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Investors in Whole Foods Market (NASDAQ:WFM) were pleasantly surprised to see the positive research coverage from Jefferies, which initiated a buy rating on the shares on Tuesday.

While I do like the very long-term prospects of Whole Foods, unlike analysts at Jefferies, I don't see catalysts which can trigger another significant move toward the upside in the short term.

Jefferies' Upbeat Report

Analyst Mark Wiltamuth from Jefferies initiated a "buy" rating for Whole Foods, accompanied by a $70 price target, suggesting some 19% upside from current levels.

Wiltamuth notes that Whole Foods is riding on 7%-10% organic food industry growth, while he sees earnings per share growth of 20%-22% in the long term. This should be driven by strong comparable sales growth and 8%-9% store openings growth.

Jefferies furthermore notes that Whole Foods emerged from the recession as a more disciplined retailer with a greater focus on pricing, cost control and capital discipline.

Valuation

Whole Foods ended its third quarter with $1.5 billion in cash, equivalents and short-term investments. The company operates without debt, but holds $509 million in total lease obligations, for a net cash position of around $1 billion.

Sales for the first nine months of the year came in at $9.94 billion, up 13.1% on the year before. Net earnings rose by 21.8% to $430 million. Based on these results and the outlook, revenues for the full year are seen around $13 billion, as earnings could approach $550 million. Note that Whole Foods is scheduled to release its fourth quarter results on the 4th of November.

Trading around $59 per share, the market values Whole Foods at $22 billion, or operating assets at $21 billion. This values the firm at 1.6 times annual revenues and 38 times annual earnings.

Whole Foods pays a regular quarterly dividend of $0.10 per share for an annual dividend yield of 0.7%.

Some Historical Perspective

Long-term holders of Whole Foods shares have seen great returns, but this was accompanied by a full boom and bust cycle. Shares had steadily risen to $40 in 2005 to steadily fall to lows around $5 in 2008. From that moment in time, a steady but impressive recovery begun, with shares currently trading around $60 per share. In 2013 alone, shares have already returned some 30%.

Between 2009 and 2013, Whole Foods stands to grow its annual revenues by a cumulative 62% to $13 billion. Net earnings are expected to nearly four-fold to $550 million, although the outstanding share base grew by a third in the meantime.

Investment Thesis

Jefferies remains upbeat after very strong momentum in recent years and in 2013 already. And now, with shares trading at nearly 40 times earnings, they initiate a buy on the stock suggesting even more upside.

Jefferies sees continued industry growth, which seems fair. Yet Whole Foods still has a lot to prove, including the ability to keep up comparable sales growth and open new stores with similar productivity. Whole Foods already communicated that it sees potential for 1,000 US stores, roughly triple the current store base of 355 at the moment. Yet it will take a long time before this is a reality, and I don't see this materializing before 2025. With 94 development leases in the pipeline, Whole Foods sees an acceleration in square footage growth in the short-to-medium term.

On an ongoing basis, Whole Foods continues to focus on price initiatives which were funded by occupancy leverage and other economies of scale, notably in logistics. These price initiatives and the strong growth within the industry are the drivers behind the reported 7.5% comparable store sales growth rates over the past quarter.

While I do see potential for Whole Foods to run a $50 billion business by let's say 2025, on which it could earn $2-$3 billion at the time, the current valuation is already reflecting a lot of good news. Perhaps a bit too much to my opinion given that it would take the company more than a decade to grow to this size, with undoubtedly some bumps on the road. I would be comfortable attaching a $50 billion valuation to the business at that time, equivalent to roughly $125 per share. Yet we are a long time away from reaching this size, although I think it should be attainable. Note that this would translate into mediocre returns of 7% per annum, excluding dividends or share repurchases.

Back in November of last year, I last took a look at Whole Foods' prospects. I held off making an investment at the time as I believed the company has been priced for correction. Shares traded around $45 at the time, and stayed in a $40-$45 trading range until April of this year. The strong returns ever since have surprised me a bit, in all honesty.

I have to reiterate my stance. Don't short this stock based on today's high earnings multiples as the company could easily grow into the valuation in the medium to long term, by sustaining current growth rates in the coming years. Yet shares remain way too expensive to my taste at the moment to consider making an investment, even if the company shows healthy growth in the decade ahead, expected returns are mediocre.

This makes shares neither a compelling long or short, while neither side shows enough margin of safety to even consider taking a position.

I remain on the sidelines, not seeing the compelling upside in the short-to-medium term which Jefferies is seeing.

Source: Whole Foods Market: Long-Term Appeal, Short-Term Cautious