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Whole Foods Market, Inc. (WFMI)

F3Q09 Earnings Call Transcript

August 4, 2009 5:00 pm ET

Executives

John P. Mackey – Chief Executive Officer

Walter Robb – Co-President and Chief Operating Officer

Glenda Chamberlain - Executive Vice President and Chief Financial Officer

Jim Sud – Executive Vice President, Growth and Development

Analysts

Simeon Gutman – Canaccord Adams

John Heinbockel – Goldman Sachs

Mark Wiltamuth - Morgan Stanley

Karen Short – BMO Capital Markets

Meredith Adler – Barclays Capital

Neil Currie – UBS

Scott Mushkin - Jefferies & Co.

Edward Aaron – RBC Capital Markets

Robert Summers - Pali Research

Operator

Good day ladies and gentlemen. (Operator Instructions) I will now turn the program over to our moderator for today, John Mackey.

John P. Mackey

Good afternoon. Joining me today are: Walter Robb, Co-President and Chief Operating Officer; Glenda Chamberlain, Executive Vice President and Chief Financial Officer; Jim Sud, Executive Vice President of Growth & Development; and Cindy McCann, Vice President of Investor Relations.

First for the legalities: The following constitutes a Safe Harbor statement under the Private Securities Litigation Reform Act of 1995. Except for the historical information contained herein, the matters discussed in this press release are forward-looking statements that involve risks and uncertainties, which could cause our actual results to differ materially from those described in the forward-looking statements. These risks include, but are not limited to, general business conditions, the successful integration of acquired businesses into our operations, changes in overall economic conditions that impact consumer spending, including fuel prices and housing market trends, the impact of competition, changes in the availability of capital, and other risks detailed from time to time in the SEC reports of Whole Foods Market, including Whole Foods Market’s report on Form 10-K for the fiscal year ended September 28, 2008. The company does not undertake any obligation to update forward-looking statements.

We are very pleased with our third quarter results. We believe we are continuing to strike the right balance between sales and gross margin while exhibiting strong cost control. On a 2% increase in sales, we produced a 23% increase in income from operations, a 22% increase in adjusted EBITDA, strong cash flow from operations of $160.0 million, $93.0 million of positive free cash flow for the quarter, $223.0 million year to date, and an increase in our total cash to $448.0 million.

Average weekly sales per store for all stores were $555,000, translating to sales per square foot of $782. Our 23 new and relocated stores produced average weekly sales per store of $577,000 and averaged 54,000 square feet in size, translating to sales per square foot of $564. In the third quarter, these new stores showed an improvement in store contribution as a percentage of sales and NOPAT ROIC versus the class of 22 new stores last year.

Food inflation, as measured by the CPI, slowed significantly from 4.3% in Q2 to 2.7% in Q3, which while difficult to accurately measure, is likely having some negative impact on our sales. However, we are seeing favorable trends with regard to comparable and identical store sales.

Excluding the negative impact of foreign currency translation, comparable store sales decreased 2.0% and identical store sales decreased 3.3%. This was our first sequential improvement in comparable store and identical store sales in 6 quarters and was driven by stabilizing sales in almost every region and team.

In Q2 we saw transaction counts stabilize and then start to recover, with a marked downward swing in average unit price and basket size. In Q3 the recovery in transaction count continued, with average unit price and basket size stabilizing and then improving toward the end of the quarter. We hope these trends are an indication that the level of trading down might be easing somewhat.

For the first 4 weeks of Q4 ended, August 2, 2009, our comps, excluding the impact of foreign currency, declined 0.7%, and idents declined 2.4%, an improvement from the declines we saw in the third quarter. Transaction count and basket size both continued to show favorable trends. While our comps and idents are still slightly negative, we are encouraged by the continued sequential improvement we are seeing.

The marketplace continues to be very dynamic, and we are constantly searching for the right balance between driving sales and maintaining margin. Excluding LIFO in both years, gross profit for the quarter increased 33 basis points to 34.8% of sales, or 11 basis points higher than our 34.7% gross margin in Q2 on slightly higher sales.

We are seeing lower cost of goods sold driven by better purchasing disciplines, as well as improved store-level execution, particularly in terms of shrink control and inventory management.

Year over year, these improvements more than offset higher occupancy costs as a percentage of sales. We are particularly proud of the improvements at the former Wild Oats stores. The fact that we are seeing healthy gross margin and a movement in the right direction on transaction counts suggests to us that we are striking the right balance between the two.

We have not experienced significant food deflation outside of produce, where we have been able to offer our customers some fantastic deals. We are seeing many competitors emphasizing value and deemphasizing organic. We have taken advantage of the increased supply and lower prices available in organic produce to offer great promotions, particularly in organic berries, cherries, and grapes.

While we’ve seen a drop in average price per item in produce, we have seen a corresponding pick up in overall tonnage, which is driving higher gross profit dollars overall.

While on a local level we watch our pricing against our major competitors in every market, we are also benchmarking our pricing versus key national and strong regional competitors in 11 metro areas on a comprehensive market basket representing perishable, branded, and exclusive brand items across the store.

Our studies show we are responding to the current rapidly changing pricing environment and are competitively priced on these items. By investing intelligently in pricing on the key items that our customers demand most, our value efforts continue to gain traction.

Customer demand for our Whole Deal in-store value guide has grown over the last year from an initial 800,000 copies for a quarterly guide to 1.3 million for a new bi-monthly guide. Redemption rates for Whole Deal coupons continue to rise, approaching 4 percent. The Whole Deal value guide drives basket size and items per basket. The average basket containing a Whole Deal coupon totaled $65 and contained 23 items versus an average basket overall of $33 containing nine items. In addition, we have nearly 500,000 Whole Deal e-newsletter subscribers.

In our most recent results from our third party bi-annual consumer insights study, we are seeing positive signs of growth and rebounds from previous declines, reinforcing increased shopping behaviors and value perception. Most notably, the percentage of customers citing every-day, low prices as a reason for shopping has grown 8% since November of last year, and we’ve seen a 16% compounded annual growth rate in the number of customers who believe Whole Foods Market provides good value for the money.

While some competitors appear to be pulling back on organic as they emphasize value more, we are refocusing on our core customers and expanding our organic offerings. Our sales growth in organic products is outpacing growth in natural products two to one. This is driven in part by organic private label products.

We recently announced that each of our stores in the United States has been individually certified as in compliance with the new stricter federal organic retailer certification requirements. While some certified retailers may have just a few departments certified and focus on shrink-wrapped organic produce, in our stores, every department that handles organic food is certified.

We believe continuing to raise the bar in areas that matter to our customers will reinforce our leadership position in natural and organic foods, resulting in greater customer loyalty for many years to come.

During the quarter, we opened four stores in Annapolis, Maryland, Denver, Colorado, Vancouver, British Columbia, and Chicago, Illinois. Our new 75,000 square foot store in Chicago was a relocation of our highly successful Lincoln Park store, the first store we opened in Chicago 16 years ago. We now have 16 stores in the greater Chicago metropolitan area.

This is a perfect example of a market where a large store makes sense: a densely populated urban location where we have strong brand recognition. I think this is one of the finest stores we have ever opened—possibly the very finest.

The store features: a strong local flavor throughout five Chicago-themed venues; a sit-down bar that operates as a coffee bar in the a.m. and a beer/wine bar in the p.m. with a small stage for live music; 400 seats, including outdoor seating so customers can enjoy their meals overlooking the Chicago River; and 42 total cash registers, including express registers using the New York-style automated system.

Opening week sales were third only to our flagship stores in Austin and London. Store sales continue to be very strong and cannibalization of our existing Chicago stores has been less than expected.

I will now turn to our assumptions for Q4 2009 and updated guidance for the fiscal year.

For the first 4 weeks of the fourth quarter ended August 2, 2009, comparable store sales decreased 1.1% and identical store sales decreased 2.7%. Excluding the impact of foreign currency, comparable stores decreased 0.7%, and identical store sales decreased 2.4%.

We are pleased with the trends we are seeing but want to emphasize that we will have 8 new stores, including 2 relocations and one very high-volume store enter the identical store base in the fourth quarter, cycling over their strong opening sales last year.

In addition, further deflation and/or disinflation, as well as increased price investments, could negatively impact our sales. As it is difficult to get a clear read on the economy or where sales are going, we prefer to stay conservative in our outlook. If our comparable and identical store sales in Q4 are in line with our quarter-to-date results, our total sales growth would be approximately 2.9% for the quarter and approximately 1% for the year.

Year to date, sales have averaged approximately $154.0 million per week, a level at which we have demonstrated strong discipline around gross margin, direct store expenses, and G&A, a discipline we hope to maintain.

However, we have historically experienced lower average weekly sales in Q4, which typically results in lower gross profit, higher direct store expenses, and lower store contribution as a percentage of sales.

We have also implemented further price investments and are starting to compare against many of the cost disciplines we put into effect last year. For these reasons, we expect store contribution as a percentage of sales, excluding LIFO and asset impairment charges, to decrease approximately 100 basis points from Q3 to 7.2% in Q4, slightly greater than the 86 basis point sequential decrease we reported from Q3 to Q4 last year.

Based on our better-than-expected year-to-date results, we are raising our guidance for EBITDA, EBITANCE, and diluted EPS. We expect diluted EPS in the range of $0.16 to $0.18 in Q4 and $0.80 to $0.82 for the year, including $0.09 per share in asset impairment charges, $0.06 in FTC-related legal costs, and a negative $0.17 impact from the preferred stock.

The uncertain economic outlook continues to make it highly difficult to predict sales results over a longer period of time. Therefore, we will wait until our Q4 announcement to provide top- and bottom-line assumptions for fiscal year 2010. We would like to reiterate, however, that while our sales comparisons will be easier, we will have difficult expense comparisons due to the cost savings realized in 2009, excluding FTC-related legal costs and asset impairment charges.

Our business model has been highly successful since we began in 1980, and with fewer than 300 stores today, we remain very bullish on our long-term growth prospects, as demand for natural and organic products continues to grow and as our company continues to evolve.

We have a loyal core customer base that is aligned with our mission and our core values. We are dedicated to maintaining our leadership position as the authentic retailer of natural and organic foods. We believe continuing to raise the bar reinforces our authority and authenticity, making us the choice for customers aspiring to a healthier lifestyle.

While these are certainly tough times for retailers, we are very pleased with our third quarter and year-to-date results. We believe we have made strategic decisions that have allowed us to maximize our short-term results in this period of slower sales, while renewing our focus on our core customers and staying true to our longer-term mission.

And we are hopeful that sales are starting to move in the right direction. We are producing very strong free cash flow and have seen significant year-over-year improvements in our balance sheet. We are well positioned to take advantage of a rebound in the economy and we look forward to getting past this recession and back on an upward growth trajectory.

We will now take your questions but ask that you limit your questions so that everyone has an opportunity to participate.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Simeon Gutman – Canaccord Adams.

Simeon Gutman – Canaccord Adams

It might be tough to separate this impact and I know you kind of alluded to it in the script, but if you estimate what sort of the deflation impact was, is it possible that the two-year trend, either comp or ID, actually flattened and we just can't see it due to some of that noise?

Glenda Chamberlain

We really can't measure the impact of that. It's very hard to distinguish. We just know that there was some impact.

Simeon Gutman – Canaccord Adams

Could you just talk a little more color on the balance between the gross margin and sales? I think this quarter, in particular, the gross margin was much better than I expected. It's very good in general. I don't know if you can put into buckets to quantify where it's coming from, the sourcing side, better shrink. I know you've made some systems enhancements, sort of its mix. It just doesn't seem characteristic or representative of what you're seeing in the channel with the gross profit dollars at least, not accounting for not being the same year-over-year due to some of the deflation.

Glenda Chamberlain

It was all those things. We do see very good store-level execution and shrink control and in inventory management we're doing a great job on the buy side. They just seem to be executing at a high level.

Walter Robb

Let me just chip in a little bit. You know, essentially, we're just looking at 11 basis points sequentially from Q2, so we're sort of staying in the same frame that we were in this last quarter and really it's just what Glenda said. We've got a slight bump in sales, we've tightened up our inventories, we reduced inventories a little bit, so that helps the gross margins and the operators across the board have been doing an excellent job tightening down their purchase to sales and watching the shrink.

And all those things add up to a consistency in gross margin, which is really the story here. It's not from pricing, it's all from discipline because we're continuing our select level price investments.

Simeon Gutman – Canaccord Adams

And if you look at the baskets, are some of the baskets tilted towards what's on promotion or not necessarily? Is that changing at all as the stabilization or sign of improvement starts to unfold?

John P. Mackey

We're looking at the overall basket and seeing, as the script said, we are seeing a sequential improvement in the basket, recovery of the basket, and we're also seeing evidence of less trading down and a tipping back towards sales of branded products over private-label products.

But in terms of the promotional dollars in the basket, I'm not sure I've got good numbers on that right here right now. Except for the whole year.

Glenda Chamberlain

The year-over-year basket size is still negative. It's just less negative than it was in Q2.

John P. Mackey

That's right.

Simeon Gutman – Canaccord Adams

I think last quarter you expressed some cautiousness regarding the summer time. You wanted to maintain some of the momentum. It looks like, just judging by the two-year and what you've seen so far in the Q4, you've had that. But are you seeing anything encouraging in terms of what's happening in baskets or do some of the stores that might have been more impacted during the summer seem to be performing better this time around?

Walter Robb

The most encouraging thing is across the board, the recovery in the traffic, the customer count, and also the sequential improvement in both basket and items per basket. So it's green shoots, really. It's signs of momentum, it's signs of stability, but it's too early to call where this is going. It's just too unclear looking out there, based on all the noise that's out there.

But there's lots of encouraging signs.

Simeon Gutman – Canaccord Adams

And that's perimeter and center-store in terms of balance?

Walter Robb

It is both and it's across the entire country.

Operator

Your next question comes from John Heinbockel – Goldman Sachs.

John Heinbockel – Goldman Sachs

I think last quarter you talked about the split between perishable and non-perishable comps and non-perishable was running a bit stronger. Is that still the case and how much of a sequential improvement was more perishable-driven?

Walter Robb

So your question is in terms of the sequential improvement, how does it break out between perishable and non-perishable?

John Heinbockel – Goldman Sachs

Yes.

Walter Robb

I don't know that I have a great answer here. I don't think there's anything that stands out about that. We had a lot of movement in produce because of the deflation in produce pricing, which allowed us to get very aggressive with pricing. We see great response there but it didn't really drive the comps because the sales were more—the prices were down.

So we'll have to get back to you on that question, I think.

John Heinbockel – Goldman Sachs

Within your store is there sort of a canary in the coal mine from a consumer standpoint, i.e., maybe prepared foods gets a little bit better as confidence increases and that's the sign of a turn, and have you seen that?

Walter Robb

It's an interesting theory, the canary in the coalmine, but I think, you know, again, the tradeoffs in this quarter have been around the restaurant business, which we were getting some of that business and at the same time we're seeing a—they're participating in a sequential improvement but nothing extraordinary.

John Heinbockel – Goldman Sachs

From a national brand standpoint, what have you seen vendor allowance-wise? I mean, you're not seeing private-label growth the same multiple of brand as in conventional grocery, but brands, I guess, could grow faster. Do you see much change in allowance activity?

Walter Robb

You're right to say that the ratio of private-label and brands has adjusted. At the peak of this thing it was 4 times and I think last quarter I think we said 3 times and it has decreased even further in this quarter. In terms of the allowance activity, yes, there has been an increase on the allowances. There has been more aggressive pricing, promotional pricing pretty much across the board in the vendor community.

They have been [inaudible] to do that than they have lowering their prices.

John Heinbockel – Goldman Sachs

And you expect that to continue, I assume.

Walter Robb

I do. Absolutely.

Operator

Your next question comes from Mark Wiltamuth - Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

On the gross margin improvement, was some of that centered around the produce areas where maybe the deflation helped you get your cost of goods sold down and you just didn't go that far down on price?

Walter Robb

I think it was actually kind of a level on terms of the declines and then the sales uptick. The gross margin improvements are not on pricing. It's based on first of all, that Wild Oats, which made a nice jump year-over-year and in addition to that, the significant reductions in inventory and the disciplines on both the purchase to sales and the operating strength merchandising disciplines. That's where it came from.

Mark Wiltamuth - Morgan Stanley

And maybe give us an update on how the Wild Oats stores are progressing on their recovery in margin and sales.

Walter Robb

We're there, in terms of the gross margins. We're there. We've made a significant jump over last year and that's pretty much across the board and really all we're looking for her now is we're looking for the timing on investments and select Oats stores that we can begin to do some sales building. We're there on the gross margins.

Mark Wiltamuth - Morgan Stanley

And what kind of signs would you look for before you would start thinking about getting your store growth back up? How good does the operating environment need to get before you would want to get your real estate program back in full force?

John P. Mackey

Well, we never stop growing, so you mean are we going to get back up to trying to open 30 stores in a year? I mean, we've never done that. The most we've ever opened, I think, is 21. I think we're opening 15 or 16 this fiscal year.

For the foreseeable future, we'll be opening between 15 and 20 stores a year, so we think that's a good rate of growth. That's sustainable and I'm not saying that we won't change or accelerate it in the future, but for now we think that's the right growth for our company. About 15 to 20 stores a year, so look for that.

Operator

Your next question comes from Karen Short – BMO Capital Markets.

Karen Short – BMO Capital Markets

I just wanted to see if you could talk a little bit about labor as a percent of sales at your smaller format stores, versus the larger, and maybe talk a little bit about what you think the contribution margin is at the smaller format stores versus the larger.

John P. Mackey

It really is very store dependent. And it depends on how much volume a store is doing. A big store that's doing very high volumes, such as Columbus Circle or Austin, Lincoln Park in Chicago—they have very high sales, they have very high labor and their percentages are still pretty good.

And a small store won't have as much prepared foods labor or won't have a scratch bakery, so sometimes their labor percentages can actually be less, even though their sales volumes are less.

So it's very hard to generalize in any kind of meaningful way between large and small stores. It kind of depends on the small store and it kind of depends on the large store. So Walter can probably throw more color on it but I wouldn't want to put down generalities that I don't think would necessarily hold up to close examination.

Walter Robb

The one generality I think we can make in this quarter was that labor discipline was excellent in terms of across the board, small stores, large stores, all regions. We continued to gain leverage with the little bit of sales gain that we got and so the discipline was there and we were able to do that, regardless of the size or the age of the store.

Karen Short – BMO Capital Markets

And do you think that's an ongoing opportunity or do you think where you're at right now is probably as efficient as you're going to get?

Walter Robb

We talked about there's a point where, for us, that we're into the muscle and the bone and we're not going to go there. That's not who we are and the team members matter a great deal to this company.

So but are there continuing opportunities to look at for productivity or ratio of full-time to part-time or store design, to take out some of the costs? Absolutely. And those we are working on.

John P. Mackey

Our company has set a long-term goal to continue to reduce our expenses as a percentage of our total sales. We have a target internally but I'm not going to put that out in the public realm, although our board of directors is holding us accountable for it and so we do monitor that on a quarterly basis.

We are very determined to slowly, continuously, but incrementally, improve the efficiency of our company and take costs out of our business model: costs out of our G&A; costs out of our store operating model; cost out of the real estate and development; take capital out of a lot of new store construction; and in general, improve the cost side of our business.

That plus being able to maintain our gross margins is what's allowed Whole Foods to increase its EBITDA and its earnings despite having negative comps this year. So have we reached the end of it? I don't think so. I think we got a wake-up call this year and we're going to continue to work on the cost side of the business for the indefinite future.

I don't anticipate us going back to growth at all costs, even with our comps beginning to trend upwards. This is the big opportunity, the teachable moment, for Whole Foods Market in 2009, was management cost side of the business, manage our capital better and we learned an incredibly important lesson and we're not going to forget it any time soon.

Karen Short – BMO Capital Markets

And I just was wondering if you could elaborate a little more on the differences in the $65 dollar basket versus the $33? Is it mostly prepared food, is it produce, is it products in the Whole Deal? Maybe a little more color on that.

Walter Robb

Well, the color on that is that when you highlight some specific items like that, it's the whole basket goes up. The whole store. The rising tide floats all boats. Certainly you get those items in the basket but you also get other associated items. Because you get them in there to shop. And so when they're in the shop they can see other things.

So while you certainly get those items, you get a balance of items in the basket. I'll dig into that in preparation for the next quarter. I'll get a little more color on that to your specific question, but that is the general answer.

Operator

Your next question comes from Meredith Adler – Barclays Capital.

Meredith Adler – Barclays Capital

You mentioned in the press release that there were some more lease termination costs. I was wondering if you could update us a little bit on the pipeline and whether you did actually have some activity of exiting some leases.

Jim Sud

We closed about 55 stores in our pipeline and in the third quarter we terminated 2 leases. We think there's probably some more leases down the pike that will likely be terminated, depending on what goes on with the economy and the landlords' ability, or inability, to deliver projects to us.

So it's something that we will continue to monitor and react accordingly.

John P. Mackey

However, we do not anticipate our pipeline declining much below the current level, in terms of total stores. We've gotten it down to where we want to get to. We don't have a big overhang now of stores and development. So while there may be additional terminations, they are likely to offset by new lease signings as well.

So if we're going to open 15 to 20 stores, then having about 55 stores in the pipeline is the number we need to achieve that goal.

Meredith Adler – Barclays Capital

And presumably the leases that have been terminated, you are just as happy because there was some feature of the store, cost, size, whatever, that could have been better.

John P. Mackey

Absolutely. Any lease we terminated was a lease we wanted to get out of.

Meredith Adler – Barclays Capital

And then you commented, and very positively, about the NOPAD return on investment capital was better for the latest class, the 23 stores versus the 22. I'm not sure you're talking about latest 12 months versus the 12 months open before that. I wasn't sure of the time period. But maybe you could just talk about what do you think the key drivers of that improved return are?

John P. Mackey

I'll start and Walter will finish.

First of all, you have to understand that Whole Foods had double-digit comps for the better part of the decade, and we kept increasing the size of our stores and development and we traditionally found we just kind of grew in to the stores. And with the downturn in our economy, of course, we haven't seen our larger stores perform at the level that we had originally projected for them. This has caused us to rethink our business model and the stores that we are signing now are smaller stores. For the most part they'll be in the 35,000 square feet to 45,000 square feet range which we think is kind of our sweet spot.

That's not to say we won't sign any more big stores but I think they'll be more rare than you've seen the previous few years. And so as we open smaller stores, we're going to get better ROICs on the capital.

We're also just showing a lot more discipline in the amount to money we're putting into our stores that we're building out right now. So that's helping drive it as well as just better expense control and just executing our business at a better level, we're really focused on it, are some of the things that come to mind for me.

Walter Robb

I think it's just kind of bearing some of the organic fruit from the right-sizing efforts that we've been talking to you about over the last couple of years, of getting the right size store in the right market.

And also the construction costs. We've talked before about bringing our costs per square foot down in terms of building new stores and we've been working hard on that the last year and have spreading best practices and we're making some progress on bringing that down. And that's all showing up in the better performance.

Meredith Adler – Barclays Capital

And my final question is just about Wild Oats. You said that the gross margin has gotten pretty much where you hoped it to be and I'm sure that sales per square foot still have opportunity, but have you been able to manage direct store expenses in a way that allows you to be close to the profitability you think is possible at those stores, on a margin basis, or do you need to drive sales per square foot to make meaningful improvement?

John P. Mackey

As we stated many times before, our acquisitions tend to take about two years for us to fully integrate the store and get them into the Whole Foods Market culture, make the necessary leadership changes, and basically evolve the acquired stores. And we're coming up on our two-year anniversary of the acquisition actually occurring, which was at the end of this month.

So we're kind of on track with what we had originally promised the investment community—it would take about two years. Can we get the type of returns without driving comps to get to where Whole Foods Market sales per square feet are and the returns that Whole Foods Market's producing? I think the answer to that would be no, I don't think we can get there unless we're able to grow the sales. However, we are growing the sales.

We no longer break out Wild Oats' comps because we don't want the investment community to focus on Wild Oats per se, and it is less than 10% of our total sales, so it doesn't have that big of an impact.

But the fact of the matter is the great majority of Wild Oats stores are growing at double-digit comps right now. So they are having a positive impact on our sales and their sales per square foot are going up at a rapid rate, as we predicted.

So we anticipate that compounding of sales and sales per square foot to go on for the next several years.

Walter Robb

And we've had our best two quarters in a row on the [inaudible] and the thing is we kind of put our investments on hold, or we were a lot more careful the last 12 months as we wanted to see where this whole thing was going, and we are now in a position to be able to fire that investment up to drive some of that sales productivity.

So the answer is kind of yes and yes. Yes, we're in a really good place there. Better than we have been before. And yes, we also are going to tend to invest in those stores now to drive greater sales to get even stronger returns.

John P. Mackey

Possibly one other comment I will make is that you have to recognize that right now 12 Wild Oats operating stores are in limbo right now with their fate yet determined. Those are the stores that we negotiated with the Federal Trade Commission to put up for sale. So obviously those stores are scared. And they don't want to be sold. And we have made job guarantees to everyone.

That deadline is September 6 and we should have some clarity. Some of the stores should return immediately back to Whole Foods. Some of them will obviously be sold. And some maybe extended, as the agreement with the FTC permits, if there's bonafide offers on the table.

So I think we'll get increased leverage on the Wild Oats stores once this fate of these stores is finally determined and the stores that are kind of in that limbo are returned to Whole Foods or are sold. I think having that uncertainty is not good for morale and not good for our customer base.

So we're looking forward to getting past that. That's kind of the final chapter in this two-year melodrama that we've gone through here with the FTC. And we're almost done with it and that's going to help all those stores.

That being said, it's business as usual at those stores and we will continue to take care of our customers but we're almost through this gauntlet and we're looking forward to it being over with and we think that will be a good thing for all of our stakeholders.

Meredith Adler – Barclays Capital

And actually though, I was asking a slightly different question. This has all been helpful but what I was really trying to understand is the ability to manage the expense structure. Is there any reason to believe that some of your smaller stores couldn't be quite profitable stores even if they don't end up with very high sales per square foot?

John P. Mackey

They are very profitable. They are already very profitable. We've increased their profitability significantly over the last two years. Will they be as profitable if they're lower volume stores than if they're high volume stores? To ask the question is to answer it. They will be more profitable if they're higher volume. They can still be very profitable if they're lower volume but we intend to get the volumes up and so far we're having great success in doing that.

So we will optimize the sales that we have but our goal is to get higher sales for those stores and we think we can get them.

Operator

Your next question comes from Neil Currie – UBS.

Neil Currie – UBS

I am looking at your second quarter earnings report and it says that the guidance for you is of non-cash asset impairment $0.71 to $0.76, including $0.06 to $0.08 in non-cash asset impairment charges and the third quarter statement says the $0.71 to $0.76 excludes the $0.06. Just wondered whether you can just confirm that this later statement is the correct one.

Glenda Chamberlain

The later statements are the correct ones. Our earnings per share guidance if $0.80 to $0.82 for the year off of $0.64 year-to-date, which leaves $0.16 to $0.18 for the fourth quarter.

Neil Currie – UBS

I wonder if I could be presumptuous for a second and split your customers into three buckets: one is the traditional, organic, and healthy consumer that's been a staple customer for many years; you've also got the sort of quite wealthy customer who isn't as impactive potentially in terms of disposable income; and then you've got a third bucket which is the middle income customer who's very discerning about their food, but has been hit very hard by the financial crisis.

I imagine that this has been the shopper that's been the reason for the drop-off in sales over the last year or so and I was just wondering how this customer, who your impression of sentiment among this customer is right now and do they need a lot of enticement to come into the store. How can you gain back the loyalty of this shopper? Through the everyday low prices or do you think you will continue to need to entice them with strong promotional activity?

Walter Robb

I'm not sure I agree with all of your buckets but I think it's pretty clear that we said last time that we lost customers in 2008 and we lost, I'm not sure that particular bucket that you're referring to is—you know, it's much more about price than about loyalty to a particular store, I think.

And so a lot of our efforts have been towards really bringing greater value to our loyal customers and building additional trips in and additional basket with that group of customers as opposed to just chasing price with a group of customers that are all about that.

But it's a fair question and I have to give it some more thought in terms of answering it.

Neil Currie – UBS

Can I ask maybe about the fourth quarter then and the gross margin outlook you talked about maybe a need to make some further price investments. Would this be a result of wanting to stay aggressive and continue the work that you've been doing, or are you seeing additional competitor activity that is forcing you to respond more?

Walter Robb

No, it's actually both. One, is we have said before we are going to continue to build our momentum and we're going to do what we have to do to continue to do that and we think that those efforts are gaining significant traction. We know that. I talked to every regional president in the last 24 hours and got a sense of their momentum and their markets and clearly the message to me was this is really working. And so we're going to continue to that.

And with respect to your second point, it's not so much that we're reacting, it's that we're actually being proactive. We are tracking the chain supermarkets and regional markets across twelve markets and watching what they say to you and what they're actually doing with their pricing and making sure that we are where we need to be on a real-time basis.

And certainly, it looks like the marketplace is heating up in the last 30 days. At least the rhetoric has been and we want to make sure we're prepared to respond and to deal and stay ahead of that as we need to. And so that's the reason for the guidance going into the fourth quarter, along with a concern about Main Street and sales and just where this thing goes.

Operator

Your next question comes from Scott Mushkin - Jefferies & Co.

Scott Mushkin - Jefferies & Co.

Walter, I just wanted to get a little bit more color. I think you guys may be the first kind of upper-end retailer that has been talking about things turning. You know, most people in the food-away-from-home or the restaurant channel haven't seen much nor in other retailers that deal with a higher income audience. So it seems, especially the broad baseness that you talked about, that maybe this is what you guys are doing. I was just wondering if you could maybe elaborate a little bit more on what you may be doing at the store level that's driving this turnaround.

John P. Mackey

I'm going to answer this question. Neal had the same kind of assumption and you're making the assumption and it's not something Whole Foods Market believes in. We do not believe we are marketing to an upper-income customer. We have never believed that.

We are primarily marketing to a well-educated customer, a customer who has made a lifestyle change and that tends to correlate in terms of healthy eating with being a better informed customer, better educated.

As you know, about 80% of our customers have college degrees. That correlates with income, but it's not income that drives our business. It's education. It's one of the reasons Whole Foods Market has held up fairly well compared to other so-called high-income retailers, is because maybe we're not a high-income retailer. We're a retailer that markets to well-educated people who tend to want to continue to buy these foods, regardless of the downturn.

And what we've seen is that they're trading down some and we have lost some of our customers and the frequency of their shops, but in general, we're not affected quite the same way, possibly because we're just not marketing the way that you think we are.

So anyway, I do think that's a very important point I want to make. And I'll let Walter take the rest of it.

Walter Robb

I think one point is that we decided last April, May that this market was heading south and we decided to tack pretty strongly towards value so we've been doing this now for well over a year. And I would say it's fair to say it took us six to nine months to begin to get some traction on these efforts and that for the customers to really begin to give us credit for being more competitive and for meeting their needs in these times.

And so I think one of the secrets to the success has been we did it early and we did it strong and we've done it consistently and we are starting to see some benefit from those efforts now, after that period of time.

You don't turn things like that around overnight, but our own internal studies and that have shown that people are giving us increasing credit for being competitive, and also they're seeing the visibility of the value in the stores. They come in the store, they can see visibly that the better deals, the better pricing, the better choices. That's what works in retail, consistent execution day in and day out of a higher profile, higher visibility where people can see that, along with, I think, our excellent execution around the locally-grown products right now, which is one of the biggest things happening in food stores. And we're doing that, I think, as well or better than anybody else out there.

I think those two things together have helped to drive the traffic.

Scott Mushkin - Jefferies & Co.

Do you feel that people are trading back up or do you really think this is a traffic, an execution at the store level, which you are obviously one of the best people in retail doing that with the employees that you have.

John P. Mackey

We don't really know. I mean, we have seen some strengthening in our sales and is that driven by the economy or people feeling better? Is there more money sloshing around due to the Fed having such, doing their alter-market operations? We don't really know but we're certainly glad to see it.

We had six consecutive declines in comps, that's rather depressing, so we're ecstatic to have the sequential increase in comps. And showing so far in Q4 that that increase is continuing to move upward. So we're thrilled about that.

Obviously, we would like to think it's our brilliant execution and the fact that we're doing such a great job as retailers and all our investments are paying off and our disciplines and inventory controls and we would like to pat ourselves on the back, but we don't really know.

I mean, it could be the economy is firming up and people are feeling like we're going to avoid a depression. So stay tuned because we don't exactly know what's going to happen and you could take this as an early indicator that maybe the economy is getting better if Whole Foods has firmed up some. But we don't really know. And we would welcome your insights on it if you've got anything that you could share with us.

Scott Mushkin - Jefferies & Co.

On the last conference call I asked you about the store contribution margin and I think you indicated at the time that you thought it would be 7% or maybe below for the rest of the year. And of course it came in well above that this quarter. So I was wondering what changed so much, so dramatically, in the quarter to really move that number much, much higher for the second half of the year?

Glenda Chamberlain

That was our guidance for the second half of the year, not for the quarter. So while our quarter was better than we expected, particularly in terms of margin, and what we're projecting for and expecting for the fourth quarter is fairly similar results. We had a 30 basis point year-over-year improvement in Q3 and we're looking at a 20 basis point year-over-year improvement in Q4. So nothing substantially different.

John P. Mackey

Maybe it's worth mentioning that this is the inverse of what we have in the past called the growth paradox. As we accelerate our growth and our store base gets younger, and those less mature stores have lower gross margins, they have higher direct store expenses and that affects the overall impact to the company.

The fact that we've grown slower this year and this has given us a chance to digest Wild Oats, we haven't opened up as many stores. Several of the stores we've opened have been relocations. We've brought experienced teams in a relocated store. And so the average age of our store has gotten slightly older.

And so this is the positive thing that happens when we slow down our growth. So I think we may have, I don't know if we quantified that or not, but it's definitely a factor and it's one way to think about it.

That this more modest level of growth, compared to the previous two years, particularly with our ability to digest and integrate Wild Oats, we're just seeing better numbers. Better discipline in gross margins, better discipline in expenses, better wage control, just better execution.

Our regional leadership, instead of having to focus on opening a new store is able to focus more energy on current operations and improve all the stores. So slower growth allows Whole Foods to improve faster and execute better.

Scott Mushkin - Jefferies & Co.

I guess a lot of that must have surprised you, if the guidance is a lot different. But I do appreciate you taking my questions.

John P. Mackey

We're trying to get back to under promising and over delivering, after doing the opposite for a while.

Operator

Your next question comes from Edward Aaron – RBC Capital Markets.

Edward Aaron – RBC Capital Markets

Where is A. C. today?

John P. Mackey

A. C. is on a well-deserved vacation. He is still co-president but hopefully he's on his tractor somewhere working on his garden.

Edward Aaron – RBC Capital Markets

Just making sure. I wanted to take a different stab at the hard questions about changes you might be seeing within your customer base. I think a couple of quarters ago you talked about your customer mix potentially shifting a bit away from that foodie and a little bit back toward that core natural and organic customer. And just curious to get your thoughts on what you've seen on that specifically, more recently, and how, if at all, you might be going about changing your merchandising our your marketing strategy so that you can cater to those core customers maybe even more than you have in the recent past, without pushing away that foodie customer, which has been a big driver of your sales before the recession.

John P. Mackey

That's a great question and a good anticipatory question. Whole Foods, in 2010, is going to be initiating a very strong movement towards what we call healthy eating education. And we haven't yet begun it in our stores, although you can see little teasers of it in many of our stores.

But beginning in Q1 of fiscal 2010 we have some pilot stores that we'll be testing healthy initiative on and then we're going to go full bore as we get into calendar 2010. You can already see that we've added a new core value into many of our stores. If you look at our core values in our stores, which is about healthy eating education for our stake holders. So we are and we do think this is going to be very important going forward. We are going to make a relative shift from being foodies to being foodist, health instead of foodist pleasure.

And I'm not going to give a whole lot of details on it now but I'm telling you it's coming, it's going to be a big deal, and we're pretty excited about it internally.

Walter Robb

So some more specifics on your question is store design, in addition to making the stores a little bit smaller on balance, we have simplified the design to save money and also to refocus on kind of more basic approaches, and let go of some of the fancy venues and those sorts of things which are high foodie venues but are not really in step with the times.

And second of all, in terms of the merchandising, we've gone back to emphasizing bulk foods which will make a wonderful comeback, more of the traditional brands, products that have been around for years that customers know. And also organic produce. Produce has been one of the things that we started with and we are really hammering on that now, the tremendous opportunity with the deflation in produce pricing and to take advantage of that and offer tremendous deals.

And as we said in the script, we are actually upping our organic presence and leadership during a time when others are scaling it back. And that shows up also in terms of what items are displayed and emphasized and trying to eliminate some of the price soar on items that, some of the extreme foodie items, which tend to be very expensive.

And then the marketing in terms of, obviously you've heard what we've emphasizing. We've been emphasizing the value and the local. Those are things that are much more grounded and it doesn't mean that the food quality is not there or it's any less, it just means that the emphasis right now, particularly, is on those things.

Edward Aaron – RBC Capital Markets

You talked a little about the growth paradox. I'm just trying to get a better sense for how to think about the margin benefits that you might experience just from a natural aging of your store base in response to the slower growth rate that you're running at now. I know that comps, they're obviously the main driver of leverage in your business, but I'm curious to maybe get a sense of how much improvement can an individual drive over time, just from coming up the learning curve and getting more efficient. In other words, if you didn't really have comps in some of these stores that you're opening, what would the margin ramp look just from that evolving of the employees there and the ability to actually get better over time?

John P. Mackey

I mean, comps are the most important driver so you can't just pull them out and get a model. I mean, we did show good comps in our stores that were a couple of years old. We had 11.6% comp, I think we reported. So I do think comps are important for driving the productivity of new stores, so you can't pull it out.

But it is true that the reverse of the growth paradox is in effect. I mean, you can see that our young stores had about a 1% return on invested capital and you can see what the returns on invested capital are on the more mature stores.

A new store may break even its first year on average, or make 1%, but a mature store could be making 12%, 14%, 15% contribution profits. So as our stores age and we have fewer new ones coming into the mix, then you will see the profit percentages slowly go up.

I do think this has been something that we've been public now for 17.5 years and I've been talking about it for 17.5 years, but it remains very confusing to the investment community that can't understand why when we grow faster our gross margins go down and our direct store expenses go up as a percentage, which is why we always break out the comp sales so they can see it.

But still, people don't seem to understand that. And now the opposite is occurring and we're growing a little bit slower so it's going the other direction. Higher gross margins and better direct store expenses.

So how high can it go? It depends on how slow we grow and how strong the comps are. Our base is bigger. If we're only going to open 15 to 20 stores, that's not going to move the overall sales number that greatly so we will be growing our sales as a total percentage, lower than we have historically done, although we will still be producing significant top line growth in absolute dollars. It's just a law of big numbers there.

But I do think that with slower growth that we will continue to see good gross margins and good expense control and G&A as a good percentage going forward. I do expect to see all of that on a year-over-year basis, although obviously our fourth quarter is a tough quarter for us historically.

But we're pretty optimistic about fiscal year 2010 because we don't have a high growth rate planned in for that year. We expect to continue to get better.

Operator

Your final question comes from Robert Summers - Pali Research.

Robert Summers - Pali Research

Can we just dig a little more into the value perception. I mean, I think last call I think you quoted a number that was like a negative value index or something like that and then now we're talking improvement in the EDLP[?] and then value. Is there some overall, or one metric, we could look at or maybe establish, like a vocabulary to understand the progress that you've made since last May?

Walter Robb

That's a fair question. The stab we quoted you last time was from a Nielsen study and one of our research team was at the conference and it was just basically a reduction from 20 to 10 in terms of the negative perception.

This is from our bi-annual national marketing institute study which dumps into Nielsen or provides some of their data to Nielsen and that is showing the uptick in the positive perception of Whole Foods. But let's work on that and see if we can come up something for you that can be consistent quarter to quarter.

Robert Summers - Pali Research

Because I'm assuming you have some bogey in mind with some expectation on how improvement in that index translates into both short- and long-term sales improvement.

Walter Robb

Well, the biggest bogey we have is comps and that's where people vote and we see the improvement in basket, ticket, and item. That's what helps us to see kind of how something, and I think that what we feel now is that we're seeing a change in the perception about what's possible at Whole Foods and that's sort of corroborating it.

But I understand what you're asking. Let us consider that and come back with some sort of an answer.

Robert Summers - Pali Research

And with respect to better capital discipline and I don't know if you're going to give me exact reductions, but as you think about thinking capex, bringing it down, and preopening along with it, are you 25% of the way there? 50% of the way there? Or is there some number we can think about in terms of how far you've come and what's left?

John P. Mackey

We haven't made a public statement about that so I'm a little hesitant to do it here. We have some internal goals that we have that we're taking very seriously. We intend to reduce the amount of capital on a per square foot basis, on an inflation adjusted basis, significantly over the next five years.

So that's an internal goal the company has, we haven't put that out there in the investment community, but over the next five years track our development costs on a per square foot basis. I believe, adjusting for inflation, which could become a bigger factor in the years to come, I think the hope is we're going to make significant progress there. It's something we're really paying attention to.

Robert Summers - Pali Research

Both those tie in to this next question, where I guess I see a world where the capital per unit is coming down, accentuating returns, prospect of a smaller box, improved value perception, continued over time. How greatly do you think this expands the potential footprint of Whole Foods? Like on a five-, ten-, fifteen-year basis. I'm not trying to nail you down near-term.

John P. Mackey

Well, if the world doesn't change very much, it increases our potential greatly. Because it's going to allow us, we will have, from an EDA standpoint, and a return on invested capital, a lot more projects are going to make sense if the amount of capital we have to invest in a project has gone down. And for the smaller box the break-evens are much lower. So we are beginning to look in communities for sites that before we hadn't considered to be good prospects for.

So we do think it increases it. I can't quantify it for you but it is significant. Of course, the unknown is always what competitors do. And seldom do they allow you to just march onward and upward without resisting. So it depends upon what other people do as well.

But right now we think we're making the right decisions to benefit our long-term positioning and we're pretty bullish.

Robert Summers - Pali Research

I guess it's pretty fair to say that's part of the overall equation.

John P. Mackey

It is very fair to say because it's true. That's a big part of the equation.

Operator

There are no further questions in the queue.

John P. Mackey

Thanks for listening in. We believe the strategic decisions we have made have allowed us to successfully manage through this period of slower sales growth and will create long-term value for all of our stake holders.

We are pleased with our results but want to reiterate that Q4 is historically a tough quarter for us for all the reasons we outlines, and we will face tougher expense comparisons in 2010.

We appreciate your support and look forward to speaking with you again in November on our fourth quarter earnings call.

A transcript of the scripted portion of this call, along with the recording of the call, is available on our Web site at www.wholefoodsmarket.com. We will talk to everybody next quarter.

Operator

This concludes today’s conference call.

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Source: Whole Foods Market, Inc. F3Q09 (Qtr End 07/05/09) Earnings Call Transcript
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