Whole Foods Market (WFM) reported its performance for the first quarter of fiscal year 2014 on February 12th after the market closed. The company missed analysts' expectations on various measures and as a result the stock price plunged by 7% during the after-hours of trading falling from $55.48 to $51.93. The company generated an EPS of $0.42 on revenues of $4.24 billion that implies a 10% revenue growth and 7% EPS growth year over year. However, analysts expected the company to earn $0.44 on revenues of $4.32 billion. However, the sales growth and CSS growth figures were disappointing on both fronts Y/Y as well as compared to analysts' expectations. Y/Y sales growth declined by 3.80% due to a 1.80% decrease in comparable store sales.
Source: Earnings Release
Looking at the Y/Y performance we discover that the company's gross profit margin and store contribution surged by 0.10% but the operating and EBITDA margins declined by 0.10%. This decline also caused the net margin to plunge by 8 basis points.
Source: Earnings Release
Another thing that was disappointing was the company's revised guidance for FY 2014 in which the company only lowered the higher end of the sales growth from 13% to 12%. However looking at the trickledown effects of the decrease it becomes evident that EPS will drop by an average of 3.3%. Revised EPS will fall in the range of $1.58-$1.65 whereas the prior outlook of EPS was in the range of $1.65-$1.69. Y/Y EPS growth will also shrink from 13.5% to 9.5% (mid value). This decline will be brought about by the decline in comparable store sales from 7% to 6.2%.
Source: Earnings Release
These figures point towards the company facing difficulty in realizing the actual results due to hype in competition in the USA. This situation casts doubt on the company's ability to maintain its double digit sales growth in the coming years.
US Market Near Saturation
Currently, Whole Foods Market operates in three geographical locations but its operations have a deep footprint in the United States of America. Other geographical locations where the company operates are the UK and Canada.
Whole Foods Market has concentrated its operations in the US and 96% of its stores are located there. The company aims to further expand its store count in the USA and take it to a level of 500 stores by 2017. Other than this the company has signed 21 new leases for 107 stores that making the store pipeline more robust with an extra 920,000 square feet. The company is targeting a saturation point in the region of around 1200 stores. The US organic food industry was forecasted to grow at a rate of 12% by 2014. Although the market is growing a large number of new entrants into the market accompanied with existing big players have made the situation slightly poor.
If we look at the industry and the growing number of organic grocers like The Fresh Market, Fairway Market, The Kroger Co (KR), and Sprouts Farmer's Market (SFM), it is evident that there is stiff competition. Moreover, other than grocers, the company has to face competition in the form of organic food restaurants like Chipotle Mexican Grill (CMG) that are growing by leaps and bounds. However, Whole Foods Market still remains the industry leader but it comes at the cost of reduced prices and slimmer margins. Higher costs of food are also denting the company's bottom line. Consumers are not ready to pay premium prices for organic food as it is their right to get food fit for a healthy lifestyle. Price contraction when combined with rising costs of food shrinks the profit margins for the company. Opening new stores at a continued rate will be the only way that it can support double digit revenue growth since the company's old stores are growing at a very slow pace compared to its newer ones.
Source: Earnings Release
Glancing at the company's quarter over quarter sales growth trend, one thing becomes clear: the growth rate is declining. This implies that the US market that generates a significant portion of the company's earnings is headed towards maturity. This means that the saturation point for the company is looming. The US Market will reach the saturation point ahead of the company reaching its 1200 stores target. The declining trend of CSS (comparable store sales) q-o-q also leads us to derive the same conclusion.
Source: Q4-2013 Earnings release
Whole Foods Market seems obsessed with its operations in the USA and is not focusing on other markets that are increasingly demanding natural and organic food.
The UK organic food industry is moving towards a growth track that will lead the industry revenue to a level of 2.02 billion pounds over a period of five years. This implies a growth rate of 2.6% per annum brought by rising health concerns and high disposable income in the region. Continued economic recovery in the UK will improve investors' confidence allowing them to regain their taste for organic produce. This scenario led to the shortage of home grown produce in the UK since the rising demand could not be kept up by local farmers. Only 3% of British farmland is organic and that creates a substantial gap between supply and demand in a growing market. This is where Whole Foods Market can come into action by expanding its store base in the UK and attaining the best possible market share leveraging on its iconic brand and business in the USA. It is easy to predict that Whole Foods Market will gain from first mover advantage.
Canada is another country with strong demand for organic growth. Farmers have to complete a rigorous process to become certified organic producers that takes almost 3 years. This process ensures no use of GMOs (genetically modified organisms), toxic chemical pesticides, herbicides and synthetic fertilizers. Whole Foods Market is America's first national certified organic grocer already has a presence in Canada and just needs to strengthen its footprint in order to avail the maximum possible opportunities offered by the region.
As far as the company's ability to invest in new markets is concerned, it is evident that company has a healthy balance sheet. This implies that the company will not find it difficult to raise debt if it needs to do so. However, the company's strong cash position allows me to predict that the company will not need external financing for its expansion plans. The company reported cash and cash equivalents (short term investments) of approximately $1.15 billion at the end of the first quarter of 2014. The company has a strong cash flow generation from its operations that allowed the company to enjoy $118 million in free cash flows out of a total CFO of $337 million.
Although Whole Foods Market has brighter future prospects they depend upon the company's store expansion outside of the USA where the company is facing stiff competition. Looking at the multiples based valuation of the stock we discover that the stock is highly overvalued. I assigned heavy weight to the price to earnings and price to cash flows ratios and calculated a fair value of the stock. A comparison of the stock's fair value with its current price led me to conclude that the stock is overvalued and has a downside potential of 43.58%.
Apart from the above valuation, a comparison of the PEG ratio also reaches the same conclusion. Whole foods Market has a PEG ratio of 2 where on the other hand the industry's average PEG stands at 1.40 (average of the company's competitors' PEG ratios). This implies that the company is overpriced in relation to its earnings growth when compared to the industry and thus it will revert back to the industry standard over time. This allows me to predict a further decrease in the stock price over time.
The Road Ahead
Whole Foods Market was once a gem of a stock and still has growth opportunities and the ability to translate those opportunities into revenues for the company. However, looking into practical dynamics, these opportunities can only come to fruition after the company expands into the regions that are far from their saturation points and can offer enough room for the company to grow. Increasing the store count in regions like the UK and Canada will enable the company to bolster its top and bottom line. Until then Whole Foods Market will see its growth declining because other competitors and organic restaurants. They will adversely affect the company's financials and dent its stock price. Apart from that, according to its current price levels, the company is overvalued and has the tendency to show downside potential. Therefore I will recommend selling this stock at its current price level and not buying it until the price experiences a significant dip.