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Whole Foods Market, Inc. (NASDAQ:WFM)

F1Q 2014 Results Earnings Conference Call

February 12, 2014 5:00 PM ET

Executives

Cindy McCann - Vice President, IR

John Mackey - Co-Chief Executive Officer

Walter Robb - Co-Chief Executive Officer

A.C. Gallo - President

Glenda Flanagan - Executive Vice President and CFO

Jim Sud - Executive Vice President, Growth & Development

David Lannon - Executive Vice Presidents, Operations

Ken Meyer - Executive Vice Presidents, Operations

Analysts

Ken Goldman - JP Morgan

Charles Grom - Sterne Agee

Jason DeRise - UBS

Scott Mushkin - Wolfe Research

Chuck Cerankosky - Northcoast Research

Stephen Grambling - Goldman Sachs

Operator

Good day, everyone. And welcome to today’s Whole Foods First Quarter Earnings. At this time, all participants are in a listen-only mode. Later you will have the opportunity to ask questions during the Q&A session. I will be standing by, should you need any assistance.

And it is now my pleasure to turn the conference over to Cindy McCann. 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-K.

Please note, our press release and scripted remarks are available on our website. We assume you’ve read our press release. So we will use this time to focus on highlights from the quarter as well as our future outlook.

I will now turn the call over to Walter Robb.

Walter Robb

Thank you, Cindy, and good afternoon, everyone. In Q1 our sales increased $383 million to record $4.2 billion. Our average weekly sales per store increased to $719,000, translating to sales per gross square foot of $983. We opened 10 new stores growing our store base to 371 and increasing our square footage over 8% to 14.2 million.

Our strong results and capital expense discipline drove a healthy 13.3% return on invested capital and generated $337 million of operating cash flow. We invested $219 million in new and existing stores, returned $37 million in dividends to our shareholders, repurchase $62 million of stock and ended the quarter with $1.5 billion in cash and investments.

We are pleased with our new record Q1 operating margin of 6% given that our 5.4% comps, while still reflecting healthy market share gains, were light of our expectations. After increasing 5.8% for the first five weeks, our comps dropped to 5.2% for the last 11 weeks reflecting a softer December as many retailers have reported.

We are not immune to the larger macro environment and severe winter weather across much of the U.S. impacted the shopping patterns, with customers making fewer trips and buying more items each trip.

The biggest change from Q4 to Q1, however, was the 106 basis point moderation in average price per item growth, which we believe reflects the impact of our stepped up value efforts, particularly over the last two quarters. These efforts include improving our relative price positioning, expanding our value offerings across the store and increasing our promotional activity.

Since the recession we have focused on improving our price competitiveness primarily within our grocery departments and we are now expanding our successful value efforts into our perishable areas as well. We are continuing to maintain our high quality standards which clearly differentiate us from our competitors, while broadening our selection to include more value.

In produce for example, we are adding more high-grade conventional offerings to complement our organic offerings allowing customers a broader range of choices. And in meat all of our U.S. stores now offer fresh packaged chicken under 365 Everyday Value brand. Well recognized for value and quality by our customers our 365 products tend to be the best sellers in most grocery categories and we believe our chicken program will show similar results.

Our sales momentum and operating disciplines along with moderating inflation helped to generate another quarter of record gross margin for Q1. Occupancy leverage was partially offset by a slight increase in cost of goods sold reflecting our expanded price investments. Our internal pricing survey showed improvements from Q4 to Q1 in a competitive price positioning across virtually all competitors in all areas, known value items, non-perishables, and perishables. While we are seeing the sales and gross margin impact based on our prior experience we believe the impact will be short-term and that our value strategy will benefit both customers and shareholders over the longer term.

Turning to growth, we continue to accelerate our rate of openings and our new stores continue to open in higher levels exceeding our expectations. Over the past three months we have had a succession of opening-day sales records. This quarter our Brooklyn store broke the record Port Chester set last quarter and then our newest Austin store broke Brooklyn’s record just one month later. With 10 new store openings this quarter there were many exciting innovations from coffee, beer and wine bars to our highly popular cold pressed raw juices to new ramen noodle and oyster venues, waffle and bagel stations and our second rooftop garden.

Our EVA based approach to site selection allows us to consider markets from Memphis to Brooklyn. While our expectations for sales productivity and operating expenses vary depending on the type of market and other factors, when balanced with the appropriate level of capital investment we are finding that a wide variety of markets can produce healthy returns for our shareholders.

For the last eight quarters on average our new store class has consisted of 30 stores open for approximately 6.5 months. At 36,000 square feet in size, they have generated average weekly sales of 505,000 translating to sales per gross square foot of $729, new store productivity levels of 86% and a contribution margin of approximately 4.5%. More importantly our comp stores less than two years old have produced an average 16% return on invested capital, which we believe is the best new store metric for investors to focus on.

Turning now to our updated outlook for fiscal year 2014 based on the first quarter results and the updated assumptions for the remainder of the fiscal year we believe it is prudent to take a more conservative point of view on our outlook for sales and earnings. For the fiscal year we now expect sales growth of 11% to 12%, comparable-store sales of 5.5% to 6.2%, diluted earnings-per-share of $1.58 to $1.65.

We have broadened our EPS range to allow us more flexibility with regard to our value efforts. The lower end of the sales and earnings guidance reflects a year-over-year decrease in gross margin for the remainder of the year while the high end assumes gross margins flat, reflecting our ongoing value strategy and record gross margin of 36.2% last year.

Over the longer term we believe we can achieve our value goals while remaining within our historical range for gross margin of 34% to 35%. The higher G&A expense is due primarily to increased spending on technology. We remain focused on improving and extending the customer experience and the integral first step is moving towards a unified commerce platform. Just yesterday we announced a new partnership with Square enabling us to offer digital check-out at venues and select stores. In addition several lab stores we will be testing out other exciting innovations.

Higher pre-opening expenses are due primarily to pre-opening rent associated with the recent opportunistic acquisition of seven former Dominick's locations which will allow us to quickly and significantly expand our presence in the greater Chicago area. The locations will remain closed for remodeling this fiscal year before reopening in 2015.

Please note the Easter holiday shift this year which we estimate will have a negative impact on comps in Q2 and a positive impact in Q3 of 50 to 60 basis points. We also note that our store openings are back end loaded this year with 13 in the first half and 20 to 25 expected in the second half.

When the first Whole Foods Market store opened in 1980 we had no idea we’d become the 8th largest public food and drug retailer in the US ranking number 232 on the Fortune 500. Our more than 80,000 team members are the heart and soul of this company and are not so secret sauce.

In January we were proud to be named one of only 13 companies ranked for 17 consecutive years as one of the best – 100 best companies to work for in America by Fortune magazine. And each week over 7 million customers visit our 373 stores in 41 states and three countries and with 4 million followers we are the number 2 retail brand on Twitter.

In 2005, it was a major milestone for us to report that we had six stores averaging $1 million of sales per week. We now have over 50 stores achieving that level with several averaging over $2 million per week.

Food retailing is more competitive than ever and with the growing demand for fresh healthy foods, the offering of natural and organic products seems to be expanding everywhere in stores and online.

Looking at the big picture, this is a positive for us as it affirms our mission for the last six -- 36 years and speaks to the increasing growth opportunity. We believe our industry-leading results highlight our ability to innovate and compete, the unique power of our brand and the excitement our stores create within their communities.

We are very confident in our future growth potential and are moving aggressively to take advantage of this opportunity. With 57 new leases signed over the last 12 months, we have a record 107 stores in our development pipeline. We believe that in 2017, we will cross the 500 store mark and over the longer term, we see demand for 1200 Whole Foods Market stores in the U.S. alone.

We will now take questions. Our call will end at 4:30 Central Time. So please do limit yourself to one question so that everyone has an opportunity to participate. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Ken Goldman with JP Morgan. Please go ahead.

Ken Goldman - JP Morgan

Hi. Thanks for the question. You talked about the number of reasons for the comp deceleration last quarter. But there was no smoking gun. Have you zeroed in a bit on what’s causing your comps to start coming in a bit below the run rate of the prior few quarters. Obviously they are still great compared to food in general. But it is a bit of a deceleration. I’m just curious. If it’s competition, cannibalization, what you really focused on at this point?

John Mackey

John Mackey here. Of course, we never know exactly because as we can only speculate like everyone else. It’s somewhat indeterminate. We do know that we’ve had heavier cannibalization than we sometimes had in the past in certain markets like Boston.

We know that there have been major weather impacts. We know that there is increased competition and frankly we have all our store bases some of the stores are older and it’s hard for us to maintain the same type of comp momentum as you can see when we break it out by age that the younger stores continues to comp very strongly.

So I think all those factors are there, and of course we don’t exactly know and we’re somewhat -- we're still sort of optimistic because we are opening so many more stores and we’re accelerating our square footage growth. If you look at the trend lines over the last few quarters, every quarter the rate of new store growth of the square footage continues to increase quarter-over-quarter. And as that begins to cycle into this store base, we expect that to have a positive impact on overall comps.

So we just announced 21 new stores and so we’re going to continue to see our square footage growth accelerate. But we are also dealing finally with kind of the law of big numbers. We had lot more storage than we use to have and it’s just a bigger cruise ship to try to steer.

Walter Robb

Walter. Just to add a couple of things, just want to point out a three-week number that we gave you is actually up to 5-6. So going back in the right direction sequentially and also that we did call out and take responsibility for the moderation of the average price per item down 106 basis points which we called out in the script. So that does give you some sort of a view into the actions we’ve taken ourselves to continue position ourselves competitively and helps you to kind of look at the comps from that perspective. So thanks for the question.

Operator

Thank you. We’ll go next to Charles Grom of Sterne Agee. Please go ahead.

Charles Grom - Sterne Agee

Thanks. Good morning. Walter, wondering how you are evaluating the effectiveness of the price investments that you are making. If you could shed some light on how long you think it’s going to take for the units to pick up and accelerate this on what you’ve seen historically?

Ken Meyer

I think the main thing, this is Ken here, the way we look at our price investment is we do the test for a period of time and grow that out to larger amount of stores and larger markets [inaudible]. Typically there is a lag time that we see and sometimes it could be between 9 and 12 months before we actually start seeing the lift because the item values are down. And we don’t and we see the item moving [inaudible] catch up to that cycling of the change that we made. So it’s usually about 9 to 12 months lag time that we usually see.

David Lannon

We index versus all of our competitors and we’ve taken a much more aggressive approach about really focusing on that on a week in, week out basis. So we are paying attention to all of our competitors and we feel we can both have a great quality position and a value position at the same time. So it's is a constant part of our being a grocer.

Charles Grom - Sterne Agee

If I could just follow up when did you actually begin those price investments, the 106 basis points, did it start last August or does it start more in the middle of the first quarter?

John Mackey

If you think about the price investments, it’s a continual – we made series of adjustments over the last couple of years. So we also had the benefit of managing our shrink very well on that side. So it’s been a series of – it didn’t just start in Q3 of last year or Q4.

Walter Robb

We did make mention last time at the end of Q3 we went hard on a batch of them which was the largest batch to date of that and the – but it’s - that’s part of a larger process which continue to be competitive but that was the biggest step we'd taken to date, at the end of Q3, start of Q4.

John Mackey

Good news about price investments is that in the short-term it hurts comps because if you had the same customers coming in and they are paying a little bit less per item that's going to bring comps down. But we found that after two to three quarters the positive impact of lowering those prices begin to be felt in the comp base as we began to see our basket size increase and when you have on the margin more customer shopping with us. So short-term it's not good from a cost standpoint but we think it’s the right strategic move for the company and we believe it's going to pay off for our shareholders down the road.

Operator

We’ll next go to Jason DeRise with UBS.

Jason DeRise - UBS

I am sure many people are going to ask about the near term and I only get one question so I am going to ask differently. Obviously intra-quarter you upped the long-term target to 1200 from 1000. Can you talk a bit about broadly where you are seeing the extra potential from? Are we talking about current markets and filling in and that being the main part of it, or are you thinking about more new markets?

Jim Sud

This is Jim. We’re seeing it across-the-board. As you know we just acquired seven Dominick’s in the Chicago market but we’re also signing stores in Huntsville, Alabama and Lexington, Kentucky. We added a new store in Manhattan. So we are looking in dense urban market and there is many stretches across the country that remain untapped. I think that’s a major opportunity for us. It gives us confidence to reach the 1200 number. We do – we have an MSA study that backs up our number which we look at major market and determine where based on the demographic profile we can have stores. And so we are confident about that number and the truth is it’s always been a moving target. When we went public in 1992 we thought that maybe we could have hundred stores and I remember back 10, 15 years ago we had endeavor in the company called Structure 250 where we were talking about how to organize ourselves and we had 250 stores. And here we are with 373 today on our way to 500 in 2017. So it’s a moving target but I think it's one that’s achievable.

David Lannon

Ken and I got to – this is David – Ken and I were in Jackson, Mississippi last week, place we never thought we’d have a store 10 years ago, super encouraging results from the first week sales. And talking to customers there, they were giving us five different locations in Mississippi we should open stores. So it’s a state that we are not - another state that we are in now, it’s just tremendous to see, so encouraging – we’re a big deal when we open in the place we’ve never been before.

Jim Sud

Also another thing we’re excited about is that these urban markets we’re able to cluster our stores closer together. And although there's a short-term cannibalization effect that of course hurts comps, we see when those stores anniversary that the stores that were cannibalized come back with very strong comps after they anniversary it and the new stores comp will also comp very well, in addition. So what we see is that in markets like New York City and Washington DC and Chicago and Boston and Miami, L.A., San Francisco, these major metro markets we can put so many more stores than we ever dreamed we will be able to put in 10 years ago. And frankly if the market continues to evolve in a positive direction, I believe that we will continue to able to put the stores closer and closer together.

I mean, as kind of a trivial example, we’ve done so well putting these stores together in these urban markets. They’ve almost had a synergistic effect that in Austin we just opened up a very successful store just a few weeks ago, our new domain store and for the longest time we were going to shut down our gateway store, which was only two miles away just thinking it’s going to be a relocation but as we got closer to it, we realize wow! I mean these are going to serve slightly different markets. We need to keep the gateway store open and we think we are going to have therefore much bigger market share by having those two stores than just the one. So we are seeing that effect all around the country. It’s very exciting for us.

Walter Robb

I think this is an eight layer lasagna, but it just seems like the -- to be clear from around the table that the size of this opportunity just continues to expand even beyond what we thought even a year ago and that’s pretty exciting. And we are putting a lot of chips down in terms of investment we are making and the pipeline that Jim and his team have been building and our confidence in opening these things well. I mean, I think we are doing some of our best work ever with these new stores. I really do. So, thanks for the question.

Jason DeRise - UBS

Can I sneak one just a follow-up on that? Just the idea about the self cannibalizations always comes up in my conversations since you guys brought it up in the last call. And your view is that, yeah, it’s a near-term effect but then eventually you benefit out of it. So when we think about comps long-term, I know this company has always been proud of the 7% to 8%; range between that and the price investments long-term is there -- how should we think about your comp growth structures? Should we kind of forget about the past and think about it differently, or is this sort of a year of rebasing to refuel and get back going again?

Glenda Flanagan

This is Glenda here. I will give kind of a short answer to that question, which is that it hasn’t been that long that our comps have been below 7%. So we certainly don’t think of it as a permanent dip in our comps by any means, and there are a lot of positive things that are happening in our comps right now that are a little bit disguised by the impact that we are seeing from the macro environment and the weather, which of course everybody talks about. But it really is true that’s been the worst winter in many decades and that certainly has affected our sales. So, no, we don’t have any reason to believe anything other than optimistically about our future comps.

Walter Robb

Thank you. Next question?

Operator

Thank you. We’ll go next to Scott Mushkin with Wolfe Research. Please go ahead.

Scott Mushkin - Wolfe Research

Hey, guys. Thanks for taking my questions. So, I just wanted to talk about the slowdown a little bit to topic of your. But wanted to, Walter, last time on the call you talked about a chicken promo you ran and that it just didn’t drive lift you thought it would. And if I kind of take a step back because you always put your traffic in basket, it looks like what’s really slowed down here is traffic. I think you guys used to run 6 to 7 bps, probably 600 to 700 basis points there. Looks like, it’s down I guess 300.

So, I guess my thought process with the gross margin, are you throwing good money after bad? In other words, is this straight out like, hey, there is just not many inspirational customers right now because of what’s going on in the economy. Let’s just do what we do and it will sort itself out. So, I guess I’m just trying to understand if these price investments are really going to payoff in the long-term for shareholders.

Walter Robb

Just want to -- just correct the traffic numbers because basically if you look the traffic numbers in the quarter there, ratio 60-40 stayed roughly level as it was in the previous quarter. So, I don’t know we can maybe follow afterwards in those numbers. But there is nothing really changed in that sequentially. But I guess to me, we just finished talking about the size of the prize there, the bigness of the opportunity. I think the aspirational thing just keeps growing. So we do what we do and more people want us to do what we do and that leads to bigger things. So you want to add to that, John? No, that’s all we have, Scott on that one.

Scott Mushkin - Wolfe Research

Thanks, guys.

Walter Robb

Sure.

Operator

Thank you. We’ll go next to Chuck Cerankosky with Northcoast Research. Please go ahead.

Chuck Cerankosky - Northcoast Research

Good afternoon, everyone. When you are looking at the guidance for the remainder of the year, you are indicating a pretty nice pickup in the operating margin. What kind of -- what parts of the income statement do you expect to help drive that especially in light of the lower average price paid per item?

Walter Robb

Good news is, it’s coming in, we are in Q2 and Q3, those are our strong – historically those are our strongest quarters every year. So operating margin always picks up in Q2 and Q3, so that's not unusual – our Q2 and Q3 are our strongest quarters, Q4 and Q1 are generally our weakest quarters from an operating standpoint. So that's why we get two of our three strongest quarter still ahead of us.

Glenda Flanagan

Basically our thinking on guidance was we had our – the range that we talked about in November, the top end of the range we adjusted down for the higher pre-opening primarily due to Dominick and also look at G&A. And the lower end of the guidance we brought down for those same things plus reflecting another $0.04, reflecting room for pricing investments and also the impact of the softer sales. So we ended up with a bigger range and that was our thinking.

Operator

We’ll go next to Stephen Grambling with Goldman Sachs.

Stephen Grambling - Goldman Sachs

Maybe as a follow-up to your comment on building stores closer and closer together, you have been building some smaller stores that had great new store productivity and profitability. Can you just give a little bit of detail on how the maturation curve looks for those stores in some of these new markets as they started to mature over the past two years relative to the historical trend?

Glenda Flanagan

We do give you a lot of information in the press release on the results by store age. I am not really sure what you're looking for beyond that.

Stephen Grambling - Goldman Sachs

I’d just be looking for profitability as these stores mature.

Glenda Flanagan

Well the ROIC is in there also.

Stephen Grambling - Goldman Sachs

I guess I will change gears and maybe focus on the SG&A, and actually direct store expenses, you continue to get good leverage on wages as well as in gross margin on rent, can you comment on what’s been driving the occupancy and wages lower and maybe any opportunity is there –

David Lannon

This is David. Our play [ph] as regional president, vice presidents, our store team leaders – store team leaders we want them to run the stores like they own the store and like it’s their own money. And there is a discipline process that all regions are working together on day-to-day expenses. So it's taking summer [ph] work – it’s all the time, it’s something that Ken and I as leading the operations that’s stuff we focus on everyday and we are seeing encouraging results. And also they take a lot of pride in achieving the expenses that they do – lower expenses.

Operator

We will take our final question from Karen Short with Deutsche Bank.

Karen Short - Deutsche Bank

Just following on the gross margin comment that Glenda just made. So the incremental, the new information on your guidance, obviously weather aside, is that you may end up – that’s a little bit more in gross margins than you previously expected to, when you had your November call, is that an accurate statement?

Glenda Flanagan

We gave ourselves a little bit more room for that and also just reflecting the continued uncertainty in the macro environment and that potentially lower comp.

Karen Short - Deutsche Bank

So is it incremental gross margin, potential for incremental gross margin investment a function of the competitive environment or do you think anything has changed in the competitive environment, any color there?

John Mackey

Karen, it’s John here, one comment is that we had this kind of happy situation for several quarters – was happy, slightly embarrassing because we kept saying about price investments but because we were doing such a good job on our shrink, and we were doing a good job on the buy side, we were able to completely offset the price adjustments we were making, we were actually in a happy situation of making price investments and so our gross margins go up. We think we have most of the shrink, the low hanging fruit we could get on the shrink we picked up and we will continue to make the price investments. So we’re still at – if you look at the gross margin we reproduced this quarter it’s still by most any historical measurement an outstanding number.

So if we just have sort of the reversion to the mean on our gross margins you get back into kind of the averages that we think would be a good result. We’re not, as we indicated in our press releases and script we’re not anticipating continually falling gross margins. We think we’re just reverting to the mean, and the Whole Foods growth story is we are going to continue to open lot of stores. We are getting great new productivity out of our new stores. We are going to continue to be more aggressive on price. We are going to continue to work our expense line. We are going to try to take -- we set a goal to take another 100, 150 basis points out of our direct store expenses over the next few years and that will flow to the bottom line.

So we think we’ve got a great crop of stores in development that are going to do very well and in its retail discipline, controlling our expenses, making our price investments and just kind of being predictable turning out quarter after quarter after quarter with strong operating profits and hopefully we’d like nothing better than to get comps back up to 7% to 8% range, that’s been our historical averages.

We don’t exactly know why they are not there right now. We only speculate, but I think the Whole Foods story is still an outstanding one mostly because we just have so much growth opportunity ahead for us. We feel like the market is continuing to expand, it’s a big, much bigger market. It’s true there is little bit more competition out there now, but the market opportunity is so much greater than it used to be. There is room for lots of players. We are the leaders and we’ve been the leader for a long time. And I think we are continuing to accelerate vis-à-vis our competitors.

Karen Short - Deutsche Bank

That’s helpful. Thanks.

John Mackey

Okay. Everybody thanks a lot for listening in today. A transcript of the scripted portion of this call along with a recording of the call is available on our website as well and we look forward to speaking with you again in May for our Q2 earnings call. Take care.

Operator

Thank you. This does conclude today’s program. We appreciate your participation. You may disconnect at any time and have a great day.

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