Following an impressive fiscal second quarter shares of Whole Foods Market (WFM) have once again crossed the $100 price level. This is a psychological price level and now it is perceived as an "overvalued stock" by many investors. Although the dollar value of a stock should not be the sole determinant of your investment decisions (the company's financial performance, future capital generating abilities, comparable price multiples and return requirements should all rank higher on the list), investors tend to shy away from stocks when they reach a psychological price level. So what must be done for shares of WFM to keep rising?
A savvy management team, especially one which earns the majority of its compensation from stock options (i.e. Whole Foods), must make a decision when these barriers are met. While I am a strong believer that stock prices will ultimately follow earnings, having the perception of a high share price can cause a slight impediment to your stock's growth continuation. Assuming the company is planning on operating as a going-concern, there are two steps for a company's management to take. Step one is to pat yourself on the back, your stock has most likely moved higher if you are contemplating a stock split (Whole Foods stock has risen from $7 a share in late 2008 to just over $100 in 5.5 years). Step two is to initiate a stock split. Following the latest earnings announcement the Whole Foods board of directors announced a two-for-one stock split beginning May 30, 2013.
Given the brief thoughts above, the question for current and prospective investors should be twofold. First, can Whole Foods continue to grow at such a rapid pace? Second, since a stock split is theoretically a non-event (your investment value remains unchanged, only the share count increases), will this recent announcement actually help boost the share price? Throughout this article I will address these two questions and offer an opinion as to whether or not shares of WFM will ever seen $100 again (post-split).
Source: Yahoo! Finance
Research behind stock splits
There are two general arguments behind the effect of stock splits. Many investors view stock splits as a positive announcement by a company. Typically we see the share price increase following the announcement as investors feel a greater sense of wealth (owning more shares of stock). The opposing argument considers the greater sense of wealth to be nonsense. Advocates of this argument propose that if you own one share of stock at $100 and it splits into two shares, you now own two shares of stock worth $50 each. Since your net worth did not increase, you have essentially created an accounting function, not an increase in wealth. While common sense leads me to believe the opposing argument is correct, academia has proven otherwise.
One of the most widely followed studies of how stocks perform after stock splits was done by David Ikenberry [pdf]. His first study, which was published in 1996, analyzed 1,275 companies with shares that split between 1975-1990. The study matched stocks that had split (2-for-1) to a control group of stocks (similar sized companies in similar sectors), which had not split. The results showed that the split group outperformed the non-split group by 8% after one year and 16% after three years.
For those who argue that this data is decades old and no longer relevant, the study was updated again by Mr. Ikenberry in 2001. His analysis grew to include 3,028 stocks on the NASDAQ, New York Stock Exchange, and American Stock Exchange which had split during 1988-1997. His results showed the split group posting a mean total return of 23.29% compared with the non-split groups' mean total return of 14.29%, a difference of 9% following the first year after the stock splits. His study goes on to provide various reasons why investors tend to "under-react" to stock split news. While I won't go into all the rationale provided, I would like to point out a few that may relate directly to Whole Foods.
One interesting hypothesis relates to the number of analyst covering a stock pre-split and post split. Since Wall Street analysts are typically criticized for being overly optimistic (always more bulls than bears), one could understand why increased analyst coverage may increase the share price. Of the firms in the sample, the median number of analysts covering a stock pre-split is nine. Following the split this number increases to a median of 13. Interestingly enough, the non-split group (comprising companies of similar size and industry) had an unchanged number of analysts covering its stock during the same time period. Investors may watch for increased analyst coverage post-split to see if this theory proves correct for Whole Foods.
Another explanation relates to earnings expectations from the analysts. The results show that the control group stocks (non-split group) had analysts who were overly bullish and did not have these expectations met. The split-stock group had analysts who were too bearish and later on revised forecasts upward. Positive earnings per share surprises tend to be associated with higher share prices. The non-split group of stocks showed EPS forecasts 5.5% too high prior to the split announcement. These estimates are then adjusted downward to +2.7% over actual results following the announcement date. The group of stocks that had their shares split had EPS underestimated by analysts prior to the split date by -2.2%. Over time the mean forecast for EPS actually grew for the split stocks. One may want to measure earnings surprises announced by Whole Foods to determine if this trend is relevant.
To briefly sum up the study, the results showed that stock splits are an event that the market tends to under react to. While critics may argue against the methods used in these studies, the data are certainly worth noting. Further proof of Mr. Ikenberry's study was expanded by three individuals in Hong Kong. Their data analyzed stocks in Hong Kong from 1980-2000 and proved that "Although stock splits seem to be purely cosmetic, there is ample empirical evidence that they are associated with abnormal returns."
My estimates on Whole Foods Fiscal Year
Following a stronger-than-expected first half of the year and new guidance by management, I have updated my income statement estimates for Whole Foods. I estimate diluted earnings per share will now be $2.86, which lies at the low end of management's guidance of $2.86-$2.89 (possibly I am just like the analyst in the study mentioned above). Below are some relevant points I factor into my estimates:
- Management is projecting full-year revenue of 10% - 11% in fiscal year 2013. Keep in mind that FY12 was 53 weeks and FY13 is only 52 weeks. My estimates assume 11% sales growth in FY13 and 12% sales growth in FY14 (due to increased store count and higher same-store sales in newer locations).
- Given management's ongoing strategy to expand "value" offerings, gross margins are expected to remain unchanged year over year. In FY14 I anticipate modest expansion (8 basis points).
- Management anticipates general and administrative expenses to be 3.1% of sales.
- Assuming 32 stores are opened this year at an average pre-opening expense of $1.7 million, "pre-opening expense" would be roughly $54.4 million
- Management anticipates an operating margin of 6.7%, my estimates fall just short at 6.61%.
- An effective tax rate of 38.5%
- Diluted share count of 187.5 million
Please note that the estimates below are not guaranteeing any of the results will be met. These estimates are strictly based upon management's guidance, the company's SEC filings, press releases, historical data, and my estimates.
2013 Full Year Estimate
2014 Full Year Estimate
Cost of Goods Sold and Occupancy Costs
Direct Store Expenses
General and Admin Exp
Relocation,store closure, lease termination costs
Other income/expense, net
Provision for income taxes
Preferred Stock Dividends
Basic Shares Outstanding
Diluted Shares Outstanding
Source: Whole Foods SEC Filings, Whole Foods Management Guidance, and my estimates based upon historical data and future expectations. Estimates given above are no guarantee of future results, please evaluate the company in greater detail before making investment decisions.
What will it take for Whole Foods to Double?
Assuming my estimates above are correct and Whole Foods is able to grow earnings to $2.86 by the end of fiscal year 2013, we can figure out how long it would take for the share price to double. I would caution investors that this is simple math I am about to perform and investing is anything but simple math. There are various metrics that must be evaluated prior to making an investment decision on Whole Foods stock.
To figure out how long it would take for the stock price to double we need to work backwards. Assuming WFM trades at $100 per share prior to the stock split, post-split the value per share will be $50. So a doubling of the share price would bring us back to $100. First, by looking at the trailing twelve month P/E of Whole Foods Markets (see chart below) we see the stock trading at very high price multiples. Since no company can continue growing rapidly forever one would assume the P/E multiple will fall over time. For my estimate I assume at P/E ratio of 30x TTM earnings. Dividing the expected future share price ($100) by the expected future P/E ratio (30x) would leave us with earnings per share of $3.33.
Assuming Whole Foods reaches the low end EPS guidance of $2.86 per share in FY13, post split this would become EPS of $1.43. If earnings grew at 15% annually, a simple present value calculation (PV=1.43, FV=3.33, i=15, Solve for N) shows it would take just over six years for the stock price to double (assuming the P/E is still 30x TTM).
Source: Whole Foods SEC Filings
Keep in mind that my example above is based upon simple math and price multiples. It does not factor in the study on stock splits mentioned above. Assuming Whole Foods is one of the stocks that is able to achieve "abnormal returns," the six-year time frame mentioned above may be shortened. Additionally, a higher earnings growth rate or price multiple in the future may also see WFM reaching $100 quicker than my estimates. Consequently, a slower growth rate or lower price multiple will expand the time frame to double.
With Whole Foods currently operating 348 stores (as of April 14, 2013), and management anticipating capacity for 1,000 in the United States alone, the growth opportunity for this company is still in the early innings. How quickly this growth occurs is the major question mark over the next few years. As competition from The Fresh Market (TFM), Natural Grocers (NGVC), Kroger (KR), and Wal-Mart (WMT) begins to intensify, margin compression and reduced same-store sales may be a challenge.
Investors should evaluate the growth prospects of this company before making an investment decision. The estimates for share price doubling I utilized above should be for illustration purposes only and not relied upon as your sole investment decision. Consider your investment goals and objectives before initiating a position in Whole Foods and please remember that the value of investments in equity securities, like WFM, will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. However given the research performed on stock splits, it may be worth considering this stock for your portfolio.