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Summary

  • Specialty/Organic grocery retail has seen a flood of new competition.
  • Whole Foods has long been the dominant player in the space.
  • Analysts have turned skeptical on the stock.
  • Whole Foods' valuation is cheaper, but is it now GARP ?

Whole Foods (NASDAQ:WFM) the iconic specialty and organic grocery chain is scheduled to report its fiscal Q2 '14 financial results after the close on Tuesday night, May 6, 2014.

Analyst consensus (per Thomson Reuters) is expecting $0.41 in earnings per share (EPS) on $3.341 billion in revenues, for expected year-over-year (y/y) growth of 8% and 10% ,respectively.

The $0.41 EPS estimate has remained constant since the early February call, while the revenue estimate has ticked a bit higher in the last 3 months.

Quarterly comps were last given at 5.2% in early February, with the Q1 '14 earnings report. I do think the Street would like to see 6%, with management guiding to +5.5% to +6.2% (for full-year 2014) on the quarterly call in early February.

Last quarter, WFM also grew revenues 10% on 8% EPS growth, which is a material slowdown over the last 3 years, but some of this was due to the horrific Midwest winter, but what is more disconcerting is that some of the weakness in the last two quarters is cannibalization driven.

The painful fact is, WFM is seeing more and more competition in major markets like Boston and Chicago, and it is showing up in the numbers.

Boston cannibalization hurt WFM's quarter last November '13 when Johnnie's Foodmaster opening 5 stores in the Boston market cost WFM roughly 30 bps in comps.

Here in Chicago, in the Lincoln Park area, which I have written about prior, Plum Market now has a store on North Wells Street and Mrs. Green's has opened a brand new store at Webster and Lincoln in Lincoln Park. Also Mariano's, which was founded by a Dominick's exec and seems focused on metropolitan Chicago and wealthier suburbs, has been opening stores left and right.

Whole Foods has tried to reach into some of the tougher areas of Chicago and raise the bar in terms of specialty grocery offerings and quality of offerings for lower-demographic neighborhoods, but some of these openings have recently been delayed, even as the traditional providers like Dominick's and Jewel have vacated their spaces. And this doesn't include the long-time WFM competitors like Trader Joe's, Treasure Island and such here on the near north side of Chicago.

The point of this is that suddenly - in the last 12-24 months - specialty grocery competitors to WFM have caught fire and the number of new and similar specialty grocery and organic choices in terms of brands has suddenly exploded.

So where does that bring is today ? When WFM management came out and said that their new, total US store target for the US was now 1,200 stores versus the previous 300, I took that as a positive, but upon reflection, I do think it is a competitive response to the number of new entrants into the specialty grocer space, and thus the implications are that WFM could be looking at a knock-down, drag-out market share battle in the specialty-grocery niche.

Two metrics will be paramount for us when WFM reports Tuesday night: the quarterly comp number, which would assuage a lot of investor concern if it managed to print 6% or higher, and margins, since if there is further cannibalization or ever direct competition, then that will always show up in margins.

Here is how we lay out the positives and negatives for this Tuesday night's report:

Strengths:

1.) Starbucks (NASDAQ:SBUX) reported 6% quarterly comps in its April earnings report, and the correlation between WFM and SBUX comps has always been positive and tight;

2.) The improvement in the "consensus revenue estimate" the last three months is a good tell since if there were competitive pressures, it would likely show up in negative revenue revisions first;

3.) Down 25% from its $65 high in late October '13, WFM has seen a lot of bullish sentiment exit the stock in the last few months. From a contrarian standpoint, that is a positive;

4.) From a market share and competitive analysis position, WFM has always been the 800 lb gorilla in the space. In the early 2000s competition was thought to be murderous from Target (NYSE:TGT) and Wal-Mart (NYSE:WMT) and Trader Joe's and such, but it never made much of a dent in WFM's growth. Frankly, WFM's management team has always been first rate, the brand loyalty is very high, and WFM has killed it with private-label offerings too;

5.) Expected forward earnings growth rates of 10% in 2014, and then 17%-18% in 2015 and 2016, tell me that despite analyst caution, forward EWS estimates are still pretty bullish. Over the next three fiscal years, analyst consensus is expecting 13% revenue growth and 15% EPS growth, on average, despite the recent skepticism;

6.) WFM, given its growth status, has been stingy about returning free-cash-flow to shareholders. Our spreadsheet is attached below, but just 60% of free-cash-flow, (which is net of capex) is being returned to shareholders. WFM increased its buyback last quarter, but management can do better should they decide to, and if the stock falters.

Weaknesses:

1.) Trading at 31(x) expected 2014 EPS for 10% growth this year is a lot of downside risk should management lower expectations once again on Tuesday night;

2.) The same could be said for the 15(x) cash-flow valuation at current prices. WFM has just a 3% free-cash-flow yield, which is better than the 10-year Treasury yield, but represents far more risk, too.

3.) The biggest threat/risk is the increased competition, which will eventually impact pricing, and which will require a response from WFM in terms of the competitive threat. How this plays out in terms of margins, comps and such is still an unknown.

In terms of valuation, retailers typically are fully-valued at 1(x) revenues. We've done this calculation before for previous earnings reports such as here and then here prior to the November '13 release, but if WFM trades to just 1(x) revenues on a 1,200 store base, then the stock could see $150 per share. While that is too extremis in nature, and let's say WFM trades more in line with Wal-Mart and Costco (NASDAQ:COST) at .5(x) 4-quarter trailing revenues, then that still portends a $75 stock price when fully saturated.

Morningstar's current intrinsic value estimate for WFM is $45 per share, while our own long-term estimate is substantially higher.

Technically, WFM is oversold on both the daily and weekly charts. In fact, WFM hasn't been this oversold on a technical basis since the 2008-2009 market low.

However, there is a gap on WFM that is still open at $46 and change. The 200-week moving average for WFM is down near $40 per share.

One of the reasons we write for Seeking Alpha is to lay out our rationale and thinking for our holdings in advance of earnings, or where we see opportunity in sectors or individual securities.

I am very torn on WFM coming into Tuesday earnings release, but writing this preview, I realized that with a horrific winter in the Midwest and Northeast, and with cannibalization of stores in a few markets, and now pretty rampant skepticism on the part of the Street on the stock, EPS and revenue growth in fiscal '14 is still 10% and 11%. Year-over-year revenue growth for the SP 500 this year is still expected at just 2.5%-2.75%.

More importantly, the 2015 and 2016 forward estimates are still looking for 13% revenue growth and 17%-18% EPS growth in the next two years, with plenty of free-cash-flow that could be returned to shareholders if management and the Board thought that would be prudent.

We currently have a 2.9% position in WFM within client accounts. We would add more at $46 if we think the stock would hold that outstanding gap.

Our premise has always been that quality growth stocks never get truly cheap, certainly never for deep value buyers, or even value investors, but investors have to buy at lower-risk points, which is the opportunity we think WFM presents today.

Consumer Discretionary, weather-affected retail, the P/E compression of growth stocks - so much has conspired to impact WFM in the last 3-6 months.

A perfect trade for us Tuesday night and Wednesday morning would be a drop post-earnings into the $46 area, then a stabilization Wednesday morning, and a close in the upper end of the range Wednesday night, to signify the bottom of the 6 month consolidation.

Here is the cash-flow table we promised above:

Statement of cash flows ($'s th's)7/14 q34/14 q21/14 q19/13 q47/13 q34/13 q21/13 q110/12 q47/12 q34/12 q21/12 q110/11 q47/11 q34/11 q21/11 q110/10 q47/10 q34/10 q21/10 q1
Cash from operationsn/an/a$337,000$191,000$228,000$287,000$303,000$453,279$210,651$255,785$260,896$159,642$192,386$149,780$253,037$124,355$117,947$181,506$161,477
Cash from investing activitiesn/an/a($273,000)($165,000)($121,000)($173,000)$170,000($277,665)($310,612)($753,072)($6,963)($153,659)($77,077)($39,512)($180,476)($132,170)$3,824($240,287)($346,773)
Cash from financing activitiesn/an/a($78,000)($47,000)$3,000($63,000)($410,000)$94,128$60,884$142,154$63,562$73,763($142,164)($111,649)($43,504)$3,109($199,570)$32,009($4,454)
Change in cashn/an/a($14,000)($21,000)$110,000$51,000$63,000$269,742($39,077)($355,133)$317,495$79,746($26,855)($1,381)$29,057($4,706)($77,799)($26,772)($189,750)
Cash from operationsn/an/a$337,000$191,000$228,000$287,000$303,000$453,279$210,651$255,785$260,896$159,642$192,386$149,780$253,037$124,355$117,947$181,506$161,477
less benefit from stk optionsn/an/a$0$0$0$0$0$0$0$0$0$0$0$0$0$0$0$0$0
less capex (dvlment and new stores)n/an/a($219,000)($160,000)($113,000)($109,000)($155,000)($241,597)($115,717)($98,935)($111,343)($89,480)($89,480)($91,049)($91,049)($57,026)($52,746)($64,491)($82,530)
less dividendsn/an/a$0$0$0$0$0$0$0$0$0$0$0$0$0$0$0$0$0
Free-cash-flown/an/a$118,000$31,000$115,000$178,000$148,000$211,682$94,934$156,850$149,553$70,162$102,906$58,731$161,988$67,329$65,201$117,015$78,947
4q trailing CFOn/an/a$1,346,000$1,462,279$1,481,930$1,253,930$1,222,715$1,180,611$886,974$868,709$762,704$754,845$719,558$645,119$676,845$585,285$573,930$615,608$576,200
yoy growthn/an/a7%20%26%44%60%56%23%35%13%29%25%5%17%5%14%36%45%

4q trailing capex

n/an/a$756,000$778,597$734,314$621,314$611,249$567,592$415,475$389,238$381,352$361,058$328,604$291,870$265,312$256,793$262,251$308,584$286,850
y/y growthn/an/a22%27%29%60%60%57%26%33%44%41%25%-5%-8%-18%-31%-24%-50%

4q trailing FCF

n/an/a$590,000$683,682$747,616$632,616$611,466$613,019$471,499$479,471$381,352$393,787$390,954$353,249$411,533$328,492$311,679$307,024$289,350
yoy growthn/an/a-7%12%22%32%60%56%21%36%-7%20%25%15%42%36%237%-2820%-209%

4q trailing CFO

n/an/a$1,346,000$1,462,279$1,481,930$1,253,930$1,222,715$1,180,611$886,974$868,709$762,704$754,845$719,558$645,119$676,845$585,285$573,930$615,608$576,200
4q trailing net incomen/an/a$563,000$551,000$542,732$517,581$493,246$465,573$428,316$399,939$372,209$342,612$324,635$301,892$279,408$240,355$211,527$180,766$140,639
coveragen/an/a239%265%273%242%248%254%207%217%205%220%222%214%242%244%271%341%410%

4q trailing FCF

n/an/a$590,000$683,682$747,616$632,616$611,466$613,019$471,499$479,471$381,352$393,787$390,954$353,249$411,533$328,492$311,679$307,024$289,350
4q trailing net incomen/an/a$563,000$551,000$542,732$517,581$493,246$465,573$428,316$399,939$372,209$342,612$324,635$301,892$279,408$240,355$211,527$180,766$140,639
coveragen/an/a105%124%138%122%124%132%110%120%102%115%120%117%147%137%147%170%206%

fcf as % of market cap

n/an/a3%3%4%3%4%3%1%3%3%3%3%3%4%4%5%4%6%

capex as % of revenues

n/an/a4%5%5%5%5%5%4%4%4%4%3%3%3%3%3%4%4%
capex as % of cash-flown/an/a56%53%50%50%50%48%47%45%50%48%46%45%39%44%46%50%50%

quarterly dividend

n/an/a$37,000$37,000$37,000$37,000$397,000$25,384$25,614$25,230$17,827$17,700$17,572$17,348
quarterly share repon/an/a$62,000$37,000$25,000$37,000$26,000$0$25,000$3,599
quarterly capital allocatedn/an/a$99,000$74,000$62,000$74,000$423,000$25,384$50,614$25,230$21,426$17,700$17,572$17,348
4q trailing dividendn/an/a$111,000$111,000$471,000$484,998$473,228$94,055$86,371$78,329$70,447
4q trailing share repon/an/a$124,000$99,000$88,000$88,000$51,000$28,599$28,599$3,599$3,599
4q trailing capital allocatedn/an/a$235,000$210,000$559,000$572,998$524,228$122,654$114,970$81,928$74,046
Capital Returned as % of FCFn/an/a40%31%75%91%86%20%24%17%19%

Source: Internal spreadsheet

Note the last line of the spreadsheet. Stingy return of capital is a hallmark of quality growth companies.

Source: Whole Foods Earnings Preview: Skepticism Abounds, But We Still Like The Retailer