

Foreground

NEC board and management negotiated an impressive and complex merger agreement that includes the following:

• Continuation of comparable services for buying clubs and retail co-ops is written into the agreement. The Columbus and Brattleboro facilities will remain open for now, and in-stock rates are likely to improve quickly. Produce services will be folded into Albert's Organics, part of UNFI.
• UNFI will assume all NEC debts, property, mortgages, leases, etc. Bank notes will be retired, and vendor relations will be improved immediately.
• NEC equity is negative--there is nothing to return to the members--but each former member will receive cash bonuses for continued business with UNFI. These bonuses will be issued during just over two years, beginning immediately, and will help co-ops "recover" much of the equity each NEC member must write off.
• Retail co-ops in the Cooperative Grocers Association (CGANE) will negotiate a joint purchasing agreement with UNFI.
• Continuing employees will receive retention bonuses and an opportunity to transfer to a new UNFI facility only eight miles away when it opens in six to nine months. Most jobs will be retained, with severance pay for those whose positions are eliminated. Severance is no more than six weeks' pay except for four top managers, who will receive up to a full year equivalent but who also will sign one-year "non-compete" agreements preventing them from taking a similar position at another company.
• Because of legal restrictions on NEC as a Vermont cooperative that would be merging with a private corporation, the merger vote actually had three parts: (a) reincorporation of NEC in Ohio; (b) new bylaws associated with reincorporation; and (c) merger with a subsidiary of UNFI.
• The merger took place immediately after the favorable vote was announced on December 15.

During November UNFI, even before the member vote, improved services to the region by investing $10 million in NEC. More importantly, UNFI had agreed to merge rather than simply purchasing NEC assets. UNFI was the only potential partner willing to take the merger route rather than "carving out" valuable NEC assets while avoiding responsibility for all NEC liabilities and obligations--which would have hurt many small business vendors, employees, and customers.

Consequently, at that late October meeting, with Halloween at hand, jack-o'-lanterns lit, and the goblin of bankruptcy just down the street, CEO George Southworth was able to announce that there would be no "carveout." Just a sad goodbye for Northeast Cooperatives.

Future ground

It's the end of an era for food cooperatives, that's certain. With a vote of approval by NEC members, the employees, members, and directors know that everyone still gets a piece of pie: a smaller piece--of a bigger pie--from someone else.

Achieving economies of scale through consolidation among cooperative distributors probably would have been most effective at least 10 to 15 years ago. UNFI itself is the result of 23 mergers and acquisitions. Some thirty years after the launching of natural/organic distributors by local food co-ops, only two small consumer co-op distributors will remain--Ozark Co-op Warehouse and Tucson Co-op Warehouse--plus Frontier, a manufacturer and distributor.

What's lost cannot be regained--but not all has been lost. Mourning losses as well as celebrating accomplishments are both in order. Northeast and Blooming Prairie along with their antecedent co-ops accomplished a great deal that continues, a living cooperative legacy of lasting value and enormous impact. They have developed community-based co-ops in thousands of locations, generating thousands of jobs, educating millions of members and the public about food and organics and about cooperatives, supporting small producers and sustainable agriculture, and much more. (On this point I have included more in a sidebar, drawing from listserve resources that were extensively used for sharing information and passionate exchanges among co-op members, directors, and employees.)

If distributor services actually improve for most local co-ops, as they are likely to, there will be less to mourn and more to celebrate. What co-ops have not lost will be determined by the three hundred outstanding or potentially strong community-based retails and, less cohesively, several thousand preorder co-ops. Amazingly, and ironic in light of co-ops' previous inability to consolidate quickly enough, the loss of distributors has resulted in the concentration of purchasing volume from nearly all the co-ops in the country into one primary distributor.

Co-ops' combined buying volume now makes them the largest customer group at UNFI. Even its CEO, Michael Funk, has said that it's up to food co-ops to get it together. The new industry landscape tremendously expands the possibilities for realizing the "virtual chain" that retail food co-ops need in this challenging market environment.

Discussions of strategy for food cooperatives are more important than ever. Among cooperators, the question remains: "Are you preparing for the future?"

Dave Gutknecht is editor of Cooperative Grocer: dave@cooperativegrocer.com.

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