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Whole Foods Market, Inc. (NASDAQ:WFM)

F4Q 2013 Earnings Conference Call

November 6, 2013 17:00 ET

Executives

Cindy McCann - Vice President, Investor Relations

John Mackey - Co-Chief Executive Officer

Walter Robb - Co-Chief Executive Officer

A.C. Gallo - President

Glenda Flanagan - Executive Vice President and Chief Financial Officer

Jim Sud - Executive Vice President of Growth & Development

Ken Meyer - Executive Vice President, Operations

David Lannon - Executive Vice President, Operations.

Analysts

Charles Grom - Sterne Agee

Karen Short - Deutsche Bank

Meredith Adler - Barclay's

Mark Wiltamuth - Jefferies

Kelly Bania - BMO Capital Markets

Kate Wendt - Wells Fargo

Mark Miller - William Blair

Joe Feldman - Telsey Advisory Group

Operator

Good day and welcome to the Whole Foods Fourth Quarter Earnings Call. All lines are currently in a listen-only mode. Later, you will have the opportunity to ask questions during the question-and-answer session.

It is now my pleasure to turn the conference over to Cindy McCann, VP of Investor Relations. Please go ahead.

Cindy McCann

Good afternoon and thank you for joining us. On today’s call are John Mackey and Walter Robb, Co-Chief Executive Officers; A.C. Gallo, President; Glenda Flanagan, Executive Vice President and Chief Financial Officer; Jim Sud, Executive Vice President of Growth & Development; and David Lannon and Ken Meyer, Executive Vice Presidents of Operations.

As a reminder, all forward-looking statements on this call are subject to risks and uncertainties that could cause actual results to differ materially from the expectations and assumptions discussed today. This may be due to variety of factors, including the risks outlined in our company’s most recently filed Forms 10-Q and 10-K.

Please note, our press release and scripted remarks are available on our website. We assume you have read our press release. So we will use this time to focus on highlights from the quarter and year as well as our future outlook. Please note, last fiscal year was 53 weeks with the extra week falling in Q4. Our comments today will reflect results on a comparative 12-week and 52-week basis. We also want to remind investors that our average week of sales and gross profit as a percentage of sales are typically highest in Q2 and Q3 and lowest in Q4 due to seasonally slower sales during the summer months.

I will now turn the call over to John Mackey.

John Mackey

Thank you, Cindy. Good afternoon, everyone. We delivered record fourth quarter results including 12 store openings, average weekly sales per store of $694,000 translating to sales per gross square foot of $947, gross margin of 35.6%, direct store expenses of 25.4% of sales, a store contribution profit of 10.3%, operating margin of 6.4%, EBITDA margin of 9.2% and a return on invested capital of 14%. We’re pleased with our better than expected financial leverage particularly given that cost while still reflecting market share gains were in line of our expectations. Following third quarters of consistent one and two year result averaging approximately 7% and 16% respectively our comps increased 5.9% or 14.5% on a two year basis. This change in trends beyond the 45 basis points contributed to our team member double discount day in Q3 were seen in both transaction count and basket size and was broad-based across geographies, department’s and storage [ph] classes.

While we cannot definitively say what drove the change we know that several factors including strategic price matching, cannibalization, competition and currency had a larger negative impact on certain regions in Q4. For example at the end of Q3 we made a significant round of strategic price matches which initially impact our sales but which we believe will drive sales growth over the long term.

In addition we have opened six new stores in Boston this year including five in the fourth quarter. Exciting innovation such as the greenhouse on the roof supplying produce to our Lynnfield Store have completely revitalized our brand and what is one of our oldest markets. It doesn’t get more local than that. These stores impact our existing stores initially but as we typically experience sheer drive, healthy comps for the region next year. On a broad level inflation continues to moderate and we’re not immune to the larger macro-environment. As several retailers are reporting discretionary spending has been impacted as consumer confidence has dropped to a six month low. While the current uncertainty in the economy might be impacting our ability to attract new crossover customers at the same rate our core customers appear to be fairly resilient. Year-over-year we have continued to see shifts towards organic products and discretionary categories as well as meaningful increases in $50 plus sized baskets. In addition our new stores are continuing to perform very well and exceed our expectations. For the last eight quarters on average our new store class have consisted of 28 stores opened for approximately 6.5 months, the 36,000 square feet in size they have produced average weekly sales of $515,000 translating the sales per square foot of $738 and have generated a contribution margin of approximately 5%.

As you know we evaluate potential new sites on an EVA basis allowing us to consider wide variety of markets from Savannah Georgia to look for New York. While we would expect different levels of sales productivity and operating expenses when balanced with the appropriate levels of capital investment, we’re able to produce healthy returns for our shareholders which is our ultimate financial goal. For the last eight quarters our comparable stores less than two years old have produced an average 15% return on invested capital and we believe this is the best metric for your investors to focus on. We remain committed to expanding our value offerings across the store, increasing our promotional activity and improving our relative price positioning and with our latest round of strategic price matches we have significantly closed the gap against the major competitor.

Our sales momentum and operating disciplines along with moderating inflation helps generate record gross margin performance for Q4 with occupancy leverage, shrink reduction and buy site initiatives more than offsetting the impact of our value initiatives. We have narrowed the price gap versus our competitors on known value items to it's narrowest margin yet while continuing to raise the bar even higher on our standards of transparency. We’re the first and only U.S. public food retailer to commit to labeling GMOs and we recently announced the new rating system for fresh produce in floral [ph] that will measure performance on important sustainable farming topics including pest management, farm worker welfare and pollinator protection.

In summary, fiscal year 2013 was yet another record breaking year on many levels. Our sales approached $13 billion translating the sales per growth square foot of $973. We opened 32 new stores expanding into 10 new markets and increasing our ending square footage 8% to 13.8 million. We improved operating margin 48 basis points to 6.8% generated over $1.2 billion in EBITDA and exceeded our initial split adjusted EPS guidance of $1.42 to $1.44 by growing earnings per share of 19% year-over-year to $1.47.

Our outstanding financial performance generated over $1 billion in operating cash flow and $472 million in free cash flow. We returned $508 million in dividends to our shareholders, repurchased $125 million of common stock and ended the year with $1.4 billion in cash and investments. We remain well-positioned to internally fund our accelerated new store growth while maintaining a healthy cash balance and reflecting confidence in our future growth and cash flow generation. Today, we announced a 20% increase in our quarterly dividend to $0.12 per share and an additional $500 million in stock repurchase authorization bringing our total available authority to $800 million.

Turning now to our revised outlook for fiscal year 2014. For the first five weeks of Q1, comparable store sales increased 5.8% roughly in line with our Q4 results. Based on recent trends, we believe it is prudent to take a more conservative point of view on our sales and earnings outlook for the year. For fiscal year 2014, we now expect sales growth of 11% to 13%, comparable store sales growth of 5.5% to 7%, identical store sales growth of 5% to 6.5%, and diluted earnings per share of $1.65 to $1.69, an increase of 12% to 15%. Please see the guidance table of our press release for additional detail.

While resetting expectations is always difficult, we want to underscore that we have just delivered our fourth consecutive year of increases in new store openings while producing improvements in our operating margin and higher returns on invested capital. And our outlook for fiscal year 2014 reflects the continuation of these trends. Each week over 7 million customers visit our 367 stores in 40 states and three countries. In 2005, it was a major milestone for us to report that we had six stores averaging $1 million in sales per week. We now have over 50 stores achieving that level.

Yes, food retailing is more competitive than ever and with the growing demand for fresh healthy foods, it seems like everyone is adding to or expanding their offering of natural and organic products. However, we believe the strength of these numbers highlights our ability to innovate and to compete the unique power of our brand and the excitement our stores create within this community. With 47 new leases signed over the last 12 months, we have 94 stores in our development pipeline and see demand for 1,000 Whole Foods market stores in the United States alone. We will now take questions. Please limit yourself to one question at a time so that everyone has an opportunity to participate. The call will end at 4.30 Central Time. Thank you.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) We will take our first question from Charles Grom with Sterne Agee. Please go ahead.

Charles Grom - Sterne Agee

Thanks. Good evening. Just I was wondering if you could quantify the level on price investments that you made and were they broad based by category and by region? And I suppose what prompted the actions and were they one-time in nature or do you think they will be recurring in 2014? Thank you.

Walter Robb

Hey, Chuck, this is Walter. We have been talking for a number of quarters about our continuous effort here to continue to make these investments over time where we felt and they are being strategic and being surgical. This was at the end of Q3 was a particular round of them, Cindy [ph], but that was more broad based across a few categories to address a couple of competitors in particular and some of those efforts continue in Q4. And as we mentioned in the script, there is a short-term effect of those even as we think the long-term puts us in the right position. So that’s the answer on that particular item.

Operator

Thank you. We will take our next question from Karen Short with Deutsche Bank. Please go ahead.

Karen Short - Deutsche Bank

Hi, thanks for taking my question. Walter, I think at a recent conference commented that the customer reaction of price investments was faster than it’s ever been. So I guess I was wondering it doesn’t appear that you saw that quicker reaction in terms of positive reaction into the fourth quarter, so maybe a little color on that? And then I guess it just seems that competitive environment shouldn’t really change dramatically from the third quarter to the fourth quarter in my view, I mean, it’s always been competitive, but anymore color on that would be helpful.

Walter Robb

What I actually said was that I still think that’s true for price investments in general but as I said in the area of produce for example perhaps you can see the response have been quicker, people are noticing in that area in particularly the change is more quickly. So I was pretty specific about individual areas of the store where that was true but we’re still gathering the data and the impact from those investments across the Board as sort of be able to draw those sorts of conclusions.

John Mackey

We listed several reasons or several speculative reasons of why our comp store sales were down just a bit in Q4 besides price and investments we talked about cannibalization. Some of the markets were heavily cannibalized such as Boston. We talked about of course competition. We also think there could be macro-environmental impacts here I think, we think the economy is falling down a little bit. So at the end of the day of course we never really know exactly what makes comps go up and what makes comps go down and we make our best guesses that we can and now. Next question please.

Operator

We will take our next question from Meredith Adler with Barclay's. Please go ahead.

Meredith Adler - Barclay's

You did a really good job of offsetting the impact of those gross margin of those price investments in the gross margin and I think you mentioned specifically shrink and some improvements in procurement. Can you talk a little bit about you know if there is a 100% opportunity, how far along are you in realizing that opportunity, in blustering and procurement?

David Lannon

On the shrink thing I would say we’re definitely in the middle innings, we see some great improvements, we’re able to offset more than all of our margin investment on prices through shrink reduction. So Ken and I both firmly believe we at least have another year plus of a long runway of improvement in shrink control and that’s definitely helping us maneuver in terms of prices.

Meredith Adler - Barclay's

And procurement?

A.C. Gallo

There is as we grow there is definitely opportunities in procurement especially on the distribution side, be able to consistently leverage our distribution but we have the distribution centers in each one of our regions that handle mainly our perishables and as we have been able to, as we grow and able to put more throughput to these they are all facilities that can handle you know our growth, we don’t have to build them out you know devising expansion here or there but it pretty much can our growth so as we grow what we’re seeing is that we’re driving the cost per case of all of our perishables to go through these facilities down and it's really helping us in that area. You know it's interesting when we look at that because of the way we look at things, we’re always looking to get improvements in cost but we’re also looking to make improvements in quality and then standards. So sometimes you know we will take the ability as we grow to actually improve the quality or the standard in certain areas like for instance right now we’re looking at in a lot of our categories we’re looking at the possibility of offering more non-GMO offerings for our customers. So we will view sometimes to our increased buying power to actually improve or raise the standard for our customer without raising the price. So sometimes you get those investments as well which we think over the long term gives us the real competitive advantage, it continues to differentiate us from our competitors.

Operator

Thank you. We will take our next question from Mark Wiltamuth from Jefferies. Please go ahead.

Mark Wiltamuth - Jefferies

I wanted to ask about the buyback, is there any buyback built into your guidance numbers and could you give us that cash and investment level again at the end of the quarter?

Glenda Flanagan

There is no buyback reflected in our guidance and it was 1.4 billion at the end of the quarter, we follow an opportunistic strategic with respect to buybacks. We don’t expect that to change.

Mark Wiltamuth - Jefferies

And how much of the $300 million that was already authorized has been used up?

Glenda Flanagan

None.

Mark Wiltamuth - Jefferies

Okay, thank you very much.

Operator

Thank you. We will take our next question from Kelly Bania from BMO Capital Markets. Please go ahead.

Kelly Bania - BMO Capital Markets

Hi, this is Kelly Bania. Thanks for taking my question. Curious back on the gross margin, which you talked about, but did still come in a lot stronger than expected, does that make you think about managing gross margin a little tighter next year to try to reinvigorate the same-store sales trends or do you feel like there is any change in the elasticity of your ability to drive comps with lower prices?

John Mackey

It’s a fair question, but if you drill into the numbers here on the quarter, you see that if you drill into the gross margin line, the cost of goods sold was actually up reflecting the income on these sort of price investments offset as David and Ken shared with the efforts around shrink and buy side rebates, which really accounts for most of the overt [ph] on the gross margin, in fact, all of the overt [ph] on the gross margin this year. So the trend line to think about is we are trying to balance this – balance these parts investments with continuing to grow sales and we continue to feel very strong about the potential gross sales over the long-term. And so we are accelerating our square footage opening new stores. And so that’s really if you dig into the number, that’s what you find when you drill into the specifics of that number. So we think it does reflect that we are continuing to step up the investments with a view towards growing the sales. And so could you fine tune it if they actually could, but that’s the art of the retail we are trying to practice each and every day.

David Lannon

Yes, with, this is David, our regional presence we have great confidence in their ability to deliver these margins, our operating regions and that’s giving us the ability to continue kind of our aggressive promotional strategy, one day sales, three-day sales just more aggressive promotional strategy, because we know it can deliver those margins.

John Mackey

Thank you. Next question?

Operator

Thank you. We will go next to Kate Wendt from Wells Fargo. Please go ahead.

Kate Wendt - Wells Fargo

Yes, thanks. Looking at this quarter, you mentioned that you have made some changes to the holiday catering program this year, then that you have potential driver. Can you talk a little bit about what’s different versus last year? And then how do you like to manage that from an inventory standpoint if it ends up being more successful than you thought?

David Lannon

We made several changes in terms of how the customer experiences the order guide and we have already seen significant sales higher than last year. And it’s really about how a customer interacts with that and how the region sort of being able to customize it for their needs. And so the interface, the ability for (indiscernible) is the big improvement and then it’s already showing that our numbers are much higher across all regions right now on e-commerce sales amount.

John Mackey

And if I could add one thing just for the first time I know we have got some standardized offer across the whole company that we never had before. So there is – we are moving together in ways that we haven’t done historically, which is quite exciting.

David Lannon

Also significantly less clicks to place the order this year and last year.

John Mackey

Alright, yes, that’s right.

Kate Wendt - Wells Fargo

Thank you.

Operator

Thank you. We will take our next question from Mark Miller with William Blair. Please go ahead.

Mark Miller - William Blair

Good afternoon. I know most of the focus is going to be on short-term trends, but I am going to do the counterintuitive thing and ask a long-term question. John, I would like to hear your vision for the home delivery in the U.S. and whether you expect it to be a significant competitive dynamic or not and you anticipated to be a material part of your business, the questions for the whole team? Thanks.

John Mackey

I am going to let Walter handle that question.

Walter Robb

I think, our vision Mark is core, what we are calling, extended experience. It’s the idea that ultimately a retailer integrates the digital world, the physical world and the space between this, the retailer that wins. And I am not sure right now that our first priority – I am quite sure our first priority is not the last mile delivery, there is others out there. We are doing some experiments right now. We have one with approval right now, where we are partnering with us to accomplish that. We are learning a lot from those tests. We have tests in click and collect going on in two different markets right now. We are giving some opportunities for this space between the store and the digital world. We have a lot going on that we are unfortunately not in a position to talk about right now, but – so I don’t see the last mile delivery is our – I do think it’s even in the UK, which is significantly more developed than United States, it’s only 5% or 6% share after significant more developments. So I think it’s growing incrementally, but I think the majority of business ultimately even 5, 10 years are still done in physical stores or in the integrated sense either through the mobile platform or the click and collect sort of model.

Mark Miller - William Blair

But you don’t think others will deliver this service to your customers and represent a meaningful competitive challenge, you just don’t see that coming?

Walter Robb

I see it. I do see those entrepreneurs and the startups and all those, it is as well some established companies who are providing those services. I do think that continues to grow incrementally, yes, but I think that you know we’re going to continue to develop options as long as either through a robust development of our mobile platform and/or click and collect to get customers options either at our stores or at drop points or by partnering with some of these companies who will be able to work with us, take our products and do the delivery. I’m just simply saying in terms of us actually being the delivers I’m not sure I see that as something that we need to do right now. We haven't see a business model that really works. A lot of people have tried in this area and I haven't seen anybody come up with a business model that is profitable and successful. So we’re going to continue to study it and we’re going to do some experiments and we’re going to continue to innovate but we think we have a really good business model right now that works really well and we’re going to do most of our attention and capital to continuing to do what we think we do really well which is open great new stores that are innovative and give great experiences to customers. We don’t think, when we look at our long term vision we don’t see the world significantly moving in the food area in this direction.

Yes there will be some incremental move. It will overtime grow but we do not think food is going to be (indiscernible) to the same degree that some other categories have been that’s our vision.

Operator

Thank you. We will move next to (indiscernible). Please go ahead.

Unidentified Analyst

I notice that you took up your annual guidance slightly on preopening expenses and relocation cost and I think on the last call you gave some quarterly color on preopening expenses for Q4 and just wondering if you can give any update for the current quarter?

Walter Robb

Yeah it's going up because we’re growing on faster, we’re opening a lot more stores than we have ever before.

Glenda Flanagan

And we just have greater visibility now into what’s going to open in 2014 and so we tweak the number as we usually do from then until now we do not give preopening guidance specifically before and certainly not about the quarter.

Operator

Thank you. We will take our next question from Joe Feldman with Telsey Advisory Group. Please go ahead.

Joe Feldman - Telsey Advisory Group

I wanted to get a better understanding of is the cannibalization that you may or may not be seeing and is that something that maybe causing some of the pressure you know as you started to get into I know it's only 300 stores but as you know it's lot more than you used to have, is that starting to weigh on comps? Are stores eating into one another in local communities?

John Mackey

I’m the foresight of accelerating our growth and we’re opening more stores than we have ever before that means temporarily there is a little of cannibalization but what we found historically with no stores anniversary a year later that both stores comp well. So, there is a little bit more cannibalization because we’re growing faster and it's one of the factors. We have listed several factors, there is greater competition there is more cannibalization, we have made in price investments and we’re seeing some weakness we think on the macro level and there could be factors that we haven't been able to identify yet. But cannibalization is I mean it depends on the market, like we singled our Boston. Boston is definitely being cannibalized right now. We have opened up five new stores in the fourth quarter alone. So that market really did feel it but that’s a temporary effect. I mean a year from now the fourth quarter in Boston is going to be fantastic as we will be comparing against weaker numbers and so it's a very temporary thing and certain select markets. However we’re opening stores in new markets, we have barely scratched the surface of what we think is possible since we think we can do at least a 1000 stores in one state. But from time to time we will have some cannibalization impacts that will be temporary, this is one of those times.

Glenda Flanagan

It's also unusual for us to open that many stores in a new market in such a short period of time.

David Lannon

Opportunistic opportunity to with the Johnnie's Foodmaster stores. So we’re able to get into markets between our existing stores. So we are able increase our market share much higher in Boston.

Walter Robb

And I am the fourth person on this question, but well this is a no excuse company. And I think the bigger picture is – this is as John said is one of the things that we are offering is kind of the explanation on the short-term numbers, but we are putting a lot of chips down to grow this company aggressively. We have got our square footage growth is stepping up to 8.5%. We have got the numbers the raw numbers are more than we have never done before. Occasionally, it will come into some markets, where we have some stores, but the bigger picture here is we are on our way to a thousand store goals in the United States and we are very confident about that.

John Mackey

On the flip side, we have our 32 stores that we opened last year, 10 of them were in new markets and eight of the 15 leases that we – 14 leases that we signed this quarter were in new markets. So there is plenty of runaway, plenty of opportunity that is untapped for us.

Walter Robb

Thanks for the question.

Joe Feldman - Telsey Advisory Group

It’s great. Thank you.

Operator

Thank you. It appears we have reached the end of our call for today. I will turn it back to Mr. Mackey for closing remarks.

John Mackey

Okay, thanks for listening in. Please visit Whole Foods market in store and online for everything you need to enjoy great meals over the holidays. Join us in February for our first quarter earning call. Check out the beyond the number section of our Investor Relations webpage for additional information about our new stores, new quality standards and more. The transcript of the scripted portion of this call along with the recording of the call is available on our website as well. Everybody have a wonderful holiday season. We will talk to you in February. Bye.

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