Whole Foods Market (WFM) recently reported quarterly earnings, which sent shares down 10%. Is this the end of the ride for high-flying WFM? After reviewing the call, I think not. I believe that this is more of a blip in the long-term story, and more importantly, a great buying opportunity for this best-in-class company. The company has a long-term plan in place to at least triple its store base and at the same time will achieve mid-single digit comps over the next few years. I am encouraging investors to use the recent sell-off to start a position in WFM, with a price target of $72.
Recent Weak Quarter
The disappointment from the last quarter had to do with lower than expected same-store sales (5.9%), lower same-store sales performance so far in the new quarter (5.8%), and lower guidance for same-store sales for FY 2014 (5.5-7.0% from previous 6.5-8.0% guidance). The company gave several reasons for this decline that I wanted to point out.
- Strategic Price Matching - in the past, the company has pointed out that they still have to compete on price. The company is matching price on specific items and hoping to make it back on other items in the basket.
- Cannibalization - the company noted that in areas where several stores opened this year, like Boston, the company saw some cannibalization. But, the company also noted that in the past they have seen this cannibalization upfront, followed by comp increase at both the new and older stores later on. This could be taken as a negative, but I'm willing to trust WFM management on this and expect market share gains in these areas.
- Competition - this is the one that the company will have to manage. It's becoming a more competitive environment, but I believe that WFM's differentiated approach will help the company win.
- Marco environment - the company sees a slowdown in the macro, which makes sense, and like most other companies, is not immune.
Overall, I think concerns are overblown. The company is still growing comps in the mid single digits, and there's upside if the company is correct that new stores eventually help comps in all stores (this is backed by the fact that 2/3 of all new stores will be placed in existing markets). I also want to point out that year-over-year, the company continued to see shifts towards organic products and discretionary categories as well as meaningful increases in $50 plus sized baskets. These are major positives for the company since this supports making out the price on other items in the basket. As the shift to health and wellness continues, WFM will be one of the biggest beneficiaries.
We Have Seen this Story Play Out Before
The recent earnings call reminds me of the company's February earnings call earlier this year, as the stock sold off over 10% due to same-store-sales decline due to many of the same factors on the latest call. But, the stock has rallied since as the comps returned as the macro environment improved. Obviously, it might not play out exactly the same, but I was happy with the company's reasoning for the comp declines and believe we will get a reacceleration sometime next year. I do think the average comp will decline as the concept matures, but for now I see this as one of the few strong execution plus store growth plus above average comp stories in the market today. I expect the stock to rebound over the next year.
The Company Can Offset Pricing Pressure with SG&A Savings
Though the company has seen some pressure on pricing, they have been able to offset this with SG&A savings (occupancy leverage, shrink reduction and buy site initiatives). The company said they have at least another year to go on savings due to shrink. The company will continue to get occupancy leverage as they open new stores. Most importantly, the company noted that they have excess capacity in their distribution centers. This capacity can support the growth plan of the company, so as the store base grows, the company will be able to leverage SG&A in the long-run.
It Sounds Like the Company Could Grow to Over 1000 Stores
One point that I found interesting in a recent presentation was management's comments on their 1000 store goal for the concept (currently have 367 stores):
Kate Wendt - Wells Fargo
"You set your 1,000 store target a while ago and I think before you found success in a lot of these tertiary markets, do you think if you find success, continue to find success that you could potentially move beyond 1,000 store goal if you look out longer term?"
Walter Robb - Co-CEO
"I do, but and we might even have number in mind but we're [not] prepared to share it today."
So it seems that the target might actually be higher than the stated 1000 store goal. If you consider the fact that the company has seen increasing ROIC on new stores and the fact that the balance sheet could support faster expansion, I think you could see an acceleration of the 8-10% store growth target over the next couple years. Even if we do not see this acceleration, we are going to see store growth of 8-10% for at least the next 10 years.
As we noted above, the company has a plan to grow the store base to at least 1000 stores. The company uses a very targeted approach to this growth as it goes into each new market and tailors the size and amenities of the stores to the local geography. Some of these amenities include bars, vinyl record stores, and pizza stations. I really like this hyper-local approach and think it will help the company going forward.
Going forward, I expect the company to grow stores at a rate of 8-10% annually, have mid-single digit comps that eventually mature, and have slight margin expansion from SG&A leverage slightly offset by lower pricing. Here's a look at my long-term outlook:
Dividends per Share
Free Cash Flow
Clean Balance Sheet
The company benefits from a very strong balance sheet, with just over $1B of net cash. This cash could be deployed in the form of accelerated store growth, which I believe is something that might occur.
Looking at the Long-Term ROIC
Management noted that when evaluating WFM, you should look at the company's ROIC. The company gave a great presentation in their latest earnings release:
Furthermore, the company has been able to substantially increase its ROIC over the last few years. Some have called WFM a short, and I would argue that a company that is growing fast, yet at the same time increasing its returns on these new investments would not be a short candidate. Not only are you getting a company that is growing the store base for at least the next 10 years and has mid-single digit positive comps, but it is also getting higher returns off these new investments.
In my recent analysis of Buffalo Wild Wings, I showed a comp chart of consumer companies that are growing their store base around 10% and have mid-single digit positive comps:
When looking at this chart, it shows that WFM trades at the low-end of these concepts. That's probably justified somewhat, but it highlights the fact that it's tough to find companies that are growing both through store growth and positive comps.
WFM trades at a discount to this other grocers, but does have a lower growth rate. I would argue that even taking into consideration the growth rate, that WFM should trade in line with the other healthy grocers due to its superior brand, less risk from its larger store base and presence, and the company's plan to at least triple its store base.
Taking all of these factors into consideration, I am valuing WFM on a combination of 15x 2015 EBITDA and 1.5x 2015 sales. This gets me to a price target of $69.
Furthermore, my discounted cash flow analysis (at an 8% discount rate) gives me a $75 price Target:
Free Cash Flow
PV of Cash Flow
PV of Terminal Value
Plus: Net Cash
Value Per Share
This gives me an all-in blended price target of $72 (about 24% upside). What would be a downside target? This scenario would occur if comps continue to decline into the low single digits. Under this scenario, considering the growth still available through store growth, I would assume that estimates for 2015 fall to $1.90, and that the stock would trade at 30x these earnings. This would also fall in line with a contraction of the EBITDA multiple on 2015 performance to 12x. Considering that comps will still be positive and the company will still be growing in the 10% range, I do not see the multiple contracting that is greater than this. Because sales growth will still be in the double-digit range, I don't see a contraction in the sales multiples. This would give me a blended price target of $55 (about 6% downside). This 4-to1 upside to down ratio makes the stock quite compelling at these levels.
Will Hedge Funds Chase Growth
One thing we highlighted above is the lack of companies in the consumer industry that have mid-single digit positive comps and above-average store growth. The slow-to-negative growers are somewhat expensive considering the environment, making these growth companies even more attractive. The hedge fund industry has underperformed this year as the market has basically moved in one direction. This could create a situation where money shifts into these strong performing growth stocks (same could be said for most funds as equity fund flows remain positive and portfolio managers choose to put their money in the companies that are executing well relative to others). This could benefit the stock over the next several months. Simply put, WFM is part of a small group of companies that is executing relatively well and I could see investors move into the stock, especially after getting a buying opportunity from the latest earnings call.
Risks for the company include:
- Further deterioration in same-stores sales, signaling that this is not a blip but a maturation of the store base (though we are only 1/3 the way to the full store bases potential)
- Further cannibalization of the current stores by new stores
- More competition on pricing
- Misexecution of the growth plan
Catalysts for the company include:
- Further store expansion than currently expected (this seems to be the case) or an acceleration of store growth
- Verification that the current same-store sales results are a blip and that older stores that were cannibalized have stronger performance next year
- SG&A saving and leveraging of capacity of the distribution centers as the store base grows
- Better than expected market share gains from the company's differentiated strategy
Overall, when you consider the company's plan to offset pricing with SG&A improvements, reasons for the comp decline, and the long-term store growth plan, I believe that this latest earnings call was a blip on the long-term story of WFM. I am recommending that investors use this sell-off as an opportunity to get into the long-term potential of this company. I have a 12-month price target of $72.