- Whole Foods reported weak earnings and cut guidance as same-store sales softened to 5.4%.
- The health food space is increasingly competitive with other high-end grocers and improving quality at value grocers.
- Whole Foods' older locations are growing far more slowly, suggesting saturation is nearer than the company expects.
- With a tough pricing environment and EPS growth of 10%, a 31x multiple is excessive.
- Fair value is roughly $40.
Shares of Whole Foods Market (WFM) were down 7% after hours on Thursday as investors reacted to disappointing results and guidance (press release available here). One of the more popular investment trends of the past five years has been in healthy eating. Many Americans, particularly young Americans, are concerned about the freshness and quality of the food they consume, and they are willing to pay a premium for organic and other healthy options. We have seen this in the restaurant space with Chipotle (CMG) gaining traction against traditional fast food restaurants like McDonald's (MCD). Investors have also flocked to healthy and premium supermarkets like Whole Foods, Fairway Market (FWM), and The Fresh Market (TFM). As you can see from the following chart, Whole Foods has been a decent performer over the past year while competitors have lagged.
(Chart from Google Finance)
In its fiscal first quarter, Whole Foods earned $0.42 on revenue of $4.24 billion. While EPS was up 7.7% year over year and revenue was up 9.9%, both figures missed expectations as the street was looking for $0.44 on $4.32 billion in sales. In the quarter, comparable same-store sales were up 5.4%, and most analysts were hoping for a figure in the 5.6-6% range. This also marked a deceleration from the previous quarter when sales were up 5.9%. The company opened 10 new stores giving it a total store count of 373, and it has leases to open an additional 107 stores, which is a record pipeline for the firm. By mid-2017, WFM expects to have 500 stores in operation and believe the U.S. could hold 1,200 stores before reaching saturation. With same-store sales in the mid-5% range, it will need to keep opening stores to maintain double-digit revenue growth.
The company continues to generate a lot of cash with operating cash flow of $337 million, and it spent $219 million in cap-ex for free cash flow of $118 million. $122 million of cap-ex was related to new stores while $97 million was related to its existing operations. The company has the cash generation to continue to fund its expansion and maintains a strong balance sheet with $1.5 billion in cash and short term investments. A continued successful expansion is critical for the WFM bull case.
Unfortunately, the company was forced to take down the high end of its guidance. First quarter same-store sales were disappointing at 5.4%, and second quarter sales are currently tracking at 5.6%. As a consequence, the company now expects revenue growth in fiscal 2014 to be 11-12% compared to 11-13%. Same store sales growth will be 5.5-6.2% down from a previous high-end of 7%. G&A expenses will be mildly higher at 3.1% due to investment in technology. This will contribute to a decline in operating margins from 6.9-7% to 6.7-7%. A combination of slower sales and higher expenses has forced a cut to EBITDA, which now is estimated at $1.32-$1.37 billion from $1.36-$1.39 billion. Consequently, the EPS range has been cut to $1.58-$1.65 from $1.65-$1.69.
As you can see, Whole Foods trimmed just the high end of its revenue guidance, but its new EPS range is almost entirely below the old one. This cut obviously has a significant impact on its earnings growth rate as it earned $1.47 last year. At its midpoint, WFM expects to grow earnings 10%, which will be slower than revenue growth thanks to higher expenses and rising food costs that WFM appears unable to fully pass on to customers. With 5.5+% same-store comps, I would have hoped for a bit of margin expansion.
The health grocer market has grown more crowded, and as we have seen, Whole Foods' competitors have not performed nearly as well as hoped, with Fairway shares more than halved since its IPO. There are several reasons for that. First on the margins, the explosion of healthy fast casual restaurant like Chipotle has put some pressure on high-end grocers as they offer quality meals at attractive prices. Second, there is an issue of supply. Other grocers like Sprouts (SFM), Fresh Market, and Fairway have opened stores to challenge a space Whole Foods used to operate in virtually by itself. Thanks to its stronger brand, WFM has outperformed these companies. Still increasing supply has cut growth rates. Finally, "legacy grocers" like Safeway (SWY) and Kroger (KR) have focused on organic and fresh options in addition to traditional offerings to maintain their customer base. Even companies like General Mills (GIS) and Kraft (KRFT) have tried to eliminate GMOs (genetically modified organisms) from some of their products, and these brands are not exactly synonymous with Whole Foods.
Finally, these premium offerings can be a bit more expensive, and many Americans don't feel a need to pay more for organic food, and this quarter does raise some concerns that saturation could be nearer than Whole Foods believes. Whole Foods commendably and transparently releases same-store sales based on the age of the store. As you can see from the following chart included in the press release, older stores are growing far more slowly than new stores.
Now, typically new stores grow faster than old stores because they have a smaller base. However, it is noteworthy how dramatic the slowdown is among stores over eight years old, which are growing about 3.2% collectively. In areas where Whole Foods has an entrenched presence, it is not winning over many new customers and lagged nominal GDP growth in the quarter. There is a large collection of Americans who will pay up for higher quality and fresher food, but there is a large group of Americans who will not. Whole Foods' growth is driven by entrance into markets where it did not previously have a location, and it is now able to appeal to those health-driven consumers. However, it is not converting many shoppers to Whole Foods at existing locations.
Investors are at risk of over-stating the healthy eating trend. Clearly, many Americans are more focused on health, but not all are. Further, with food companies taking steps on their own, there is less reason to pay more for Whole Foods. Simply put, the quality gap between Whole Foods and a traditional supermarket like Safeway is shrinking. The shrinking of the quality gap is putting severe pressure on less established premium grocers like Fairway. While Whole Foods continues solid growth, a decline in margins suggests its pricing power is not as strong as it once was. In many markets, Whole Foods is reaching saturation, which will drag down system-wide growth rates and leaves open the possibility that terminal saturation is closer to 800 than 1,200 units.
Factoring in the after-hours drop, Whole Foods is trading 31.5x 2014 earnings despite a lackluster earnings growth rate of 10% and sales growth of 11.5% (using guidance midpoints). This multiple suggests meaningful acceleration in growth beyond 2014 when in fact the performance of WFM and its competitors suggest slowing growth. At these prices, WFM is pricing in a re-acceleration of same-store sales growth (which would require older stores to restart meaningful growth despite steeper competition), a continued expansion plan, and a saturated market of at least 1,200 stores. Shares are pricing in all of the potential good news, and the risk remains to the downside as lower end grocers apply more pressure. I would be unwilling to pay more than 25x earnings or $39-$43. Until then, Whole Foods is a sell.