Whole Foods: Love the Company, Avoiding the Stock

I have been shopping at Whole Foods (WFMI) (43.50, $6.3 billion, S&P 500) for over a decade and continue to do so. I really like not only the products that they carry, especially some of the private-label ones (365 brand), but also the way they treat their customers. I have spent enough time and money there to consider myself somewhat of an expert.

I never bought the stock, as my former employer had an aversion to “grocery store” stocks, and I will confess that I tried to make some money from the short-side briefly after they reported their last quarter and the acquisition of Wild Oats (OATS) (only to get stopped out in the mad short-covering rally that briefly followed).

With that said, I want to share both my opinion and some facts about the company and the stock that lead me to expect that the stock will not beat the market for a while. As you can see from the chart below, it hasn’t exactly been beating the market in a while:

The (Lack of) Growth Story

I expect that growth at Whole Foods will not meet expectations. The current consensus for the next 3-5 years is that they can grow EPS 19%. My experience suggests that analysts don’t put a lot of thought into this type of number, as they aren’t graded on it the same way they are on quarterly or annual earnings estimates or recommendations. The consensus has been in the 18-20% area since 1999. It isn’t that surprising, as historically the company has produced 21% compounded EPS growth for the last 5 years. Folks, this is a stale number! Many, many investors are using that number as the denominator in their PEG ratio or in their valuation analysis, which begs the question: Can the company grow EPS anywhere close to that number? I will discuss valuation in more depth, but, with the stock trading at 28X the forward EPS estimates; clearly someone is expecting some growth.

If I were buying this stock, I would want to make sure that I understood the growth drivers. Prior to the recent Wild Oats acquisition announcement, the exercise was somewhat easier, as now one has to make a judgment regarding their potential success with integrating a poorly run competitor. This acquisition is totally out of context with their historical M&A strategy, as the overlap is significant. Traditionally, the company has used acquisitions to expand geographically. I don’t want to credit them in advance as Wall Street has seemingly done. While I wouldn’t rule out a near-term earnings boost if everything goes right, I don’t think that it raises their level of growth over the long-term. The mistake that many analysts are making is the assumption that OATS was “the” rather than “a” competitor. This leads me to my main point: Whole Foods isn’t so unique anymore.

As I mentioned, I am a long-time customer of the firm. I noticed their raising prices about a year ago and became quite alarmed. Why? It was clear to me that competition was emerging. People were talking about Wal-Mart, but I was seeing my local grocery stores not only start to mimic some of WFMI’s better differentiating features, but also start to carry a lot of the same products at lower prices. I didn’t have evidence at the time, but I now firmly believe that WFMI raised prices in order to combat flagging unit volume. This is an irrational and dangerous response if that is the case. I may be a “growth-stock” kind of investor, but I am a “value” shopper, and I noted that many of the products that had appealed to me had appallingly high increases. I had so often defended the company’s “high prices” by correlating them with higher quality. Well, “organic foods”, fancy salad bars and better customer service have become commoditized, and WFMI is no longer the draw that it once was. As we unwind from the “house as a piggy-bank” mentality that has been in effect since 1995 (and especially post-2001), customers may become more price-conscious and move to some of the cheaper alternative suppliers.

Well, what was above is certainly just my opinion. For the facts, one need only listen to the last two conference calls. I was astounded by the company’s revelation late last year that it didn’t understand why same-store sales were decelerating (or why they had been so strong before!). Real comforting... Then, this past quarter, defending tepid same-store sales, the CEO benched the grocery store business as how investors should view WFMI (positively). Well, for years, I have heard (and believed) that WFMI wasn’t in fact a grocery store but rather a high-end retailer. When the CEO starts using a moribund group of companies as a benchmark, he is telling us to forget about the high growth that the company historically enjoyed. Finally, amidst turmoil, the company announces a huge acquisition that is inconsistent with their historical practices. I guess this is opinion too, but that, folks, is a giant red flag.

So, absent this rabbit in the hat (fed organic carrots, no doubt), the company was going to be challenged to meet long-term EPS expectations. They have decelerating same-store sales (and no plan to address that), have had to move to increasingly less attractive markets (Seeking Alpha had a great discussion of this) and now face their largest integration ever.

Valuation

I wonder what type of investor is buying WFMI now. It certainly isn’t a “value” investor, as the stock is quite expensive still. “Growth” investors typically don’t like falling EPS estimates, increased business risk and poor price momentum. That leaves the “rear-view mirror guys”, the “hope and pray” crowd, “falling knife” fans and some potentially smart people who have figured out something that isn’t apparent to me.

I think that WFMI ultimately settles in at about 22.5X forward earnings over the next 6 months. The estimates have been falling, but I will assume that the Sep 2008 estimate of 1.69 holds (not an expectation, just an assumption). 22.5X would represent a PEG ratio of about 1.5 assuming a more reasonable (but still perhaps generous) 15% long-term growth rate. That represents a “target” in September of about 38, a good 10% or so below current levels.

Note in the chart below that the PE has come down, but it is still a healthy 28X, about double the S&P 500. RPS and EPS are decelerating. With increased competition, a risky merger that will devalue its pristine balance sheet and clearly slowing growth, this stock doesn’t justify its current valuation.

Disclosure: Author has no position in WFMI.

Comments

[mahesh reddy]

Company will have a good stock growth...My reasoning is that...most of the companies are sucessfull because of the BRAND NAME create not because of the product they have...for example look at others like APPLE AND STARBUCKS...its not they are no competing products ...there are many but these companies win over over the others becuase they created BRAND NAME to which mimic iconic status...which people love to adorn so they can feel great or show off...

In that respect...whole foods created a BRAND NAME to itself and they will start showing more results as they expand nation wide...and their stock will respond...more steady growth for next decade...I feel its a stock to own in a portfolio....

--Mahesh Reddy

[Alan Brochstein]

Are you familiar with Eatzi's? It too is (was) a place with "iconic status" where people went "so they can feel great or show off". Not an exact analogy, but here in Houston there was serious overlap with respect to the take-out business. Eatzi's is down to just two locations now. Here in Texas, HEB, which may be one of the best grocery store companies in the country, operates Central Markets, which is expanding rapidly from its original single location in Austin to now 8. The high-end shoppers prefer CM to WF, but they do pay a price in my opinion. CM pushes the quality and experience more than "organic", but the crossover is extreme. CM definitely has greater variety and also has its own private-label brands. Until WF started jacking prices a little over a year ago, I thought that it had the price advantage, but that is no longer the case in my opinion.

The point that I make is this: Don't underestimate the low barriers to entry. Here, where WF got its start, there is another very formidable competitor. It has also created a brand, in many ways just as strong if not stronger with high-end shoppers. It came from an old-line grocer, who distributes some of CM's private label brands now in its traditional stores. This doesn't mean WF won't continue to grow, but it makes me question the rate of growth. Don't forget Trader Joe's too!

I get back to my original point: Is the stock worth 28X? The defenders chide me for assuming what I think is obvious: growth will be slower than analysts assume (19%). The quality of the growth has diminished. It is based upon opening new stores and taking the fleas and worms off of a dog rather than "organic" growth. Yes, square footage growth is nice (if the company does meet its goals), but if that's all there is, then the value of that growth is questionable, as an opening produces only one year of "growth".

[Greg Harris]

I'm surprised you think 7% SSS is a case to stop growing? Do you really care if it's a chartists dream? So Whole foods has gone from low teen SSS for several years and now it's going to be a zero, almost immediately because WMT is going to carry organics? Actually I'd be more inclined to think this was a good analysis if it came when WF was doing well and pointing out it was likely unsustainable and the stock was way ahead of itself.

A wonderful thing that Starbucks discovered was that on a product everyone sees as totally commoditized, that they can still charge more for it and do it for years on end. So why is that? 180 total stores don't seem like a lot to me for a grocery chain, where convenience is key.

[7c-ranch]

Very good analysis. I like the store as well and have been looking for an entry point. Does the foregoing suggest 38 as the level--or no level?

[Alan Brochstein]

That level in six months, in my opinion, is where the stock starts to make sense but doesn't mean it is a "buy" there, especially if there is any continued deterioration rather than stabilization in sales trends.

[Greg Harris]

I'd suggest you look at their plans for rolling out new stores by the end of the decade before you cast your stone about what the growth rate looks like. It looks to me like you just chose an arbitrary number. Of course they're under more pressure, but a trip to competing supermarkets will show that they are still focused on different customers. I have personally not been extraordinarily impressed by renovations at Safeway that are supposed to materially make them more competitive. The last several years have shown extraordinary SSS, not not very extraordinary square footage growth. That's going to start to reverse itself. IMO, the SSS were unsustainable, especially in light that new competition is of course on it's way. SSS may be decelerating, but they're not overall horrible numbers and there's gonna be a lot of new total square footage around by 2010 - actually a little above CAGR of 15%, the number you chose from thin air and that excludes the purchase of OATS, which was a POS and I do believe WFMI should be able to improve profitability. Execution risk? - definitely.

I fully understand many very smart people think that margin contraction is a foregone conclusion and obviously that is what needs to be watched closest.

Good luck in your investing.

greg

[Liebs]

Good analysis. Wrong conclusion. You were wrong not to buy the stock "over a decade" ago, wrong to short it this year and nothing here tells me you'll be right this time.

[Daniel Jacome]

3 quick observations:

1) WFMI's gargantuan brand equity (when people think of $14 mozzarella, they think of WholeFoods) isn't listed on the balance sheet, obviously. One should not discount that, or the fact that although there are some people who rather get their organic goods @ Target, WFMI's core customer is for the most part price inelastic.

2) The founder is still CEO of the firm & doesn't pay himself much ($1 annual salary): most of his compensation is in stock, so it is John Mackey's best interest to see WFMI climb out of its its dark hole. The extent to which the firm achieves returns in excess of its WACC factors heavily in determining incentive compensation, need I remind you....

3) From a chartist's perspective, it doesn't get better than this. WFMI in the mid 40s is @ a 4Y bottom. If you believe in management, and WFMI survives, you'd be buying WFMI @ a really attractive price.

[Alan Brochstein]

Daniel, see my response to Mahesh regarding "brand equity". Actually, in Texas, they don't think of WF first, they think of Central Markets when it comes to fancy cheeses!

On your third point, the stock is not at a 4yr bottom but rather a 28 month low. 4 years ago, the stock was at 23. More to the point, it isn't a chartists dream, but rather a nightmare. The big up volume was clearly short-covering. The stock is in a downtrend with no discernable bottom formed yet. The recent rally didn't change the pattern of lower highs and lower lows.

[Alan Brochstein]

www.chron.com/disp/sto...

This link is to an article that serves as a nice follow up to the changing competitive environment to which I alluded. Key excerpt: "Offering more gourmet items and organics is a way of providing convenience by being a bridge between the traditional grocer and Whole Foods"