Whole Foods: Not Every Sale Is a Bargain

| About: Whole Foods (WFM)

Black Friday is coming – that dreaded day when consumers look for bargains, and retailers stay open from dawn (or pre-dawn) to dusk in a day that could make or break sales goals for the entire year. Investors are shopping for bargains as well, and many are looking for quality stocks on sale. The problem with buying something at a cheap price, is that unless you are careful, you could end up buying poor quality goods.

Whole Foods Market Inc. (WFMI) appears to be one of those “on sale” retail stocks. Investors can pick up shares for a 22% discount to the high posted in October, and if you look back to the stock’s all-time-high in 2006, investors are now able to buy at a 65% discount. Since the company sells high quality organic groceries at relatively wide profit margins, it is easy to understand why investors would be willing to pay a premium for the shares. But at the end of the day, Whole Foods is still simply a grocery store, and one with relatively stagnant growth at that.

Back in August, ZachStocks noted that WFMI stock was as “pricey as it’s wares.” We stated that the company had cloudy visibility into the year ahead, and that the US consumer would have difficulty rationalizing the higher costs for commodity goods. While the stock still made new highs along with a strong market in October, the recent weakness has now pulled the stock below the level it traded at when our last article was posted.

On November 4th, the company announced its fourth quarter earnings (working off of a September year-end), which came in at $0.20 per share. That represented an increase of 43% over last year’s fourth quarter earnings which would appear to be positive news on the surface. However, this was the fifth quarter in a row that the company reported sales levels that represented growth of 0% to 3%. Not exactly the kind of sales increases that you would expect out of a healthy growing company.

Despite the ugly sales growth numbers, management appears to be optimistic about what the figures represent…

We believe our sales have stabilized and officially turned the corner. Our comparable store and identical store sales trends improved for the second quarter in a row and, after five quarters of year-over-year declines, so far in the first quarter are up 1.6% and 0.4% respectively. ~John Mackey, CEO

Same store sales growth of 1.6% may be an improvement, but they hardly warrant the kind of optimism that investors are indicating with the share price. Currently, WFMI trades between $26 and $27 even after falling 22% from its recent high. Considering the company is expected to earn $1.10 this year (and I think analysts may have this number too high), the stock is trading at more than 24 times 2010 earnings. A multiple of 24 may make sense for a rapidly growing technology company, but it certainly seems aggressive for a grocery chain (however swanky they may be) which is forecast to grow by 10% to 13% over the next couple of years.

There are several different ways that traders could profit from a fall in WFMI. The most obvious would be to short the stock outright, but I would recommend managing risk carefully. Stocks have been resilient lately and just because something is overpriced doesn’t mean that it will immediately fall. Long-term puts are a bit expensive, but could turn out to be a risk-averse way to play this trend. You can buy the May 25 puts for $2.75 right now which means that if the stock dropped to $20, the puts would realize at least an 82% gain. However, there is a legitimate risk that these puts will expire worthless if WFMI manages to be stable for the next six months.

My suggestion would be to short the stock and then sell puts against the position to help offset risk. Using this strategy, you cap the level of gains you can receive, but you also lower the volatility. Shorting the stock today and selling the May $25 puts gives you a potential 18.5% return on capital in six months time. Compounded (assuming you can find a similar trade for the second half of the year) that would yield roughly 40% annualized. The best part about this trade is that you only need the stock to trade down to $25 to realize maximum profit, and you break even if the stock rallies to $29.45.

The bottom line is that Whole Foods appears to be a risky investment at the current price. I expect shareholders to dump this position over the next several quarters as the lack of growth and poor consumer spending causes profits to remain pressured.

WFMI Chart

Disclosure: Author does not have a position in WFMI